November In Review: Macro-performance, Micro-trends, and Bitcoin


By Rob Edel, CFA

Highlights This Month

Read this month’s commentary in PDF format.

The Nicola Wealth Management Portfolio

Returns for the NWM Core Portfolio Fund were up 1.2% for the month of November.  This fund is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.  Actual client returns will vary depending on specific client situations and asset mixes.

Both the Canadian and U.S. yield curves continued their year-long flattening trends last month, with the spread between 2 and 10-year Canada’s narrowing nine basis points to 0.45% and 2 and 10-year U.S. treasury spreads declining five basis points to 0.63%.  Short rates in both Canada and the U.S. continue to drift higher but long rates remain stubbornly low.  For the month, the NWM Bond Fund was up 0.4%, a good result in a tough interest rate environment.

The NWM High Yield Bond Fund was flat in November, compared to -0.3% for the Bank of America Merrill Lynch U.S. High Yield Index.  The high yield market was down over 2% at mid-month, but post-U.S. Thanksgiving inflows supported the market by the end of the month.  The fund’s defensive posturing outperformed during this brief sell-off, and we remain patient and ready for any volatility that may return to high yield.

Despite a flat Canadian dollar, global bond returns were strong again last month, with the NWM Global Bond Fund returning 0.7%.

The mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning both +0.4%.  Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity, all interest and principal were repaid and in no way is a predictor of future performance, are 4.4% for the NWM Primary Mortgage Fund and 5.3% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund ended the month with negative cash of $1.2 million or -0.7%.  The NWM Balanced Mortgage Fund ended the month with $54.8 million in cash or 11.1%.

The NWM Preferred Share Fund returned 0.6% for the month while the BMO Laddered Preferred Share Index ETF returned 0.5%.  The move higher felt quiet as the 5-year Bank of Canada’s were effectively unchanged while 10-year yields moved lower.  Fund flow continues to be strong as ETF’s grew almost $170 million for the month, creating buying pressure for high rate reset spreads.

Canadian equities were stronger in November, with S&P/TSX +0.5% (total return, including dividends).  The NWM Canadian Equity Income Fund returned +1.1%, while the NWM Canadian Tactical High Income Fund was +0.4%.  Our underweight position in the materials sector helped performance last month, as did our consumer staples holdings.  The NWM Canadian Equity Income Fund exited its position in CGI Group and WestJet in favor of Roger’s Sugar and Air Canada.

In the NWM Canadian Tactical High Income Fund, strong performance from Aritzia and Intertape Polymer helped performance while Sleep Country and Guardian Capital detracted from returns.  The fund still maintains a low net equity exposure (current delta adjusted exposure is 41%), which helps the fund’s relative return in a down market, but hurts relative returns when the S&P/TSX is strong.

Foreign equities were also higher last month, with the NWM Global Equity Fund up 2.1% compared to a 2.3% increase in the MSCI All World Index and a 3.1% increase in the S&P 500 (all in Canadian dollar terms).  Results for our external managers were all higher last month, with Pier 21 Value Invest +4.2%, BMO Asia Growth & Income +2.4%,   Edgepoint Global Portfolio +2.2%, Lazard Global +2.0%, Pier 21 C WorldWide +1.7%, and our new internal EAFE Quantitative Fund returned an index-like +0.8% (the iShares MSCI EAFE ETF was +0.7%).

The NWM U.S. Equity Income Fund increased 3.1% in U.S. dollar terms, and the NWM U.S. Tactical High Income Fund increased 2.1% versus a 3.1% increase in the S&P 500 (all in U.S. dollar terms).  In the NWM U.S. Equity Income Fund, relative performance was helped by strong performance in Costco, Estee Lauder, and Walmart, while Newell, AIG and Boston Scientific hurt performance.  We initiated a new position in Crown Castle and added to our existing positions in Vulcan Materials.  As for the NWM U.S. Tactical High Income Fund, we were called away on our Aptar and GGP Inc. positions and we added new naked put positions in Lowes, Disney, and Federal Express.  The net equity exposure (delta) in the NWM U.S. Tactical High Income Fund is down to a very defensive 15%.

