April 7, 2020

Bitcoin’s Stock to Flow Model Is Becoming More Accurate | PlanB on The Pomp Podcast

Check out The Pomp Podcast Episode Page & Show Notes

Key Takeaways

• Most institutional investors have yet to invest in Bitcoin – Here is why:
  • Pension money is usually invested in Fixed-Income assets (Interest generating) – Example: Bonds, mortgages, consumer loans
  • As Bitcoin is considered a risky asset, regulations limit the amount of capital that can be allocated to it
    • Also, central banks are not fond of Bitcoin
  • Even so; PlanB believes it’s a matter of time before you see the first banks and pension companies investing money into Bitcoin – His reasoning:
    • Bitcoin is not correlated with traditional markets (better than a safe haven asset)
    • It has a Sharpe ratio above 1 (Rare to find in assets)
• PlanB discovered that the S2F (Stock-to-flow) ratio of all commodities is correlated with their market value; The S2F model tracks bitcoin’s value closely for multiple reasons:
  • It directly measures scarcity
  • It also quantifies network effects
  • Central banks are engaging in quantitative easing (printing trillions of dollars)
    • “As long as central banks keep printing, Bitcoin keeps rising” – PlanB
• US remains the only country with a positive yield curve, but rates are quickly dropping
  • People get interested in buying Bitcoin when they see negative interest rates
• If the internet is a peer-to-peer decentralized network to route messages, Bitcoin is a peer-to-peer decentralized network to route value
  • In a crisis involving major disruptions to daily life, Bitcoin will relay transactions and keep working

Resources Mentioned

• In The Bitcoin Standard, author Saifedean Ammous describes the scarcity of a commodity in terms of its Stock-to-Flow (SF) ratio
• The Bitcoin whitepaper, Bitcoin: A Peer-to-Peer Electronic Cash System
• Stephan Livera Podcast – Episode 154: Quantitative Bitcoin Analysis & Stock-to-Flow Co-Integration with Nick (@Btconometrics)

Intro

• With the Bitcoin halving quickly approaching, Pomp and PlanB discuss their thoughts on where Bitcoin is headed
• PlanB (@100trillionUSD) is an anonymous quant known for his statistical work on the Stock-to-Flow analysis of Bitcoin. Read his article: Modeling Bitcoin’s Value with Scarcity
  • If you haven’t, check out the Podcast Notes from his appearance on The Investor’s Podcast
• Host – Anthony “Pomp” Pompliano (@APompliano)

PlanB’s background

• He holds an economics degree in quantitative finance and a law degree in banking and financial markets law
• His first day job was in a dealing room in Germany where he learned all about technical analysis
  • He now works as a quantitative analyst for a large institutional investment firm
  • His work focuses on pensions balance sheets with a focus on mortgages and securities

Bitcoin’s Inception: Post-2008 Crisis

• “2008 crisis wasn’t a total surprise, what was a total surprise was what the central banks did after that: The quantitative easing and the very low and even negative interest rates in Europe” – PlanB
  • It lead PlanB to question the system and to look for hedges and eventually falling down the Bitcoin rabbit hole
    • “I think I am in it [bitcoin] almost 24/7 as far as my job allows” – PlanB
• Satoshi offered an elegant solution to a complex long-standing problem – Namely: Achieving digital scarcity
  • PlanB read the Bitcoin white paper, then followed people like Adam Back (@adam3us) and other prominent figures like Nick Szabo (@NickSzabo) and Andreas Antonopoulos (@aantonop)
    • Nick is a polymath & computer scientist – Check out these Podcast Notes from his appearance on The Tim Ferris Show, co-hosted by Naval Ravikant, where he spoke about cryptocurrency and blockchains
    • Andreas Antonopoulos is a public speaker and a popular Bitcoin evangelist – Check out the Podcast Notes from his appearance on Joe Rogan and What Bitcoin Did shows

Institutional vs Retail investing

• Investing your own money (retail) is not like investing someone else’s money (Institutional) – Here is how:
  • Pension money is usually invested in Fixed-Income assets (Interest generating) – Example: Bonds, mortgages, consumer loans
    • Commodities like Gold or Bitcoin have no yield or interest return, they are not a very logical fit
  • Institutional investing is subject to regulations from central banks and other regulators
    • Regulations determine how much capital can be held in each asset class. The more risk, the more capital you have to hold – Bitcoin is not even considered
    • Also, central banks are not fond of Bitcoin – With that said;
      • Some central banks are more open than others and PlanB aspires to be the bridge between the bitcoin world and the more traditional investing world
• “I think it’s a matter of time before you see the first banks and pension companies that have a balance sheet that invests other peoples’ money go into Bitcoin” – PlanB

Why institutional investors will be interested in Bitcoin?

