Last month, many people were surprised to learn that the FBI had tracked and retrieved a large portion of a bitcoin ransomware payment made by Colonial Pipeline. After all, bitcoin is touted as being ultra-secure and nontraceable. How did they do it? “We followed the math,” said one FBI agent. This should be a warning to those thinking about investing in cryptocurrency, of which there are now hundreds of options. No one’s got your back, and you’ll need a strong stomach for volatility. This month we share some common sense observations about crypto-investing from DFA’s Weston Wellington. First, a review of May market data.
May Market Report
Global markets started May under pressure but then came back to overtake US markets by the end of the month. Overall, global markets as measured by the MSCI All Country World Index increased 1.56%, and without the 0.70% return from the U.S., that number jumped to a healthy 3.13% for the month. The top performing category was International Developed markets with a 3.48% return. Emerging markets returned 2.32%. Foreign REITs gained 2.3% and domestic REITs rallied 1%.
Concerns around inflation clearly tempered US market performance, as investors fretted over whether governments and central banks will be forced to combat rising prices by withdrawing stimulus money. Nevertheless, investors did not react badly to worse-than-expected inflation data recently reported by the Labor Department. The Consumer Price Index surged 5% in May from a year ago. Prices rose 0.6% from April to May, and an index that excludes volatile food and energy costs rose 3.8% from a year earlier, the briskest pace since 1992. But will it last?
The critical question is whether those stronger than expected price pressures are a transient trend tied to reopening or something more persistent. Many analysts continue to expect inflation to be temporary and tied to a resurging economy. The challenge is trying to separate short-term factors from longer-term changes in economic policy. Historically what’s happened says Nobel Laureate Eugene Fama is, when there’s a spike in prices, it persists for a long time, so it’s something you want to be prepared for.
This leads to a duration or interest rate sensitivity issue, Seth Bernstein reminds us in the June 16th edition of the Financial Times. At moderate levels of inflation, bonds would sell off but equities would be more resilient as earnings would rise. But at higher levels of inflation, both equities and bonds would suffer from the prospect of steeper interest rate increases, prompting investors to explicitly reduce their duration risk by shifting more towards shorter-term bonds and by laying more emphasis on value investing. Undervalued companies tend to have higher yields and so a larger part of their present value is from near term cash flows. Hence, value stocks are less sensitive to shifts in long term interest rates than higher profile fast-growing companies.
Despite these concerns, central bankers remained calm on the inflation news. Mixed signals around the U.S. economic recovery sent the yield on the benchmark 10-year U.S. Treasury note down to 1.5%, its lowest level in more than three months, and put off worries of higher interest rates for another day.
The 30-year U.S. Treasury Bond recently closed at 2.17%, down from 2.26% at month's end. Oil closed at $66.63, up from last month’s 63.48. U.S. gasoline prices increased, closing the month at $3.11. Gold closed at $1,906, up from last month's $1,769.
Crypto Mania and Common Sense
On February 9, 2011, the price of a single bitcoin hit $1 for the first time. On April 13, 2021, a little over ten years later, it hit $63,000 before losing half its value in just a few weeks. That, in a nutshell, is what makes speculators crazy with joy and angst about a currency that exists only as computer code.
By now you’re probably familiar with the dark side of bitcoin: how it’s used for illicit activities including international drug trafficking and increasingly disruptive ransomware attacks. By enabling a digital-only identity, bitcoin is the perfect currency for those seeking anonymity.
Another downside is the high environmental cost as massive amounts of computing power are consumed by “miners” who process each transaction. Bitcoin processing also spews out tons of electronic waste and is linked to hugely destructive mining operations. It’s ironic that one of its loudest cheerleaders is Elon Musk, the man who intends to clean up the planet with battery-powered Teslas.
As an investor, let’s say you are willing to put moral considerations aside, and also willing to go through the inconvenience of getting yourself a bitcoin or two. If that’s the case, where does such a volatile, unpredictable asset belong in your portfolio? Does it replace cash, bonds, stocks, or real estate? Not cash and not bonds, says Weston Wellington of DFA: “Any asset subject to such sharp swings may be catnip for traders but of limited value either as a reliable medium of exchange (to replace cash) or as a risk-reducing or inflation-hedging asset in a diversified portfolio (to replace bonds).”
It’s also problematic to assess the merits of bitcoin as an investment, he says, and would mean paring back stocks, property and fixed income investments for a high-risk asset with uncertain expected returns. “The owner of stocks or real estate generally expects to receive future income from dividends or rent, even though the size and timing of the payoff may be uncertain. A bondholder generally expects to receive interest payments as well as the return of principal. In contrast, holding bitcoin is similar to holding gold as an investment. Even if bitcoin or gold are held for decades, the owner may never receive more bitcoin or gold, and unlike stocks and bonds, it is not clear that bitcoin offers investors positive expected returns.”
Wellington points to issues that bitcoin speculators ignore at their peril:
- Bitcoin passwords must be protected in a digital wallet, and if a password is forgotten or lost, there is no “reset” option to restore access. Users get a limited number of attempts before permanently losing access to their bitcoins. Wellington points to a recent New York Times article that profiled a man holding more than $200 million worth of bitcoin he can’t retrieve. “His anguish is apparently not unusual—a prominent cryptocurrency consulting firm estimates that 20% of all outstanding bitcoin represents stranded assets unavailable to their rightful owners.” If you’ve ever lost your passwords, keys or wallet, this may not be the asset for you.
- Then there’s the issue of unreliable intermediaries. Wellington points to the story of Mt. Gox, a Tokyo-based bitcoin exchange launched in 2010 that was at one time “the world’s largest bitcoin intermediary, handling over one million accounts in 239 countries and more than 90% of global bitcoin transactions in 2013. It suspended trading and filed for bankruptcy in February 2014, announcing that hundreds of thousands of bitcoins had been lost and likely stolen.”
- Finally, Wellington points to this sobering assessment: “The UK Financial Conduct Authority cited a number of concerns as it prohibited the sale of ‘crypto-asset’ investment products to retail investors last year. Among them were the inherent nature of the underlying assets, which have no reliable basis for valuation; the presence of market abuse and financial crimes in cryptoasset trading; extreme price volatility; an inadequate understanding by retail consumers of cryptoassets; and the lack of a clear investment need for investment products referencing them.”
Bottom line, if you choose to move money into bitcoin, do it with money you can afford to lose. Like most speculative schemes, bitcoin is a huge gamble. You could get lucky. Or you could get hung out to dry. At today’s price of roughly $40,000, those who bought bitcoin at $60,000 have already lost one-third of their money in about two months. True, some have become wildly wealthy by buying low and hanging on. There’s no telling which way the future crypto-winds will blow. Gold became a store of value because through most of history, it was also a medium of exchange. But if crypto never finds such wide acceptance, its usefulness as a store of value is also in doubt, wrote economic commentator Greg Ip in the May 21, 2021 edition of the Wall Street Journal.
Meanwhile, if you have questions about your current asset allocation, or are concerned about inflation risk threatening your portfolio, please contact me. I am here to help.
Cardiff Park Advisors
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