October 2018 Commentary

April 27, 2020

Let us start with some of the major developments in the crypto-currency ecosystem that came out in the past 4 months. It is evident to me that wall street herd is rushing into crypto as a new asset class.

  • July 2018: Northern Trust started developing a strategy to secure custody-held digital assets such as cryptocurrencies. Founded in 1889, is one of the largest custodial and asset management banks in the U.S. It has $19 trillion of assets under custody or administration, and $1 trillion of assets under management
  • August 2018: Intercontinental Exchange ( The owner of the NYSE, and in partnership with Microsoft, Starbucks and BCG) announced Bakkt, a global platform and ecosystem for digital assets. The launch of a regulated, physical bitcoin futures contract and warehouse is planned for November 2018. Starbucks intends to be the flagship retailer to develop applications for customers to convert digital assets into cash for purchases at their stores.
  • August 2018: Bank of America filed a patent to offer crypto custody solutions catering to large-scale institutional investors and retail traders
  • September 2018: Citigroup created a Digital Asset Receipt, which works much like an American Depository Receipt (ADR).
  • October 2018: TD Ameritrade, in partnership with DRW Holdings, Virtu Financial and others invested in a new cryptocurrency exchange called ErisX.
  • October 2018: The endowments of Yale University, Harvard University, Stanford University, Massachusetts Institute of Technology, University of North Carolina and Dartmouth University have invested tens of millions in both directly-held cryptocurrencies as well as in the equity in the various cryptocurrency-focused companies
  • October 2018: Fidelity in one of the most anticipated institutional custody announcements, announced the launch of a new company, Fidelity Digital Asset Services, that will shortly begin providing cryptocurrency custody and trade execution for institutional investors.

I usually do not spend much time looking at any other asset class other than crypto assets, because all the exciting developments are happening in crypto. I don’t have enough hours in the day to follow the developments in crypto markets. But recently I have taken a look and surprised by what I found. I remember reading an article in Fortune magazine in early 2000s from Warren Buffett, when he commented on stock market’s valuation. There was lot of froth in the market at that time due to the dot com bubble of late 1990s. It is not normal for Mr. Buffett to comment on market valuation, as a value investor you don’t try to judge the market. You always maintain a neutral stance about the market valuation overall, but look for stocks in a bottom-up valuation methodology. It worked very well for him over his illustrious career. I followed Mr. Buffett’s methodology in my stock selections in the past. I was a shareholder in Berkshire Hathaway since 2001 and attended many of his annual shareholder meetings in a huge stadium in Omaha, Nebraska. One of the market valuation metric that Mr. Buffett trusted, was to look at the ratio of the market capitalization of all stocks to the U.S. GDP. I agree that this ratio is least subject to manipulation or mis-interpretation. The Wilshire 5000 index is the most complete measure of the stock market.

                The market capitalization of the Wilshire 5000 at the end of September was $30.25 trillion and the U.S. GDP is $20.4 trillion. So, the ratio of the market value of all stocks relative to GDP, which is to say relative to the productive capacity of the nation, is 1.73x. It is now higher than it has been in the past 50 years, including the dot com boom! This graph comes from Federal Reserve of St. Louis.

Wilshire 5000/ U.S. GDP

                In a bear market that S&P 500 has experienced in 1974, this ratio was 0.13. This ratio was close to 0.18 in 1982, when the bull market in stocks got started. At the peak of the dot com bubble, which happened around the 1st quarter of 2000, this ratio was at 1.18. After the dot com bust this ratio went down to 0.65. At the peak of the housing bubble which happened around 3rd quarter of 2007, this ratio was at 1.01. At the bottom of the housing bubble crash, this ratio dropped down to 0.56. Today this ratio is at 1.73, which is the highest ratio seen in the last 50 years. If you look at this chart it says clearly that stock market is ready for lot of trouble. This statement is pure deductive reasoning, so it does not mean that the stock market cannot go higher; it certainly can. It just means that we have not seen an instance of it going higher and, therefore, it makes one uncomfortable to say that it could go meaningfully higher when it has never happened before. Remember that Mr. Buffett called the boom of 2000 as a bubble based on this chart, when it was at 1.18 and today we are pushing over 1.73.I think this chart is a clear danger signal.

