By Ellen Hazen, CFA®, Chief Market Strategist
January Takeaways:
- Q4 GDP was very strong at +3.3%. This follows +4.9% in Q3 2023, also a strong result. Current estimates are for 2024 GDP to slow fairly sharply, to between 1-2%. This anticipated deceleration in economic growth is the result of the cumulative impact of two years of monetary tightening
- Equity markets narrowed again. Not all of the Magnificent Seven (Apple, Amazon, Alphabet, Meta, Microsoft, NVIDIA, and Tesla) did well in January, but many did. In a return to a narrow market, large-capitalization stocks (S&P 500 Index +1.6%) outperformed mid-sized indexes (S&P 400 MidCap Index -1.7%), which in turn outperformed small-sized companies (S&P 600 SmallCap Index -4.0%)
- Q4 2023 earnings growth has been 4% so far. Earnings surprise has been modest, at +7%, while the percent of companies beating estimates has softened a bit, from 81% for Q3 results to 79% for Q4 results
- Federal Reserve on hold. The Fed kept rates steady at its January 30-31 meeting and communicated that a cut in March was not their base case (most likely scenario). Markets are currently pricing in a cut in May, followed by more later in the year
- January new jobs of 353,000 was surprisingly strong. The strong labor market has buoyed equity markets for the past twelve months, and January’s report was much stronger than the 185,000-consensus estimate. This bodes well for the equity market going forward
- Average hourly earnings increased by 0.6%. This increase is the one concerning datapoint in the January jobs report; if this flows through to cause higher inflation in the coming months, then the Fed may be forced to actually increase rates, rather than cut them
What We Are Watching in February
- Earnings wrapup. After this week, about half of S&P 500 Index companies will have reported Q4 2023 earnings, leaving the other half to be reported in February. Currently, estimates for 2024 have drifted down by about two percentage points, to 9% growth.
- Market internals. Will the equity markets broaden out, as they did in November and December, or stay narrowly focused. In January, the Magnificent Seven barely edged out the S&P 500, at +2.0% vs. +1.8%, but in the first few days of February, have widened that gap by four percentage points
Bitcoin – The ETF Era
Blockchain technology has captured the world’s imagination over the past decade as the concept, originally conceived by Satoshi Nakamoto, has become broadly accepted. What is blockchain technology? At its heart, it is a technology that can track ownership and does not depend on a centralized authority to do so. Most ownership in our modern society is tracked by institutions, such as banks (which track your bank accounts) or governments (which track the deed to your house and other assets). Blockchain technology is appealing to many people, particularly those who prefer information and knowledge to be decentralized rather than in the control of a corporation, financial institution, or government.
Bitcoin is a digital currency built on blockchain technology. Ownership of Bitcoin is authenticated by algorithms run by crypto participants, in a public and decentralized manner. Bitcoin is effectively a way to exchange money or stores of value without a centralized institution in which all participants must trust. It runs in parallel to the conventional banking system but does not require trust in a centralized institution. It is therefore perhaps no surprise that its popularity increased after the Global Financial Crisis in 2007-2009, when peoples’ trust in financial institutions was severely tested.
Since inception, the price of Bitcoin has significantly increased, from zero to approximately $43,000 per Bitcoin. This rapid increase has attracted a lot of attention. For many years, individuals could not easily purchase Bitcoin in a traditional brokerage account. Access has been slowly getting easier. In 2021, the SEC approved an exchange-traded fund (ETF) that held Bitcoin futures; and last month, the SEC approved ETFs that hold spot (actual) Bitcoin. So, does it make sense to buy a spot Bitcoin ETF now?
Traditional currencies are money-backed by the faith and credit of a national government. Like most assets, their value is determined by supply and demand: if more people want to purchase an asset, the price goes up. Supply and demand in turn are a function of how investors incorporate economic fundamentals: what is the country’s gross domestic product? What are its prevailing interest rates and inflation rates? What is its population growth and economic productivity growth? Currency investors consider those factors and determine what they think the currency is worth. They can buy or sell with other investors, which results in a crowd-sourced consensus of what the currency’s value is.
Stock and bond values are also determined by supply and demand, although the factors that investors typically consider are somewhat different than those that impact currency valuation. Stock and bond investors discount future cash flows to be received back to the present, using the prevailing interest rates. Bond values are typically fairly well-defined, because the coupon payments are known, as is the principal to be repaid at maturity. Simplistically, the key question in valuing a corporate bond, for example, is whether or not the issuer will default. This is why bonds are much less volatile than stocks. Stock values fluctuate much more than bond values because dividends in the future are not known with the same degree of certainty as bond coupons. Nevertheless, an investor can make assumptions about earnings growth and dividend growth, and discount those back to the present time, using the prevailing interest rates, to determine fair value for a stock.
Cryptocurrencies such as Bitcoin do not pay any dividends or coupons. There is no way to analytically value them because the owner does not have claim to any future cash flows. The value is driven entirely by supply and demand in the marketplace. Thus, even though shares in ETFs that hold spot Bitcoin can now be bought and sold in the same manner as a stock, it is still not possible to analytically value them. The wrapper—in this case, the ETF—is more streamlined, and more easily traded, but the asset inside the wrapper—Bitcoin itself—remains valued simply by supply and demand, and not by any claim the holder has on future cash flows.
Some claim that, like other currencies or commodities that also do not pay dividends, Bitcoin justifies a place in an investment portfolio because it is a diversifying asset – it could be negatively correlated with other holdings, so could provide stability. The problem with this argument is that Bitcoin has proven to be more volatile than either equities or bonds. Over the past year, for example, stock volatility (as measured by standard deviation of daily returns) has been 17%, bond volatility has been 8%, and Bitcoin volatility has been 51%. Bitcoin has also been positively correlated with stocks: over the past two years, the correlation has been +0.30, and has been positive nearly the entire time. So rather than increasing when stocks decline, and vice versa, it has moved in the same direction.
At heart, a purchaser of Bitcoin or a Bitcoin ETF is reflecting a belief that demand for Bitcoin will outgrow supply, driving up its price. This could happen. One example might be if Bitcoin became the primary medium of exchange in the metaverse, and if more and more economic activity moved into the metaverse, then demand would increase, and Bitcoin price would go up. Analytically, though, it’s hard to say by how much, as again, the holder is entitled to no cash flows from the Bitcoin.
The bottom line: Bitcoin is not an investment in the traditional sense. It is an instrument that may go up or down in value as a function of how future demand evolves. Thus far, it has proven neither less volatile nor negatively correlated with more traditional asset classes. The new ETF wrapper on spot Bitcoin makes it appear more like a stock, as it can be traded on exchanges, held in brokerage accounts, and holds Bitcoin itself rather than futures on Bitcoin. But unless demand materially increases, we do not believe that the advent of spot Bitcoin ETFs makes its price more likely to increase.