With Bitcoin correcting from the newly achieved all time highs I thought it may be worthwhile to revisit the investment case for Bitcoin.
If one listens to sceptics or opponents of cryptocurrencies, it is common to hear Bitcoin being called a bubble or a speculative asset. The proponents might use the terms: store of value or “digital gold”. My view of Bitcoin has not changed in about a decade: it is a prospective store of value in the adoption phase.
In this framework, both the sceptics and proponents may be half-right: it is a speculative asset and the speculation is that Bitcoin will become a store of value in the future. The notion that Bitcoin is a store of value right now can obviously be ridiculed: in the last decade it had three bear markets with losses as deep as 82%, 83% and 76%. However, Bitcoin’s volatility has been falling recently (finally!), so the hypothesis of it becoming a store of value is gaining strength.
To better understand the investment case for Bitcoin (and Ethereum), let’s look at their expected returns. I’m looking at the “terminal” expected returns – after the end of the adoption phase.
The returns can be divided into two parts: the income component and the growth component. If bought when issued, bonds will deliver their return wholly through income, while stocks investors will get their return from a combination of growth and income (dividends). Gold is an example of a financial instrument that gets its return solely from growth, as it does not generate any income – unless lent out, but it is relatively uncommon practice for most investors.
One of the ways to look at the capacity for growth of any given asset class is to compare it to the GDP growth. Back in 2001 Warren Buffett called the ratio of stocks market capitalisation to GDP “(…) probably the best single measure of where valuations stand at any given moment.” The ratio of government debt to GDP is a frequently used metric to judge the indebtedness of any given country. There’s a corollary to that: over the (very) long term the “growth” portion of an asset class return cannot increase much faster than the GDP. If it did, it could become so large that the holders would have a very strong incentive to sell a small portion of their holdings and purchase goods or services the GDP consists of.
It is also important to look at the supply of “units” of an asset class. Gold mining adds about 3.1 thousand tonnes to the total of 210+ thousand tonnes ever mined, or about 1.5% annually. Supply of stocks is a bit more difficult to estimate. While historically the net effect if issuance and buybacks has been a few tenths of a percent annually, more recently stock buybacks tend to dominate and can amount to as much as 2% of total supply per year. Current supply of bitcoins increases by 1.7% annually and with the coming April halving the pace will drop to 0.85%. Of course, the terminal supply will stay fixed at 21 million coins for an annual change of 0%. Ethereum, with the switch from PoW to PoS, begun to burn small amounts of tokens that add up to about 0.3% decrease in supply annually.
Let’s try to put the historical and expected returns for the aforementioned asset classes together:
Some comments and observations:
– based on expected returns alone, gold is an inferior store of value to Bitcoin and Ethereum due to increase in its supply through gold mining.
– note the difference between the growth of US GDP (2.5%) and global GDP growth (3.5%). Gold, Bitcoin and Ethereum are global asset classes and they should grow at the pace of global economy. Substantial portion of global population has been catching up in the past decade or two (notably China and India). This is likely to continue for the next couple of decades.
– strong increase in the valuation of gold since 1971 results from the fact that the value of gold was fixed between 1933 and 1971. It could not reflect the inflation and global GDP growth in these years and this effect has been unwound in the great bull market of the 1970s.
– returns for staked Ethereum can rival or exceed the return from US Stocks. The question remains whether current level of staking fees is sustainable in the long term.
This post was mostly about expected returns. However, when it comes to any asset class being the store of value, arguably the volatility and drawdowns are even more important. That’s a topic for a future post.
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