A market cycle analysis framework for Bitcoin
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.
In terms of trading volume, the daily average of Bitcoin increased sharply from USD4,324 million in early January to USD26,677 million at the end of May and exceeded the daily average of USD18,800 million during the bull market in January 2018. The high activity indicates that the market has recovered from the previous bear market downturn.
In the long term, the market performance of Bitcoin is also striking. Since 2013, although Bitcoin has spanned two bear cycles, the return is far higher than that of traditional assets such as stocks, commodities, gold, silver, and precious metals in the same period. From May 2013 to now, the annual compound return of Bitcoin is 83.75%, while that of Standard & Poor’s 500 Index is only 10.77% over the same period and that of gold and commodities (copper, crude oil, cotton) is negative.
When we forecast the future return of the market, we assume that the return of assets has a normal distribution. Under this assumption, the probability of extreme market conditions is very low. However, the “leptokurtosis” phenomenon does appear in the distribution of return in the financial market, increasing the probability of extreme market, which is commonly known as the “black swan” phenomenon.
Generally speaking, the “fat tail” of the financial market tends to the left (the skewness of S&P 500 index and cotton is negative), while the “fat tail” of Bitcoin market tends to the right (the skewness of Bitcoin is positive). This means that the price of traditional assets tends to fall when abnormal fluctuations occur, while Bitcoin price tends to rise.
Three historical cycles of Bitcoin
Bitcoin’s historical price fluctuation shows a distinct cyclical characteristic and is currently in the third cycle of fluctuation.
As a special virtual commodity, the price of Bitcoin is influenced by the supply and demand fundamentals. Unlike ordinary commodities, because the supply curve of Bitcoin is inelastic and the demand curve is relatively elastic, the price of Bitcoin is more sensitive to marginal changes in demand. Change in short-term demand is often driven by the speculative demand of Bitcoin, which causes the price of Bitcoin to fluctuate drastically within a short time.In the long term, the supply cut cycle of Bitcoin once every four years has resulted in cyclical changes in Bitcoin price in a bull market once every four years; combined with the trend of long-term demand growth, Bitcoin price is generally on the rise.
Analysis of Bitcoin demand: Volatile fluctuations in the short run, rise in the long run
• The speculative demand for Bitcoin is influenced by multiple factors; the demand curve often moves within a short period, so there is no apparent regularity in the changes in Bitcoin price within a short period.
In the long run, the price of Bitcoin is significantly affected by reward halving and expected to rise
From the perspective of supply and demand, Bitcoin price fluctuates cyclically around a supply cut once every four years, but overall it rises.
Considering the long-term and short-term changes in demand and the impact of the halving, the following figure shows a time-varying curve of Bitcoin price. Bitcoin price fluctuates cyclically around the drop in supply once every four years, but overall it rises.
*Bitcoin OTC Price in North American at the end of May 2019: USD8,300
The financial characteristics of bitcoin — the impact of investor emotional pendulum and risk attitude cycle
At the current stage, Bitcoin is a type of high-risk asset. Its speculative behavior is subject to the impact of “investor emotional pendulum” and “investor risk attitude cycle”. The speculative bubbles reflect a specific cyclical characteristic.
In Bitcoin’s cycle of speculative bubble, the stages of “reform” and “boom” usually last at least 11 months.
The financial characteristics of Bitcoin: At the current stage, Bitcoin is a high-risk asset rather than a risk-averse asset.
As shown in the diagram on the right, the beta coefficient of BTC is 7.72, meaning that the fluctuation of BTC prices is larger than the market (represented by the S&P 500 Index). Some people believe that residents of hyperinflation countries are more likely to buy Bitcoin. This is an illustration of the hedging function of Bitcoin, and in fact, a phenomenon of currency substitution. Like all high-risk assets, its price is impacted by the emotional pendulum and risk attitude of investors, reflecting the characteristics of cyclical changes.
Note: Although Bitcoin contains some functionalities of a currency (e.g. medium of transaction, means of payment), its price is currently too volatile to be a real currency. As such, strictly speaking, the phenomenon of Bitcoin’s popularity in hyperinflation countries is an indirect currency substitution (the substitution between a currency and a non-currency financial asset).
