Cryptocurrency’s Next Massive Catalyst? An Imminent Stock Market Correction & The Search For Yield
What do 0% interest rates and Bitcoin have in common? Both spawned out of the 2008 Financial Crisis. Both having seemingly proven to stand the test of time to date, but we have yet to see their long term implications. Some say Bitcoin and crytpocurrencies are the future, others say it’s a bubble. Some say the stock market is overvalued and due for a correction, others believe the market is poised for further growth. While we don’t know what the future holds for either, it is safe to say something is going on…something big…
Call me crazy, but I believe a stock market correction in the imminent future is very real. I also believe that such correction could lead to massive inflows of institutional dollars into the cryptocurrency market. Why? Well, depending on how you slice it one could argue the S&P500 is overvalued. Overvalued and inflated by prolonged periods of artificial earnings growth through corporate buybacks; buybacks which have been funded by cheap debt as a result of a zero interest rate policy (ZIRP) by the U.S. Federal Reserve. On the other hand, we’ve seen an entirely new SPECULATIVE market emerge in 2017 with lots of new capital being put to work.The possibility of this new technology changing the way we transact, store value, and conduct business is very real…yet very nascent. Some are realizing this sooner than others, heads are starting to turn…
Cheap Debt and Expensive Equity
The U.S. Federal Reserve has two jobs: maintain a healthy level of inflation and keep the labor market afloat. The Fed achieves this through its interest rate policy. From 2008 to 2015 the Federal Reserve set interest rates to 0%, an unprecedented level. When interest rates are low people will yield lower interest on savings, but borrowing money becomes cheaper and easier (such is also true for businesses). A more attractive lending environment means an economy’s money supply will tick up and more spending will take place, thus fostering economic growth. But what goes up must come down. It can be said that 7 years of cheap debt has led to dangerous levels of corporate leverage and this has purported artificial earnings growth.
When a business buys back its stock, the company is signaling to the market that their stock is cheap. This ultimately leads to greater returns to share holders (assuming earnings growth remains flat at the very least) because there are fewer outstanding shares to divvy up shareholder’s returns. This directly impacts the price-to-earnings ratio (a popular metric used by Wall St. to determine if a stock is over/undervalued) of a stock. It causes the ratio to look optically lower and a more attractive investment. Sometimes buybacks are funded by cash on hand, sometimes debt. But, there comes a point when amassing debt in exchange for share buybacks, as opposed to funding capital expenditures & working capital, becomes toxic. A shocking +40% of the EPS growth and +30% of the stock market gains since 2009 are estimated to be from share buybacks. Since 2009 companies have spent a record $3.8 trillion on share buy backs financed by historic levels of debt issuance[1]. While the S&P500 may look cheap on a P/E basis, if you factor in share buybacks and screen on other metrics (EV/EBITDA, P/B, P/S) the S&P500 looks expensive.
Furthermore, the correlation between the S&P500 Index and the S&P500 Buyback Index has begun to converge since 2008. This moreover raises the question of, “What effect has the abundance of share buybacks had on the market?” Note: S&P500 Buyback Index measures the performance of the top 100 stocks with the highest buyback ratio (cash paid for common share buyback in the last four calendar quarters divided by the total market capitalization of common shares) in the S&P500.
To support the buyback of shares companies since 2009 have spent a record $3.8 trillion through historic levels of debt issuance[2]. Between 2018 and 2020 high yield issuers (businesses with junk credit rating, higher yield = higher risk) will have to rollover $300B in expiring debt[3]. If the market finds itself in a state of rising inflation, along with the Fed raising interest rates, new debt issuance and debt refinancing will be at a higher rate and could be catastrophic.
When The Institutions Come Crawling…
Let’s say I’m an investor or asset manager. I’ve got cash and need to put it to work, presumably in liquid assets. That leaves me to invest in either stocks, expensive, or bonds, also expensive. Remember, the Fed is coming off of 7 years of a ZIRP that we’ve never seen before. Because the relationship between a bond’s price and it’s yield is inverse, rising interest rates means falling bond prices & a great way to lose money. Dang it, I’m starting to run out of investment options...
Let’s once more put this whole interest rate thing into context: currently long term government bond yields are now the lowest levels in the history of human civilization as far back as 1285[4]. On a global basis roughly $9 trillion of global government debt still trades at negative rates (holders receive less than the face value of bond if held to maturity) [5]. Negative-yielding debt has grown by around $900 billion over the past few months alone [6]. Lastly, while the U.S. has slowly come off of an 0% interest rate base, rates in the euro zone and Japan currently sit at 0% or below in hopes of an economic resurrection.
