How low can crypto go?

The answer is “to zero”.

Over the past two weeks, investors have seen their bitcoins go up 10% in a day, down 10% in a day, down another 10% over 4 days, down 20% in a day, and down 15% in a day.

Having a bitcoin fork (Bitfinex) distributing its own fraud of a cryptocurrency shutting down isn’t helping matters any. There’s plenty of others out there which have no purpose in life to exist except to suck up cash in favour of their incumbent creators.

Stop to think what would happen if you had three-quarters of your networth (measured at the beginning of the year – after all, Bitcoin did go to USD$20,000 at one point) go through a string of days like the above.

I see a lot of obviously young and inexperienced investors in the reddit forums (e.g. /r/bitcoin) that have never been involved in anything resembling a bear market in their lives, and their mentality will be “buy the dips and hold on”. This is financially ruinous when holding an asset going to zero (see: Nortel investors). Another group will be “diversify into other cryptocurrencies”, but what good does diversification do when the entire asset class (if you want to call it an ‘asset class’) is garbage, just like the dot-com stocks in the late 1990’s? Is your bitcoin truly going to be one of the survivors like Amazon (which went down about 95% from peak-to-trough after the tech wreck) or is it going to more likely be like Alta-Vista, Lycos, Excite, Infoseek, or a zombie like Yahoo that never was able to resume its glory days?

My only regret is that they haven’t opened options trading yet on Bitcoin, although the implied volatility on those puts would be extreme.

Interest rates and Macroeconomic ramblings

This is a rambling post, so be cautioned that there is little rhyme or reason to the thought pattern here.

I look at the following chart of the 30-year treasury bond:


The risk-free return is very low at present. Relative to other sovereign entities (e.g. Euro-zone, Japan, Canada, etc.), however, the US 30-year bond actually still looks cheap and this can explain why it is the best performing asset class in 2014 to date.

As an exercise to the reader, please reconcile what we are seeing in front of us:

– S&P 500 is at all-time highs (approximately 1,900 as I write this)
– The economy appears to be plodding along at a low real rate of return
– Inflation is rising but not at ridiculous proportions (yet)
– US currency appears to be making a comeback
– Short-term rates are still basement low (fed funds target is 0-0.25%, but the effective daily rate has been closer to around 0.09%)
– Long-term treasury rates are relative low (see above chart)
– US government is still projecting $500 billion deficits although this is quite better than previous years; other liabilities (e.g. social security) and various other entitlements (e.g. pensions) generally remain huge liabilities and difficult to get a good rate of return
– Almost every retail Joe that is not involved in stock (lottery) picking is dumping their money in a variety of index funds that invest in the same things in the same proportions (Typical Canadian allocation: 40% TSX 60, 30% S&P 500, 30% some fixed-income ETF)

The demographic story is that the bulk of the population pyramid is entering in the stage of life where they are transitioning their capital into income-bearing instruments, which accounts for the very high cost of yield at present.

It remains very difficult to say whether we are entering in the Fairfax world of upcoming deflation despite everything (which would guarantee low interest rates for some time to come), or whether we’re entering some sort of inflationary world (because of all of the available credit, which would presumably translate into spending and consumption).

Although my style of investing does not depend on macroeconomic outcomes, it is always nice to know where you have the winds at your back. In terms of the big world-picture view, it is difficult to tell where these winds are blowing at present.

The only real convictions I have at this point is a general aversion to commodity-related products and a realization that those that are paying for yield are likely paying a premium beyond what the risk/reward ratio would suggest.

In other words, you are more likely than not to find the “hidden gems” amongst the list of zero-dividend yielders (or very low) on the equity side. Due to the “rising tide lifts all boats” phenomenon that we are encountering at present, until we see defaults of junk debt issues that go out for insanely low coupons and high durations, finding these gems is not easy. Most of them have been bidded up.

This leaves potential investment candidates in very un-ideal categories: the nearly illiquid and special situations (e.g. spinoffs, emerging from Chapter 11/CCAA, SEC/SEDAR “fine-tooth comb required because GAAP financials simply don’t explain the story” companies, closed-end ETFs, etc.). Not a lot of pickings here.

Positioning for deflation

I’ve been doing some research on which sectors perform best under deflationary conditions.

Obviously, cash is first and foremost as it will generate a natural real return over time without having to do anything, plus the nominal return you get from parking it in short-term funds (the Bank of Canada short-term rate right now is 1%).

