30 Jul Bridge Perspective – To Bit or not To Bit
While society is still not completely back to “normal,” it certainly feels like the world is a lot closer to normal than where we were at the peak of the pandemic. And that feels great! People are taking vacations again, though staying closer to home or at least in the same country, our National Parks expect record setting visitation, and hard hit industries are seeing a surge in demand. That being said, there are still challenges and questions ahead, both for the course of the pandemic and investors alike. There is no shortage of new terms in the common lexicon that highlight some of these questions – delta variant, cryptocurrencies, Personal Consumption Expenditures (“PCE”), Special Purpose Acquisition Companies (“SPAC”), etc.
What does the world look-like post pandemic? Is crypto an actual asset class? Is inflation here to stay? Are SPAC’s a good investment?
You can find any number of hypothetical answers to these questions but it’s fair to say that only time will tell the truth. We visit the cryptocurrency topic below. It is arguably the most unfamiliar topic yet one that is in the news on a daily basis and probably of interest to many investors.
To Bit or Not to Bit: What Should Investors Make of Bitcoin Mania?
Bitcoin and other cryptocurrencies are receiving intense media coverage, prompting many investors to wonder whether these new types of electronic money deserve a place in their portfolios.
Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and no regulator or nation state stands behind it.Instead, cryptocurrencies are a form of code made by computers and stored in a digital wallet. In the case of bitcoin, there is a finite supply of 21 million, of which more than 18.5 million are in circulation. Transactions are recorded on a public ledger called blockchain.
People can earn bitcoins in several ways, including buying them using traditional fiat currencies or by “mining” them—receiving newly created bitcoins for the service of using powerful computers to compile recent transactions into new blocks of the transaction chain through solving a highly complex mathematical puzzle.
For much of the past decade, cryptocurrencies were the preserve of digital enthusiasts and people who believe the age of fiat currencies is coming to an end. This niche appeal is reflected in their market value. For example, at a market value of $57,000 per bitcoin, the total value of bitcoin in circulation is less than half of a percent of the aggregate value of global stocks and bonds. Despite this, the sharp rise in the market value of bitcoins over the past weeks and months have contributed to intense media attention.
What are investors to make of all this media attention? What place, if any, should bitcoin play in a diversified portfolio? Recently, the value of bitcoin has risen sharply, but that is the past. What about its future value? You can approach these questions in several ways. A good place to begin is by examining the roles that stocks, bonds, and cash play in your portfolio.
Companies often seek external sources of capital to finance projects they believe will generate profits in the future. When a company issues stock, it offers investors a residual claim on its future profits. When a company issues a bond, it offers investors a promised stream of future cash flows, including the repayment of principal when the bond matures. The price of a stock or bond reflects the return investors demand to exchange their cash today for an uncertain but greater amount of expected cash in the future. One important role these securities play in a portfolio is to provide positive expected returns by allowing investors to share in the future profits earned by corporations globally. By investing in stocks and bonds today, you expect to grow your wealth and enable greater consumption tomorrow.
Government bonds often provide a more certain repayment of promised cash flows than corporate bonds. Thus, besides the potential for providing positive expected returns, another reason to hold government bonds is to reduce the uncertainty of future wealth. And inflation-linked government bonds reduce the uncertainty of future inflation-adjusted wealth.
Holding cash does not provide an expected stream of future cash flow. One US dollar in your wallet today does not entitle you to more dollars in the future. The same logic applies to holding other fiat currencies — and holding bitcoins in a digital wallet. So we should not expect a positive return from holding cash in one or more currencies unless we can predict when one currency will appreciate or depreciate relative to others.
The academic literature overwhelmingly suggests that short-term currency movements are unpredictable, implying there is no reliable and systematic way to earn a positive return just by holding cash, regardless of its currency. So why should investors hold cash in one or more currencies? One reason is because it provides a store of value that can be used to manage near-term known expenditures in those currencies.
With this framework in mind, it might be argued that holding bitcoins is like holding cash; it can be used to pay for some goods and services. However, most goods and services are not priced in bitcoins. A lot of volatility has occurred in the exchange rates between bitcoins and traditional currencies. That volatility implies uncertainty, even in the near term, in the amount of future goods and services your bitcoins can purchase. This uncertainty, combined with possibly high transaction costs to convert bitcoins into usable currency, suggests that the cryptocurrency currently falls short as a store of value to manage near-term known expenses. Of course, that may change in the future if it becomes common practice to pay for all goods and services using bitcoins.
If bitcoin is not currently practical as a substitute for cash, should we expect its value to appreciate?
Supply and Demand
The price of a bitcoin is tied to supply and demand. Although the supply of bitcoins is slowly rising, it may reach an upper limit, which might imply limited future supply. The future supply of cryptocurrencies, however, may be very flexible as new types are developed and innovation in technology makes many cryptocurrencies close substitutes for one another, implying the quantity of future supply might be unlimited.
Regarding future demand for bitcoins, there is a non zero probability that nothing will come of it (no future demand) and a non-zero probability that it will be widely adopted (high future demand).
