What’s an Owl market? — Three Body Capital

We once gloated to an elder statesman of the emerging markets about our great trading gains (all of which were unrealised and still in a multi-year bull market).

The gentleman remarked with a smirk:

Do you know what an owl market is?

We replied with a nervous laugh:

“An owl market? What on earth is that”

With a wry smile, he replied:

“It’s when you arrive and tell everyone you are keen to sell your stocks and all you hear is “To who? To who?”

Needless to say, we ultimately learned the hard way exactly what he was talking about.

The ominous silence of an absence of bids is terrifying for the owner of any asset. In markets that make up a core position in top-down asset allocation portfolios, these dry patches are usually temporary. For others, more speculative than core in nature, the tide going out may turn out to be much more permanent, or at least, long-lasting.

For many long-time Emerging market investors, the episodes of liquidity drought in domestic equity markets make for painful events to recall – the infamous “Sudden stops”. For just as a rising tide lifts all boats, a falling tide grounds them all, regardless of quality. While no one bemoans a bull market where everything goes up, the reverse is orders of magnitudes more painful, sudden and violent. Much less palatable, and certainly nothing worth celebrating.

Core to a lot of our thinking is the effect of market liquidity on prices and valuations. And just like in the emerging markets of decades past, where undoubtedly optimistic fundamentals have been outpaced by even more optimistic market sentiment and price action, only to have the rug pulled from beneath as liquidity dries up in an EM-ex-China-style “sudden stop”, the crypto markets too find themselves in a somewhat uncomfortable position of having made too much money, too quickly.

So, while we remain long-term structural proponents of the crypto ecosystem and the value it can potentially deliver, we are equally conscious of the risks inherent in what is a still nascent market – of a sudden stop in liquidity, of disappearing bids and of finding ourselves in an “owl market”.

Where the only answer we get when we’re in the market trying to sell is “to who?”.

If it moves, buy it

As much as all investors like to believe in their own cleverness, ourselves included, the hard truth is that cleverness, perception, research and insight can only be successful if applied and deployed at the right time.

The parabolic rise in price within the crypto space could well be attributed to some extent to a recognition of the potential value which this revolutionary new technology brings. Some are calling it a new renaissance – this podcast on Bankless with historian Josh Rosenthal is well worth a listen, as he compares the internet and the blockchain to the printing press and double-entry accounting and lays out a compelling case for us being in the midst of a new renaissance.

That may well be true, and we are inclined to be in agreement with such a view at a macro level. At the same time, looking at the numbers, it is difficult to attribute the pace of rising prices in the crypto space purely to “fundamentals”. Yes, there are highly profitable protocols that are growing revenues and earnings are phenomenal rates. But try explaining this chart of Dogecoin’s price with fundamentals:

Here is a token that is a self-declared meme, with no real use case other than speculation, built around what was meant to be a joke and a cute looking dog. Put on a crypto analyst’s hat, and the first question is: what is the long-term supply cap on this, if any? Answer: none.

What is it meant to be worth? Its official site gives the definitive answer:

Dogecoin is perhaps the most extreme example of a meme gone viral and accruing an inexplicably (and certainly non-fundamental) large amount of temporary value. Added to the resurrection of a plethora of protocols once declared “dead” – forks of Ethereum (like Ethereum classic) and Bitcoin (like Bitcoin Cash and Bitcoin SV) that were born from the bubble of 2017, to name a few – and the army of believers rallying across the twittersphere to pump their favourite coins for no reason other than “numba go up” and that they “believe” in it, and one cannot help but be wary that the rug is being prepped to be pulled from under one’s feet.

The numbers speak for themselves too – this article in the FT published just this week pointing to a boom in crypto trading volumes as momentum shifts out of equities and traditional assets (not surprisingly as equities come off the boil – no more “numba go up” in stonks) has a couple of charts that are worth showcasing.

Coinciding with a cooldown in equities volumes:

The market for crypto, whether in the form of Ether futures on the CME…

… or overall crypto volumes…

… has gone through the roof.

Fundamentals, yes. THAT MUCH fundamentals? Probably not.

No surprise either that as equity volumes move to crypto, the name that benefit the most happen to fall on the list of cryptos supported by Robinhood:

Hello dispersion, my old friend

Frequent readers of our blog might have come to the (inaccurate) conclusion that we have disowned the principles of fundamental investing, with our frequent discourse on how prices are driven by flow, narrative and sentiment.

That is, of course, far from true. As we have explained many times, the weight we place on what is “important” is a function of the structure and nature of the market. In the world of listed equities, where flow is driven largely by top-down asset allocation decision, passive vehicles and hedging flows on derivative markets representing notional values way exceeding the underlying market, relying on fundamentals to drive investment and valuation decisions is sub-optimal, if not outright dangerous.

The decision we have to make at any point in time is: “What matters?”

Sometimes, it’s about fundamentals – growth rates, margins, earnings multiples etc; other times, it’s about market drivers – liquidity, spreads, yields, positioning etc. Not everything matters all the time, nor is the balance of what does/doesn’t matter constant.

Interestingly, and contrary to some the critics (and cynics), crypto offers much greater opportunities for fundamental analysis. Transparency into token revenues, activity, governance and ownership in this decentralised world makes analysis much more accurate. Furthermore, the plethora of projects in existence necessarily means that token-picking based on fundamental value is essential to making long-term, exponential returns.

As one participant in our webinar last week put it in his feedback, “so basically in crypto, the more hardworking you are, the more likely it is that you find a good project.”

Ultimately, the nascent phase of development in which the crypto world still finds itself suggests that the opportunities are immense.

At this point, we will put on our fundamental analyst hats and paraphrase the grand master of value investing, Ben Graham: that the market in the short run is a voting machine (Dogecoin is winning, for now), while in the long run, one would hope that it turns out to be a weighing machine.

Dispersion is, after all, where the art of the fundamental investor lies: that was our game back in the heydays of emerging markets, and as the mechanics of flows took over and overrode the influence of fundamentals, we have had to adapt.

So, imagine our excitement when we discovered the world of crypto years ago and realised there was an opportunity to do REAL fundamental analysis which once again mattered for making money.

The maps say, “Here be owls”

Of course, none of this would matter if the rug got pulled from under our feet. The fact remains that crypto is a market that is still developing – not so much a newborn but perhaps more like an angsty toddler in the grand scheme of things.

Just like the Emerging Markets of old (with much more nitro glycerine in the tank), streaks of massive wins (and losses) are par for the course, exacerbated by an abundance of liquidity and access to leverage via futures, margin and other derivatives. Not to mention layers of collateralisation in staking protocols (some with extra leverage stacked on) and the inadvertent friction in trying to unstake those assets from on-chain contracts.

If the bid goes, the owls come.

Could we find ourselves in an “owl market”? We’re probably already a little too far down that road. Imagining an orderly climbdown from where the market is now is in fact more intellectually demanding than envisioning a violent selloff that purges excessive leverage and ebullience.

When could it happen? Anytime, really – perhaps even between the time we plug this post on our website and the time the email gets sent out. Or tomorrow, or the day after.

But would that end be the definitive end? In our view, it’s just the beginning.

We’re all still early. WAGMI.