The total value of all cryptocurrency assets has just exceeded US$3-trillion, according to news reports. It’s such a big number that it needs some context to be meaningful. Consider Microsoft and Apple, which have market capitalisations that recently topped $2.5-trillion. So, the entire crypto sector is around 20% more valuable than the equity of the two biggest tech companies.
The previous crypto bull run peaked at the end of 2017 at about $800-billion, also about 20% higher than Microsoft and Apple at the time. Over the following year, crypto crashed almost 90%, while Microsoft, Apple and the Nasdaq 100 Index didn’t change much. By December 2018, crypto was worth only a bit more than 10% of the largest tech companies. But over the next three years, crypto recouped the lost ground and is back at its peak valuation compared to tech companies.
Analysing crypto valuation is difficult. There are three main approaches. One is to consider the sector like a tech company. There are thousands of crypto ideas out there, generating useful services. Some of them, like peer-to-peer financial services and smart contracts, are traditional services that crypto can arguably deliver cheaper and better than centralised finance. Others are entirely new end-user services, or are crypto-to-crypto, meaning things that do not deliver services directly to consumers but allow consumer-facing crypto to operate better.
How does the total future value of all crypto services to end users compare to the potential future revenues of Apple or Microsoft? I’d say the potential of crypto is far greater than any one company today, but the risk is far higher. Crypto may never generate significant profits to investors, while Apple and Microsoft have large revenues and profits. Those companies also have employees and assets, and histories of developing valuable new businesses. Even if crypto growth continues, the value may be captured by users and developers, not by people who own coins today. Regulation may force crypto investors to take profits in crypto services rather than traditional currency.
Anyway, taking this view, you have to be an optimist to like crypto at current prices. The price-to-earnings ratio for the S&P 500 Index is near all-time highs, tech company valuations are particularly stratospheric and crypto is selling at its all-time high ratio to the largest tech companies. Froth upon froth upon froth. Moreover, there’s been no obvious breakthrough good news from crypto to justify the run-up in prices. Unless you’re sure that “this time is different”, crypto values seem likely to revert to mean. That doesn’t mean a crash, but it could mean years of mediocre returns. Although there are plenty of crypto assets that are promising investments, it’s hard to see much short-term upside for the fundamental value — based on real services delivered to real end users — of the entire crypto universe.
A separate economy
A second way to get a handle on crypto value is to consider it a separate economy. This is what I did in 2013 when I forecast crypto would represent 2% of the total economy in 10 years. So, I would keep 2% of my portfolio allocated to crypto, buying when prices are low and selling when they are high. Over the years that has generated profits that now make up 40% of my wealth. And if crypto goes to zero tomorrow, I’m still 38% to the good. On the other hand, if crypto continues to soar, I profit enough not to be filled with regret. The less certain you are about the value of something, the more important it is to pick a value and stick with it. Much better to guess a wrong value and leave some money on the table compared to what you might have made, than to buy whenever crypto is hot, and sell when it crashes.
The 2% figure was nothing but a guess. I wrote at the time that if someone chose 0.5% or 5% or anything in between, I had no strong counter — but I thought zero or more than 5% were difficult to defend. Today, crypto is about 3% of total global equity value, so I’ve been selling into this rally. But someone who sees a bigger future for crypto might find it fairly priced, or even undervalued.
The third major valuation approach to crypto is as an alternative to the traditional financial system. From this perspective, crypto is worth $3-trillion because dollars are less solid than they used to be, not because crypto has developed better than expected. Having a solid presence in the crypto universe has obvious appeal looking at the world today, with the economy having severe problems restarting, worrying geopolitical events, politics and governments seeming dysfunctional, US threats of financial repression and confiscation of assets and ultra-loose monetary and fiscal policy in the US and elsewhere despite faster inflation.
My personal strategy is to keep 2% allocated to crypto without worrying about valuation. But there is a case for optimists that crypto can go up from here, even relative to big tech companies in general, by continuing to develop ideas and deliver useful services to end users. And there’s a case for pessimists that high traditional asset valuations and shaky traditional currencies and financial institutions make crypto worth its high prices. I have no idea if today is peak crypto for this market cycle, but it does seem to be a particularly bad time to be either over or under exposed to it. — (c) 2021 Bloomberg LP
- Aaron Brown is a former MD and head of financial market research at AQR Capital Management. He is the author of The Poker Face of Wall Street