PlanB on Bitcoin Math & Value – The Investor’s Podcast, Hosted By Preston Pysh and Stig T. Brodersen

Check out The Investor’s Podcast Episode Page & Show Notes

Key Takeaways

  • Because of its supply cap of 21 million coins, Bitcoin is the first scarce digital object the world has ever seen
  • One can describe the scarcity of a commodity in terms of its Stock-to-Flow (SF) ratio
    • Bitcoin currently has an SF ratio of 27
  • The SF ratio of all commodities is correlated with their market value
    • Gold currently has an SF ratio of 55 and a market value of $10 trillion
  • Bitcoin halving is a significant event (every ~4 years, or 210,000 blocks, the supply rate of new coins is halved) – this doubles its SF ratio and increases Bitcoin’s value
    • The next halving in May 2020 will increase its value by 8-10x, resulting in an estimated Bitcoin price of $50,000-100,000
    • The halving in 2024 will double Bitcoin’s SF ratio again to 100 (something humanity has never seen before), resulting in a Bitcoin price of ~$400k – 1MM
  • A futures market settled in Bitcoin will make investors cautious shorting Bitcoin
    • If the price goes up, they will need to deliver physical Bitcoin, not just put up more cash
  • Bitcoin has a Sharpe ratio above 1, which indicates the average risk is smaller than the average return
  • “If you invested just 1% of your portfolio in Bitcoin and let the other 99% do nothing—if you kept it cash, or something similar— that would have outperformed the S&P 500 over a 4-year period for all years in the past 6, 7, or 8 years” – PlanB
  • If Bitcoin proves to be inversely correlated with traditional assets during a financial crisis, it’ll make it an undeniable safe-haven asset

Books Mentioned

  • In The Bitcoin Standard, author Saifedean Ammous describes the scarcity of a commodity in terms of its Stock-to-Flow (SF) ratio

Resources Mentioned

Intro

How PlanB Got Into Bitcoin

  • PlanB is currently based in Amsterdam where he works for a multi-billion dollar international fund focused on traditional assets
  • He became interested in Bitcoin because of its supply cap of 21 million coins; it’s the first scarce digital object the world has ever seen
    • Surely, this digital scarcity has value, but how much? – To find an answer, PlanB decided to apply his expertise to perform solid statistical econometric analysis

Valuing Bitcoin Based on its Stock-to-Flow Ratio

  • In The Bitcoin Standard, author Saifedean Ammous describes the scarcity of a commodity in terms of its Stock-to-Flow (SF) ratio; if you’re unfamiliar with Stock-to-Flow:
    • The Stock (S): the existing supply of a commodity
    • The Flow (F): extra production in the next period
    • Stock-to-Flow: How much extra is produced compared to existing stockpiles – (S/F)
      • Currently, Bitcoin has a stock of 18,000,000 coins and a yearly flow of 750,000 new coins—an SF ratio of 27
  • PlanB discovered the Stock-to-Flow ratio of all commodities is correlated with their market value
    • For instance, the SF ratio of gold is 55 and its market value is $10 trillion
    • “If you plot the SF ratio of all commodities against their values, you get a straight line—it’s actually a power law with super high R2 correlation”PlanB
      • If you’re unfamiliar with R2, it measures the quality of fit for a model on a 0-100% scale
  • PlanB applied two models to test the correlation between Bitcoin’s Stock-to-Flow ratio and price:
    • The cross-asset model, which resulted in an R2 value of 99.5%
      • “It’s amazing; I have never, ever seen that before” – PlanB
    • The time series model, which resulted in an R2 value of 95%
    • These above values indicate Bitcoin’s price is closely linked to the halving function (discussed below)

The Bitcoin Halving Function

  • The halving is a significant Bitcoin event: The supply rate of new coins is halved every 210,000 blocks (roughly every ~4 years)
  • This halving doubles the Stock-to-Flow ratio and increases Bitcoin’s value
    • Currently, Bitcoin has an SF ratio of 27 – the model estimates the price to be little under $10,000 per bitcoin
    • The next halving in May 2020 will increase its value by 8-10x, resulting in an estimated Bitcoin price of $50,000-100,000
    • The halving during 2024 will double the SF again to 100, resulting in a Bitcoin price of ~$400k – 1MM
  • A Stock-to-Flow ratio of 100 is something humanity has never seen before. and is made possible with a decentralized/fixed supply of a digital token
    • Preston comments that you can keep mining more gold out of the ground, but with Bitcoin, its absolute scarcity, thus tightening the halving function
  • “People underestimate the speed at which this is going; [Bitcoin’s] SF ratio will double to near gold levels after May 2020, which means the market cap of Bitcoin will be in the trillions of dollars—$1-2 trillion, compared to the USD monetary base of $3 trillion. That’s an order of magnitude in the same range. In 2024, [assuming Bitcoin’s] SF ratio doubles to 100, its market cap will be in the $10-20 trillion range, way above the USD, which has all kinds of implications.” – PlanB