Alternatively, you’ve got the Bitcoin and cryptocurrency market. Both have become buzzwords in 2017 both have offered absolutely mouth watering returns YTD, ~850% and ~520% respectively. Bitcoin’s and other cryptocurrencies share unique properties that make for an attractive store of value and are built ontop of a revolutionary technology; blockchain. Bitcoin is not fiat or government issued, it has a fixed supply, is non-inflationary, and is incapable of being counterfeited or confiscated. On top of that, they’re utilitious respective to the platform they’re built on and can be exchanged for fiat currencies instantaneously & nearly fee free. If that doesn’t get you excited, well…I guess you’re not like me.
While the debate for where this all goes is for another time, the fact is governments & institutions can no longer ignore what is going on. Money is flowing in and it seems as though the best has yet to come. Here’s a few milestones that have taken place in one year’s time:
- November, 2016: CME Group launches two bitcoin prices index, a first step toward a bitcoin futures contract.
- April, 2017: The Bank of Japan recognizes Bitcoin as legal tender. On July 1st, Japan removes the 8% excise tax on goods and services bought with Bitcoin to further encourage use. Retail chain stores and airlines start accepting bitcoin.
- May 23rd, 2017: Abigail Johnson, chief executive of Fidelity ($1.9 trillion in Mutual Fund assets under management) tells an audience at the 2017 Consensus conference in New York that Fidelity has begun mining Bitcoin and Ethereum[7].
- July 1st, 2017: Australia’s central bank recognizes bitcoin as legal tender, purchases made with bitcoin are exempt from 10% excise tax.
- July 11th, 2017: Switzerland’s Financial Market Supervisory Authority approves the Swiss private bank for bitcoin asset management for the first time.
- August, 2017: Chicago Board Options Exchange announces it intends to establish a bitcoin futures contract within the coming year.
- September, 2017: J.P. Morgan CEO, Jamie Diamond, publicly condemns Bitcoin as “a fraud” despite the investment bank fulfilling client’s request to purchase Bitcoin.
- October, 2017: Goldman Sachs begins exploring Bitcoin and other cryptocurrency trading operations[8].
- In the last year alone more than 90 cryptocurrency funds have launched (a total of 124) with more than $2.3B under management. A third of the total are using venture-capital style investment strategies[9].
The Tipping Point
Is it possible the stock market keeps afloat and the 8 year bull run marches on? Sure. Is it possible we see inflation tick up, interest rates rise, cheap debt turn expensive, and earnings growth via buybacks come to a screeching halt? Sure. What about cryptocurrencies? Possible the “bubble” pops and billions of dollars of value are destroyed? Of course. Possible the adoption and technical innovation of cryptocurrencies continues alongside inflows of capital investment? Without a doubt.
I can’t predict the future, but I can say a lot of smart money is starting to take notice of cryptocurrencies and blockchain technology (at an accelerated rate, too). It’s also safe to say the pickings are slim in the search for yield at a fair price. I believe that 2018 could make for another interesting year for bitcoin & cryptocurrencies. As acceptance and understanding of bitcoin and cryptos among governments and institutions grows, inflows and innovation into the space will remain strong. At what rate? Well, that all depends on at what rate, if at all, the broader market starts to realize the illusive earnings growth fueled by buyback alchemy. That depends on at what rate FOMO really starts to sinks in among investors. That all depends on at what rate the general public, institutions, and governments start to do their homework and wake up to the power and potential of bitcoin and cryptocurrencies.
Bitcoin and the broader cryptocurrency market have had an incredible run year to date. I believe the risk-reward trade off for both remains asymmetric and we can expect to see institutional dollars flow into the space regardless of whether or not we see a stock market correction. This is crypto after all…except some volatility along the ride…
-Pete
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Sources:
1. “Volatility and the Alchemy of Risk” Artemis Capital
2. Bloomberg
3. Estimated by Bank of America
4. Global Financial Data
6. Fitch Ratings.
7. https://qz.com/990229/one-of-the-worlds-largest-financial-services-firms-is-mining-bitcoins/
8. https://www.wsj.com/articles/goldman-sachs-explores-a-new-world-trading-bitcoin-1506959128