Long-term bonds of solvent entities also are a good investment during deflationary conditions.

However, on the equity side things are a little more muted. The only direct play which I know explicitly has taken a position on deflation is the Canadian equivalent of Berkshire Hathaway, Fairfax Financial (TSX: FFH). Prem Watsa was fairly early to the subprime mortgage crisis in the USA but was able to profit handsomely on it, and he seems to be early on the deflationary game as well. His company has also been significantly short on S&P 500 equity index futures which also resulted in their portfolio performance suffering losses they really shouldn’t have been suffering. So while Watsa is likely paranoid, inevitably if you believe deflation is going to hit the marketplace and still need some form of equity exposure coupled with fairly competent management in asset allocation, then Fairfax is probably a good meal ticket. Regrettably, it is trading a shade over book value and historically it gyrates around it so there is likely a better opportunity in terms of market timing.

Interestingly enough, Watsa was also quite early in accumulating his (via FFH) 10% stake in Blackberry (TSX: BB). It remains to be seen whether this will be a win for him.

Negative interest rates

Negative interest rates have a very odd effect on the financial math. Certain European countries are selling short-term debt at negative yields, which is somewhat odd. Specifically if you bought a bond from Germany with a 2-year term, you would receive a yield to maturity of -0.06%. If you just held your Euros under the bed, you would receive a yield of 0%.

This is somewhat of an interesting statement by the market in that holding Euro cash is more risky than holding German debt. The decoupling of sovereign debt and its underlying currency is quite steadfast in Europe, while it is highly unlikely you will see such an occurrence in Canada or the USA unless if investors have a good reason to believe that the Canadian dollar or the US dollar will be broken.

I will not talk at this point about Quebec separation and the impact to the Canadian dollar.

The EU bailout comes to an abrupt finish

I believe it was George Soros that was quoted that the recent bailout agreement with Greece would last “between one day to three months”, and it appears the answer will be less than a week. With the Greek government exercising a political move to have the bailout criteria go to a public referendum, it once again ratchets up the risk of a sovereign default and extends the drama and impact on the financial markets.

Even if this wasn’t the case, I would think that the next focus would be on Portugal’s solvency.

How long can the people of Germany and France allow their governments to subsidize the lifestyles of people in other countries? This is essentially the political question – admission to the Eurozone will inevitably have to be revoked if countries go beyond a certain metric regarding their financial performance.

If there is another push on credit, we’ll be seeing the usual happen – US dollar up, US treasury bond yields down, and commodities taking a nose dive – the typical “risk off” trade. Everybody investing in the markets at this time is forced to become a macroeconomic/geopolitical analyst to explain some of the risk in the securities they are investing in today. There will probably be continued aftershocks as this drama continues to unfold.

Kicking the can forward

Now that the European debt situation is seemingly resolved, the markets are now on rally mode. Credit is loosening again and this gets reflected in the price of debt and equity.

How long will be it before the other countries in Europe line up at the trough?

The fundamental problem is debt accumulation and it is not solved by a one-time papering over – somebody has to pay for it. It is just a matter of when.

Of course this is sour grapes because of my high cash position, and I do suspect that plenty of others are on the sidelines. This is especially for pension fund managers that have to make their mandated 7.5% return on assets while sitting on a mount of 10-year treasury bonds yielding 2.2%. They are forced to buy equities since there is no other assets that can possibly generate a higher return.

Commodities are also making a return, assisted with the US dollar depreciating again over the past month.

This is almost turning out to be a mirror image of the 2008 financial crisis – in October of 2008, the world’s problems were solved with things like TARP and QE, but it took another six months for the markets to fully digest it and reach a panic low. It is something I am open to believing may happen again.

The largest rallies happen with short squeezes

While the Canadian markets were closed due to Thanksgiving, the US equity markets skyrocketed up 3.4% on the S&P 500. There was no particular news other than nothing catastrophic happening over the weekend, but it has been my experience that sharp rallies up tend to be due to traders caught on the short side that suddenly buy into the markets.

I also remain fascinated with the history of the markets from 2008 to 2009 – about how most of the actual crisis was over in October of 2008, but the reverberations and pessimism came to a crescendo in February and early March. This was despite the fact that TARP and practically every liquidity measure conceived had been implemented and all that was left was for that excess liquidity to end up shoring credit across the entire marketplace.

