Messari: Are Bitcoin and Ethereum risky assets in the current market?

After a period of skepticism, cryptocurrencies have steadily made their way into the big leagues of global finance. Bitcoin, Ethereum, and other major cryptocurrencies have seen their fair share of market volatility, with financial professionals directly pegging them to major asset classes and indices. While crypto industry participants have viewed the asset class as mainstream since the release of the Bitcoin whitepaper in 2008, it took a while for the financial community to make the switch. We now see Bitcoin and Ethereum appear on daily price charts alongside all other major assets, and are even among the few projects mentioned during major market moves.

(This didn't exist a few years ago.)

Of course, there are good reasons why these assets are discussed every day, and not just because of their price movements. It is no secret that cryptocurrency provides millions of people with open, fair, and decentralized access to a new world of financial opportunities and innovation. Not to mention its groundbreaking use cases in decentralized finance, web3, and more.

However, the rising prices have attracted those who were not originally interested in the ethos of the industry or the use cases of the new technology. In terms of pure returns, BTC and ETH have been a once-in-a-generation investment opportunity with returns averaging over 80,000% since their launch. Even stripping out the huge volatility, these assets are some of the best performing investments in history. Using the Sortino Ratio, which allows investors to view positive volatility as a benefit to their investment (unlike the Sharpe Ratio, where both positive and negative volatility imply a negative impact on the asset), BTC and ETH have both measured above 2.0, and even exceeded 3.0 for a while. These are very good numbers for any asset and should be included in any portfolio. Of course, the size of the asset allocation is up for debate based on how much volatility the investor can tolerate, but at this level of returns, it would be unwise not to have some asset allocation.

Due to crypto’s impressive profile and growing track record, many in the financial community have begun to view it as an entirely new asset class alongside stocks and bonds. This view is often devoid of any nuance, with allocators referring to crypto as a whole. This is because most traditional investors have yet to even comprehend the fundamental differences between Bitcoin and Ethereum. Over time, this view will likely gain proper nuance, but at this juncture, it is indistinguishable even to most institutional allocators.

Investors in the traditional financial world like to categorize investments on a risk and return spectrum. This helps them make portfolio decisions when deciding how to allocate their assets. Starting from the framework of a 60/40 portfolio (60% stocks, 40% bonds), if an investor wants a higher or lower expected return, they can decide to add or subtract risky assets from this baseline, but understand that higher returns come with greater expected volatility. The image below is an example of how a traditional risk-return range might be presented if an investor were to speak with an advisor today.

BTC, ETH, and other popular cryptocurrencies are firmly placed high on this risk spectrum due to their historical volatility. Most advisors consider them so risky that they don't even include them in the spectrum at all. This type of asset allocation will assume that the asset has cash flows far, far into the future (if at all) and is more volatile than any other asset class. In this regard, most traditional financial advisors still consider cryptocurrencies to be zero-cash flow assets that are purely for speculation.

“On one side, we have all of the things I call bubble assets: technology, innovation, disruption, and cryptocurrencies. On the other side of that seesaw, you have everything else in the world.” — Richard Bernstein, former chief investment strategist at Merrill Lynch.

In terms of cash flow, we know this is not the case for much of the investable crypto market. The Ethereum network alone captured over $10 billion in cash flow in 2021, making it comparable in size to large multinational corporations. This does not include the growth rates of tech startups. Revenues grew over 500% year-over-year in Q3 2021. Not shown in the chart below, but Q4 2021 grew over 1,000% year-over-year, with revenues growing from $230 million to $4.3 billion.

After the protocol transitions to Proof of Stake (PoS), the distribution of these cash flows will change, but the protocol-level revenue will not change. Once transitioned to PoS, the distribution of the fund pool will also be more evenly distributed among network participants. In addition, the Ethereum fee burn per block acts as a buyback for existing holders. Ethereum still has the image of a fast-growing technology company that maintains cash flow. Such an asset should generally have at least a small portion (0-5%) in the portfolio.