In real estate, the NWM Real Estate Fund was up 0.9% in November versus the iShares REIT Index +2.0%.  We report our internal hard asset real estate limited partnerships in this report with a one month lag.  As of November 30th, performance for the SPIRE Real Estate LP was +1.2%, SPIRE U.S. LP +0.9% (in U.S.D), and SPIRE Value Add LP +2.4%.

The NWM Alternative Strategies Fund was up +0.3% in November (these are estimates and can’t be confirmed until later in the month), with Winton +0.6%, Citadel +0.1% (this position is being redeemed at the request of the manager at the end of the year), and Millenium -0.1%.  Of our other alternative managers, all had positive performance with RP Debt Opportunities +0.2%, Polar North Pole Multi-Strategy +0.4% and RBC Multi-Strategy Trust +0.6%.

Precious metals stocks were slightly up last month with the NWM Precious Metals Fund -0.1% while gold bullion increased 0.4% in Canadian dollar terms.

 

November in Review

Markets were strong again last month, with the S&P/TSX up 0.5% and the S&P 500 +3.1% (in Canadian dollar terms).  Year-to-date, the S&P/TSX is up a respectable 7.8% but the S&P 500 has soared +15.6%.  Not only have U.S. large-cap stocks done well, but they have done consistently well all year long.  Throughout 2017, the S&P 500 has been setting new record closes while avoiding even a single down month.

On a total return basis, in fact, the S&P 500 has recorded 13 consecutive months of positive returns stretching back to 2016.  As a consequence of this strong run in performance, volatility has fallen to multi-decade lows.  This month, we are going to take a closer look at what’s driving this performance and what it might indicate for returns next year.  After taking a macro look at performance, we’ll also dig a little deeper into some of the micro trends in the markets by taking a closer look at perhaps the biggest price bubble the world has ever seen, Bitcoin.

Most asset classes are in positive territory this year, and while big-cap U.S. stocks do not have the highest absolute returns, when volatility is included, the S&P 500 has been hard to beat on a risk-adjusted basis in 2017.  While most forecasters were predicting positive returns for 2017, year-to-date performance has outstripped even the most optimistic targets.

Next year doesn’t look any easier to call.  Valuations for stocks look high, but so do valuations for all asset classes, especially bonds.  Economists have had a poor track record predicting the direction of interest rates and bond yields since the financial crisis, typically predicting rising rates, only to see yields generally fall or tread water.  For their part, Wall Street strategists nearly always forecast a rising market so at least they get the direction right some of the time.  Rarely, however, do they get both magnitude of the move in the S&P 500 as well.

In order to help forecast what going to happen next year, it is useful to take a closer look at the market year-to-date beyond just the top-line return numbers.  Not only has volatility for the market as a whole been low but the inter-sector correlation has plunged to levels not seen since the tech bubble of the late 1990s.  Sectors and industries have been trading independently from each other, resulting in definite winners and losers.  Doing well were technology stocks, particularly the disruptive FANG names, Facebook, Apple, Netflix, and Google (now called Alphabet).  Growth stocks, in general, outperformed their value counterparts, and international companies fared better than those with more than 50% of their revenue generated domestically.

Slow domestic economic growth explains most of these trends.  First, growth stocks do well when growth is scarce.  If the economy is struggling to expand, investors are willing to pay a premium for companies who are still able to grow.  Alternatively, with a strong economy, a rising tide lifts all boats, meaning even a company with a struggling business model could see its prospects improve if the economy is strong.  Domestic economic growth has been ok, but only in the third quarter of this year has economic output finally reached its maximum sustainable level according to the Congressional Budget Office.

Absent is a pickup in export growth and with some inventory building, the U.S. economy really hasn’t been gaining much traction.  The real story in 2017 has been the improvement in global growth, with the IMF forecasting only 6 out of 192 countries will see their economies contract next year, the fewest on record.  This helps explain why large multi-national companies have outperformed this year and why growth stocks are still being favored by investors.

Backing up the concern over stagnant domestic growth is the fact the yield curve has continued to flatten.  With the Federal Reserve raising overnight interest rates, the short end of the yield curve has been rising, but the long end hasn’t been following suit.  A flattening yield curve in itself isn’t really a problem, and according to BMO Strategist Brian Belski, it has actually been associated with good investment returns historically.  The concern is if the yield curve continues to flatten and eventually inverts.  This is bad and is almost always followed by a recession and a bear market for stocks.  Even if the yield curve were to invert, however, it typically takes over a year before the market finally corrects.

