Speaking of bubbles…

Sparkling champagne flutes on tray with pomegranate seeds.

As investment managers we always look forward to December as it is such a welcome break in routine.  This time of year we check to ensure clients have complied with Required Minimum Distributions from IRAs and consider harvesting gains or losses in preparation for year-end tax calculations.  We look back and think about the major events throughout the year, how they effected markets and our portfolios, how we addressed each event and finally what we learned.  We’re decorating the house, planning meals with family and thinking about bubbles on New Year’s Eve.  We wish you lots of love and happiness this holiday season!

Speaking of bubbles…

The one topic clients, prospects, and the guy who installed my new hot water heater were most interested in exploring this year were our thoughts on cryptocurrencies and Bitcoin specifically. We are happy to share our thoughts, but first a little primer for those who aren’t quite sure what cryptocurrencies are and how they work.

Let’s begin with the notion that cryptocurrencies (of which there are many different types, but we will generically refer to them as bitcoin from now on in the same manner someone who requests a tissue might ask for a Kleenex) allow for two parties to exchange value safely, without an interested third-party mediating (and perhaps profiting) on the transaction.  If that is in fact a reasonable and not overly-simplistic definition then it should be clear to see that those “interested third-parties” might not look favorably on this new technology.  More on that later.

The general idea is that bitcoin (lower case, which is the actual currency) is a unique string of code that can be owned or exchanged with another party.  The code itself is very secure because it is tracked on a public ledger for all to see so it cannot be duplicated or altered.  That ledger is called Bitcoin (capitalized).  In order to own bitcoin one must agree to the rules of the Bitcoin ledger. One such rule is there will only be 21 million units of bitcoin, ever.  This is an interesting rule because if a finite number of units may ever be created than the possibility of inflation due to new units being issued is eliminated.  Recently it was reported that around 17 million units are in existence so we are rapidly approaching the limit of all possible units.  You remember the old chestnut attributed to Mark Twain “buy land, they aren’t making any more”.  It is precisely this scarcity that some would argue favors higher prices for bitcoin in the future.  For what it’s worth, that’s terrible reasoning to buy either land or bitcoin.

Another interesting rule is that the ledger itself is open for all to see.  When a transaction takes place that transaction is recorded on the ledger which is held on computers all over the world.  It is the very nature of this de-centralized ledger which makes hacking super difficult if not impossible. Every ten minutes all of the transactions that have taken place in the prior ten minutes are “blocked” together and added to the ledger.  Those blocks, one after another form a “chain” of transactions on the ledger, hence the term “blockchain”.  Some argue that it is this methodology that is the true value to humanity, not the scarcity of individual bitcoins.  The nature of “blocking” many transactions together and putting them on a “chain” of a diversified ledger that is spread over computers across the planet creates perhaps what is the perfect way to protect digital information from corruption or hacking.

The implications are potentially so far-reaching as to be almost unquantifiable.  How about protecting your identity from theft?  Keeping records of property ownership? Medical records? Any digital data that needs to be safeguarded from theft or corruption “blockchain” may be the ideal way to protect it.

Imagine for a moment an individual wants to transfer value to another individual (or company) digitally.  We do this all the time.  Autopay service from our checking accounts at banks or paying for an item with our Visa card.  Banks and credit card companies earn money serving as intermediaries in these types financial transactions.  Is it any wonder the CEO of JP Morgan Chase, Jamie Dimon, calls Bitcoin a “fraud” and refers to people who buy bitcoin as “stupid”?  Perhaps he’s right, he is considered to be very bright.

However, he has a huge conflict of interest that can’t be ignored.  If cryptocurrencies become mainstream, banks become significantly less important.

Banks are one thing, but how about governments? If people are less interested in traditional currency than interest payments from Government Bonds are less appealing, so the cost of borrowing (interest rates) would have to rise.  How would the government tax the exchange of digital code for something else? Would you have to pay your taxes in dollars?  What if dollars and other currencies lost strength relative to cryptocurrencies, thereby meaning the purchasing power of incoming taxes would be less and less.  It’s a Libertarian’s dream and arguably an existential threat to Governments as they currently exist.

Bitcoin and other cryptocurrencies are already being used around the world in countries with fragile or poorly-regulated banking systems.  However, the potential for abuse is enormous.  What about terrorists being financed with cryptocurrencies?  Drugs?  With this technology it’s pretty much the Wild West right now.  One thing is for sure it’s hard to imagine when people agree to exchange digital code for goods, services, regular currency, or code from a different cryptocurrency what could possible be done to prevent or tax that exchange.

A final note before we move on to our thoughts on cryptocurrencies within the context of investing.  We have presented our understanding of cryptocurrencies as best we can given our modest understanding of a rapidly evolving, highly technical phenomenon.  Our hope was to introduce the reader to general concepts within this space, a deeper dive into cryptocurrencies shows that there is so much more to it.

