07/20/16   Bitcoin Naivety

Editor’s Corner

Ron Rowland

I’ll be the first to admit that I do not understand or appreciate the attraction of bitcoin. The vast majority of all financial transactions take place digitally today. Whether using a credit card, writing a check, or performing a bank-wire transfer, actual cash seldom passes through anyone’s hands. Here in the U.S., all those digital transactions use the U.S. dollar as the medium of exchange. That concept extends to other countries where the typical transaction is agreed upon and then settled in terms of the local currency.

Cross-border transactions are a different matter. When a U.S. company transacts business with a Canadian firm, the two must agree upon whether the settlement will occur in U.S. or Canadian dollars. One of the parties then has the extra burden of exchanging one currency into the other at the prevailing exchange rate. Eventually, the transaction will be settled digitally without any actual cash changing hands and the currency exchange happening behind the scenes. This model applies around the world to any transactions involving countries using different currencies.

Currencies were invented as a convenient medium of exchange (although some historians might argue they were created to satisfy debts). Rather than a farmer exchanging his corn for clothing, meat, and shelter, all of his transactions could be conducted with a common currency. Not only was it easier to carry cash than multiple bushels of corn, finding a clothing merchant that was in need of corn was no longer required when the farmer wanted a new pair of overalls. Eventually, society reached the point where even carrying cash became inconvenient, and electronic transactions became the norm.

Hundreds of different currencies evolved out of local need, and as the transactions became more global, the most stable currencies were sought out as the basis for cross-border agreements and settlements. It is no accident that the U.S. dollar, the Japanese yen, the British pound, the euro, and the Swiss franc are included in the list of major currencies of the world. They achieved that status through their relative stability.

To me, that should be the primary objective of any medium of exchange—stability. Other objectives might include safety, global recognition, freedom from manipulation, and digital settlement. The objective of digital electronic settlement has already been solved, and the major currencies have achieved global recognition. Therefore, if a new currency is to make inroads, it needs to be stable, safe, and free of manipulation to gain an advantage on the status quo.

Enter bitcoin and other so-called digital currencies. They claim to be safe, but they are created on computers, and one such computer was recently hacked. About $55 million worth of ethereum, a digital currency, was stolen from the Decentralized Autonomous Organization (“DAO”). They claim to be free of manipulation, but earlier today, the DAO modified the software and essentially “erased” the fraudulent transaction with a hard fork of the blockchain, thus destroying any claim of being free from manipulation. Another digital currency claim is that they offer a “full-reserve” approach to banking, although central banks could eliminate “fractional-reserve” banking if they truly wanted to.

That brings us to stability. Bitcoin, the leading digital currency, is extremely volatile. In 2013, it gained 1,816% against the U.S. dollar over a few months, and then crashed 70% in a week, only to rise more than 1,500% before the year ended. It plunged more than 84% the following year, and it has posted numerous wild swings in the interim. Last month, it dropped 21% in just three days.

Call me naive, or perhaps a little old-fashioned, but I do not see how any digital currency presently meets any of the objectives outlined above. Apparently, I am not alone, because the digital currency proponents have added a new objective of cutting out the middleman (the bankers) to gain efficiencies. Most currencies are backed by a government or by gold, while bitcoin is backed by open-source software that is administering a blockchain distributed ledger.

I’m willing to grant that a blockchain distributed ledger will generate efficiency, but I’m of the opinion that more than that is needed. Computers and software are vulnerable to hacking. How is the safety of the system guaranteed? Who (or what) is in control when the inevitable problem occurs? Perhaps these questions can be answered to my satisfaction eventually. For now, the volatility alone is reason enough for me to treat bitcoin and other digital currencies as speculative trading vehicles, and not as alternatives to the world’s major currencies.

Sectors
Telecom holds the top spot for a second week, and Real Estate has chalked up four weeks in a row in the second-place spot. The remaining edgecharts-2016-07-20sector categories were not as stable. Materials was the week’s winner, surging from eighth to third place despite the setback for basic metal stocks. Industrials climbed three spots higher to fourth on strength in transportation companies. Utilities dropped another two places after relinquishing the top spot a week ago. Energy and Health Care held relatively stable in the middle. Consumer-oriented sectors posted the largest relative-strength declines, with Consumer Staples falling four places to eighth and Consumer Discretionary dropping from ninth to the bottom. However, the reason wasn’t necessarily weakness in these two sectors as it was strength in the others. Technology and Financials each edged a notch higher due to the decline in Consumer Discretionary.

Styles
Small-Cap Value took over the top rankings a week ago and has now widened its lead over the other styles. Small-Cap Blend held on to its second-place honors, but Small-Cap Growth and Micro-Cap were not able to keep the four smallest-capitalization categories at the top. Mid-Cap Value was the culprit, as its ascension from fifth to third broke up the party. Interestingly, Mid-Cap Growth moved the other direction and broke up the large-capitalization cluster that occupied the lowest four places a week ago. Although the ranking changes were subtle, they point to a shift toward Value over Growth. Supporting that theme, Large-Cap Value moved two spots higher and Large-Cap Growth remains on the bottom.

Global
All 11 global categories are in the same relative-strength ranking order as they were a week ago. However, do not confuse this stability with lack of market action, as there was plenty this past week. Latin American stocks surged higher, but since the category was already ranked #1, it was impossible to improve on that. However, it was possible for Latin America to increase its margin over the rest of the field, and that is exactly what it did by increasing the spread between it and Emerging Markets from 14 to 24 momentum points. All categories posted momentum improvements, although Japan produced the smallest increase. Still, it was able to hold its position above the bottom three. The U.K. made the transition from red to green, leaving the Eurozone as the only equity category still registering a negative trend.

 

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“This is one of the nightmare scenarios everyone was worried about: Someone exploited a weakness in the code of the DAO to empty out a large sum.”

Emin Gün Sirer, a computer science professor at Cornell


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