The Federal Reserve is in a tough spot.  They want to start normalizing monetary policy given the economy is no longer in a crisis situation, but the lack of inflation in the economy is making them cautious.  They don’t want to get behind the curve and see growth heat up such that more aggressive tightening is needed, but they also don’t want to tip the economy back into recession by tightening too soon.  Most forecasters believe the Fed will err on the side of caution and raise rates slower than they have indicated.  The Fed itself has conceded that there could be structural reasons why inflation isn’t increasing even though the economy appears at full capacity, and the unemployment rate is down to 4.1%.

Though the new Fed Chairman, Jay Powell is expected to follow much the same path as outgoing Chairwoman Janet Yellen, some draw an analogy between the reversal in trend of increasingly shorter Fed Chairmen and the potential for higher interest rates (we don’t really believe in this relationship but like the graphic, below).

Low inflation might not be the only factor keeping the long end of the yield curve low, however.  With the European Central Bank (ECB) and Bank of Japan (BOJ) continuing their quantitative easing programs, keeping their domestic bond yields near zero. Despite economic growth being on par with the U.S., global investors are attracted to the higher yielding U.S bond markets, thus helping keep longer-term U.S. yields from rising. At some point, the ECB and BOJ will need to join the Federal Reserve and begin tightening monetary policy.  When this happens, rising foreign bond yields should provide room for U.S. yields to increase again.

Slow growth and low-interest rates are not a bad environment for investment returns.  This Goldilocks environment may result in a flattening yield, but it could take longer than normal to actually invert.  Also, expect investors to slowly shift away from growth stocks and into value names.  In early December, we did see a shift.  Technology stocks were sold off and domestic value stocks started to perform better.  Was this a sign that inflation and economic growth have turned the corner?

We think it is too early to draw this conclusion.  Growth stocks were severely over-bought so some kind of consolidation was in order.  Also, the other factor likely causing the shift into value names was the increased chance that tax reform would make it through Congress.  With both the House of Representatives and the Senate passing separate plans, all that remains is for the two to be reconciled into one bill, and it doesn’t appear they are too far apart.  Though it’s debatable what the final impact on economic growth will be, corporate earnings are forecast to move higher.  Not only would stronger growth help value stocks in general, but domestic companies with higher tax rates, in particular, would benefit.  The offset to the economy and markets, however, would also cause the yield curve to invert faster if the Federal Reserve believes stronger growth and inflation would follow.  Nothing is ever clear-cut when it comes to the markets.  Tax reform will be positively received in the short term, but the longer term effects might not be as positive.

The future path of interest rates influences economic growth, but at the individual stock level the impact on valuations can vary.  Technology and growth stock valuations have benefited from the slow growth economy and also benefit from ultra-low interest rates. Their earnings are deemed to be generated further in the future, and low-interest rates increase the present value of those future earnings.

Higher interest rates could facilitate the shift out of the technology and growth sectors, but technology has another factor in its favor.  Many of the faster-growing companies within technology are viewed as disruptive to traditional business models.  This is particularly the case with Amazon versus bricks and mortar retail, Netflix versus traditional media, and Tesla versus the big auto companies.  Extreme optimism over new and disruptive technologies has a history of creating valuation bubbles.

In the late 1920s, it was the automobile and radio companies that were all the rage, while the late 1990s saw the internet bubble dominate the investment landscape.  Today, disruptive technologies could radically change the way we live and work, just like the automobile and radio did, but will they be good investments?  According to Wikipedia, between 1894 and 1930, there were over 1,800 automobile companies in the U.S., now there are just a handful.

From the dot-com bubble of the late 1990s, only Amazon has gone on to provide good returns for investors.  Most internet companies never made money, and few are still operating today.  Even some of the survivors haven’t provided good investment returns, with networking leader Cisco still trading about 50% below its early 2000 all-time high.  Just because a technology eventually becomes mainstream doesn’t mean all the companies involved will be good investments.

While it’s not a company per se, Bitcoin and Blockchain technology have dominated the investment headlines over the past few months, and could go down in history as either the investment opportunity of a lifetime or the biggest bubble on record.  Either way, it deserves a closer look.

