TerraUSD USTUSD,
and LUNA LUNA,
are falsely accused of what has come to be known as the “crypto crash”. A good counter-argument can be made that the real culprit is Bitcoin’s BTCUSD,
overestimation.
The idea that bitcoin’s fair value can even be calculated can take some getting used to, and I’ll explain how in a moment. But first, it’s important to document the magnitude of bitcoin’s recent crash: in mid-May, bitcoin was trading more than 30% below its April high and nearly 40% below its March level. It was down nearly 60% from its peak in November 2021.
Most commentators blame the stablecoin market for causing the crash, and that undoubtedly played a part. TerraUSD, a so-called algorithmic stablecoin designed to never deviate significantly from $1, recently traded at 10 cents. LUNA, the stablecoin that is part of the algorithm to maintain Terra’s dollar peg, has become virtually worthless.
But while bitcoin was significantly overvalued to begin with, it was already vulnerable to a fall. Terra and LUNA may have been the straws that broke the camel’s back, but if not, there would have been another trigger instead.
Valuing bitcoin
The valuation model that showed bitcoin to be overvalued is based on Metcalfe’s Law, a formalization of what is known as a network effect. This effect exists when the overall value of a network increases with the number of users. When Metcalfe’s law applies, this value is proportional to the square of the number of users.
One analyst who used Metcalfe’s Law to construct a fair value model for bitcoin is Claude Erb, a former commodity portfolio manager at TCW Group. Assuming that each bitcoin mined so far represents a user in a bitcoin network, Erb calculates that the fair value of bitcoin is currently around $24,000.
I first wrote about his model for Barron’s in December 2020, when the model calculated the fair value of this cryptocurrency to be around $12,000. Almost immediately after Barron’s column, bitcoin surged from around $20,000 to over $60,000, leading many to dismiss Erb’s model out of hand.
Since then, bitcoin has fallen while the Erb model’s fair value estimate has risen, with the result that the two are now close to each other, as you can see in the chart below. -below. This led many to give the model a second look.
How much importance should you place on Erb’s Metcalfe-Law-based model? Perhaps the strongest case is that it does a good job adjusting historical data. When bitcoin is trading well above or well below the model’s fair value calculation, the model suggests that bitcoin’s value will approach that figure.
In any case, it is important to recognize that every publicly traded security sometimes deviates significantly from fair value. For example, the S&P 500 SPX,
over the past 150 years, has on occasion traded well above its average price-earnings ratio than bitcoin has exceeded its fair value, and on other occasions has fallen even lower. However, investors do not conclude from these strong variations that the P/E ratio is useless as a valuation indicator. The same courtesy should be extended to Erb’s model.
Another reason to pay attention to Erb’s model is that it is plausible. Even though the value of the bitcoin network does not increase precisely via Metcalfe’s law – via the square of the number of connected users – it makes sense that the value of the network will increase as more people own and use the cryptocurrency.
Yet, as Erb acknowledges, Metcalfe’s law model is not perfect. Many investors own more than one bitcoin, for example, so the number of users logged into the network is not the same as the number of bitcoins mined. Additionally, a significant number of bitcoins were lost, further reducing the actual number of logged in users.
Erb told me that he actually offered his model as a challenge to those who believe bitcoin is much more valuable. “If anyone wants to come up with a better estimate of bitcoin’s fair value than Metcalfe’s law, fantastic,” he said.
Don’t just assert that Erb’s model is wrong; you need to come up with an alternative model that specifies what the fair value of bitcoin is at each point in the past and future. That way it can be tested, analyzed and critiqued – just as Erb hopes his model will be. In the meantime, Erb’s model remains the most plausible fair value estimate for bitcoin that I know of.
Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]
Read also : MakerDAO’s Rune Christensen says Terra was ‘long overdue’ to collapse, calls for rules on stablecoins
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