Traditional definitions of bull and bear markets do not hold for the high volatility crypto space. A 20% decline from market peak is the widely ascribed to bear market definition. However, 20% is an arbitrary number. Bitcoin (BTC-USD) has suffered three 20%+ drawdowns in the last seven months as shown below and six in the run-up to the 2018 cycle high.
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(source: author; nftgamef.com)
Is the current correction natural volatility, or a harbinger of further downside? This article shows evidence of a near-term bottoming in price for Bitcoin and continuation to the upside in Q1 2022. I also propose both a bearish counterargument and bullish narrative to explain potential future outcomes.
Signs of a Bottom?
Bitcoin’s price generally moves in line with the hash rate as shown below. The hash rate is the amount of hashing power in the form of miners competing in the network. In terms of causation, I believe that price affects hashing power, not vice versa. The number of miners increases or decreases based on profitability. Higher Bitcoin price leads to higher margins. Lower Bitcoin price leads to lower margins, and many miners being forced out of the network due to a lack of profitability.
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Difficulty adjustments in SHA-256 prevent too many miners from going offline at once. An adjustment lower requires less hashing power to successfully mine Bitcoin. Aside from a speed bump in June from Chinese miners’ mass exodus, the hash rate continues up and to the right in logarithmic terms, pointing to a healthy network in spite of choppy price action. In fact, it is near breaching all-time highs as shown below.
The second chart below shows the Bitcoin balance on exchanges. Exchange balances shrink during periods of accumulation as long-term investors take Bitcoin off exchanges and into cold storage. This decreases Bitcoin’s available circulating supply and is short-term bullish for price action. Exchange balances increasing means long-term investors are getting ready to sell their Bitcoin, and supply being dumped back on the market has been historically bearish. Exchange reserves have plummeted to 3 year lows, indicating a massive reduction in circulating supply as high conviction investors pull Bitcoin offline. The figure below shows recent plummeting exchange reserves.
The final metric is the Crypto Fear and Greed Index from Coinglass, which reached 15.78 in early December. Currently at 21, the last time it reached levels this low was in the May correction. A fear and greed index below 20 is historically a great time to buy in any asset. As the Buffett adage goes, “be greedy when others are fearful.” When this metric dips below 20, one of two things can occur: 1) a quick spike higher such as that of the September run to the all-time high; 2) consolidation at low prices before an eventual price increase. Price remained subdued for one month in the March 2020 correction and two months in the May 2021 correction before explosive moves. I believe investors should be prepared for price to go nowhere through end of year. Medium term price action depends on the narratives below.
A Bearish Narrative
Real Disposable Income is barely above pre-pandemic levels due to the on-again, off-again shutdowns, fiscal stimulus roll off, and most importantly, high inflation eating away at the average salary. More money spent on gas and groceries is less money spent on risk assets. One theory is that a large swathe of retail investors is not participating in markets at all due to these pressures encapsulated in consumer Real Disposable Income.
Additionally, institutional adoption is morphing the crypto space into a macro asset that moves according to metrics of risk-on and risk-off. In essence, the structure of the market has changed due to institutional portfolio rebalancing and a futures ETF giving a larger pool of investors the ability to short the asset. There is no denying that Bitcoin is trading like a hyper-volatile S&P 500 (NYSEARCA:SPY) at the moment. Time will tell how long this correlation lasts. Despite current trends, adoption rates are what matters in the long-term; and adoption rates across crypto assets continue unimpeded.
A Bullish Narrative
This cycle witnessed unparalleled institutional adoption. There are currently more than 800 crypto-focused hedge funds and venture capital firms alone. Nearly every financial institution seeks to maximize their profit and loss at year’s end to show positive metrics and attract more investors in the new year. It is likely that most institutions took profits at some point in the cycle and are sitting on a very healthy P&L. As opposed to risking a negative annual P&L, these institutions are waiting for the new year to join the market en masse. Therefore, a counterbalance to the lack of retail participation and general sense of risk-off in markets is the institutional capital of hedge funds and venture capital firms sitting on the sidelines.
Bitcoin bear markets are typified by 1-2 years of sideways price action. Though possible, I believe certain metrics point to a local bottom and lead me to believe that the bull market is not over. A high hash rate, near historic lows in balance on exchanges, and incredibly low sentiment offer evidence of a great buying opportunity.
Additionally, Bitcoin is undoubtedly becoming a macro asset. Stagnant real disposable income may be a factor in the lack of retail participation. Institutional involvement may also have a volatility dampening effect by selling at quarter and year end to maintain P&L benchmarks. However, the start of a new year should also lead to an influx of capital and strong Q1 2022.
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