Absolute Beginner’s Guide | Lesson 5: Bitcoin’s Intrinsic Value
Wall Street veterans hate Bitcoin.
Warren Buffett has called it “rat poison squared.” Jamie Dimon, the CEO of JP Morgan, still doesn’t support Bitcoin. Ray Dalio, the founder of Bridgewater, which is the world’s largest hedge fund, hated Bitcoin for years, before finally coming around to it just last month … and just before the crash.
Now, they all represent “the establishment,” and all have large billion-dollar stakes in the existing financial system. So, it’s easy to conclude that they hate Bitcoin because of personal self-interest.
But I think the issue is deeper than cynicism.
Mohammed El-Erian, an economist and now President at Cambridge, bought Bitcoin at $5000 and then sold it at $19,000 thinking he was the smartest person around. So, clearly, he is no Bitcoin hater. Yet, the reason he didn’t hold longer–unlike me–was that he couldn’t find a clear metric to value Bitcoin.
And that’s the rub. Wall Street wants to buy things based on their intrinsic value. They employ legions of specialists who can assess the intrinsic value of companies and then they go to buy the cheapest ones based on that analysis.
But since there is no consensus around how to value Bitcoin, those legions report back that Bitcoin has no clear value, and then the veterans dismiss it.
What I want to explain is a paradox: the old-timers are right about this uncertainty and it’s perfectly rational to ignore them.
The Art of The Bubble does find firm footing in macro-economic cycles–because prices do reflect reality in a broad way.
Importantly, there are macro conditions that preclude the possibility of any bubbles. During a prolonged recession or depression, for example, you will not find people bidding up $GME or $AMC, because no one has any money.
Just look at Bitcoin’s performance during the stock market crash of 2020 (Bitcoin is in black, while the S&P 500 is in blue).
No money means no bubbles. That’s why Daily and Weekly Bubble subscribers pay to get access to algorithms that track macroeconomic cycles.
But it’s important to understand why the valuation problem exists, both to avoid charlatans and to find a strategy that works.
Let’s get started with the most basic question.
Is Bitcoin An Asset?
This one seems obvious, right? Well, from a financial standpoint it is–and in just about the opposite way that most people think.
Most people think Bitcoin is an asset, and I call it an “asset” by analogy. But it’s not. An asset is something that produces cash flows.
To explain, my university is in a “college town,” meaning that it’s the largest business there. Obviously, there are a lot of college students and they buy a lot of alcohol.
They also get the munchies late at night, when everything else is closed–except for one pizza place. It’s a narrow shop that has almost no seats and sells pizza by the slice. They also do deliveries and they make tons of money.
How much is this Late-Night-Pizza-Joint worth?
Well, theoretically, if you had infinite knowledge, you could just sum up all the company’s earnings–their cash flows (to speak loosely)–and then discount those back to present dollar amounts.
You have to discount the $10,000,000 it makes in 2050 to today’s dollars because of inflation (at least).
So, Late-Night-Pizza-Join is worth the cash flow of 2021 + 2022 + 2023 … for as long as the business is in operation, and then you discount that back to today’s value.
Doing that for a real business is hard because no human has infinite wisdom. But there are standard ways to approximate how to do this–and this is what finance specialists do.
Now, does Bitcoin produce cash flows? Not really. You could stake Bitcoin, and then you would have a Bitcoin staking business, and that would produce cash flows, but Bitcoin itself doesn’t do that.
So, Bitcoin isn’t an asset. You can’t find its intrinsic value that way. So, what do you do?
Well, you have to use a different value model. There are quite a few proposals out there on the internet, and for nerds like me, this is a fun, ongoing debate.
I’ll only talk about one wrong one here–because it is used in scams–and then I’ll talk about a model that does work theoretically.
Why The Stock-to-Flow Model Is Wrong
The idea behind this model is simple: when something has a scarce supply, it’s worth more. Also when the flow (of gold out of the mines for example) is low, it’s worth more. You should be able to combine these points and get a sense of value–expressed as a ratio.
Here are the Stock to Flow ratios (SF) as calculated in the Medium post that made this idea a big deal in the first place.
See, gold has the highest stock to flow ratio, so it’s worth the most.
Now, let’s apply this to Bitcoin, which has an ever decreasing stock, and a flow that halves every 4 years. Using those two ideas you’ll get the following projection of price.
You’ll see that Bitcoin’s early price history mostly tracks the stock to flow model.
Yet, that model also predicted that by sometime around April, Bitcoin would hit $100,000 US Dollars. In the years after, it’s supposed to go to $1,000,000.
Now, you might have noticed that there are a few problems with this model. First, it’s past April 2021, and Bitcoin never hit $100,000. Next, if you really follow this chart out, you’d find that Bitcoin’s value will be infinite because its stock will be exhausted–which is obviously absurd.
These problems result from a root cause. Stock to flow models only make sense when the supply side isn’t limited. It works for beef, for example, because that’s not running out any time soon.
But, Bitcoin isn’t in that situation. Logicians (like me) call this a category error.
It’s like the following scenario. Suppose someone asks you “Where’s Manhattan?” and you give them directions. They go there and come back and complain: “There was no Manhattan where you described. Just Broadway, and Times Square, and the Empire State Building. No Manhattan.”
It’s clear that they have confused what sort of thing a city is. They got the category wrong and thought it would be a thing like a building.
