What governs Bitcoin (BTC)'s price and where is it headed? (No Paywall)
By Yimin Xu - a thorough analysis of Bitcoin's place in the financial system and its price outlook.
DISCLAIMER: This note is intended for US recipients only and, in particular, is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Cestrian Capital Research, Inc., its employees, agents or affiliates, including the author of this note, or related persons, may have a position in any stocks, security, or financial instrument referenced in this note. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice. Companies referenced in this note or their employees or affiliates may be customers of Cestrian Capital Research, Inc. Cestrian Capital Research, Inc. values both its independence and transparency and does not believe that this presents a material potential conflict of interest or impacts the content of its research or publications.
Yimin Xu, July 31, 2024
7 Steps to understanding Bitcoin
Today, we are going to analyse the most exciting asset of the past decade - Bitcoin (BTC).
In our previous article on Tesla, we mentioned that Elon doesn’t like stock pickers like Warren Buffett and me (of course).
But what does Warrent Buffett hate?
Apparently, rat poison.
And to Buffett, Bitcoin is “probably rat poison squared”.
“In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending” - Warren Buffett, January 2018
Buffett does not invest in non-cash-flow producing instruments, such as Gold. According to Buffett, Gold or Bitcoin, dubbed the digital gold by investors, are not useful to him. The buyer is solely relying on selling the asset at a higher price in the future to another willing buyer.
But is this too simplistic a take from the Sage of Omaha?
Let’s find out.
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1. There will only ever be 21 million Bitcoins…right?
The Bitcoin hard cap is the highest number of bitcoins that can ever exist, set at 21 million BTC. Satoshi Nakamoto, the creator of Bitcoin but nobody know who he actually is (please let me know if you do, and it’s not Craig Wright or Hal Finney), included this limit in Bitcoin's source code.
The reward for mining new blocks is reduced by half after every 210,000 blocks (about every four years). This process, called "halving," slowly decreases the amount of new bitcoin created until the maximum limit is reached.
This is a monumental feature of Bitcoin. Proponents would argue that because of its scarcity, Bitcoin is theoretically disinflationary.
Bitcoin’s theoretical resistance to fiat currency inflation was an invention to combat relentless central bank money printing after the Financial Crisis. Today, this feature ever more important as the central banks around the world printed money even faster during COVID.
Here is a chart between the rise in the US M2 money supply (linear, right) versus the price of Bitcoin (log, left).
(M2 is a measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and travelers' checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds. - St. Louis Fed)
The US M2 steadily rose in the years before COVID, coinciding with the rise of Bitcoin but there wasn’t much of a more granular pattern. However, during COVID, the Fed slashed rates to 0 and started large-scale QE, effectively printing fiat money at an accelerated pace. The Fed did this by buying US Treasuries, putting them on the balance sheet, and thereby pouring extra liquidity into the financial markets. M2 Jumped as a result.
You can see that Bitcoin surged by nearly 1700% in the next 12 months, between March 2020 and April 2021. As the pace of M2 slowed into a peak in April 2022, Bitcoin fell into a bear market.
Of course, because Bitcoin is global, the US M2 is only part of the picture in terms of global liquidity. But it’s a massive part, and global central banks nearly all resorted to similar liquidity injections during COVID.
Meanwhile, we can also observe the effect of greater money supply on equities. S&P 500 followed the US M2 even more closely.
Bitcoin’s 21 million hard cap is practically immutable, but not impossibly. The hard cap can be lifted, if the majority of nodes would agree on it. (A Bitcoin node is a computer that connects to the Bitcoin network by using Bitcoin software. These nodes check and share transactions and blocks according to the rules.)
Given the decentralised nature of the Bitcoin network, getting wide spread consensus on changing the supply cap would be extremely difficult and could bring an existential crisis. To the majority of Bitcoin owners, it would ruin the point of owning Bitcoin altogether.
2. But Microsoft shares are also disinflationary
Because of the share buy-back programmes, the most profitable companies in the US also see their total shares outstanding steadily decrease over time. This is a way to distribute a company’s free cash and reward the shareholders.
If we look at Microsoft’s total shares, they decreased from 8.3 billion shares to the latest 7.4 billion shares in the past decade. You can argue that Microsoft is deflationary as the supply shrinks versus the growing M2. Indeed, Microsoft’s share price grew over tenfold in the same period.
Why buy Bitcoin over Microsoft?
Well a lot of investors do prefer Microsoft - it prints a tonne of free cash flow each quarter and is much less volatile. It has a larger market cap than Bitcoin with more institutional ownership.
The tradeoff is, of course, that the tenfold performance by Microsoft is dismal compared with Bitcoin going from $350 to $68000 in the same decade, a nearly 200x increase.
Moreover, if we go by the disinflationary and store of value school of thought, Bitcoin’s supply is practically immutable, but Microsoft’s isn’t. Investors rely on a small management team at Microsoft to not issue a tonne of stock options or secondary offering to dilute the existing investors. And yes, a lot of public companies do actually do this.
3. Is Bitcoin a Digital Gold?
We are not going to debate the “digital” part.