About relevance

Investors also consider correlations between assets in their portfolios. They want to group negatively correlated assets together so that one part of the portfolio is moving up while another is moving down. This can provide investors with a smoother overall return pattern. In this case, it is currently assumed that cryptocurrencies are once again highly correlated with the riskiest asset classes. In the eyes of allocators, this would minimize the additional diversification benefits of holding these assets. While Bitcoin and Ethereum do have volatility, they do not actually track the riskiest parts of the market as closely as most people think.

Using the Russell 2000 Growth Index as a proxy for small-cap stocks with little or no earnings (⅓ of the index typically has negative earnings in any given period), BTC has averaged about a 35% correlation over the past four years, while ETH has averaged about a 30% correlation over the same period. This correlation has also been heavily negative on several occasions, primarily during periods of strong equity markets. During risk-off events, strong positive correlations can be seen. Notably, Ethereum has recently been showing a lower correlation with low/no revenue tech stocks. This is an interesting development in the overall market, likely due to the increasing and more stable cash flows generated by the Ethereum protocol.

This relationship still holds true if we compare BTC and ETH to the major market indices of the S&P 500 and Nasdaq (which is dominated by tech stocks). ETH has recently behaved more like a stock than BTC and has a higher correlation with these two major indices than BTC. Overall, BTC has an average correlation of about 40% with both indices, while ETH has an average correlation of 45%.

The top four stocks in both the S&P 500 and Nasdaq are virtually the same: Apple, Microsoft, Amazon, and Alphabet. So while ETH behaves like a cash flow tech stock, BTC is actually closer to large-cap value stocks. Below is BTC's correlation with the Russell 1000 Value Index. It has averaged a positive correlation of more than 60% over most tracking periods. The top performers in the Russell 1000 Value Index are Berkshire Hathaway, J&J, JPMorgan Chase, United Healthcare, Procter & Gamble (P&G), Bank of America, and Exxon.

While BTC and ETH have a more volatile relationship, it is interesting that they have similar correlations with high-yield bonds. BTC and ETH have a correlation of about 25% with the U.S. High Yield Bond Index. During multiple periods, the correlation reached 80%. During the risk-off period, the 30-day correlation with high-yield bonds reached almost 100%.

The periods of extreme negative correlation (late 2017 to 2018 and late 2021) occurred in rising yield environments, which could explain the departure from the positive correlation seen in other cases. Bitcoin’s movement appears to be more in line with that of high yield bonds. For a period in early 2019, Bitcoin’s correlation was above 60%. This makes intuitive sense, the asset is moving along the risk spectrum towards a more stable asset shape while still maintaining a risk-on bias. For this lower risk profile, investors would expect lower returns than equity-like assets, and ETH appears to be becoming that.

Therefore, both BTC and ETH should probably be a bit lower on the risk-reward spectrum than what is currently seen. BTC might be viewed as a value stock as it matures as an asset class and even as a high yield bond in periods without rising interest rates. ETH's recent performance makes it more comparable to large-cap tech stocks. These relationships are newly developed and may not have held true in previous phases. Nonetheless, let's continue the analysis and look at how these assets have performed in previous cycles versus other major asset classes to see if we can glean additional insights.

Interest rate changes

Because our sample size is short, we only have a few periods of cuts and adds to look at. To strengthen the analysis, we include periods when the 10-year yield moved significantly (such as early 2022).

It’s not surprising that most risk assets perform well during periods of falling yields. BTC rallied sharply after its first major halving, with a peak around December 2013, and compared to the post-halving decline, the 70% sharp drop is unlikely to be related to the interest rate environment at the time.