Bitcoin’s Path to a $10 Trillion Dollar Market Cap

  • Hitting the $10-20 trillion market cap will change what people use as a unit of account—it wouldn’t make sense to price things in dollars anymore
  • Bitcoin’s current market cap is only $150 billion, compared to $500 trillion for derivatives and $200 trillion for bond markets
  • Many traditional markets (like stock and real estate markets) have a monetary premium beyond the fundamental value they hold; they’ll likely lose that premium to the asset that captures and holds it best (Bitcoin)

The Implications of a Bitcoin Futures Market Settled in Bitcoin

  • Derivatives are important—they allow for more liquid markets that attract bigger institutional investors. Bitcoin has several big futures markets.
    • A futures contract lets you buy and sell bitcoins at a predetermined price at a specified time in the future, settled in the future
  • CME Bitcoin futures are settled in cash – you could theoretically sell more than 21 million bitcoins, even if they don’t exist
  • Bakkt Bitcoin futures are settled in physically delivered bitcoins – to sell bitcoins, you need to actually have them (and that changes the whole game)
  • There can be arbitrage between Bakkt and CME, and investors will be more cautious shorting Bitcoin
    • If the price goes up, they’ll need to deliver those bitcoins—it’s not a matter of putting up more fiat

The Significance of the Sharpe Ratio When Investing in Bitcoin

  • Bitcoin has a Sharpe ratio above 1, which indicates the average risk is smaller than the average return; this is hard to see in assets
    • Bitcoin’s average return is above 200% per year, while the worst loss is 80%
    • (The Sharpe ratio is a measure of risk-adjusted return)
  • Using the Kelly Criterion, just like in poker, you size your bet depending on your odds
  • “If you invested just 1% of your portfolio in Bitcoin and let the other 99% do nothing—if you kept it cash, or something similar— that would have outperformed the S&P 500 over a 4-year period for all years in the past 6, 7, or 8 years” – PlanB
  • Ray Dalio explains how his investing revolves around two principles:
    • Finding something with a very high Sharpe ratio
    • Mixing it with 10-15 uncorrelated positions that also have high Sharpe ratios

Bitcoin Has Yet to Be Tested By a Financial Crisis

  • Bitcoin was invented in 2009 as a response to the 2008 financial crisis
  • Inverted yield curves and other measures are pointing to an incoming recession—this will be the time to test Bitcoin for negative correlation with other assets
    • If Bitcoin proves to be inversely correlated with traditional assets during a financial crisis, it’ll make it an undeniable safe-haven asset
  • “The negative interest on $17 trillion dollars worth of bonds together with quantitative easing is the reason I’m in Bitcoin” – PlanB
  • PlanB mentions the IMF report proposing deep negative interest rates (-5 to -10%)
  • Negative-yielding bonds mean that buyers holding the securities to maturity are guaranteed to make a loss
    • Preston explains that making a profit on a negative-yielding bond means buyers expect the interest rates to go even lower; the only way to make money is by finding a greater fool willing to take an even bigger loss—it’s the definition of the greater fools theory of investing (a Ponzi scheme)
    • Most investors are starting to see the unsustainability of this and more will hedge against it with Bitcoin

Hyperinflation & Bitcoin:

  • The 1920s collapse of the German Mark against gold is the most famous example of hyperinflation – PlanB published a chart comparing it with Bitcoin’s USD price
  • A coalition of smaller countries is most likely to adopt Bitcoin
    • The U.S. has too much to lose by giving up its reserve currency status; this is similar to Germany, who has too many exports to make the jump
  • Bitcoin is the solution in the Triffin dilemma, but only if everyone works together

How should investors educate themselves about Bitcoin?

  • (With the resources mentioned above)
  • PlanB is amazed by the level of misunderstanding in the traditional investment field – this reminds him of the Nobel Prize-winning Black-Scholes Model invented in 1973 for pricing options
    • The model was in public for 10 years but wasn’t understood or exploited – it’ll probably be the same with the Stock-to-Flow model
  • Why did Satoshi leave? – If you research and come to know the answer to this question, you’ll protect yourself against a lot of scammers, misunderstanding, and misinformation.
    • “Why is it important NOT to have a leader—no CEO, no corporation, no government, no pre-mine? If you understand why that is, and why you only need a peer-to-peer network governed by a mathematical protocol and some energy to protect it, you know the answers to a lot of things in Bitcoin.” – PlanB

Ask The Investors: Should I invest in China?

  • Stig explais it’s important to not overestimate the effect of the rise of China on US stock investors
  • Stig and Preston agree you could get exposure by buying a Chinese ETF tracking the stock index. But keep in mind:
    • The risk of investing in a country with very different regulations from the west
    • It can have expensive management fees and can have other risks
  • If you’re feeling adventurous and want to focus on individual companies, focus on three things:
    • Find a company that originated in China
    • Look for companies that have a fairly large market cap with room to grow
    • Look for companies that have government leadership entrenched within them, such as Tencent and Alibaba
  • Stig personally owns Alibaba stock as a bet on e-commerce in China in general, but he doesn’t recommend investing for China for its own sake
    • Preston doesn’t personally have any investments in China.