How to Make Sense of Cryptocurrency Valuations
Bitcoin is the largest and best-known cryptocurrency, but there are dozens of other major products and hundreds of minor ones, as well as cryptoassets and tokens. Yet there is no method or established tool that allows investors to analyze and value the assets that are being created seemingly every day.
What if we applied factor analysis? This powerful quantitative tool is generally used to break down the stock market into three to six factors, each a specially constructed portfolio. The “value” factor, for example, is long stocks with low price-to-book ratios and short stocks with high price-to-book ratios. The claim is that the long-term expected return of a diversified portfolio is explained by its exposures to these factors, so you don’t need to understand each individual stock holding to predict performance.
When it comes to cryptoassets, we lack the quantity and quality of data to do as sophisticated a job of factor analysis as has been done for the stock market. Here’s an attempt, nonetheless. Statistics tell me that four factors -- that, is four portfolios -- are enough to explain the last 13 months of returns of cryptoassets. We can regard individual cryptoassets’ ups and downs as random noise that averages out. (Full disclosure: I own Bitcoins and other cryptocurrencies.)
The chart below shows the value of $1 invested in each of the four factor portfolios on Feb. 25, 2017 , on a logarithmic scale. The blue line, the Service portfolio, roughly corresponds to the price of Bitcoin over the period. But the other three portfolios show significantly different patterns. Size had the largest gains and the smallest drawdowns. Service made good money, but had the biggest crash. Quality and Coin performances were modest by crypto standards. Only the Service factor portfolio appears to be continuing to decline rapidly, while the other three seem flattish.
The Size portfolio (yellow line) has zero weight on the two megacurrencies, Bitcoin and Ethereum. It has roughly equal weights on smaller (but still big) currencies like Ripple, Litecoin, NEM and Ethereum Classic. Litecoin is a Bitcoin clone, and Ethereum Classic is an Ethereum fork. Ripple and NEM are blockchains that address some of the perceived problems in Bitcoin. These are Bitcoin and Ethereum competitors that have vibrant and talented developer communities, but are more nimble than the behemoths. The Size portfolio has increased in value three times, each time more than tripling in value, and has been flat in between.
The Quality portfolio (red line) is long Bitcoin and short Ethereum. In most categories, it is long the highest market capitalization cryptoasset and short all the smaller ones. Although it’s up 50 percent for the period, it has doubled and fallen back twice. Because it does not show a clear pattern of outperformance, most cryptoinvestors should at least look at assets that are not market leaders in their categories.
The Service portfolio (blue line) is long cryptoassets that do things, such as STEEM (social media), Factom and MaidSafe (secure data storage and transfer), Augur (prediction market), and Iconomi (manage digital assets), and is short the currencies. One dollar invested in the Service portfolio in February 2017 grew to over $9, before falling to $3.50. This is the only portfolio to really crash, which may mean the service idea failed, or that service cryptoassets are good values.
Finally the Coins portfolio (green line) is long coins, like Bitcoin and Litecoin, and short smart contracts, like Ethereum, service assets and tokens. After some early losses, it enjoyed the steadiest run-up of any factor portfolio but was the first to decline around the end of 2017.
Charts don’t tell the future, but they suggest four things to watch. First, is the second tier of Bitcoin and Ethereum challengers capable of tripling again? This event provided much of the crypto gains in 2017. Second, will category leaders outperform competitors? They did on average in 2017, but with a lot of reversals. Third, can the service providers recover from their crash? Although they seem to be headed straight down, they are still priced more than 250 percent higher than they were in February 2017. Finally, can coins repeat their low-volatility 10-month run outperforming non-coins? Or is the future in smart contracts, services and tokens?
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To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net
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