Though we cringe at the thought, if we are going to discuss the investment merits of Bitcoin, we would be remiss if we didn’t start with some kind of description of what exactly Bitcoin is.  Before we do, however, we feel compelled to include a disclaimer and an honest admission; we aren’t Bitcoin experts.  In fact, we don’t really understand Blockchain or Bitcoin.  Sure, we have read as much as we can and can throw around a few buzz words with the best of them, but our understanding is at best superficial.  If we were to heed the advice of investing sage Warren Buffet and “never invest in a business you don’t understand,” this would end the conversation right there, but what would be the fun in that?  As you have been sufficiently warned, let us press on.

According to the website Coindesk, Bitcoin is a digital currency (cryptocurrency) created and held digitally.  The idea of Bitcoin is attributed to a software developer called Satoshi Nakamoto, though no one has ever been able to find him, and it has even been speculated the name presents a group of individuals rather than a single person. According to a recent article in Report on Business titled “Bitcoin investors party like it’s 1999”, Bitcoin transactions are recorded in a non-centralized public ledger across a network of participating computers using cryptography.  In a process referred to as “mining”, these participating computers use their computing power to record Bitcoin transactions and solve complex math problems.  In return, they are awarded freshly minted Bitcoin.

According to the original protocol created by Nakamoto, the total number of Bitcoins that can be mined is limited to 21 million.  As of today, about 16.7 million have been created.  Perhaps even more interesting than the currency itself is the distributed ledger technology it is based on, Blockchain.  The application of Blockchain technology has evolved beyond just digital currencies like Bitcoin, and its application in other areas in the financial services industry is being actively pursued.  Because of its decentralized nature, it is nearly impossible to retroactively alter a single record, making Blockchain technology very secure and efficient.

But is Bitcoin a bubble?  Opinions on this subject are very polarized.  Certainly, the bulls have had the upper hand, with the price of Bitcoin up over 1,700% year-to-date.  Even compared to some of history’s epic valuation bubbles, Bitcoin’s appreciation has been stunning.  And it’s not just Bitcoin that has been going higher.  Other cryptocurrencies have also been moving up, as have any companies associated with Blockchain technology.

Reminiscent of the internet bubble of the late 1990s, even companies that have added Blockchain or some association to the technology to their name have experienced nice stock gains.  But a big price gain doesn’t necessarily mean it is a bubble.  As the old market adage says, “a bubble is a bull market you don’t have a position in”.  What defines it as a bubble is if the price appreciation itself is responsible for driving prices higher.  It’s called the greater fools theory.

The value of something isn’t based on its intrinsic value, but rather the belief that you will be able to sell it to someone else (the greater fool) in the future for an even greater price.  There is also an investor psychology element to a bubble, namely FOMO, or the fear of missing out.  To quote bubble historian Charles Kindleberger, “there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich”. C’mon, admit it, it’s true!

“Experts” (in quotes because we are not sure who to consider an expert in Bitcoin) are predictably split.  Firmly in the bull camp is Mike Novogratz, who is starting a $500 million cryptocurrency fund, Galaxy Digital Assets Fund.  Novogratz’s claim to fame is that he was a former macro hedge fund manager at Fortress Investment Group and is returning to the investing world following a self-imposed two-year exile after his funds were shut down (never a good sign).  He must have done okay at Fortress, however, as it is rumored he is pitching in $100-150 million of his own money to the new fund.

Vancouver native and ex-internet gambling kingpin Calvin Ayre is also making a big bet on Bitcoin, or Bitcoin Cash to be specific (more on the difference below).  According to a recent article in ROB Magazine, the Bodog.com founder claims to be one of the biggest private Bitcoin processors in the world, and has investments in a number of cryptocurrency fundtech startups.  On Wall Street, one of the biggest bulls is Fundstrat Global Advisor’s Tom Lee.  He sees Bitcoin going to $11,500 by mid- 2018 (okay, he was a little conservative on this one given it’s currently trading around $17,000), and has a 2022 target of $25,000 (who knows, it could hit this level before we hit the send button on this report).  Anti-virus pioneer Jon McAfee sees Bitcoin going to $500,000 in three years while an unnamed hedge fund manager in a recent WSJ article speculated the price could eventually hit $1 million.

