Market Outlook Fundamentals vs Price
Analyzing and investing in the Crypto market offers its own unique set of challenges very different from that of traditional markets. Bitcoin’s price has fallen from a high of $20,089.00 on 12/17/17 to its current price of $3,297.18 as of December 7th, 2018, a decline of 82% from the all-time high. This extreme volatility and price movements are often seen as fundamentally irrational, but I don’t think that is the case. In an attempt to develop my 2019 market thesis, this blog post is the first part of a deep dive into the current fundamentals for Bitcoin, Ethereum, and developments in the greater crypto asset market sector. This is designed to act as an introduction to key on-chain fundamentals where in the next post, I will be using them for key metrics such as the NVT ratio. The next post will also look at correlations, risks, and narratives, that I am watching to signal the end of this crypto drawdown.
Note: The analysis and the majority of this writing was done between Dec. 7th and Dec 16th of 2018. This post was put on hold for finals and the holidays. Any distinct changes in the markets will be discussed in Part Two of this series.
Bitcoin
I started with Bitcoin since it still represents the majority of the crypto market cap. As of 12/27/18, Bitcoin represents 64 billion of the 120 billion market cap, or 52.9%.
Active Addresses
As we can see from the graph, the number of active addresses has fallen significantly since around BTC’s all-time high.
As we can see from the graph, the number of active addresses has fallen significantly since around BTC’s all-time high. It is important to note that active addresses do not have a significant impact on the price. Doing some regression analysis with price and active addresses, I found a coefficient of 0.009 and an R-squared of 0.51. This shows that active addresses are not a driving factor behind prices in BTC. It is important to note that the graph above is in daily form while I used averaged monthly data when running the regression. Higher time frame data is better to work with when running regressions because if price lags behind active addresses, changes in price are more likely to respond in changes in active addresses are more likely to show up in the same time period. We have also seen a slight decoupling in price and active addresses. Since March of 2018 active addresses on the Bitcoin network has grown by an annualized rate of 243%. In that same time frame prices have continued to slump. Overall even though active addresses are down 54% since its high in December, the current growth trend since April is a good sign.
Transaction volume has fallen significantly since its December 2017 high, falling 68.98% YTD. This doesn’t tell the whole story in the last month TX volume has fallen 12.30%, in the last 3 months, 15.67% in the last 6 months, 33.17%. This shows that BTC transaction volume fell significantly right at the beginning of the crypto recession, and though still falling has been leveling out significantly over the past 3 months. Looking at the velocity of BTC in pairing with the TX volume of BTC we get an interesting picture. Velocity being the measurement of a single bitcoin changes hands in a year. As seen in the chart below, Bitcoin velocity has hit its lowest point since late 2014 (The mid to end of the 2014 decline). This could indicate that transactions per day and velocity have fallen because those willing to sell have already sold, and those still holding are not willing to sell. However, even though I don’t give this thesis too much weight, it is still a metric worth watching.
Hash Rate
If you haven’t been following the Bitcoin Hash Rate bubble the best place to start is this article written by Christopher Bendiksen, you can find it here
The Bitcoin Hash Rate is the measurement unit of the processing power of the Bitcoin network. In other words, it is a good measurement for the amount of time, energy, and electricity that miners put in to secure the network. As we can see in the graph above, Hash Rate on the Bitcoin network has entered its recession. This indicates that miners are no longer turning a profit with bitcoin’s price down 82%. We have not seen any delayed block times in the network and the difficulty on the network has also peaked and begun falling. This indicates that the cost to mine will likely begin to fall ultimately driving mining to be profitable again. These self-correcting aspects of the bitcoin system are extremely impressive. The issue with the difficulty adjustment is that it happens slowly. It adjusts every two weeks(2016 blocks) and is only allowed to fall 25% of its previous difficulty. Because of this, it is inherently a lagging indicator, It took almost 10 months after the price high of 2017 for the difficulty to also peak. However, it did just saw its second largest drop in history, with a -15% adjustment on Dec. 3. I suspect an equilibrium between hashrate and difficulty will likely be a good signal for the bottom. At the very least I am looking for these to find their feet and begin to rise again before I make any further investments.
