Crypto only follows macro fundamentals

Many experienced business professors, analysts and those who attended business school sometimes wonder how to analyze crypto-digital assets. Aside from negative impressions of high-profile implosions of entities in the crypto space such as Three Arrows Capital, Terra/Luna, Celsius and FTX/Alameda, they are at a loss as to how to analyze and view these “digital assets”. In fact, old-timers like Jamie Dimon of JP Morgan or Warren Buffett of Berkshire Hathaway simply reject it.

For those coming from a corporate equity analysis background, it becomes difficult to analyze as they look for discounted cash flow, earnings per share, price-to-earnings ratios, and the like. What they fail to consider is that crypto is more of a commodity and has none of the typical analysis factors that corporate stocks have. While there are some metrics that are useful, let’s take a look at them.

Those with a macroeconomics background usually like crypto. Crypto can essentially track macroeconomic fundamentals, so if they can predict what will happen to the economy, they can predict where crypto can go. The joke is that all you have to do is listen to Jerome Powell and the Fed statements and that can lead the way. Of course, it’s a bit more sophisticated than that.

Crypto and technology stocks are what are known as “risk-on” assets. When there is a lot of excess money flowing around in the economy, people buy it in hopes of getting rich. But when interest rates rise and prices rise due to inflation, most money goes into paying higher rent, mortgage payments, car loans, etc., leaving little money for nice discretionary spending like iPhones—“risk-on” assets.

Crypto basically follows liquidity (or excess money) in the markets. This is the thesis of many macroeconomists. If there is cheap debt (low interest rates) caused by low inflation, it bodes well for crypto. But since debt has long-term and short-term cycles, crypto is also affected by it. When central bankers want to reduce liquidity, they usually raise rates. When they want to encourage economic activity, they lower rates and use quantitative easing, which buys bonds and securities from banks and other entities to get more money into the system.

The CARES Act of 2020 pumped $2.2T of stimulus money into the economy and into the hands of ordinary people. This blew the US M2 money supply in circulation sky high, thus leading to inflation. This generated a lot of money for stocks and crypto that reached asset bubble levels. The Fed finally burst this bubble when it began its interest rate hikes and began tightening its balance sheet by selling some of the assets it had accumulated in the past to try to reduce the money in circulation.

In general, when there is a lot of cheap debt and money flooding the economy as measured by a high M2 money supply, crypto usually goes up. When the M2 supply indicating liquidity is swept up and dries up, less money goes into risk assets like stocks and crypto. Tech stocks and crypto have been somewhat correlated in recent years, with crypto not burdened by disappointing earnings reports. It basically follows macro fundamentals.

In terms of useful statistics for specific crypto tokens, one of these is the tokenomics of crypto itself. What is the ratio of tokens sold to the public to the actual number of tokens minted? Is it like Bitcoin limited to a hard number (like 21 million)? Or can the issuers mint tokens at will? The problem is that if only a small percentage of tokens are actually released to the public, the advocates can easily become whales, manipulating the price movements and dumping tokens at will.

Another metric that is useful is Total Market Cap divided by Total Value Closed. Total market capitalization is the spot price of one token in the market times the total number of available tokens. When it says fully diluted market cap, it means it counts all the tokens out there, including those that haven’t been released to the public yet. Total value locked, on the other hand, refers to things like the amount of crypto invested, the number of transaction fees, and other indicators that crypto is actually being used and not just being speculated about. If the TMC/TVL ratio is large, it usually implies that the token is overvalued because the TVL is small. One can compare the TMC/TVL ratio with the P/E ratio in stocks, although it differs slightly.

Similar to stocks, there is also the relative strength index (RSI) from 0 to 100 which measures whether a token is oversold or undersold. If it is oversold (an RSI above 70), it means that the market is oversaturated with a particular signal and may crash. If it is undersold (an RSI below 40), there may be an upward movement in price, but there is no guarantee of that.

Finally, there is the Stock to Flow model used by a former Dutch fund manager with a background in quantitative finance whose pseudonym is Plan B. Stock to Flow, abbreviated as S2F, gives a valuation based on scarcity similar to how we value gold. S2F divides the stock (quantity available) over the flow (use or consumption).

According to Plan B, the flow cannot be increased and is constant, but the supply counter depletes over time because the peak supply when it started was set at 21 million Bitcoin. Unlike gold, where you can discover a new gold mine and thus increase the supply, it remains fixed in Bitcoin. Hence the exponential rise in prices.

Crypto is here to stay. There are other indicators that professional technical traders use that are beyond the scope of this article. Just because it doesn’t follow the normal analysis methods for corporate stocks doesn’t mean it isn’t an asset that can’t stand on its own.

The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.