Acknowledging Gravity: Notes On The Crypto Meltdown

May 19, 2021, will be burned into the minds of investors and speculators alike, specifically those with exposure in the crypto space, as the moves witnessed in tokens like BTC and ETH were once-in-a-lifetime events for market makers that maintained liquidity throughout this vol event. — Read more from Identity Element  here or follow on Twitter

When markets have tantrums, I always enjoy documenting the moves because they are a piece of history, no matter how inconsequential our financial history may be in the grand scheme of things. In any case, 19-May-21 will be burned into the minds of investors and speculators alike, specifically those with exposure in the crypto space, as the moves witnessed in tokens like BTC and ETH were once-in-a-lifetime events for market makers that maintained liquidity throughout this vol event.

The backdrop leading up to this day is as important as the day itself. Last week, ETH saw all-time highs, only to swiftly give up its parabolic breakout on the back of three events – (1) an inflationary CPI print, (2) the retraction of Elon Musk’s BTC endorsement, and (3) the revelation of Tether’s balance sheet (which, I believe, is the true driver of this sell-off). Indeed, according to the graph below, only 5.17% of Tether’s balance sheet was truly allocated to cash/cash equivalents (cash + treasury bills). In lieu of this, institutions with crypto exposure likely applied haircuts to their positions due to the revelation of Tether’s credit risk, which, when coupled with the other two events and the general excess in the crypto market, likely cascaded into the sell-off we witnessed Wednesday.

Indeed – last week began on a high note for bulls of the ETH trade, and their bullishness was (and likely still is) warranted – EIP-1559 rollout is on the horizon, the amount of ETH staked was increasing. These two phenomena would lead to –and are actively contributing to – deflationary pressures in the ETH market. But the issue I take with crypto bulls is a simple one: there is a lack of intellectual honesty. Unconditional bullishness only works until it doesn’t, and “HODLing” isn’t a prudent risk management strategy. In the game of compounding, volatility taxes must be avoided at all costs. Mark Spitznagel became a billionaire from helping institutions avoid volatility taxes, and Nassim Taleb became an a**hole from being on the other side of the volatility trade on Black Monday.

Consequently, crypto investors and speculators that grit their teeth and HODL through 50% drawdowns, only to sell after an extended period of consolidation, cannot harvest the risk premium that exists within the space. HODLing is nonsense except in the case of the most capitalized investors and speculators. Crypto Twitter clearly never developed a functioning theory of mind, because the advice they are peddling to the uninformed masses of retail speculators – clearly motivated by FOMO – is unlikely to prove fruitful when these retail participants are questioning their decisions in the face of a 50% peak to trough drawdown.

Avoiding the Tax

For anyone with a modicum of intellectual honesty, or with a framework, I truly believe prudent risk management would have enabled you to exit this trade before the bottom completely fell out of it. Indeed, the thesis for owning ETH is sound, and I still believe in it over the long run (I will publish this thesis at a later date. Disclaimer: this is not investment advice).

But crypto is simply a macro trade; it is a bet on hyper-technologicalization, and, as we know, investments in assets that have negligible capital overhead tend to outperform in compressed rate environments since they are duration intensive. From a DCF perspective, an expansion in nominals compresses the PV of the cash flows the asset generates, or in the case of ETH, the internalization of deflation.

Suppose one truly did believe in the ETH thesis and was well informed. Then, they must recognize the nature of the speculative excess that existed in the crypto market prior to this liquidation event. Consequently, any vigilant investor or speculator should have been aware of macro drivers that could dwarf and strong micro theses as in the case of ETH. In the case of 12-May-21, we had the CPI print, which is detrimental to the rate outlook and consequently bearish to duration intensive assets. These minor undulations rock markets that have bubbled to speculative excess; we saw this play out beautifully Wednesday.

Simple trend-following tools communicate the extent of the run-up in excellent fashion. Below is ETH’s graph at the end of last week – it highlights the divergence of ETH’s spot price relative to its 50-day moving average, with the most recent print being the second-largest witnessed in this cycle. Additionally, in our limited sample, of the four instances when ETH’s spot price exceeded its 50-day moving average by more than 50%, ETH’s realized forward 20-day and 50-day returns were abysmal in three cases, and positive in only one. This divergence marks instance #5 in our sample, and suffice to say, it is highly likely to be another atrocious print on a forward basis:

The divergence witnessed on the 10-May-21 was distinct to the 1-Jan-21 divergence for a simple reason – BTC showed no signs of consolidation or breaking trend at the time.

