Cryptocurrency (crypto) markets can be volatile. To anyone who has kept an eye on crypto markets for even a short period of time, this is not news. However, the recent downturn has been unnerving to some investors alongside the pullback in equity markets, with bitcoin declining more than 30% in the last two months of 2021 and then another 27% through January 27, 2022. Drawdowns of this magnitude could have even the most well-intentioned hodler.[1]

For traditional investments, a bear market is typically defined as a 20% correction. By that same measure, the Bloomberg Galaxy Crypto Index (BGCI) would have suffered two such periods in 2021 alone! Despite those sharp declines, the BGCI delivered a return for the year of more than 150%. Continuing the comparison with traditional investments, a greater than 50% pullback would be a signal of economic collapse. For crypto, a pullback of that magnitude is merely a typical drawdown. Over the five-year history of the BGCI, the median calendar year drawdown was 59% and ranged from 39% to 88% — the volatility of crypto markets cannot be overstated. At times, cryptos have produced enticing returns, but they also carry outsized levels of risk.

Rather than focusing on price fluctuations, we approach crypto analysis using our Business Cycle – Valuations – Technicals investment process framework to assess the health of the market. Regarding the crypto business cycle, instead of analyzing measures like GDP growth, industrial production or retail sales, we believe the crypto business cycle is centered on all-important network effects. Using bitcoin as a proxy for crypto markets, the number of longer-term users has been increasing in recent weeks as seen by an increase in the number of users holding bitcoin for at least a year. We believe this is important because it indicates the strength of the network is increasing and therefore should be less influenced by the impact from short-term speculators.

Figure 1. Bitcoin Age Distribution vs. Price
Longer-term bitcoin holders have been increasing


As of 1/25/2022. Source: glassnode.com, PNC

View accessible version of this chart.

The open-source nature of crypto provides a wealth of data that can be used in a similar way to fundamental analysis, albeit with a little more creativity. A common measure of crypto valuation is the realized value-to-transaction volume (RVT) ratio, which is like a stock’s price-to-earnings ratio. Looking at the RVT of bitcoin and Ether, the two largest cryptos by market cap, valuations have declined from the most recent peak in late 2021 and have dipped slightly below their long-term average but remain above the lows of the 2018 – 2019 “crypto winter”

Figure 2. Bitcoin vs. Ether RVT Ratio
Valuations have pulled back, but are above 2018-2019 lows

As of 1/25/2022. Source: glassnode.com, PNC

View accessible version of this chart.

From a technical analysis perspective, the weekly bitcoin price trendline beginning in March 2020 finally broke in December 2021. However, we do not view this as a significant concern considering bitcoin was up nearly 1000% over that period. From a support/resistance perspective, the next level of support for bitcoin is in the $30,000 range.

Figure 3.  Bitcoin Support Level
The next support level for bitcoin is around $30,000

As of 1/25/2022. Source: Bloomberg, L.P.

View accessible version of this chart.

Given the strength of the business cycle and lack of alarming signals from a valuation or technical perspective, what is causing recent crypto market volatility? Market movements are formed from a mosaic of information, and theories abound about recent crypto volatility, but we can point to four areas that might be influencing recent price movement — the Federal Reserve (Fed) and equity correlations, increased regulatory rhetoric, an internet blackout in Kazakhstan and technical difficulties at one of the largest crypto networks, Solana.

 

The Fed and Crypto-Equity Correlations

One rationale about crypto market declines is that anticipated changes in monetary policy from the Fed, including increases to the fed funds target rate, are driving a selloff in high-risk, high-valuation investments, including crypto. While there are only a few coins such as bitcoin with histories that stretch back to the last rate hike cycle to compare to, higher rates did not appear to be negative for crypto markets until well into the rate hike cycle. During the last cycle, the Fed began raising rates in December 2015. When bitcoin peaked in December 2017, it had rallied to return an annualized 515% over that two-year period. In our view, the blanket assumption that rate hikes are a headwind for equities is incorrect, and we believe it applies to crypto markets as well.

We believe the more likely culprit is rising crypto-equity stock correlations rather than a specific headwind for crypto valuations. Over the last four years, the BGCI 30-day correlation to the Nasdaq 100 has averaged 0.16. However, since March 2020, it has nearly doubled to an average 0.31. Compared to correlations across the traditional multiasset-class universe around 0.80 or higher this may seem low.  But correlations have been increasing, and the BGCI reached a pandemic-era high correlation just last week, peaking at 0.58. However, correlation does not equal causation; this pullback is likely due to a combination of factors.