Bitcoin Narratives
Currently when writing this (12/19/18) Bitcoin is 500 days from its next halving. Historically the price of Bitcoin has done pretty well leading up to and immediately after the previous halvings. The one in 2020 is special though. In the US, the Federal Reserve has a target inflation rate of 2%. After the 2020 block halving, Bitcoin inflation rate will fall below that mark making the digital currency a legitimate hedge against inflation. I am interested to see when the market is going to price this in, or if it has if you believe Efficient Market Theory.
I am also looking at further development of the Bitcoin Lightning Network. Summarized, the lighting network is a layer two peer-to-peer payments channel. The Lightning Network is seen as the scaling solution in replacement to larger block size. As more nodes come online in the lightning network we have seen a continued drop in fees. This drop in fees is a good thing if Bitcoin is to ever operate as global decentralized money.
Though the goal of this post was to look at fundamentals in relation to price, it is important to mention the price on its own. In Proof-of-Work systems, the security of the network is directly tied to the price of the given crypto asset, so the farther price falls, the cheaper specific attack vectors become. This can be seen with an Ethereum classic 51% attack only costing roughly 10,000 USD per hour. You can read about that here. We often see arguments that rational actors are incentivized not to attack the network through cost and rapid price depreciation that would likely follow, but with Futures markets and shorting crypto assets becoming easier, (Dydx and Expo) these economic incentives become murky. With the current price of $3300 price to attack the Bitcoin network is 582,622 USD per hour. I would argue that is currently not state level resistant, with HNW individuals or corporations easily being able to cover the cost of a 51% attack if they felt like it. This will be a narrative I will continue to watch if prices continue to fall.
Ethereum
Moving over to Ethereum we also the number of unique daily active addresses has fallen sharply since then it peaked in December of 2017. However, like Bitcoin, Active Addresses has fallen significantly less than price has. (65% fall since daily active address high, 93% fall since December price high).
Looking at Tx Volume on the network
Here we see tx volume on the Ethereum network has fallen almost as much as the price has since it’s all-time high (94% decrease in price, 93.63% decrease in tx volume). However, I don’t think Tx Volume shows the whole story. Compared with the GasUsed Chart below, we see a relatively stable chart since the January 2018. From this, we can conclude that even though txs are down, we are seeing much more complex txs in usage and people are using heavier contract functionality over simple sends and receives. I see this as some maturity of the Ethereum network/ecosystem and overwhelmingly a good thing.
The previous point is confirmed with the continued increase in DAPPS on the Ethereum network. The total amount of DAPPS and the rate at which DAPPS are being created has continued to increase over the course of 2018.
However, the top-rated DAPPS on Ethereum according to Dapp Radar still have less than 1000 daily active users. Even though Ethereum’s fundamentals have not fallen as far as its price, it still lacks a top layer consumer-facing DAPP that has truly caught hold.
Ethereum Narratives
Over the past year, we have seen more and more ETH become locked up as collateral in projects such as MakerDAO and Augur. The total percent of ETH locked in Maker CDP’s has reached 1.25% and I expect will keep rising as these protocols become more popular.
Sticking in the theme of ETH supply, Ethereum’s Constantinople fork is coming on block 7080000, around January 16, 2019. It will be limiting the block reward from 3 Ether to 2. This will limit the inflation rate of Ether year over year. My only concern with this is that it might undercut miner’s bottom lines if the price of Eth continues to fall. However, until Ethereum switches over to POS, it operates on a similar Hash Power, Difficulty system as discussed above about Bitcoin, so the likelihood of a death spiral still seems like a fallacy. This will require further research in the future.
Conclusion
From an analyst’s perspective, it is still not yet clear what the best metrics are to measure the health of assets in the crypto space. However, it is clear to see that even though the price has slumped over the past, the scale of the drop doesn’t seem to be warranted when compared to the fundamentals of the crypto asset. Furthermore, 2019 has been a year of building and we have seen the beginnings of use cases outside a speculative asset. Looking at MakerDAO here.
It is not yet clear what will lead to a reversal in the crypto markets however, it is clear that the health, security, and users are still there.
In the next part of Market Outlook Fundamentals vs Price at correlations with traditional markets, risks, narratives, and metrics that I am watching to signal the end of this crypto drawdown. Would love to hear any questions or feedback you may have!