Back to the Buffett talk, Gold is unlike equities and bonds which should bring investors cash flows (hopefully, but in many unprofitable companies’ case, actually never).
Therefore, the price of Gold is essentially determined by the demand versus supply. To model the price of gold is to model the drivers of demand and supply. The demand side drivers include a whole host of uses cases such as jewellery, technological hardware, bars and coins, central banks. The supply side drivers include mining, producer hedging, and recycling.
Today, Gold is a $16 trillion asset class. It is well above any individual companies, but much smaller than real estate, debt, equities, and land.
Another distinct quality Gold enjoys is that as a precious metal, it is head and shoulders above the next-in-line, silver ($1.6T). Throughout history, Gold has enjoyed a very special status as a medium of exchange, a store of value, and a symbol of status.
Bitcoin shares many similarities, albeit with a much shorter history.
Bitcoin has a market cap of $1.3 trillion, over half of the entire cryptocurrency asset class value and $900 billion larger than Ethereum (ETH).
Bitcoin was designed to be used as a currency and it can now be used for legitimate monetary transactions. For example, you can now buy a Ferrari directly using Bitcoin in the US and Europe. As aforementioned, Bitcoin’s value has risen with greater fiat monetary supply, and is essentially priced according to the intersection of supply and demand like Gold. And finally, Bitcoin has become a status symbol, with those supporting it wearing laser eyes (instead of Gold chains) on their social media profiles.
4. The case against the “Digital Gold”
There are many differences between Bitcoin and Gold.
Bitcoin and Gold exhibit very different volatilities.
The chart above compares the standard deviation of Bitcoin’s daily price changes (rolling 1-year) with Gold’s. Today, Bitcoin is over 3 times more volatile than Gold (3.1% vs. 0.8%), even after coming down a lot from its early days.
In the past decade, Gold merely doubled its price from $1200 per ounce to $2400. In fact, Gold was already at $1800 in 2011 but went through a long winter between 2012 and 2020. This wrong-footed a lot of investors (including John Paulson from The Greatest Trade Ever) given that the Fed still conducted QE between 2012 and 2014.
Bitcoin has much shorter cycles between the “halving” dates, and each cycle has propelled exponential growth - more on that below.
While the overall trajectory is up, many investors would argue that Bitcoin is simply too volatile to be a reliable “store of value”. In a crypto winter, Bitcoin easily loses 75-85% (2017-18, 2021-22) of its value before recovering. And this dramatic fall occurs frequently. For the same reason, it is very difficult for average investors to hold onto their Bitcoins between peaks and troughs.
Bitcoin and Gold are largely uncorrelated assets
By examining the rolling 3-month correlation of the daily changes, we see that the most correlated Bitcoin and Gold have ever been was during the Covid crash and the subsequent recovery fuelled by the Fed’s monetary policy.
The correlation between the assets are sometimes weakly positive, sometimes weakly negative, and often times uncorrelated.
Finally, is there enough demand for Bitcoin AND Gold?
If Bitcoin rises to tens of millions USD, it would be worth 10 times more than Gold as an asset class. Is this possible? Following the “Digital Gold” school of thought, Bitcoin should be competing for Gold’s market share in the global financial system.
This implies that the total pie between the two is growing, but capped in practice. At any moment in time, there is an overall demand for safe haven assets as a whole.
Of course, that demand can rise and fall due to global conflicts, but as a Digital Gold, Bitcoin looks to eat Gold’s lunch. For the overall demand for safe-haven assets (Gold AND Bitcoin) to grow by over ten-fold, as the popular Bitcoin price predictions imply, we are looking at a WWIII. And while WWIII may happen given the current global development, not many Bitcoin investors actually believe Bitcoin’s price is contingent on a world disaster.
To match Gold’s market cap ($16T), Bitcoin needs to be at $750k, but beyond that, it will need investors dumping other assets - Real Estate and Bonds are potentially the biggest sources.
Of course, this may also happen. Commercial real estate has been in steady decline in the developed nations, and if we get another era of zero-interest rates, investors could ditch bonds too.
5. Bitcoin’s long-term outlook and models
Before we get into the various predictive models celebrated by the Bitcoin community, let’s start with a raw chart.
This is Bitcoin’s historical price using a log scale (10^x). The red dotted line is the regression trend line over time. Extrapolating it forward, we can see that Bitcoin’s price has the potential to break over $1 million within this decade, if behaving as it did in the past decade.
Power Law
The Power Law model is an advanced version of our raw chart above. It is derived by running a regression of the historical bitcoin price against time. It then adds a resistance and a support band around the regression line.
Historically, Bitcoin is oversold when it touches the red support line and tends to climb back, even if not immediately reaching the green line. When it goes near the purple resistance, it is likely “overvalued” (although given it’s entirely priced by what the next person wants to pay, it’s hard to say it’s ever over- or under-valued).
Bitcoin is currently near the green line, and you could even say it’s poised to explode above it. And if it does, oh boy, we are looking past $100k, or even $500k if it couches the purple line again.
Its a big IF.
