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How The Next Crash Happens

Portfolio Armor's Photo
by Portfolio Armor
Monday, Feb 22, 2021 - 5:44

Stonetoss mocks Bitcoin bears. 

What Might Cause The Next Crash

We've been thinking recently about market crashes and what might cause the next one. Our speculation at this point is that broader adoption of bitcoin, followed by a crash in Bitcoin prices, could lead to the next market crash. Our Twitter correspondent Anatoly Karlin's recent prediction of a Bitcoin crash caught our attention for two reasons. 

First, Karlin, unlike, say, Peter Schiff, is a long term Bitcoin bull. 

Chad Spencer Schiff trolling his Virgin dad (meme via Bitcoin Meme Hub).

And, second, because Karlin's predictions about COVID-19 last year were prescient. 

The Crash Last Time

We wrote a couple of posts last year warning investors to hedge in light of the novel coronavirus. The first we wrote before the crash started, 

And the second we wrote a couple of weeks later, 

In that second one, we linked to Anatoly Karlin's post ("Corona Will Kill Millions And Crater The World Economy"). So far, Corona has killed nearly 2.5 million globally, and, according to a Statista estimate, caused a 4.5% contraction in global GDP in 2020. So as in the old E.F. Hutton commercials, when Karlin talks, we listen. 

Listening To Smart Bitcoin Bears Too

By "smart bears" there we mean successful investors who happen to be bearish on Bitcoin, not perma-bears or financial journalists who have been calling Bitcoin a bubble since they first heard about it. Two come to mind here. The first is Michael Burry. In a recent post ("Why You Didn't Hear About GameStop Until Too Late"), we wrote that Burry was arguably the greatest investor of his generation, having shorted the mortgage bubble in the aughts and then invested in the GameStop short squeeze last year. Since then, we've learned Burry exited before the January 2021 blow-off top in GameStop, but still a great trade nevertheless. He made a good point about Bitcoin here, about how sovereign governments will zealously defend their currencies. 

By itself, that doesn't doom Bitcoin or other cryptocurrencies - or any other investment, for that matter. Shares of Apple aren't going to replace the U.S. dollar either; that doesn't mean Apple shares are doomed. But it does pour cold water on some of the Silicon Valley folks ideas' of Bitcoin replacing the dollar. As long as the United States has the power to levy taxes, and demands those taxes be paid in dollars, the dollar will have value. The U.S. government has no incentive to give up the control and seigniorage it gets from the dollar for Bitcoin. 

John Hempton also qualifies as a smart bear in our book, having pantsed Bill Ackman a couple of times. His quote tweet below touches on a couple of recent moral arguments against Bitcoin. 

Whether those arguments are motivated by FOMO or are genuine (Alex Gladstein of the Human Rights Foundation counters the energy usage argument here), they're worth paying attention to, as they may influence institutional investors at some point. 

How Bitcoin Could Lead To A Broader Crash

If Bitcoin crashed tomorrow, it might not cause a market crash. What would make the stock market more vulnerable to a Bitcoin crash would be broader corporate exposure to Bitcoin. That may be starting to happen. In a recent post, we mentioned how the CEO of one of our top names, MicroStrategy (MSTR), convinced the CEO of another of our top names, Tesla (TSLA), to add Bitcoin to Tesla's balance sheet. 

Earlier this month, MicroStrategy CEO Michael Saylor spread his gospel to representatives from thousands of other corporations. 

What happens if dozens of the largest S&P 500 component companies add Bitcoin to their balance sheets, and then Karlin's prediction of a crypto bust comes to pass? Nothing good, for those companies' shareholders. That's how a Bitcoin crash could cause a market crash. 

Our System's Take On Bitcoin

Our system doesn't make top-down macro calls. Instead, it analyzes every stock and ETF with options traded on it in the U.S. every trading day, based on their total returns and options market sentiment on them. And each trading day we rank those names by our estimates of their potential returns over the next six months, net of hedging costs. Nevertheless, that bottoms-up process results in some broader macro trends. And one of the recent ones is bullishness on Bitcoin-related names. 

For example, MicroStrategy hit our top ten on December 17th. 

This and subsequent screen captures are via Portfolio Armor.

And Riot Blockchain (RIOT) hit our top ten about a month later. 

More recently, the Amplify ETF (BLOK) has appeared among our top names. 

What About The Bitcoin Crash Prediction?

Our system focuses on the next six months. When it selected these Bitcoin-related names, it was bullish on them over the next six months. Its general approach is to buy what's going up (and looks like it's likely to keep going up over the next six months) and hedge in case it's wrong. 

Investing From The Viewpoint Of Calamity 

We tend to think of stocks and ETFs "from the viewpoint of calamity," to re-borrow the expression Benjamin Graham borrowed from the philosopher Baruch Spinoza. Hence our focus on hedging. Here's what that looks like in practical terms. 

Let's say you have $2,000,000 in cash you want to invest, but you aren't willing to risk a drawdown of more than 20% over the next six months.* If you indicated that in our hedged portfolio construction tool on Friday,

This is the portfolio it would have presented to you.

With that portfolio, your maximum drawdown over the next six months - that is, if every underlying security went to zero - would be a decline of 19.04%. Your best case scenario would be a gain of about 40%, and a more likely return would be about 15%.

Why Those Names?

Digital Turbine (APPS), Baidu (BIDU), Enphase Energy (ENPH), Li Auto (LI), RIOT, Square (SQ), and TSLA were selected because they were among our top names - the ones that had the highest potential returns, net of hedging costs, when hedging against a >20% decline. The last three names there had Bitcoin exposure, with Jack Dorsey's Square having added Bitcoin to its balance sheet before Tesla did. Our system started with roughly equal dollar amounts of each, and then rounded them down to round lots, to reduce hedging costs. It swept up most of the leftover cash from the rounding-down process into another LI position (this time tightly collared) to further reduce hedging cost.

Why Those Hedges?

On our website, if you click the plus signs in the portfolio above, the positions expand to give you a better look at the hedges. For example, this is what the Square position looked like expanded.

As you can see, SQ was hedged with optimal puts. The other positions were hedged with optimal collars. Our system estimates returns both ways to determine which type of hedge is best. We elaborated on that process in a recent post: When To Hedge With Puts Versus Collars.

What Happens Now

We'll check back in a few months and see how this portfolio is doing. If the market keeps going up, this portfolio should do well. If the market crashes within the next six months, we know ahead of time that the downside risk of this portfolio will be strictly limited. Heads you win, tails you don't lose too much. A quick follow up on a previous post, which mentioned a forex site called Olymp Trade. Some have asked is olymp trade safe. That link has some information about that. 

*Although we used a $2,000,000 dollar amount and a 20% decline threshold for this example, our system can create hedged portfolios for dollar amounts as small as $30,000 and decline thresholds as small as 2%. 

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