The traditional composition of stocks and bonds portfolios could be modified to include bitcoin, says the investment manager Fidelity in the report “Understanding Bitcoin.” Investors and portfolio managers should consider bitcoin “as one of the components on the bond side of a 60/40 portfolio,” argues Fidelity.
60/40 portfolios are made up of 60 % of stocks and 40% of bonds, a formula long considered ideal because bonds traditionally outperformed stocks. In light of central bank policies that keep interest rates close to zero, global bond yields have declined, making bitcoin appear as a portfolio diversification option, Fidelity says.
Bitcoin and the reserve versus flow model
Fidelity states in the report that one of the main characteristics of bitcoin is its scarcity, both from its total supply limited to 21 million, and from the reduction of the miners’ reward by half ( halving ) that occurs every four years.
Fidelity addresses, first, the model of reserves versus flow ( stock -to-flow or S2F) of which it says: «the model simply measures the number of years (flow) needed to replace the current supply ( stock ). A high S2F is considered bullish, since it indicates a shortage, and vice versa. ”
The following graphs show, on the right side, how the supply of bitcoin and the BTC issued annually has evolved (left ) and on the right side the curve of reserves versus flow is shown, together with the price of BTC.
Decrease in the annual supply of bitcoin and the model of reserves versus flow. Source: Fidelity.
Although this S2F model has served as a price predictor so far, Fidelity thinks it has limitations.
Like any model, the S2F approach to bitcoin has its limitations. Aside from the obvious dangers of curve fitting two data streams and assuming that one causes the other (“correlation is not causation”), the S2F model is limited because it assumes that price is entirely a supply function. Price is at the intersection of supply and demand. So we see S2F as a one-dimensional model in that sense.
Fidelity.
This aspect of the S2F model, which does not take into account the demand , has been criticized by Grayscale, and reported by CriptoNoticias in an article on the metrics used for the valuation of bitcoin.
Metcalfe’s Law applied to Bitcoin
Fidelity claims that bitcoin has an integer dynamics of the demand in operation. This dynamic is described by Metcalfe’s Law, which holds in its simplest form that, while the number of users grows linearly, the value of the network (or, by inference, the price of bitcoin) grows much faster than the network of buyers, sellers, exchanges, ATMs or merchants of retail involved with bitcoin, says Fidelity.
In the following graph (left) you can see the growth of subscribers to telephone lines cell phone in the world, which follows the pattern of an “S-curve.” Fidelity explains that, at the beginning, the growth slope is almost zero, then the slope becomes steeper and at the end there is saturation.
In the graph on the right it is represented (in gray) the growth of bitcoin addresses, reaching 23 million in a span of 10 years.
Growth of subscribers to cell phone lines and Bitcoin addresses. Source: Fidelity.
Fidelity notes that there may be a limitation in the fact that two series are being compared of different data (subscribers vs. bitcoin addresses). However, Fidelity explains that bitcoin growth may still be in an early phase and continue on a similar slope for several years. “This suggests that the demand side (which had not been considered in S2F) could also be growing exponentially,” says the study.
Gold and bitcoin as store of value
Regarding gold, Fidelity maintains that it was first currency and then it was used as a backing for the dollar and other national currencies. However, since 1971, under the Richard Nixon administration, such support has been abandoned, leading to the era of “fiat money.”
World gold reserves are less and less significant compared to the global money supply. In 1970, the ratio of world reserve assets (money) to gold in reserves was roughly 2 to 1. Today that ratio is more than 10 to 1.
Fidelity.
Gold price vs. inflation in the UK. Source: Fidelity.
Such disproportion has deepened in recent years, especially in 2020, when central banks began expanding their balance sheets, Fidelity argues. The balance sheet of the US federal reserve rose to 35% of GDP, well above the historical peaks that occurred during the civil war and in the second world war . The monetary base reached 24% of GDP in December 2020, the highest percentage in the history of the United States, the report says.
In this context, gold maintains its attractiveness as an asset standby, the authors state, adding: “Recently, bitcoin has joined the conversation as potentially a form of digital gold.”
But bitcoin may have a unique advantage over gold: the supply of bitcoin, for design, it is finite. The graph to the left of Exhibit 6, below, shows the gold supply curve (that is, the cumulative global gold production since 1970) versus the bitcoin supply curve. We know that bitcoin supply growth is stagnating. Note how gold production has been fairly stable over the years: there is no asymptote here!
Fidelity.
The supply of gold vs. the bitcoin. On the right, S2F gold and bit-coin models. Source: Fidelity.
While gold production continues, bitcoin supply is limited by protocol says Fidelity. Gold, on the other hand, would need 60 years to replace the current existence. Bitcoin has a lower S2F than gold, but is growing rapidly, the study says, so it will be scarcer than that precious metal.
The valuation of bitcoin
With the low levels of the interest rates, the yield of the bonds approaches zero, highlights the study. This makes both gold and bitcoin competitive against bonds.
Gold and bitcoin are competitive with bonds at low levels current interest rates. In a world of 60/40 stocks / bonds, gold and bitcoin are poised as potential disruptors on the 40 side of the allocation, but not so much on the 60.
Fidelity.
For investors, according to Fidelity, the question should not be whether to include bitcoin in portfolios, affecting the bond component. The relevant question is how much ?, emphasizes Fidelity. That is, the task is to determine the optimal percentage of bitcoin that should be invested in that cryptocurrency, according to Fidelity.
That investment management firm has already studied the effectiveness of various percentages of bitcoin in 60/40 portfolios, as seen in the second part of his Bitcoin Investment Thesis, which was reported in this medium. In it, simulations of the inclusion of bitcoin were carried out in percentages of 1%, 2% and 3% in portfolios 60/40.
