The total cryptocurrency market capitalization has fallen from over $2.2 trillion at the start of the year to just over $1 trillion at the time of writing. The cryptocurrency market has been struggling all year, shattering the idea that cryptocurrency is a hedge against inflation. Instead, as inflation has risen, cryptocurrencies have been one of the worst performers. At the same time, commodity stocks have been among the best-performing stocks on US markets, with energy stocks, in particular, delivering solid gains.
Why Are Crypto Markets Down?
An inverse relationship exists between the demand for an asset or asset class and future returns. In other words, the more people want something, the lower future returns will be. This simple principle relates to supply and demand and is the single most crucial market principle. The anonymous writer of the blog Philosophical Economics, discussing a variant of this principle, calls it the “Single Greatest Predictor of Future Stock Market Returns”.
So, in 2021, when the crypto market started seeing coins like Dogecoin take off and when non-fungible tokens (NFTs) became a global craze, that was a signal that the demand for cryptocurrencies had reached a crucial tipping point: demand was so great that any kind of crypto innovation was immediately swallowed up whole as groundbreaking. That signaled that future returns from crypto markets were headed south.
Investing is about buying low expectations and selling high expectations. The mania for Dogecoin (down more than 63% year-to-date), was symbolic of investors getting ahead of themselves. Indeed, the demand for cryptocurrencies is such that, although there is a cap on the supply of Bitcoin and other cryptocurrencies, the supply of cryptocurrencies now stands at more than 10,000. The success of Bitcoin, and Dogecoin, over the last decade has been so great that even doubters, such as JP Morgan Chase, have been forced to embrace it. The chart below shows that the cryptocurrency market has become too big to ignore.
Source: CoinMarketCap
The supply of cryptocurrencies is now more significant than the demand, which has triggered a price plunge as capital has exited the market. The market cap of cryptocurrencies is likely to keep falling until the market clears. For long-term crypto investors, this is not necessarily a problem. If you have held a portfolio of cryptocurrencies over the last decade, you are still up and likely doing better than anyone else. The problem lies in the near term. An investor who bought at the start of the year needs a bounce of more than 100% just to get back even. Remember that losses impact portfolios more sharply than gains: a 50% decline demands a 100% gain to get back even, for example. That 100% gain may not emerge within the next year or two. That is a tremendous amount of pressure to put on a portfolio. An investor may be unable to wait a year or two for the markets to bounce. Given the asymmetric relationship between losses and gains, it’s not surprising that there has been a scramble to exit the cryptocurrency markets because investors fear they may not return their money very soon.
Cryptocurrency Investors Have Rotated into Commodities
Given inflationary expectations, many investors have ditched cryptocurrencies for commodities. This makes sense. One person’s risk is another person’s opportunity: although there is a case to be made that the decline in cryptocurrencies will at some point become attractive and signal a significant opportunity for gains, for those investors holding cryptocurrencies, especially those who got in within the last year, the decline in crypto markets is such that it poses an existential risk to their portfolios. Remember, a 50% decline demands a 100% gain just to get back even. That’s a high bar even for crypto markets within the near term. So it’s rational for one person to see risk and sell, and another to see an upside and buy.
While cryptocurrencies have enjoyed a renaissance over the last decade, commodity markets have become less and less favored. Among the world’s 20 leading miners, for instance, capital expenditure has declined sharply in the last decade. Even with inflation in the last two years at its highest level in more than 40 years, capex remains much lower than its 2012 decade peak.
Energy stocks have experienced a similar level of disinvestment in the last decade, with oil & gas firms being very disciplined in their capital allocation strategies. Even with growth in Capex predicted, as the chart below shows, that growth is very moderate.
A similar trend of underinvestment can be seen in the agricultural markets, leading to a global food shortage.
Source: Agricultural Economic Insights
Added to that, ESG and other impact investors have withdrawn funding from oil & gas in the belief that these industries are contributing to global warming. Agriculture has also come under pressure because of the impact of cattle farming on carbon emissions.
As CAPEX has declined, the future returns of the sector increased. The decline in CAPEX was initially triggered by the Great Recession of 2008 before which commodity firms had dramatically expanded CAPEX, issued new shares, and assumed large amounts of debt in the belief that rising commodity prices would make their investments profitable in the future. Instead, they created a scenario with an excess supply of commodities. Consequently, commodities prices collapsed, and commodity firms were left with vast amounts of debt that needed servicing. Many firms, particularly in oil & gas, were forced into bankruptcy. That mass exit of capital continued until profitability returned to the industry. Since then, many firms have had stricter capital allocation policies and are less inclined to ramp up production. That inverse relationship between asset growth and future returns, known as the asset growth effect, primed the industry for future success. Those investors who got in at the bottom of the industry’s returns, have been richly rewarded.