Both BTC and ETH have consistently performed well, outperforming other risk assets, during the only rate hike cycle of the past 10 years. The results for both assets were mixed during the two important periods of rising interest rates. Between 2012 and 2014, real yields (Treasury yields that are indexed to inflation) remained in a range. Treasury yields, as a risk-free return, when inflation is taken into account, result in a real minimum return on any investment. When interest rates are low or negative, the hurdle is not high, resulting in less incentive for people to keep cash in banks or short-term securities. Risk assets are very sensitive to real interest rates. Real yields have been negative for quite some time. As inflation rises during the 2021-2022 period, real yields soared, and BTC and ETH sold off with it.

If we are entering a period of rising interest rates and higher real yields, risk assets should be affected based on historical data. During the sell-off, BTC and ETH appear to remain firmly in that category. Rate hike cycles typically lead to a downturn in the broader market, as can be observed in the chart below from Bank of America.

Source: Bank of America

Changing the inflation regime

We saw above that inflation does have an impact on the price of an asset through real yields. Bitcoin and Ethereum have always lived in a world with inflation rates below 3%. They only exist in a stable inflation environment (that is, until mid-2021). Take a look at the graph below for the Consumer Price Index (CPI).

Source: Federal Reserve Bank of St. Louis

Cryptocurrencies have had mixed performance during this brief inflationary period. ETH has decoupled from BTC, but also from all other major asset classes.

This can largely be attributed to strong network demand throughout 2021, with renewed interest in DeFi and NFTs emerging. Leading DeFi exchange Uniswap spent the most fees on Ethereum until it was surpassed by NFT exchange Opensea in September 2021. Opensea now regularly generates twice as much daily fee volume as Uniswap, the second-largest fee spender.

Do we have reason to think the current inflationary environment will persist? The causes of this inflation still seem to be due to conditions that will pass or (cue the Fed joke) be transitional. Supply chains are a pressing issue, but imports at the largest U.S. ports show that backlogs are nearly 50% less congested than at the peak. Wage pressures are the main driver of future inflation, which can come through government checks or higher wages. We have experienced both of these throughout 2021.

In the 1970s, a persistent feedback loop of increasing consumer costs and therefore labor demand for higher wages (a "wage-price spiral") was a major factor in the last great inflationary period in the United States. Rising wages are a legitimate inflationary concern. Now that stimulus checks have been written, wages can only go up to a certain point before it becomes unprofitable for employers to continue operating their businesses. Most of the recent wage growth has come from service and hourly jobs. There is a natural ceiling on how much a person can make in these types of businesses. At the time, unions had tremendous bargaining power and could continue to demand higher wages. Currently, union membership is at an all-time low. In general, workers do not have the bargaining power to demand higher wages, and industries where wages have been rising may have hit a natural ceiling. Oil prices also quadrupled in the early 1970s, which had a huge impact on inflation. Even the most bullish oil analysts don't think oil prices will reach $400 a barrel.

Looking at the actual mechanisms that make up reported inflation, (see CPI breakdown below) housing makes up over 40% of the index. With home prices up nearly 20% year over year, the average home now costs over $400,000, which is pretty shocking. With the median annual wage in the U.S. at around $35,000, this gap is the highest it has ever been. Overall, housing data should ease after the spring home buying season. Mortgage applications in January, a strong leading indicator of future purchases, have fallen 12.5%. The latest data suggests that home price increases may have peaked and are turning over. Rising interest rates will only further squeeze demand for new home prices. Adjustments for housing in the CPI do have a lag of several months, so we shouldn’t expect an immediate drop in the CPI, but by the end of 2022, we should be back to a more reasonable headline CPI number.

One final note, 16% of the CPI is transportation (airfare, used cars, etc.), which is propped up by historically high used car sales numbers (10% per month for months in a row!). Used cars alone add 1% to the current CPI number. This too shall pass. Or used cars will hit $100,000 and people will not be able to afford them (driving prices down). Whichever happens first. But really, much of this growth is due to chip shortages in new cars (expected to ease soon), forcing people to consider older cars, and demand from new job cohorts (most of whom have probably already bought their cars). We will see demand start to fade in early 2022. The Fed also expects 7 or more rate hikes through the rest of 2022, which should keep any remaining inflationary impulses in check.