Lining up with the bears is JP Morgan Chase & Co. chief Jamie Dimon, who has called Bitcoin a “fraud” and says anyone buying Bitcoin is “stupid.”  He’s not the only Wall Street leader to warn the public to stay away.  Warren Buffet believes it is a “mirage’ and questions whether it will exist in 10 or 20 years, while others take issue with the criminal element involved in Bitcoin.  Allianz Global Advisors Neil Dwane has called Bitcoin a “scam for criminals of the world,” while BlackRock’s Larry Fink sees it as an index to gauge demand for global money laundering.  Perhaps the most graphic quote we have read is from the Pan Gongsheng, Deputy Governor of the Bank of China, who recently warned, “there’s only one thing we can do – watch it from the bank of the river.  One day you’ll see Bitcoin’s dead body float away in front of you.”

Predictably in the middle are the Canadians; with the Canada Pension Plan Investment Board President Mark Machin recently commenting that he doesn’t think Bitcoin is “investable” yet, has more than 100 people carefully watching the space.  Your tax dollars hard at work folks.  Or more specifically, your retirement.

So what’s driving the bulls?  Certainly, the prospect of Blockchain technology is part of the allure.  While it’s hard for Luddites like us to understand, it’s real and could change the way many financial transactions are processed in the future, especially cross-borders.  In a recent CIBC Research report written by Stephanie Price, it was estimated 80% of banks were working on private Blockchain applications.  Case in point, Goldman Sachs, and JP Morgan recently completed a six-month test in the $2.8 trillion equity swap market.  Of course, the successful adoption of Blockchain technology doesn’t mean Bitcoin’s will be worth more, or anything for that matter.

Bitcoin’s mission statement, if you will, is to become either a digital global currency to be used for everyday transactions around the world, or a safe haven store of value, similar to the role gold currently plays.  As far as we can see, it’s neither.  In a market with volatility hitting historical lows, Bitcoin’s volatile trading patterns do provide traders with opportunities to make money.  Over a five-day span, Bitcoin has increased as much as 44% and fallen upwards of 25% this year alone.

As we write, volatility appears to be hitting a peak.  Over a 40-hour span in early December, Bitcoin was up 40%, only to subsequently fall 20% in 10 hours.  But does this make it a viable currency or a store of value?  Frankly, the volatility of Bitcoin alone precludes it to be used for either.  There has certainly been a spike in trading, but few of these are coming from everyday transactions.  Its use as a transactional currency may, in fact, be falling, not growing, as the cost of transactions increases in line with the price of Bitcoin.  According to a recent Barron’s article, Visa is able to process 10,000 times as many transactions a second as Bitcoin.  In order for transactions to be prioritized by miners, fees need to be relatively high and low fee transactions can take days to be confirmed.

According to Morgan Stanley, the number of the top 500 global online merchants accepting payment in Bitcoin fell in the third quarter to just three, down from five last year.  The website Airbitz.com identified only three restaurants in Manhattan that accept Bitcoin.  Two have closed and the other, which only sells ice cream, hasn’t taken a Bitcoin payment since early July.  Some might try and use it to buy a pizza as a novelty, but it makes for an expensive snack.  Website Pizzaforcoins.com enables Brooklyn diners to get a Domino’s pizza delivered to their home using Bitcoin, but a pie normally costing $8.70 will set them back $34.12, before tip.

With the price of Bitcoin up more than 1,700% this year alone, who would be crazy enough to use it to buy a pizza?  Case in point, Vancouver resident Nathan Wosnack agreed in 2010 to trade a half case Rickard’s Honeybrown Ale with a friend for 10 bitcoins, a fair deal at the time.  In retrospect, those six beers cost Wosnack’s friend $170, 000 in today’s value.  It’s no wonder most people buying Bitcoin have no intention of selling it anytime soon.  Oh, and don’t forget where you have stored your Bitcoin or misplace the key needed to access your tokens.  In 2013, Briton James Howells is said to have accidentally discarded a computer containing about 8,000 Bitcoins on its hard drive.  Worth about $140 million USD today, he has been unsuccessful so far in gaining permission to search the local landfill, which is the size of several football fields.

As a store of value, one of the reasons Bitcoin is viewed as a substitute for gold is the theoretical 21 million limit that is hardwired into the cryptocurrency’s DNA, which means it can’t be inflated away like fiat currency issued by a government.  There isn’t, however, a limit to the number of competing cryptocurrencies that can be created.  The total cryptocurrency market tracked by the CoinMarketCap.com website is about $500 billion, of which Bitcoin represents the largest market cap at about $290 billion.