The same error is happening here. When you don’t have both supply and demand, then you can’t determine price by that interaction. Here are just a few articles explaining this point in a lot more detail than I have here, but I’ve already told you what matters.
Ok, so let’s look at something that would actually work.
Why Metcalfe’s First Law Works In Theory
Imagine for a moment that the telephone is just being invented. You are setting it up in the “Wild West” with one person across town. How valuable is that “network” of two people?
Well, let’s say value, V = 1 because the two of you just have one connection.
What if you added 1 more person, how much more valuable would that be?
Well, V = 3 because even though you can call 2 different people, they can call each other, so there are three connections.
If you keep going this way, as Robert Metcalfe did, you’ll find that the number of unique connections for each node (user) = n(n-1) / 2. This is asymptotically proportional to n^2 in the long run.
Here’s a little graphic that explains it (and it links to the source to give credit where it is due).
So, Metcalfe’s Law states that the value (V) of a network is proportional to the square of its nodes, V= n^2.
Now, to be really technical. That’s just the first of Metcalfe’s laws. He had a second one about the adoption rate among users — and for the math nerds, it’s a sigmoid function (of course).
All of this looks like a good way to figure out the value of Bitcoin.
Why, after all, is it still the most valuable coin, despite the fact that its technology is terrible (relative to competitors like Ethereum and Cardano)?
The answer is that it has more active users, hence more nodes, and hence more value.
Way back in 2017, I was the first to propose on SeekingAlpha (a site for finance nerds) that Metcalfe’s first law could be used to find an intrinsic value for cryptocurrencies. I even developed a ratio for doing it.
The actual modeling is more complex (you need to find a scalar constant for the n^2 value by regression analysis), but I still think the idea works in theory.
It just doesn’t work in practice.
Why Metcalfe’s First Law Is Hard In Practice
The problem is that it didn’t take people long to figure out that Bitcoin is a public blockchain. It’s the opposite of private. So, if you actually want to launder some money, or just hide the fact that you are paying for your mistress’ apartment, then Bitcoin is among the worst technologies ever.
–Nefarious aside: use Monero for that–
When this problem was recognized, people invented crypto laundry services called coin tumblers at places like Coin Gape.
It turns out that this doesn’t really work. The NSA can still figure things out if they need to–it just takes higher skills and more effort.
What these tumblers definitively do accomplish is to add lots of unnecessary transactions and fake wallet activity to the blockchain.
As a result, you can’t just go to blockchain.info and see how many unique daily users there are, because that information is skewed unpredictably by how often people are using tumblers.
Now to apply Metcalfe’s law, you might treat the number of unique wallet transactions as “nodes.” But, because of the tumblers, you don’t really know how many nodes there are. So, you can’t use Metcalfe’s law to find Bitcoin’s intrinsic value.
Of course, there are some ways to algorithmically clean up this data, but it is not a trivial problem. For a little while, I used a service that did this for me. But when I added this new data into my own algorithms, it didn’t improve returns much.
(Or, at least, the advantages it did confer fell within the range of statistical noise that made me suspicious and I wasn’t going to bankroll an expensive idea for years on a hunch.)
Maybe the data I was paying for was still not accurate. Maybe it didn’t integrate well with my algorithms. I don’t know. The point is, I found it quite difficult to apply Metcalfe’s law to assess Bitcoin’s value from early 2018 forward.
I did find a better solution though.
The Macro and Momentum Approach
The better solution was to combine an analysis of macro-conditions with an industry-wide level momentum analysis.
The process is simple:
- Check the macroeconomic conditions (Lesson 9 of The Art of The Bubble).
- Check the industry health (Lesson 7 of The Absolute Beginner’s Guide).
- Buy and sell individual coins (what we talk about on Discord).
Basically, as long as the macro-conditions are good, you can just buy and sell following simple moving averages. I explain exactly how to do this with Lesson 7.
To illustrate, the 200-day simple moving average has ample empirical support for picking out winners in stocks. It’s the black line in the image below.
If you bought when Bitcoin’s price crossed above it and then sold when it dropped below it in 2016-2018, you would have earned 26x on your investment.
I used a modified form of this to earn 17.7x on Ethereum in about 13 months this bull run (as opposed to the 25 months of Bitcoin’s previous bull run).
So, that’s the lesson. Bitcoin has an intrinsic value even though it’s not an asset. The problem is that you can’t practically figure out that value in a way that could inform your trades.
Despite all that, you should ignore the Wall Street establishment and just use a different strategy for investing. The one that I’ve found which works is to combine a macro-economic analysis with momentum.
That’s why paid subscribers get access to both signals.
Now, momentum analysis is part of technical analysis, and I need to disambiguate the two. So, that’s why Lesson 6 of this series covers that problem, while lesson 7 (as noted) explains in detail what to do with momentum trading.
That’s it for this week and I hope to see you on Discord! Happy Trading!
General financial disclaimer: This post is provided for entertainment purposes only. I am not giving you financial advice and I am not a financial advisor. You should expect no financial returns one way or another based on my statements. These points hold equally for any statements that could be attributed to The Art of The Bubble or any related business entities. If you decide to buy or invest in anything, then your returns and potential losses are your own. No statements about taxation are taxable advice and you are encouraged to consult your own tax professional. You are also encouraged to do your own due diligence before investing in anything.