Therefore, it is reasonable to believe that inflation will fall to a more normal level of around 3-4% over the next 12-18 months. Helping the mechanical changes mentioned above are a wider range of technological advances that have reduced costs and made the economy more efficient. Specific impacts include reduced wage pressures, lower input costs due to the rise of globalization, and reduced consumption due to an aging population. This is further demonstrated by the Pantheon Macro Q3 2021 macro analysis chart.

Source: Pantheon Macro

But if we do move to a lower inflation regime after this brief period of high inflation, we will be entering uncharted territory for cryptocurrencies. Cryptocurrencies have never experienced a backdrop of rapidly declining inflation. Looking at inflation expectations does give us some clues, though.

While BTC and ETH have not been highly correlated with inflationary pressures in the past, both tokens have popped up on the release of strong CPI data in the past few months. This suggests that at least algorithmic traders are pricing in a positive correlation now and trying to trade it. Setting aside this developing relationship, ETH and BTC are well correlated with future inflation expectations. Below is a comparison of Bitcoin and Ethereum with the next 5 years, the 5-year forward rate is a commonly used measure of the implied inflation rate 10 years out. We can track this indicator for signs of price action as we enter the next inflation regime.

Bull and Bear Markets

Bull Market

Both Bitcoin and Ethereum started out in historic market bull runs. Since Bitcoin launched in 2009, the overall market direction has been “digital up.” Here’s how BTC and ETH have performed versus the broader market since BTC’s first bull run in 2012, and the subsequent COVID bull run that began in early 2020.

The returns across the board have been amazing. Even though these assets are mature, they still have amazing returns in the bull market of 2020-2022.

So, what about a falling market?

Selling off

Below is a chart of all stock market corrections of 10% or more since Bitcoin’s inception (as defined by the S&P 500). It’s a surprisingly short list.

As we can see from our previous analysis, correlations may be changing, but in previous market sell-offs, BTC and ETH looked very much like the Russell 2000 Growth Index. Therefore, we can hypothesize what normalizes these assets and makes them appear less risky, as outlined above? Continued development and experimentation. Builders continued to build throughout the recession, and users continued to grow. Bitcoin is the more mature network and has dropped significantly less in the recent recession, likely due to this dynamic.

Developers

As you can see in the chart below (arrows mark the recession period), there was no substantial drop in developer activity throughout the recession, and we actually saw spikes in developer activity around big market sell-offs, such as in December 2018 and March 2020.

Event Address

Bitcoin’s active addresses fell in early 2018, but otherwise it’s skyrocketed in terms of unique addresses holding the native unit. The stock market sell-off was bad. Ethereum is a more impressive case. Aside from a lull in address growth in the summer of 2021, it’s never experienced any real period of address contraction.

The nature of future sell-offs will follow a path paved during previous downturns. While both Ethereum and Bitcoin have experienced market downturns, developer and user activity has remained quite strong.

Conclusion and Key Points

BTC and ETH are behaving less and less like risk assets in normal times, with BTC in particular exhibiting price patterns similar to value stocks in environments of stable or declining yields. Nonetheless, when sell-offs occur, cryptocurrencies move in line with the riskiest parts of the market. During these downturns, builders continue to build and network activity remains strong. As the market develops, this could increase use cases and overall cash flow, leading to shorter downturns, even in broader macro bear markets.

As we get more time series data and the asset class matures, we will likely have to further refine our thinking about the role of BTC, ETH, and other cryptocurrencies in portfolios. If these trends continue, the role each asset plays in a traditional portfolio may become easier for investors to understand, driving more mainstream adoption.

Given the shorter price history of other crypto assets, this analysis is limited to ETH and BTC, but we will soon have more data to understand how different protocols perform in a range of market environments. Currently, the two largest cryptocurrencies remain closely correlated (see chart above), although from our above analysis, we see that this may be changing as Ethereum and those operating on its network begin to look more like cash flow generating companies than currencies.