Inflation, Profits, and Bitcoin
“I believe that the present, accurately seized, foretells the future.” V.S. Naipaul
There is a lot of uncertainty today in the markets, but there has always been uncertainty in the markets. We have never had certainty regarding the economy or the future. The most reasonable exercise, as V.S. Naipaul reminds us, is simply to understand the present.
So what’s going on?
1. The economy is accelerating.
2. Inflation isn’t a problem.
3. The Fed is going to keep interest rates as close to zero as possible for the foreseeable.
These components are driving valuations higher, and in some cases, approaching stratospheric levels. Some concern is warranted in certain sectors, but overall, things seem to be relatively steady and not too overblown. Earnings appear likely to grow, and in many cases, quite rapidly, for the next couple of years — assuming something unforeseeable does not occur (but this probability is not zero).
However, the risk of inflation is higher now than it has been for many years. Money supply has increased dramatically. While we have seen this has not increased overall liquidity, causing inflationary pressure, it may pose a challenge to the Fed’s overall policy to keep interest rates as low as possible. Fixed income securities will face pricing pressure, and we may be entering a bear market for bonds. But, there are attractive equities that still appear to have great growth prospects, aside from hyper-valued recent IPO’s and SPACs. There is still room to invest outside of otherwise overpriced securities.
Despite some friction, including the prospects for higher corporate taxes and a higher minimum wage, it looks like corporate profits are on an upward trajectory, and the stock market will benefit overall. We have also seen prices run higher, and then pull back to a 5% to 10% correction. That is likely to happen again (probably multiple times) because, despite an upward trajectory, market direction is never smooth, and volatility is likely to be even greater.
We need to talk seriously about Bitcoin
It is an opportunity in the present that, accurately perceived, can foretell the future.
Why should Bitcoin be taken seriously?
1. It is extremely volatile, subject to enormous moves in short bursts influenced more by social media and other extraneous factors than fundamental economics.
2. It has been called a fraudulent scheme that will ultimately be worthless
3. It has also generated spectacular returns. But then again, so did Tulip bulbs.
So, are we experiencing a fraud and worthless speculative bubble about to burst, or is Bitcoin a great investment opportunity? That may not matter much because as long as this debate occurs, profits can be made by understanding the inherent volatility. There is certainly an argument that Bitcoin is not worthless because demand is too pervasive and building. The argument here is that Bitcoin is here to stay, and its ultimate value is less important than understanding its volatility, sustainability, and how it’s an effective tool in an arsenal against uncertainty.
Why Bitcoin is Here to Stay
Bitcoin has a few interesting characteristics worth understanding.
1. It is a decentralized, permissionless, peer-to-peer network of computers that’s permanent and unhackable.
2. An investment in Bitcoin is, in reality, a part of the peer-to-peer computer network (essentially, a slot on the database), and almost all of those slots have been allocated.
a. Only 21 million Bitcoins will be produced and 18.5 million have already been mined and circulated.
b. Price is a function of supply and demand (see Economics 101).
i. Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin.
c. Bitcoin supply grew 2.5% in 2020; it will grow 2.0% in 2021.
3. The question for Bitcoin valuation is simple: Is demand growing faster or slower than 2.0% annually?
It’s Supply and Demand — and Demand is Winning
One big factor driving demand is Morgan Stanley and Goldman Sachs making Bitcoin available to customers and establishing Bitcoin exchanges (every other money center bank will likely follow). Another is the establishment of Bitcoin exchange-traded funds (currently in Canada) in the U.S. (several have already filed).
As Bitcoin is adopted more broadly as an investment, price pressure will grow increasingly because increased demand is pursuing a limited supply. This asymmetry between supply and demand is driving pricing, along with volatility. As demand ebbs and flows, the price whipsaws — but the overall direction has been up and there seems to be little pressure driving it elsewhere for any sustained.
We know the supply curve. The demand curve is the uncertainty so there is one simple question to be asked.
Can Bitcoin Demand be Sustained?
Central governments have a monopoly over the money supply and banking systems. This is characteristic of every developed economy since economies were developed. Bitcoin offers a different, and many argue a much more attractive, alternative. It is attractive because the central governments’ monopoly over the money supply and banking systems has led to financial crises, nationalization, hyperinflation, and other systemic failures. Bitcoin is a solution because it protects the owner from central bank policy, and potentially from any of these economic and financial disasters, and central government policy failures.
Bitcoin can be divided and transferred anywhere digitally and is becoming regarded as a more effective store of value and protection against economic mismanagement than gold. If this is the case, we can compare relative values. Bitcoin’s market value is currently approximately $1.1 trillion; gold’s total value is estimated to be approximately $10 trillion. So, if Bitcoin ultimately matches the stored value of gold, that implies a 10x return for Bitcoin from its current value. Although this may not be a valuation metric, it does represent an intriguing calculation for the demand curve.
So, as Bitcoin becomes more broadly available, increasing demand, it will be added to portfolios and wealth management accounts, and, based solely on supply and demand dynamics, there will be upward price pressure that is likely to be sustainable for some time. Bitcoin is likely to reach a level of institutionalization, and at that point, the price is likely to be sustainable and much higher than where it is today.