                The next exhibit I want to present is the S&P 500 companies operating profit margins. The U.S Bureau of Economic Analysis publishes a figure for U.S.  corporate profits after tax. In 2017, the figure was $1.8 trillion. This only marginally exceeded the 2012 level and was less than 2014 level. S&P 500 operating profit margins were near 12% in the second quarter of this year, compared to peak profitability of less than 10% during 2006/2007 cyclical peak, and are the highest they have been in at least the past 25 years. This number is an aggregate and difficult to manipulate. So, we have a stock market that trades at a record high valuation relative to GDP and which has a record high profit margins. The important point is that the opportunity set in traditional bond and stock investing has been narrowing. This leaves no better choice for investors other than crypto-assets, which are improving hugely.

  I think it is remarkable that in such an environment of stock market valuation being at the top of its valuation over the last 50 years and profit margins being at their all time high, Federal Reserve tries to push the interest rates down so low. Federal Reserve probably thinks that we are in a great depression as the interest rates seemed to be lower than even when we were in great depression. In 1970s short-term interest rates used to be 17.5% and recently it was pushed all the way down to 0. This is not due to natural market forces but due to Federal Reserve.

                The global bond market is in a massive bubble as well. As of 2017 there was $9 trillion of negative yielding bonds. People are lending their money to the governments around the world with a guarantee of loss if held to maturity. In another estimate from McKinsey states that we have added $57 trillion dollars of debt since 2009. The ratio of debt to GDP has increased in all advanced economies since 2007.

                Today U.S GDP is close to $20.5 trillion and has an interest payment of $3 trillion annually, which rising at about $600 million a day. In the early 1990s, interest rate on 10-year treasuries was in the range of 7%. Let us not even think about what would happen if interest rates return to 7%. Let us just play around with a 1% increase, which is an easy number to work with. The U.S has $71.3 trillion of total debt, which includes everything from car loan and credit cards to a U.S. Treasury bond. If rates were to increase, across all instruments by 1% the additional debt service would be $713 billion. The U.S consumes about 20 million barrels of oil a day. At roughly $70 a barrel, it costs $1.4 billion a day to pay for the oil, or $511 billion a year. So, imagine, using the 1% increase in debt service as reference point, if the country had to pay another $713 billion for its oil. That would be a 140% increase over what it is right now. That works out to an oil price of $168 a barrel.

                Thus, it is safe to say that 1%-point increase in interest rates across the entire yield curve is the equivalent of oil price shock, which is one of the reasons the planet’s central bankers are very reluctant to increase interest rates. They have it within their power to create the equivalent of oil shock, the potential magnitude of which gets worse every day because the amount of debt outstanding rises every day.

                My main point here is that the bubble is never in bitcoin. It is a response to very real bubbles in our economy. Government control of money and the most important price in a capitalist economy – the interest rate – was kept too low for too long to cause all sorts of distortions in the capital markets. The world is in search of a safe haven, which is a hedge from the central bank and political mismanagement since dollar was untethered from gold in 1971. Even if bitcoin were not to become a fully fledged global money and were simply to compete with gold as a non-sovereign store of value, it is currently massively undervalued. Gold’s market capitalization is close to $8 trillion, which when divided by bitcoin’s supply of 21 million coins gives a value of approximately $380,000 per bitcoin. As I have elaborated in September letter that bitcoin is superior to gold along every axis except for established history.

 Our thesis is that owning bitcoin is one of the few asymmetric bets that people across the entire world can participate in. Much like a call option, an investor’s downside is limited to 1x, while their potential upside is 100x or more.As a non-sovereign store of value, it will help the world citizenry to protect their savings from the insidious theft of wealth in the form of inflation from nation states all around the world.

Managing Partner
Email: sam@ikkurty.capital