Washington, D.C. Regulatory Rhetoric

While crypto networks are decentralized, most trading in the United States takes place on exchanges run by corporations. Therefore, when headlines surface about potential pending regulatory action on the horizon, it can add uncertainty when the macro backdrop is already volatile. Current markets are on notice for regulations and executive orders regarding crypto markets that may be announced within the next few weeks, according to White House officials. In addition, the Fed recently published a discussion paper titled, “Money and Payments: The U.S. Dollar in the Age of Digital Transformation,” written to solicit feedback on a broad range of topics including cryptocurrencies, particularly stablecoins. The paper also explores potential use cases for a U.S. central bank digital currency. Unsurprisingly, the BGCI declined more than 11% the next day.

Kazakhstan Internet Blackout 

In early January, the Kazakhstan government shut down internet service across the country for five days. Why is this relevant to the crypto pullback? Although the country has a GDP equal to less than 10% of the market capitalization of the crypto ecosystem, it is home to nearly 20% of all bitcoin mining! The bitcoin community may be smaller than it appears as this event added to a similar realization in the Spring of 2021 when power outages in China revealed approximately 50% of bitcoin mining was taking place in the country. During the Kazakhstan blackout period in early January, the BGCI declined -14.5%.

These discoveries are important because, as we mention above, one of the key metrics used to analyze crypto value is the strength of network and corresponding network effects. Is there a large, distributed group of miners and node operators minding the network? Is the user base of long-term crypto holders (hodlers) growing or is the network in a state of decline? These characteristics apply not just to bitcoin, but also to how we believe investors should value crypto markets in general. Network effects drive value in the long run.

Solana Technical Difficulties

Over the years, there have been a number cryptos vying to be the next major network protocol. The Solana network experienced exceptional performance last year, delivering a more than 9500% gain in 2021 and reaching a peak market cap of nearly $80 billion. This is a remarkable feat considering the coin launched in March 2020! However, in recent weeks, the network has run into technical issues and even had to go completely offline twice, leaving users who were looking to make transactions temporarily stranded. As a result, the coin is down 44% through January 25, wiping out approximately $50 billion in value in the process. While this example is specific to Solana, it is a reminder to crypto investors that these networks are internet-native software platforms, and there is always the risk such an event could happen elsewhere. 

Where Do We Go From Here?

Volatility is inherent to crypto as it is a still nascent technology. While we continue to believe crypto markets remain speculative, there is more to the crypto story beyond the rise and fall of coins that dominate the headlines. We believe there are larger secular trends involving the underpinning blockchain technologies that have much potential for innovative, real use cases such as non-fungible tokens (NFT), gaming experiences and other yet-to-be-developed technologies and applications.

Accessible Version of Charts

Figure 1. Bitcoin Age Distribution vs. Price
(view image)
Longer-term bitcoin holders have been increasing

This figure illustrates the fluctuating price of bitcoin from January 2021 to January 2022. There is a downward trend in the price of bitcoin from November to January of this year. The figure also illustrates the number of bitcoin users who’ve held the currency for six months to one year has grown significantly in the last several months.

Figure 2. Bitcoin vs. Ether RVT Ratio

Valuations have pulled back, but are above 2018-2019 lows

 (view image)

Date Ether EVT Bitcoin EVT
12/31/2015

0.462015

1.421006
1/20/2016

0.710667

1.289985
1/20/2017

1.163127

1.998482
1/20/2018

3.713763

2.326425
1/20/2019

0.504217

0.818294
1/20/2020

0.795004

1.536316
1/20/2021

2.866827

3.043941
1/20/2022

1.660847

1.740961


Figure 3.  Bitcoin Support Level
The next support level for bitcoin is around $30,000

(view image)

Date Bitcoin Price ($)
3/1/2020 8563.41
6/1/2020 10170.40
8/1/2020 11766.95
10/1/2020 10623.33
1/1/2021 29354.31
3/1/2021 49768.16
6/1/2021 36642.32
9/1/2021 48763.85
1/25/2022 36579.75