It can be dangerously tempting to look at the past trend and just say it should continue forever. For example, this is Cisco’s price chart a decade pre-2000.
If we extrapolate its trend, we are looking at $40m per share in 2024.
Cisco is trading at $48.6 today.
Back to Bitcoin.
Stock-to-Flow
One of the most popular models is “Stock-to-flow” (SF) by PlanB. This is a supply-side model, meaning that it explains the Bitcoin price through scarcity. The model was actually inspired by modelling Gold.
By looking at the current total stock versus the yearly production (flow), the SF model derives how many years it takes to produce the current stock. For Bitcoin when the initial model was released in 2019, it was 18m BTC / 657k annual production = 27 years.
A high SF number means high scarcity. It implies that one cannot easily / quickly replicate the entire stock of Bitcoins to flood the supply.
The SF line in the chart is a linear regression function between the market value and SF. PlanB’s function was “market value = exp(14.6) * SF ^ 3.3”. The specific chart above is an adapted version, but nevertheless it shows that Bitcoin price had been climbing closely with the SF model.
However, since 2021, Bitcoin has significantly undershot the model prediction and never reached the $100k mark that PlanB was so sure would. Today, the SF model suggests Bitcoin should be $170k, nearly triple the current price of $66k.
Is this the first sign of a crack for the SF Model?
Metcalfe’s Law
Metcalfe’s Law models Bitcoin’s long-term price as a function of the logistic growth of number of users over time. This theory originates from Timothy Peterson’s paper, “Bitcoin Spreads Like a Virus”.
Bitcoin enjoys network effects and therefore, like Facebook, should enjoy network economics.
Here is the Bitcoin price vs the number of active addresses with $1k+ holdings.
Using Metcalfe's Law formula, V=n*(n-1)/2, we get the below relationship between the Bitcoin price and the value of its network effect:
This is a sensical model that accounts for the demand-side of the Bitcoin economics, and we could monitor this by looking at the growth in total addresses.
Elliott Wave Theory
BTC Monthly Chart (Click here to enlarge)
Who doesn’t like an old fashioned Elliott Wave chart? Looking at the monthly chart, it would appear that Bitcoin is progressing through the heart of cycle wave III of (III). Wave (III) (in red) is around $14 million.
Coincidentally, this is a similar price level to Michael Saylor’s $13m by 2045 (29% CAGR) at the Bitcoin 2024 Conference. Saylor predicts that Bitcoin will account for 7% of global wealth.
Again, the danger with my own EW chart is that Elliott Waves work best on the most liquid, large-cap names as its based on the psychology of the masses. It often does not interpret growth assets very well because there are fewer participants and frequently dominated by local whales.
6. Examining Bitcoin’s short-term factors
MVRV Z-Score
The MVRV Z-Score chart assess whether Bitcoin is overvalued or undervalued compared to its 'fair value' through blockchain data. It essentially compares the Market Cap (i.e. total Bitcoins versus the last traded price on exchanges), the Realised Value (the average price of Bitcoins when they moved from one wallet to another, multiplied by the total number of Bitcoins), and the Ratio between these two values.
When the Z-Score reaches above 7 (the red band), it can be deemed very overvalued (i.e. the market cap is too big versus the realised value). When the Z-score is below 0.2 (the green band), Bitcoin’s market value can be deemed very cheap.
Currently, it’s neither here nor there.
HODL Waves
Bitcoin’s HODL waves measure the percentage of Bitcoin holders that have held Bitcoin for over 1 year without transacting. It’s a long-term vs short-term money gauge.
The chart above shows that every time there is an explosive price action, the percentage of long-term holdings goes down. Fast money enters the play and people start to cash out. However, over time, 1Y+ HODL rate has been trending up. The increased number of long-term players is supportive of Bitcoin’s price.
Net Bitcoin ETF Flows
Another short-term factor for Bitcoin is the latest net flows between the Bitcoin ETFs.
Since January, Bitcoin ETFs have received a tremendous inflow. Incredibly, IBIT (BlackRock’s Bitcoin ETF) received more inflow than QQQ this year.
However, most of the action occurred in Q1.
Since mid March, Bitcoin has mostly consolidated sideways. There has been much less net inflows across the ETFs. This suggests weak ongoing institutional support after the initial launch.
Government holdings, Miner balances, Trump’s advocacy, Futures basis trade, and more
It is impossible to cover everything in one article. We will have to leave out these fascinating topics today and talk about them in the future.
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7. Technical Analysis of the short-term price action
This note is written before the FOMC today.
BTCUSD Daily Chart (Click here to expand)
I think Bitcoin has bottomed in July, but is also due a pullback to form a wave (1)-(2) setup in red. If not breaking the July low of $53.6k, Bitcoin could break out and head towards the $100k wave (5) target.
This will depend on the depth of the wave (2) pullback (if shallow then the target can move higher).
As we head into today’s FOMC, here is a bonus chart:
In the previous rate-cut cycle (Trade War + COVID in 2019-20), Bitcoin prices moved down until the end of the rate cuts. A repeat of this may conflict with our technical analysis (as well as the long-term price models). This is therefore definitely worth keeping an eye on.