Everybody (don't) Panic!

Anyone with exposure to risk assets in some form or fashion is in outright panic mode after the price action over the past 48 hours.?

Bears are taking the victory lap they have been waiting for since circa 2011 and bulls are staring blankly at their computer screens in utter disbelief.

Take a deep breath. Close down the Interactive Brokers / Coinbase tab. Remove your finger from the 100x leverage button.?

Let’s take a step back and try and understand if this is a bull market sell off (“a bear trap”) or start of a new bear market.

What Happened?

Pundits have called the US equity markets (and US tech in particular) overvalued for the better part of the last two years. There are certainly a number of signals that help make their case:?

1. Market concentration into the Top 5 stocks by Market Capitalization (~20% of the S&P 500) is currently at levels not seen for 50 years.?
2. Valuations, based on simple metrics like price to earnings (P/E), appear stretched at a P/E of 22 vs the historic average of 18.?
3. The FED funds rate remains at a 25 year high, and has held at this level for ~18m with no hindrance to risk assets. Higher rates should mean a higher cost of capital, higher hurdle to invest in risk assets, and higher borrowing costs. AKA all else equal lower risk asset prices.?
4. The yield curve (historically the best predictor of a recession) has been inverted for two years.?
5. The US has the highest levels of debt to GDP in almost 100 years and continues to run massive fiscal deficits with no end in sight.

Macro sentiment continued to worsen into late July following poor US unemployment data which saw the unemployment sharply rising, and producer prices increasing (read: stagflation). This added fuel to the fire that the Fed was “behind the curve” in cutting rates ahead of an impending recession. Additionally a disappointing reading on manufacturing PMIs led to growth concerns. To add fuel to a tenuous macro environment, Israel killed a senior leader of Hamas over the weekend. Iran has vowed to act, and the US has started deploying troops into the Middle East. This confluence of tensions finally came to a head on August 4th.?

The straw that broke the camel's back was a sharp increase in the Japanese Yen unwinding what is known as a “carry trade”. The yen carry trade is where investors borrow low yielding Japanese government bonds and invest those assets in higher yielding securities such as US Treasuries (or even equities / crypto).? The balance of this trade is greatly affected by the difference between the exchange rates in the USD and JPY, because the investor is borrowing in JPY and investing in assets denominated in USD.?

Recent inflation readings in Japan saw the prices of goods and services in Japan rising at the fastest pace since 1980.To combat inflation, the Bank of Japan announced on August 1st a 0.25% interest rate raise. An increase in interest rates, all else equal, will increase the value of the currency. The value of the yen rose ~10% the past few weeks, a HUGE move in the currency world. Risk assets denominated in US dollars were sold and exchanged for yen to repay debts.

Specifically within crypto we had a confluence of idle investments change hands from a number of parties. The US government, Genesis creditors via bankruptcy distributions? and Mt. Gox creditors. Most importantly we had a net new seller in Jump Trading. Jump Trading has sold over $377 million worth of Wrapped Lido Staked ETH (wstETH) since July 24. This liquidation is likely due to the firm reportedly being investigated by the US Commodities and Futures Trading Commission (CFTC). The firm’s president, Kanav Kariya, resigned from his role on June 24. Jump sales have tightly correlated with ETH price decreases.

The move by Jump was likely exacerbated by market makers scrambling to cut positions as front-end ETH vols spiked more than 30% to 120%. This led to $1.1B (!) in liquidations over a 24 hour period and $800m over a 12 hour period.?

Current State of the Market?

So where do we stand after the events noted above? Since the start of August all markets have been a sea of red. Risk assets are down sharply across the board, hitting notable local lows: ETH (~-30%), BTC (~-25%), S&P 500 and Nasdaq (~-7%), and Russell 2000 (-~10%). Japan’s Nikkei was down 12% on August 5th alone; the worst day for the index since 1987. Crypto and macro are still intimately intertwined, particularly on down moves. To paraphrase an old market saying, “in sell offs all correlations go to 1”.?

The most popular measure of market volatility, the VIX index, is now the highest level since April 2020, hitting almost 70. The VIX measures the volatility of the S&P 500. Without getting into the nuts and bolts of how it's derived for simple intuition we can divide the VIX by 16 and find the expected market move within 1 standard deviation for the next 30 days. So the current VIX is calling for ~4% daily moves.?

The market today is largely driven day to day by quant funds and HFT flows (~60% of daily flows). These flows use the VIX as a toggle for exposure: low VIX, more risk asset exposure, high VIX, less risk asset exposure. Generally, if the VIX doubles and you are managing to vol - you should cut your exposure in half. This only exacerbates the deleveraging and becomes a self-reinforcing prophecy as volatility increases. The chart below shows vol control funds have on average $6B in aggregate to sell on a 2% move.

All of this couldn't have come at a worse time. August is a historically thin month in terms of liquidity. Crypto in particular has seen even less liquidity the past few days. BTC's 1% market depth on major exchanges is down over 40% since Aug 1, from ~$150M to $86M as of Monday morning. These dynamics often lead to negative price action. Historically August has seen a bitcoin decline of 2.8% during this month over the last five years (-0.5% over the last ten years).

This recent drop has also put stress on BTC miners who might be forced to make further sales. According to f2pool, when Bitcoin dropped to $52,000, only Antminer S21 Hyd and S21, Avalon A1466I, Antminer S19XP Hyd and S19XP were profitable. At $0.07/kWh, most Bitcoin miners have fallen below the break-even point.

