Cryptocurrency and Financial Mania

In 1952 Professor Harry Markowitz developed the seminal ideas of what is called Modern Portfolio Theory.  He later won a Nobel Prize for his work.

While his insights have been expanded by others, his original ideas still echo today when investment people talk about diversification, asset allocation, and portfolio efficiency.  It is so common today to see the familiar pie chart of investments in the literature, in client statements, in financial plans; that one forgets the origins of this now widely practiced concept.

While MPT as it is called, does argue for diversification, it also argues for portfolio efficiency. Portfolio efficiency could be defined as getting the highest rate of return with the least risk.  Most of us recognize that there is generally a trade-off in investing, and in fact in most decisions in life, that the higher the risk, the higher the return, and vice versa.

Distilled to its basics, Markowitz made a mathematical argument for the already present common-sense notion that you should not “put all your eggs in one basket”. He showed with math that if investments do not all move together, it makes for a safer portfolio.

When investments move in the same direction and about the same magnitude, they are said to be correlated.

He also argued that “risk” is volatility or the amount the portfolio jumps around over time.

It could be argued that volatility is just one risk that must be dealt with and that volatility alone, is too narrow of a definition of risk. There is currency risk, default risk, political risk, tax risk and regulatory risk. But volatility clearly is important to the psychology of the investor. If the holding of investments is to be made for the longer term, the experience cannot be too terrifying, or mortal humans won’t be able to “hold for the long term” and let growth compound.

Thus, a truly diversified portfolio should be made up of investments that are not all correlated. The net result of volatile investments that move in different directions and different magnitudes is the entire portfolio actually becomes less volatile and dangerous.  What may be true for a part, is not true of the whole.

For years, money managers have argued that a portfolio should mostly include stocks and bonds because these investments are not only quite different than each other, they typically do not correlate closely with each other.

However today, that may not be true. We have some special circumstances today that are unusual in history.

The combination of huge increased government spending and deficits (fiscal stimulus) and a very aggressive Federal Reserve (monetary stimulus) and zero interest rates, has created the worst inflation in 40 years and widespread excessive debt in almost all sectors of the economy.  It has created the everything bubble, where many investments from stocks, bonds, art, NFTs, SPACs, cryptocurrencies, and real estate have all been elevated in price by massive liquidity flows.

Now the FED must move to stop the inflation it is largely responsible for in the first place.   The arsonist must become the fireman. They must raise interest rates and drain liquidity.  It seems logical that those investments that benefited most from the floatation upward will be harmed as the liquidity levels drain.  The FED either does this, or they let inflation run into double digits.

The typical recommendation by investment managers for a person about to retire, or in retirement, is the classic 60-40 portfolio.  That means 60% in stocks and 40% in bonds.

Now comes the problem. While that worked in most eras, rising interest rates cause both stocks and bonds to fall. If they fall together, the portfolio, while made up of different things, is correlated. If bonds and stocks fall together, there is no real diversification.  In addition, bonds today yield next to nothing, thus not providing a return even though you are taking a risk.

The lack of diversifying effect is likely true today with real estate, which also feeds on liquidity and ultra-low finance rates.

Cash is not correlated but currently has a deep negative rate of return. It is also issued by governments that got us into this problem in the first place. They have a terrible historical record of maintaining the purchasing power of their paper money. Cash works only as a short-term expedient.

Many today have fled to cryptocurrencies, which are not issued by the government and claim to be limited in quantity. But while individual cryptos may be limited in issuance, that is not true of the universe of cryptos. There are now over 9,000 of them and their market cap recently hit $3 trillion this past October. That market cap is now about half of the recent high.  This is not an auspicious start during a market correction.

What limited information we have about them indicates they are strongly correlated to stocks, and hence, they are not a portfolio diversifier. Bitcoin has offered no diversifying protection but likely rather increased the volatility of a stock portfolio.

Some have argued that cryptos have now taken on the historic function of gold.

Historically, gold is actually negatively correlated to stocks, meaning it usually moves opposite in direction to stocks. Thus, gold is a true portfolio diversifier.

Gold also is a special kind of money, a central bank reserve, which is something cryptos have not achieved.

Why do governments hold gold? While they do hold the bonds and currencies of other countries (typically the US), they do not totally trust each other because governments do default on occasion. And, quite often countries that trade heavily with each other can go to war with each other. Is Russia comfortable with dollars and are we comfortable with rubles? What about the US and China? Central banks want an asset to hold not issued by another government just as we investors do.

Gold has at least a 3,000-year history as money and developed that function in civilizations separated by both time and geography.

It is the only international asset that is not someone else’s liability. Yes, sovereign treasury bonds are usually “safe”, but they are a liability of governments who often get themselves deeply in debt and resort to currency debasement to pay their bills.

Critics of gold say it does not pay interest or a stream of earnings. This is certainly true and it is true of bitcoin, art, diamonds, and many other things. However, to get a stream of interest or earnings, you have to trust that the party on the other side of the contract performs. What if they don’t or can’t?

Gold is the asset to hold if you don’t want to take that claim because you think there is a high probability of default in the system, where both companies and governments may not meet their obligations.

Gold in a sense is more like cash, not issued by a government. But unlike cryptos, gold is negatively correlated to stocks rather than being positively correlated.

Because it is a true diversifier and because it has no counterparty risk, gold both hedges against volatility and default.

The FED has pumped money rapidly into our economic system. It now must either cut back and take the consequences or let inflation run and face the consequences of that.

At least in this initial stage of tightening, cryptocurrencies have not hedged a portfolio very well and may prove to be simply a novel new byproduct of a financial mania.