• While Bitcoin is not a safe haven asset, it’s an uncorrelated asset (which is even better)
  • A safe haven asset goes up or down in response to market conditions, “This thing goes up no matter what”
• Bitcoin has a Sharpe ratio above 1; this is hard to see in assets (It indicates the average risk is smaller than the average return)
  • Bitcoin can crash 80% but you get rewarded with 200% return. This volatility can scare off investors, but quants know how to handle it via position sizing
• “As a potential investor, ask yourself this: If S2F has even 10% chance of being right, and bitcoin’s value goes to $200K, how do you capitalize on that in context of your own risk preference?” – PlanB

The Stock-to-Flow Model

• Stock to Flow model is an attempt to quantify the value of Satoshi’s digital scarcity invention. It’s a fundamental valuation model
• 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)
• 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
  • Currently, Bitcoin has an SF ratio of 27 – the model estimates the price to be little under $10,000 per bitcoin
    • The model estimates an increase of value by 8-10x after the next halving (The production rate of new bitcoins will be halved in May 2020)

Why the model fits as well as it does?

• The model directly measures an important factor: Scarcity
  • S2F is known for a 100 years to come, that helps with prediction and modeling
• It also quantifies the network effects: More developers are working on bitcoin, increasing merchant adoption, attracting more investors and spawning more markets that expand and support it.
• Moreover: Central banks are engaging in Quantitative easing (printing trillions of dollars)
  • This money goes into buying bonds, mortgages, etc. A portion of it finds its way to Bitcoin
  • Bitcoin measures the increase of money supply of government currencies and “As long as central banks keep printing, Bitcoin keeps rising” – PlanB
• Bear in mind: S2f only works if you have HODLers (HODLing refers to holding your bitcoins and never selling regardless of price volatility)
  • It’s akin to companies having loyal shareholders who don’t sell stock during crisis

Co-integration, What is it and why is it important?

• With computers going mainstream mid-1980s, many statisticians started using linear regression on time series data. The problem was getting a lot of spurious – or nonsense – correlations (You get a very high R², but it means nothing)
  • Clive Granger and Paul Newbold solved the problem by introducing the concept of Co-integration, which earned them the Nobel prize in 2003
  • Co-integration tests if regression is spurious or not by modeling the difference between two trending series – up or down
    • If the difference is stationary (values stay together), then you know it’s not spurious
• A good way to think about co-integration: A drunken man and his dog connected by a leach and walking randomly
  • Although they are both walking randomly, the difference between the drunken man and the dog is stationary – sometimes high or low but there is a relationship (Co-integrated)
• Nick (@Btconometrics) shows in his article that Bitcoin’s S2F and value are co-integrated, which means the relationship is real (not spurious)
  • The co-integration is also getting stronger over time and it will be interesting to see how it holds after the halving
  • Nick discussed his work on the Stephan Livera Podcast – Episode 154: Quantitative Bitcoin Analysis & Stock-to-Flow Co-Integration
• All other time series are not co-integrated (hash-rate analysis, difficulty adjustment, number of active accounts, etc.) All show high R² but only S2F is co-integrated

Is the Halving Priced In?

• The strongest argument against the model comes from the Efficient Market Hypothesis (EMH)
  • EMH states that the model predictions cannot be profitable because it is based on publicly available information (S2F, bitcoin’s supply rate, the halving)  
    • The market already knows it and it is priced in, there is no edge
• The discussion revolves around: Is stock-to-flow publicly known or can it be considered insider information? (PlanB notes that insider information still move the price, information doesn’t necessarily have to be public)
  • He discusses the topic in depth in his article: Efficient Market Hypothesis and Bitcoin Stock-to-Flow Model
  • In professional investing, markets are assumed to be efficient. It’s much better to examine if risks are priced in (Government bans, miner capitulation, futures market manipulation, coronavirus, etc…)
  • To examine this, PlanB ran twitter polls, which showed a recency-bias in risk estimation
    • Participants were worried about futures market, then US laws, then fear from coronavirus
• “Stock-to-Flow might be a little bit underestimated, and there might be a little overreaction to the risk we see around us” – PlanB

How will Bitcoin Behave in an Economic Crisis?

• Bitcoin was a response to the 2008 financial crisis and is yet to experience a crisis
• It might be similar to the internet – a communications protocol that works no matter what
  • If the internet is a peer-to-peer decentralized network to route messages, Bitcoin is a peer-to-peer decentralized network to route value
  • In a crisis involving major disruptions to daily life, Bitcoin will relay transactions and keep working
    • “If you ask me, I think Bitcoin is made for a situation like that” – PlanB
• US investors read about negative rates, but don’t feel it. US remains the only country with a positive yield curve, but rates are quickly dropping
  • People get interested in buying Bitcoin when they see negative interest rates
  • Check these Podcast Notes from Raoul Pal’s appearance on The Pomp Podcast, where he calls for a potential economic depression and sub-zero rates

The Biggest Risks to Bitcoin

• Nation states might implement draconian laws (Like aggressive tax and AML laws)
  • This is especially true for the US because it holds reserve currency status
  • Even so: “That’s a very big risk but you see other countries may be taking advantage of that situation and opening their markets and be very clear legally about bitcoin and giving it a place as a regular asset” – PlanB
    • Check out these Podcast Notes from The Investors’ Podcast, where Caitlin Long discusses Bitcoin law & legal implications in the US
• Governments might supress/ manipulate Bitcoin’s price futures market, but this can only work for a limited time
  • “Manipulation with derivatives like futures is in my view like pushing a ball under water, you can do that temporarily but not all the time, and you can do it long but you get tired and then it goes up” – PlanB