The whole world knows about Greece, but calculating the after-effects of a default or restructuring is the tricky part – if credit goes into a deep freeze once again, we will likely see a miniature version of that crescendo. It could also be the case that we have seen it – if that is the case then the time to buy is now – but you’ll never know it until after the fact. This is indeed gives markets such an impression to outsiders that it is all luck. I remain pessimistic, however, mainly because the underlying cause of the problem – profligate spending by governments – has not been resolved. Any recovery is likely to be temporary at best until economic foundations can actually heal.

Items to watch out for in the upcoming week

All eyes continue to remain on the macroeconomic situation in Europe.

There is also the the other continuing drama in the Middle East area, but it is always difficult to determine whether it is media sensationalism working its ugly head or whether there is something genuine brewing there.

I note with interest half-way through the market session that commodity stocks are getting hammered. In particular, I observe that most of the oil/gas majors (e.g. Suncor (TSX: SU), EnCana (TSX: ECA), Canadian Oil Sands (TSX: COS)) are trading down despite the underlying commodity (West Texas Intermediate) remaining seemingly range-bound around the $90 mark.

I also believe the market is seeking resolution to the Greek debt crisis (specifically the formal point in time where the EU gives up on them), but just like how the resolution of the US debt ceiling failed to provide relief for more than a trading day, I do not believe the resolution of the Greek crisis will resolve the EU situation – in particular the key countries are Italy (10-year yield chart) and Spain (10-year yield chart) – if their yields go higher then the crisis will morph into something much larger. Italy did, however, pass a measure which closes the theoretical gap in their own deficit. The usual European bank suspects (Societe Generale, Deutsche Bank, etc.) are all trading down around 5-10%, pricing in some future problems.

Also, for the first time since the 2008-2009 financial crisis, Goldman Sachs (NYSE: GS) briefly traded under $100. Their preferred shares (e.g. GS-PB, callable, perpetual with 6.2% coupon) are still trading at around 99 cents of par value, so that side of the market is not seeing much fair, just the equity. If you go to page 157 of their last quarterly SEC filing, they managed to vaccuum up money out of the market in 48 of 63 days – this is significantly worse than their previous track records. For example, in the previous quarter (page 139) they made money on 61 of 62 days in the market. Think of who you are competing with if you are involved in the short-term trading business – at least in a Las Vegas casino if you shop around correctly you will get about 99 cents of equity on one dollar bet in a hand of blackjack. Against Goldman Sachs Casino, you will be lucky to see 90.

Anecdotal measures of inflation

The Nomad Lawyer (Paul Lukacs) notes the following in his web posting:

When I visited Hong Kong in December 2010, the cost of one Mrs. Fields cookie was 11 Hong Kong dollars (US$1.43).

In early spring, the price rose to 11.5 Hong Kong dollars (US$1.49).

This week, the price rose to 12 Hong Kong dollars (US$1.56).

That’s a lot for a small cookie.

Applying some Canadian grade 11 math, the compounded annualized rate for the 8 months of price change is the following:

exp(ln(1+[{1.56 – 1.43} / 1.43]) / [8/12]) = 13.94%


I find these anecdotal measures of inflation to be more realistic than government-released statistics. Although the US Dollar has depreciated about 7% against the world basket of currencies, increases in sugar and flour prices (derived from wheat) have also skyrocketed.

Inflation, whether the US government reports it in its statistics or not, will be the only politically practical way the they can ever pay off its mammoth debt. There are too many entrenched interests to allow other options at present. The result is the currency depreciating, which will increase commodity prices (as they are US dollar-linked). This depreciation also highly affects the competitiveness of Canadian exports to the USA, but also gives net importers (such as most consumers) higher purchasing power – most cross-border shoppers know this.

My own personal anecdotal explorations of inflation are usually at the supermarket. I notice a jug of homogenized milk (albeit protected by the BC Dairy Board in the province I live in) is about $4.50 for 4 litres. Bread costs are creeping up at around the $2.70-$2.80 level for a 680 gram loaf (although you can still find cheaper options). Coffee has skyrocketed on a per pound basis. I also notice those concentrate juice mixes in the freezer section have been downsized in volume but still sell for roughly the same price. There are signs of inflation everywhere similar to Mrs. Fields Cookies that was noticed by the Nomad Lawyer.