Bitcoin's Pandemic

Bitcoin and other cryptos may be on the verge of a much larger drop. Legitimate activity in the crypto space continues unabated, much of it rebranded as Web3. As Chris Dixon from A16Z has pointed out, price action is volatile, but the long-term innovation cycle remains. This next wave of disruptive downward price action will force out the weak hands and many speculators, clearing the way for another wave of true technological innovation in the crypto space.

Disruptive Price Action Signals

1. Presence of Critical Slowing Down - an early warning signal for a major disruption in complex systems - financial markets are complex systems
2. Macro environment is murky - What happens when choppy markets meets Internet disruption? Inflation is here and the Fed is going to raise rates. Bitcoin is considered digital gold and thus an inflation hedge. However, gold is actually not a great inflation hedge. Bitcoin may not be either. Beyond markets, the probability of conflict has gone up, and government sponsored Internet disruptions could be the next black swan event.
3. Price trend action in Bitcoin and some of the most correlated companies in the space such as Coinbase and MicroStrategy is downright negative. No reason to suggest any change there

Presence of Critical Slowing Down

The Bitcoin market is flashing an early warning signal of a much larger drop. In complex systems, the presence of critical slowing down is often an early warning signal. CSD is when a system or market takes a a long time to recover from a slight disruption. CSD is typically measured by rising correlation and increased variance. In my research, increased variance is more prevalent in more financial markets disruptions than rising correction.

To identify CSD, researchers have found that an increase in the lag-1 autocorrelation (AR(1) increases as the system approaches a critical state. AR(1) can be estimated using the following autoregression model:

Rising variance is also indicative of CSD.

Leveraging the open source ewstools Python library, I calculated core Early Warnings Signals (including some that are not covered in this post) for BTC:USD over the last five years through 1/14/2022. I used daily price data for this analysis which I adjusted to achieve mean-stationarity of the data.

The analysis shows rising variance although not rising autocorrelation in BTC:USD. Taken in isolation, this would not be sufficient to predict a transition. However, in conjunction with the convergence of macroeconomic cycles and shifts in price momentum, it becomes a more relevant data point. The full code for this analysis can be found here.

Murky Macro Environment

Interest Rates

2022 begins with the shadow of higher interest rates. The Federal Reserve has all but signaled multiple rate increases with inflation at recent highs. Bitcoin is considered digital gold and thus an inflation hedge. However, gold is actually not a great inflation hedge.

Gold as an inflation hedge? History suggests otherwise

Gold is often touted as a way for investors to protect against rising inflation. But the asset class has a mixed track record during past inflationary periods.

CNBCGreg Iacurci

Bitcoin may not be either.

Conflict + Internet Disruption

Nassim Taleb, now a Bitcoin bear argues:

"It is also uncertain what could happen should the internet experience a general, or an even a regional, outage — particularly if it takes place during a financial collapse." Source

While outside the scope of this post, the risks of armed conflict have risen. Government sponsored Internet disruptions could be the next black swan event. Combine that risk with rising interest rates and you have a recipe for a price crash.

Negative Price Action

I’ve written previously about how price has memory and markets tend to gravitate back to important price levels from where major moves occur. At these levels, buyers, sellers, or nonparticipants relive the pleasure, pain, or regret they experienced, driving a new round of price action. I also believe that this implicit human bias is built into many of the algorithms that now drive investment decisions, given their reliance on historical data.

Bitcoin seems to have strong price memory at certain key levels that will serve as strong attractors for the market. A sustained break below $40,000 would increase the odds of a quick drop to $30,000 where significant price memory exists.

Stock prices of some of the most correlated public companies in the space are at crash levels relative to All Time Highs, all achieved in 2021.

MicroStrategy holds ~125k Bitcoins, per public sources. At current prices, that is ~$5Bn, or about 100% of the market cap of the company. It has over $2bn of debt and ~$50M of cash on hand. MicroStrategy has been able to raise capital, but will that continue if Bitcoin prices plummet? A vicious cycle of forced selling and falling prices could follow.

Any opinions or forecasts contained herein reflect the personal and subjective judgments and assumptions of the author only. There can be no assurance that developments will transpire as forecasted and actual results will be different. The accuracy of data is not guaranteed but represents the author’s best judgment and can be derived from a variety of sources. The information is subject to change at any time without notice.