A currency alternative is just one of many forms this technology has taken.  Many of the newer cryptocurrencies offer “ownership” in something, or enhanced transaction capabilities or other perks that seek to be enhancements to or improvements on the classic bitcoin.  Some entrepreneurs are literally founding new businesses capitalized by issuing cryptocurrencies.  In that regard cryptocurrencies are more like stocks than currencies. From our point of view this is how governments and regulators are finding their way in the door. If a new business issues a cryptocurrency in exchange for real currency isn’t that like issuing a stock or bond?  If so wouldn’t the Securities and Exchange Commission or state regulators have jurisdiction to regulate?  This is one of the many risks to cryptocurrencies. They truly are a direct threat to some of the largest and most powerful institutions in the world.  On the other hand, cryptocurrencies are something out of a science fiction novel where borders and currencies disappear in favor of a single unit of exchange for all of humanity; a way to find common ground.  Pie in the sky, absolutely.  But is it possible?  While unlikely any time soon we have to concede that it is possible.  It’s that possible future which drives many investors.  Some think this technology and its possibilities are as big if not bigger than the internet.  With this in mind…

…is it time to dive in?

The definitive answer is maybe.  In our opinion it goes back to what is generally accepted as the best framework for investing and that’s Markowitz’s Modern Portfolio Theory (1952).  Markowitz believed that investors could maximize or optimize returns given a specific level of risk, noting that risk is an inherent part of higher reward.  By owning assets with different risk/return profiles, especially assets that don’t behave in the same way (diversification) investors could construct better performing portfolios.  Well, bitcoin certainly hasn’t performed in a similar manner to many other investments this year.  It is a wildly volatile, speculative asset with the potential for staggering returns both positive and negative.  Within the context of Modern Portfolio Theory that type of asset may well have a home within prudent portfolios.

An individual with no other investments who chooses to go buy bitcoin isn’t, in our opinion, really investing. They are gambling.  As my poker-night friends will gleefully attest I’m not qualified to advise anyone on gambling.  However, in the context of a well-diversified portfolio perhaps there is a place for volatile, speculative assets.  In our opinion those types of assets should never amount to more than 10% of overall investable assets.

Now that we have established our opinion as to the appropriate upper range of speculative assets in a well-diversified portfolio (10%), allow us to suggest the appropriate allocation to bitcoin and/or other cryptocurrencies for the typical individual investor.  Zero percent.

Monarch has no plans to allocate any of our clients’ portfolios to cryptocurrencies in the foreseeable future.  As of this writing there really isn’t any way for us to participate in those markets aside from buying and selling futures contracts (which we do not do) anyhow.  Even so we expect that it won’t be long before one or more cryptocurrency exchange trade funds are available for purchase.  When that time comes we will discuss the appropriateness of the holding with individual clients and make determination whether to hold the asset class on a case by case basis.  Until then we will remain focused on managing our three largest asset classes; cash, stocks, and bonds.  It’s been a bull market for the ages but…

…how long can it continue?

For a while, we think.  Exactly how long is a while, you ask?  Best guess is Summer of 2018.  Spring is probably more realistic.  We expect a correction.  Not a full-blown repeat of 2008 but a normal, healthy correction.  Based upon this expectation how should our clients’ position themselves?  The expectation of a correction after a protracted bull market is not sufficient cause to fundamentally realign a portfolio.  The tricky part about investing is not buying when things are bad, it is actually not selling when things are good.  Long term it is devastating to portfolio returns to sit out rising markets because of fear of a correction. By definition doing so really only exposes investors to flat or down markets.

Do we worry about a sharp pullback?  Of course, all day every day.  Yet we’re still in a historic bull market and it’s entirely possible that we’re wrong about an impending correction.  This thinking is based on the routine ebb and flow of markets over time.  We don’t know exactly how to handicap the possibility of a black-swan event which would probably be the result of some specific action or inaction by…

…the Commander in Chief.

We assign a 25% probability that Mike Pence will be President next December, 40% by June 2019 after the Republicans are shellacked in the midterm elections and any remaining support Mr. Trump has within his party has evaporated.  If he survives to see them we assign an 80% probability that Mr. Trump will either not seek reelection or is defeated in the primaries. Collusion with Russia seems unlikely (or unlikely to be proven). A more likely scenario is the President’s remarks eventually find their way across the line of no return and even the most stalwart of his anti-establishment base throw in the towel.

How does the market react to an intra-term transfer of power?  Frankly, we expect fairly well.  Agree with his politics or not Mr. Pence is predictable and markets like predictable.  President Trump not seeking or losing re-election likely has no measurable effect on markets.  Of greater importance to the markets would probably be the Democratic nominee.  Joe Biden and Elizabeth Warren would likely each invite a different reaction, for instance.

As always, please feel welcome to contact me directly to discuss, correct, or berate me for our current thinking.  Stress-testing opinions and beliefs helps to improve future outlooks.

We are so thankful to serve you and truly value our relationships.  Personally, I feel I learn more than I teach when working with our clients and appreciate your trust, your kindness and your willingness to share the story of our firm with your friends and neighbors.  We wish each of you another year of health, love and prosperity!




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