The large fluctuation of the Bitcoin market cannot be explained by the fundamental changes in enterprises, industries, economy, etc. To a large extent, it can be attributed to the enormous psychological and emotional pendulums of investors. Particularly in the short term, the psychology of investors is like a pendulum clock, oscillating between the realms of optimism and pessimism. It seldom stays in the middle for a long period. In the highly volatile Bitcoin market, the fluctuation from one extreme to another extreme is evident.
The tug-of-war theory: When the market environment is maintained at a balanced state, a tug-of-war competition begins. One side is the optimists, while the other side is the pessimists. The optimists want to buy to earn money, whereas the pessimists want to sell off to protect their capital. Often, the market does not rise much, nor does it tumble much. The tug-of-war is a close competition between the two sides. However, at the critical moment of the competition, many people tend to defect and go from one end to the other end of the rope. This gives an overwhelming advantage to one of the groups.
According to the financial theory of the Chicago School, assets that seem to have higher risks must appear to have higher risk premiums. Otherwise, no one would invest in these assets. The same for Bitcoin. Despite its excessive risks, it has attracted loads of investors to enter the market because of the potentially high returns.
Excessive risk tolerance leads to a flat capital market line; while excessive risk aversion leads to a steep capital market line. When Bitcoin price spike, investors think there is a bright future ahead of the market, and therefore, they make significant investments. At this time, only a small amount of risk aversion is reflected in the price. Risky investment behaviour makes the market risky; when the market is at its lowest point, investors avoid any risk. Although it is almost a sure gain to buy assets at this point, they are still feeling the pain from the market collapse just before. So, they are more likely to sit on the fence and not make any investment while the market is low.
Like other financial assets, under the impact of the emotional pendulum and risk attitude changes of investors, Bitcoin forms into a bubble cycle. According to Kindleberger, a typical asset bubble can be divided into five different stages: reform, boom, euphoria, dilemma, and panic.In the three current cycles of Bitcoin, we can observe three critical factors of reforms: In the first cycle, the birth of a Bitcoin exchange made trading more convenient; in the second cycle, Bitcoin as a type of new digital currency, attracted global attention, leading to the rise of counterfeit coins; the third cycle was represented by the official growth of a new type of financing model represented by ICOs. These three cycles of reform created three bubble cycles.
In addition to its commodity and financial characteristics, Bitcoin also has strong currency characteristics. Bitcoin is designed based on the concept of a “non-state, free competition currency.” It has become a complementary “currency” solution in today’s “highly abusive” international monetary system. In the long run, there is a competitive relationship between Bitcoin and sovereign credit currencies. However, Bitcoin’s current price fluctuation is apparent, and it has not yet achieved the functions of a currency. Only in some hyperinflation countries (e.g. Zimbabwe, Venezuela, etc.), when the price fluctuation of Bitcoin is less than that of the country’s sovereign credit currency, Bitcoin possesses the function of “store of value” similar to that of a currency.
There is a negative correlation between Bitcoin price and the U.S. dollar index. When the U.S. dollar index enters a cycle of depreciation, Bitcoin price usually go up; when the U.S. dollar index enters a cycle of appreciation, Bitcoin price often tumble.
Currently, at the end of the third cycle, and with increased market demand, there is a clear signal for market recovery.
In the whole year of 2018, investor sentiments were mired in a pessimistic expectation, and the market was also relatively lacklustre. Since 2019, investor sentiments have gradually recovered, and the optimistic sentiment has been driving a growth amidst fluctuations for four months. The potential for price growth is slowly becoming evident, and there are clear signs of market recovery to boom. However, it is predicted to take five months to reach a euphoria sentiment.
With a domestic economic slowdown and a spiraling decline of inflation in the U.S., the Fed’s interest rate cut is almost a foregone conclusion. The Chicago Mercantile Exchange report showed that the market expected the probability of the Fed to cut interest rate by July is over 85%; the probability of an interest rate cut by September is close to 95%, and the probability of an interest rate cut by December is almost 100%.
In the meeting on 1 May, the Federal Reserve was satisfied with the current monetary policies. There was insufficient evidence to support a raise or a cut in interest rates. However, in early June, the Federal Reserve Bank of St. Louis President James Bullard declared that “the interest rates may be cut soon.” Soon after, on 4 June, Chairman of the Fed Jerome Powell also said that “appropriate measures will be taken to sustain the economic expansion”, hinting that the Federal Reserve is prepared to lower interest rates in the foreseeable future.
Risk Warning: Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.