Topic: [2017-09-21] Bitcoin isn't wild and wacky enough yet to make a good hedge (Read 3813 times)

Let's say the bitcoin bubble has just burst.

From its peak of $4,921 earlier this month, the digital currency is already down 16 percent at $4,076. Over the next two months, imagine it continues to slump to barely more than half its peak valuation. After a brief recovery, the price slides again, until by the start of 2020 it's dropped by another third, to below $2,000. For 20 years it then languishes around that point, never to recover its September 2017 levels in inflation-adjusted terms.

Does that vision of the future show that digital currencies have no place in an investment portfolio, or that they do? The answer is worth pondering, because that's the trajectory gold followed after its peak in January 1980.

Full disclosure: I don't, and wouldn't, invest in either gold or bitcoin. Still, as someone once said, markets can remain irrational longer than you can remain solvent -- and trying to shake other investors out of their unreason is as pointless as fighting the tide. Rather than asking whether digital currencies make sense philosophically, we should be asking whether they stack up as investments.

As Gadfly argued last week, with a conventional market in digital-currency-settled derivatives emerging, the best argument for owning those currencies is the same as the best one for owning gold: Their potential to have negative beta, to rise when stocks fall and vice versa. If a negative correlation to equities can offset periods of underperformance in shares, they can go a long way to improving returns.

Suppose you bought a basket of digital currencies, and held them alongside gold as the negative-beta slice of an investment portfolio, valued at no more than (say) 3 percent of the total. Would that make sense?

If all digital currencies are going to be worth zero in five years, clearly not.

That's the argument made by those who say cryptocurrencies don't have any "fundamental value." Gold is genuinely useful in niche medical and electronic applications, and it's been coveted aesthetically since the dawn of civilization. Central bank bullion holdings are another 31,500 metric tons of proof that the yellow metal is more than just a fad.

What's supporting a floor price for digital currencies, though?

One answer to that question was given by JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon in his anti-bitcoin spray last week:

If you were in Venezuela or Ecuador or North Korea or a bunch of parts like that, or if you were a drug dealer, a murderer, stuff like that, you are better off doing it in bitcoin than U.S. dollars ... So there may be a market for that, but it’d be a limited market.

Not that limited, though. As demonstrated by the popularity of bitcoin in China, people living in countries with closed capital accounts show a great deal of interest in moving funds outside of official exchange controls. About 40 percent of the world's population and 20 percent of its gross domestic product are in such jurisdictions.

Other gray segments of the global economy suggest further sources of demand for anonymous transactions, as Bloomberg View's Aaron Brown argued this week.

More than $12 trillion is stashed in tax havens, according to the Tax Justice Network, an advocacy group. The trade in illicit drugs may be worth $320 billion, or close to 1 percent of global GDP. The 500-euro banknote, which most Europeans have never seen but is popular with criminals, still accounts for more than one-fifth of the value of euro notes in circulation, more than a year after the European Central Bank stopped printing it. Yes, digital currencies can be used to launder the proceeds of crime -- but so can JPMorgan.

Possible value of illicit drugs trade $320 billion
While this may seem unsavory, it cuts against the argument that demand for digital currencies can just go back to where it was in 2007, absent coordinated government crackdowns of the sort we've never seen.

The stronger argument against digital currencies is not that they're going to zero -- it's that they don't make a good hedge at all. Since 2010, gold and Treasury bonds have a negative correlation with the S&P 500; bitcoin, on the other hand, has a positive relationship, multiple regression analysis done by Gadfly shows. In addition, bitcoin moves so radically that you can't even construct a meaningful long-short strategy with your equity portfolio.

If you believe the bluster of bitcoin bugs, they're putting their money in code because they think the fiat-money economy is on the verge of collapse. Their revealed preference, though, is to punt on bitcoin whenever rising stock markets lift their risk appetite, and vice versa.

In principle, the biggest advantage of digital currencies is they have no connection to anything that's happening in the real economy. In reality, the two are intimately connected through that most powerful of conductors, investor sentiment. Only if that changes will virtual money really be able to bite off part of gold's domain.

http://economictimes.indiatimes.com/markets/stocks/news/bitcoin-isnt-wild-and-wacky-enough-yet-to-make-a-good-hedge/articleshow/60783142.cms