Fast forward to 14-May-21, and the picture was fundamentally different. Bitcoin had broken trend (measured by the difference between a 50-day simple moving average, and a 20-day simple moving average), and the market was shaky due to the events mentioned here at the outset.

Yet, Ethereum was still outperforming. One could interpret this as speculative excess – market participants ignoring the gravity being exerted by Bitcoin in the wake of its drawdown. Eventually, ETH and the rest of the altcoin space would have to acknowledge this gravitational pull, much like Wile E. Coyote in Looney Tunes. Indeed, the exact same dynamic – this suspension of gravity – played out at the end of the 2018 cycle. For those that say history rhymes, I assert that in this case, it may have truly repeated. The charts below are hilarious from a probabilistic perspective:

In both 2018 and 2021, ETH’s and BTC’s peaks were separated by exactly 28 days. Additionally, Bitcoin lost trend only 1 day later in this cycle relative to its 2018 predecessor. These charts have no efficacy unconditionally, and if one attempted to apply these timeframes for predicting future declines, they would certainly be fooled by randomness.

Yet, while the number of days across peaks and BTC’s break in trend is unimportant, the realization that ETH was clearly outperforming crypto’s north star BTC – in the wake of some significant revisions to the macro picture – should have raised some suspicion. Given the speculative excess that clearly existed in the space, taking profits in the ETH trade would have been recommended sometime last week (and most likely after a breach of the 20-day moving average) simply from a risk management perspective. This is not to assert that technical analysis is the definitive systematic strategy, or that it generates alpha unconditionally, but I would state that it does have efficacy for determining when to curtail risk, or take profit, in asset classes that are quite clearly challenging to value and subject to bubble dynamics, particularly in lieu of new information that alters one’s thesis.

The Path Forward

The capitulation of the crypto trade leaves us with some questions in its wake; chiefly, the near-term outlook of rates. Inflation narratives are surfacing left and right in the wake of the CPI print; large media outlets are pushing recommendations for positions that will benefit from inflation upticks. These recommendations may turn out to be correct, but if inflation has truly arrived, investors may be troubled to find assets to park their capital, largely due to the dilemma it would place the Fed in.

In an environment where the Fed is clearly central to the performance of risk assets, every asset is inextricably linked to rates. Given that monetary and fiscal policy have been tightly coordinated in the wake of the pandemic, each serving to enforce the stimulative effects of the other, the Fed seems hesitant to shift its relatively dovish stance. Aleks Kocic of Deutsche Bank covers this new paradigm eloquently in his most recent piece (emphasis my own):

An underreaction of the Fed to inflationary pressures is consequently the greatest risk to markets at the moment. If inflation begins to truly run hot, the Fed will have limited maneuverability because of the paradigm we currently find ourselves in. We are amid an economic recovery, and any hawkishness exemplified by the Fed would place significant strain on this recovery effort. Consequently, two potential responses come to mind:

1. If the Fed does nothing about the inflation issue, risk likely sells off. Higher nominals are propagated by higher breakevens, and inflation affects Main Street. Secular tech likely underperforms in this paradigm, and cyclicals may continue to run.
2. The Fed raises rates, bumping the front-end, but potentially pursues an operation TWIST 2.0 by pursuing asset purchasing programs on the long end. This is likely conducive for supporting equities and the like due to the yield curve’s flattening, but Main Street would be hit by higher financing costs, slowing down the recovery. In this event, one would likely want to own secular tech, and reduce exposure to cyclicals accordingly.

In a contrarian take, there is a possibility that inflation never surfaces, and the market is forced to revise its expectations of inflationary pressures. In this instance, the yield curve likely shifts lower on the back of breakeven compression.

This scenario would surface due to the existence of debt which was created via temporary suspension of rent collection, or other expenses, during the coronavirus. The notional value of this debt is difficult to quantify, but there is certainly a significant amount of debt owed by renters to property managers that softened rent collection to mitigate the effects of the pandemic on businesses and individuals alike (to name a specific case). In this scenario, the market’s expectation for inflationary impulse may never surface, and secular tech (which is currently trading well off of highs due to the rally in reals seen in the middle of February) seems to be an interesting play at current valuations.