Where do we go from here?

While the last few days may have been stressful, we believe there is no reason for panic.?

Sharp sell offs over periods where other markets are closed has often been the pattern for crypto markets, as it is the only market trading over the weekend. Add in thin trading liquidity for August, a number of structural market sellers (Genesis, Mt. Gox, US Government), geopolitical uncertainty, macro uncertainty, BTC/ETH ETF outflows, political tension, and crypto was positioned for sharp near term declines.?

Taking the above concerns in turn we see counterpoints that ameliorate our concerns:

• Thin trading liquidity→ As noted August is the worst month on the calendar for liquidity. Order book depth gets notably better in September and peaks in November each year. Volatile swings should decrease in Q4.
• Structural sellers→ ~50% of the total of 140k BTC (~$8B), has been redistributed to creditors of the defunct Mt. Gox exchange. Despite receiving nearly $4 billion worth of Bitcoin, the Mt. Gox creditors aren’t selling, according Glassnode data. The US government has roughly 180k BTC (~$12B) to sell, though if Trump is elected this would be held in a new BTC reserve. Genesis creditors will receive roughly $2B in crypto and $2b in cash. We believe these also are long term holders.? In terms of positive flows we have a number of new structural net buyers. Microstrategy has announced a new purchase of $2B BTC. FTX creditors will receive $12B-$15B in cash in October, at least a portion of which is likely to flow back into crypto.
• ETF Flows → Morgan Stanley said it would allow its financial advisors to offer spot Bitcoin ETFs to select clients from Aug. 7. We expect more wirehouse approvals into Q3 and Q4, thus providing further on-ramps for asset allocation to bitcoin. Currently estimates put around 20-30% of financial advisors who can currently offer these ETFs to their cliffs. Bitcoin ETF flows have remained sticky so far, exceeding $17 billion year-to-date. ETH ETF flows should be net positive once the ETHE unwind stabilizes, likely in late August. ETHE outflows are happening much quicker than GBTC.

• Geopolitical uncertainty→ Wars and conflicts are often short term market news but rarely have a long term impact. Regions exposed to conflict over the last 0+ years often make up a very small share of global GDP. They do often have geopolitical weight in terms of natural resources. The bear case for natural resources (leading to global inflation pressures) is often overstated as these countries rely on exports for income and keep these resources flowing despite conflicts.?

• Macro uncertainty→ Odds of a 50 bps rate cut at the September FOMC are now at 98.5%. Lower rates will reduce credit stress on both consumers and businesses. The hurdle rate is also lowered for competing risk assets. Household balance sheets are already historically strong with debt to disposable income around 50 year lows.

• Political uncertainty→ Tensions seem to have decreased after the assassination attempt on Donald Trump. Polarized as the US may be, both Trump and Harris are experienced and previously elected political leaders and now somewhat of known quantities. For markets, Q4 of election years has historically seen a ~5% increase in government spending. This is positive for overall markets. Both candidates seem to be open to exploring clear regulation and less punitive action for crypto specifically. This is of course positive for crypto assets.?

We may have already seen the bottom put in.?

Early on August 5th the US ISM non-manufacturing PMI for July was 51.4, with an expected value of 51 and a previous value of 48.8, indicating that economic activity expanded in July. The market has already been bought back on this news with BTC bouncing back to $55k and ETH to $2.5k. We are seeing additional positive readings in the credit market. The Fed loan officer surveys are key leading indicators used to gauge the credit cycle. The latest data shows continued loosening of lending standards and recovering loan demand for consumers and businesses. Historically these patterns of recovery are seen after recessions are already over.

Based on the above analysis, we firmly believe this recent downturn is a “bear trap” vs the start of a new bear market and are positioning accordingly. Other asset classes don’t provide 20-25% flash sales seemingly every year like crypto does, and we are happy to continue to allocate on what we believe are irrational dips.

Remember there’s always a “good reason” to sell risk assets (equities or crypto), yet structurally the long term path of travel is clear.?

Author: Thomas Dunleavy, CFA, CAIA

About the author

Thomas Dunleavy, CFA, CAIA is a prominent investment professional with significant experience in venture capital, investment management and financial strategy. His insights have been featured in Bloomberg, Yahoo Finance, Forbes, and more.? His career began in investment management at State Street, followed by a leadership role at top three institutional investment consultant, building and managing institutional investment portfolios from $100 million to $8 billion. He also sat on the firm's macroeconomic committee voting on tactical positioning for the firm's $1T+ in assets.

Currently he is Partner MV Capital, where he oversees a ~$40 million venture capital fund in the Web3 space. The fund has invested in over 30 projects since 2021 and evaluates over 1000 projects annually. He is also an active angel investor and advisor for Web3 projects.

About MV Global

Established in 2019, MV Global has emerged as a force in the Web3 landscape focused on early-stage investments and venture building. Our mission is clear: to partner with mavericks, visionaries and free thinkers to leverage blockchain-enabled technologies to build for the future.

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Disclaimer

The views expressed here are those of individual MV Global personnel quoted and do not represent the views of MV Global or its affiliates. The content is for informational purposes only and should not be considered investment advice. It does not constitute an offer to sell or a solicitation of an offer to buy any securities and may not be relied upon in evaluating the merits of any investment. Consult your own advisers for legal, business, tax, and other related matters. MV Global makes no representations about the accuracy or completeness of the information provided. All content is subject to change without notice.