There are, however, over 1,300 cryptocurrencies listed in total, and counting, 22 with a market cap of over $1 billion.  Using initial coin offerings (ICO), it is very easy for startups to create new cryptocurrencies and raise money without any of the usual disclosure security regulators require to protect investors.  According to Coindesk, ICO’s have risen over $3 billion this year in more than 160 different offerings and have earned the endorsement of investing luminaries such as Paris Hilton and Floyd Mayweather.

After creating a white paper detailing the purpose and rules of the ICO, investors use either cash or other cryptocurrencies to buy tokens in the new venture.  The tokens are typically meant to be exchanged for some future service provided by the project, but they are often kept or traded for profit.  Some ICO’s actually provide very little information on what services they plan to provide or what the coins could be used for.  In some ways, an ICO is like a cross between an IPO (initial public offering) and crowdfunding.  We don’t think Bitcoin is a fraud, but chances some of these ICO’s turn out badly for investors is very high.  It is unlikely, however, regulators will turn a blind eye forever and rules will tighter in the future.

Already the SEC (Securities Exchange Commission) has acted against Canadian ICO PlexCorps, calling its $15 million offering of PlexCoins a “scam” with the proceeds being used for “extravagant” personal expenses of its Canadian founders.   Another cryptocurrency, called Tether, is said to be backed one-for-one with U.S. dollars, meaning for every Tether coin there is a U.S. dollar held in a reserve account.  Given there is $814 million Tether in circulation, there also has to be $814 million held in safekeeping somewhere.  Trouble is no one is able to confirm that there is.  Security regulations exist to protect the public.  When the cryptocurrency market gets big enough that the general investing public is involved, it will be regulated.  At the very least, you can bet the IRS will be taking a close look to make sure investors are paying the appropriate taxes.

Even if it becomes harder to create new cryptocurrencies through the ICO process, thus limiting the supply of cryptocurrencies in general, there is some question whether Bitcoin’s supply is really capped at 21 million tokens.  The mining community works by consensus, meaning the majority has to agree in order for a change in the mining process to take place.  If they agree to disagree, however, one group can split off on their own, effectively creating a new version of Bitcoin.  This event is referred to as a “fork” and holders of Bitcoin tokens would, in theory, own both the original Bitcoin and new Bitcoin.  Calvin Ayre’s Bitcoin Cash, for example, was created in August of this year when it split off from Bitcoin in a fork.  Unlike stock splits, however, the price of both the new and old Bitcoin isn’t cut in half to account for the increased number of tokens.  It all depends on the supply and demand and where the mining community chooses to concentrate their computing power.

And speaking of computing power, this leads us to one of the biggest flaws in the continued evolution of Bitcoin, the growing consumption of electricity in the mining process.  Currently, the Digiconomist website estimates the electricity needs of the global network of computers running Bitcoin has increased 40% since the beginning of October to about 28 terawatt-hours a year, more power than Nigeria and its 186 million residents consume in a year.

Citigroup’s Christopher Chapman estimates the cost for mining a Bitcoin in 2022, which is marginally profitable at the current market price of $8,000 (now $17,000), could soar to between $300,000 to $1.5 million, at which point the Bitcoin network could consume as much power as Japan.  The growing consumption of computing power needed to mine new Bitcoin is one of the reasons miners tend to reside in countries with low electricity costs.  Even so, miners are barely profitable now and would unlikely be able to maintain mining if costs continue to rise.  Bitcoin mining is unsustainable from an environmental perspective and an economic perspective.

Cost of electricity isn’t the only factor limiting where Bitcoin is mined and traded.  Just like we expect future regulation around the ICO process, it is unlikely central banks will stand by while their government-issued fiat currencies are replaced by Bitcoin.  This is particularly an issue for the U.S. and the Federal Reserve.  Being the world reserve currency bestows huge monetary benefits upon America, not the least of which is an estimated $70 billion a year in seignorage (profit made by the government issuing non-interest bearing notes versus the cost to produce the notes).