Future regulation adds to this uncertainty. While recent media attention has ensured bitcoin is more widely discussed today than in years past, it is still largely unused by most financial institutions. It has also been the subject of scrutiny by regulators. For example, in a note to investors in 2014, the US Securities and Exchange Commission warned that any new investment appearing to be exciting and cutting-edge has the potential to give rise to fraud and false “guarantees” of high investment returns. Other entities around the world have issued similar warnings. It is unclear what impact future laws and regulations may have on bitcoin’s future supply and demand (or even its existence). This uncertainty is common with young investments.
All of these factors suggest that future supply and demand are highly uncertain. But the probabilities of high or low future supply or demand are an input in the price of bitcoins today. That price is fair, in that investors willingly transact at that price. One investor does not have an unfair advantage over another in determining if the true probability of future demand will be different from what is reflected in bitcoin’s price today.
What to Expect
So, should we expect the value of bitcoins to appreciate? Maybe. But just as with traditional currencies, there is no reliable way to predict by how much and when that appreciation will occur. We know, however, that we should not expect to receive more bitcoins in the future just by holding one bitcoin today. They don’t entitle holders to an expected stream of future bitcoins, and they don’t entitle the holder to a residual claim on the future profits of global corporations.
None of this is to deny the exciting potential of the underlying blockchain technology that enables the trading of bitcoins. It is an open, distributed ledger that can record transactions efficiently and in a verifiable and permanent way, which has significant implications for banking and other industries, although these effects may take some years to emerge.
When it comes to designing a portfolio, a good place to begin is with one’s goals. This approach, combined with an understanding of the characteristics of each eligible security type, provides a good framework to decide which securities deserve a place in a portfolio. For the securities that make the cut, their weight in the total market of all investable securities provides a baseline for deciding how much of a portfolio should be allocated to that security.
Unlike stocks or corporate bonds, it is not clear that bitcoins offer investors positive expected returns. Unlike government bonds, they don’t provide clarity about future wealth. And, unlike holding cash in fiat currencies, they don’t provide the means to plan for a wide range of near-term known expenditures.
Because bitcoin is being sold in some quarters as a paradigm shift in financial markets, this does not mean investors should rush to include it in their portfolios. When digesting the latest article on bitcoin, keep in mind that a goals-based approach based on stocks, bonds, and traditional currencies, as well as sensible and robust formulations of expected returns, has been helping investors effectively pursue their goals for decades.
Market Update – A Brief Around the World Tour of Markets
It was all in the black for the major markets and asset classes around the world in the second quarter. Both developed and emerging markets had mid to upper single digit returns, bonds had slightly positive performance and real estate top the charts with low double digit returns. The biggest questions on the minds of investors were related to inflation and the ever present pandemic. The market consensus around inflation seems to be pretty clear that it will not last long, or that it is “transitory” in nature. The consensus around the pandemic is ever changing. Will the new variant cause policy makers to introduce new measures to stop the spread? How well will the vaccines work as the virus mutates? Will the Olympics be successful?
Equity markets around the globe posted positive returns in the second quarter as the roll-out of vaccines accelerated. Looking at broad market indices, US and non-US developed markets outperformed emerging markets for the quarter. The S&P 500 reached a new all-time high in late June and there were positive returns across major sectors as well. Larger companies generally outperformed smaller companies but the strength in smaller companies to start the year still has them on top year-to-date. As the quarter came to a close, markets seemed to pause in order to digest all the relevant information that has come to light recently.
In the US, interest rates on intermediate and longer-term bonds reversed course in Q2 and fell across the maturity spectrum. This drove bond prices higher and as a result performance was positive. Short term bonds were unchanged. Despite the positive movement the broad based bond indices remain slightly negative for the year. The picture around the world was also mixed depending on the country but the global indices produced similar numbers to the US and squeezed out slightly positive performance. Inflation protected bonds benefited from the continued concern around inflation. The risky areas of the bond market (e.g. High Yield) continued their outperformance and remain the best performing bond sector year-to-date.
On the Economy
The global economy continued to gain steam in the first two months of the quarter but started to moderate towards the end of the period. Most of the economic focus was on inflation data and the US Federal Reserve (Fed) meeting in June. Policy makers continued to downplay the concern around inflation despite some very big increases in inflation measures and the market seemed to agree. Given the improving economic situation in the eyes of the Fed, they updated their forecasts to telegraph the potential for an earlier than expected rise in interest rates. This was considered to be a more “hawkish,” or conservative, move by the Fed. The change caught many by surprise. Overall, economic activity reported in the quarter showed the Q1 GDP grew by an annualized 6.4%, slightly lower than expectations. The jobs situation also saw marked improvement with weekly data continuously reaching new pandemic era lows. As of the date of this letter, further simulative policy is in the works with a massive infrastructure bill being hotly debated in Congress.
 Adapted from “To Bit or Not to Bit: What Should Investors Make of Bitcoin Mania?” from Dimensional Fund Advisors LP.
 A currency declared by a government to be legal tender.
 Per Bloomberg, the end-of-day market value of bitcoin was $57,624.01 USD on March 11, 2021.
 Describes an outcome that is possible (or not impossible) to occur.
 “Investor Alert: Bitcoin and Other Virtual Currency-Related Investments,” SEC, 7 May 2014.