Already China, which used to account for the bulk of Bitcoin trading, has enacted a comprehensive ban on all channels of buying or selling virtual currencies, including fundraising through ICO’s.  Though Western governments haven’t followed suit, UBS Wealth Management economist Paul Donovan makes the argument that not accepting cryptocurrencies to be used to pay tax will doom their use as a viable currency.  Donovan claims 34% of all economic activity in the OECD is taxed and not being able to meet the demands from this large part of the economy, will mean the supply of Bitcoin will eventually exceed demand.  Even its use by criminals engaged in illegal activities is being questioned as the anonymity of Bitcoin transactions is not as secure as first believed with the 2013 bust of online black market site Silk Road.  It’s also possible for Bitcoin exchanges to be hacked, as was evident in 2014 when the world’s then largest exchange, Mt. Gox lost more than $470 million in Bitcoins and was forced to declare bankruptcy.

We see the appeal for cryptocurrencies in emerging market countries where governments have poor historical track records as stewards of financial stability, like Zimbabwe and Venezuela.  It’s one of the reasons Google Trends show countries like Nigeria and South Africa leading the world in keyword internet Bitcoin searches.  We could also see central banks creating their own virtual currencies, as was explored in a recent analysis by the BIS (Bank for International Settlement).  We don’t, however, see an unregulated, non-government backed virtual currency taking the place of fiat currency.  Not without a fight anyways.

The biggest reason bulls have for arguing Bitcoin isn’t a bubble is the lack of a mania around Bitcoin.  Despite its rapid rise, how many retail investors are buying Bitcoin or even talking about it?  An anecdotal observation, we get more questions from clients on marijuana stocks than Bitcoin (okay, this has changed over the past month given the parabolic rise in Bitcoin).  Granted, this may have more to do with the demographic makeup of a client base heavily skewed to the baby boom generation that remembers the 60s better than they understand cryptocurrencies, but increasing ownership is one of the bulls big arguments.

Up until now, Bitcoin has been a niche investment for members of the technology community.  As mentioned above, Coinmarketcap.com estimates the entire cryptocurrency marketplace at a market capitalization of about $500 billion with Bitcoin accounting for about half of that total.  By contrast, gold’s market cap is estimated at $8.2 trillion.  If Bitcoin is destined to compete or even replace gold as the ultimate safe haven store of value, it has a long way to go before it reaches a comparable weight in investment portfolios.  This is how outrageous targets like $500,000 per Bitcoin are derived.  Assuming Bitcoin finally hits its 21 million token limit, the price would need to rise to $390,000 in order to equal gold’s $8.2 trillion market capitalization.  Looking at the recent decline in the sale of American eagle gold coins, some Bitcoin bulls believe the trade is in the process of happening.

On December first, Bitcoin got an early Christmas present from the U.S. Commodity Futures Trading Commission by allowing the CME Group and the CBOE to launch Bitcoin futures contracts and it’s likely the NASDAQ is not far behind while Cantor Fitzgerald is planning to roll out an options product.  With reputable commodity exchanges vouching for the creditability of the unregulated exchanges trading Bitcoin tokens, it could clear the way for the Securities and Exchange Commission to give the green light for Bitcoin Exchange Traded Funds, which have the potential to bring in a flood of pent up retail demand.  The bulls would see all these moves as signs the market is going mainstream.  Keep in mind, however, while futures contracts make it easier for institutional investors to get exposure to the cryptocurrency market, it doesn’t necessarily mean the price will go higher.  Futures contracts also enable speculators to short Bitcoin, something they haven’t been able to do up until now.  In the book/movie The Big Short, the first problem the main protagonists needed to overcome was to find a vehicle to bet against the housing market.  There’s no big short if you don’t have something to sell.

Bitcoin developers are likely working on solutions to address some of the major pitfalls with Bitcoin, like electricity consumption and transaction times.  Even with these changes, however, we don’t see Bitcoin filling the role of either a currency or a store of value. Bitcoin can continue to move higher, perhaps much higher, but that appears to be its only real value, which it the very definition of a bubble.  Even Bitcoin bull Michael Novogratz admits it’s a bubble, the real question is how much bigger can it get, and perhaps more importantly, how much richer will your friends become? For us, we don’t need to be there, and we are not.  To quote Vanguard founder Jack Bogle, “Bitcoin may well go to $20,000 but that won’t prove I’m wrong.  When it gets back to $100, we’ll talk”.

What did you think of November’s economic activity?  Let us know in the comments below.

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