THIRD QUARTER PARKOUR VENTURES I INVESTOR LETTER
“When you reach the end of your rope, tie a knot in it and hang on.”
― Franklin D. Roosevelt
“Never let the fear of striking out keep you from playing the game.”
― Babe Ruth
By the 20th day of the third quarter, the Parkour team was following ex-President Roosevelt’s advice as the crypto market was dangling on the end of the proverbial rope. As we are sure everyone who lived through it is aware, the first 20 days of July saw a continuation of the downward price action that started with the Chinese Communist Party putting in place firm restrictions on digital assets, including Bitcoin, and banning cryptocurrency mining. As we explained in our June letter, we have not wavered in our belief in the four-year Bitcoin price cycle, nor in our price target for the end of this run of over $100,000 per Bitcoin. However, there has never been a bull market year that has had a mid-cycle correction as extreme as we have witnessed this year. In 2013, the second quarter was the only negative quarter, registering a -3.97% drop. In 2017, every quarter saw a positive return. This year has been truly unprecedented, especially considering that, as of July 20th, Bitcoin was headed for two back-to-back negative quarters during a bull-market year. What happened next was nothing short of amazing. On July 21st, Bitcoin hit its bottom around $29,300 and began ripping higher, finishing out the month around $41,840, a 43% recovery off the lows!
The remainder of the third quarter has also been very positive. Despite some major macroeconomic concerns, Bitcoin closed the quarter at $43,790, only 32% away from its all-time high in April of ~$64,800. As we write this letter, Bitcoin is consolidating just under this level after pushing to new all-time highs in mid October. Since the beginning of the fund in February, the trading team has never been as bullish as we are right now. The chart below shows the runs that have transpired after similar set-ups.
This is not a moment when we want to lose conviction. In fact, the following analysis shows this is a time to size up our exposure. There are 47 times in the past when the Bitcoin price has moved over 1.2 times the 200-day moving average. In 88% of those occurrences the price continued to rise. In the 90-day period following the crosses, the average return for the 41 positive outcomes was 72%. Those are very good odds, especially considering Parkour’s broad view into other indicators and understanding of where we are in the 4-year cycle.
Like in poker, you want to get your chips in the middle when you have the best percentage chance of winning and the payout is large. This is one of those times.
Fourth Quarter 2013 & 2017 Encore
Crypto is such a new asset class (the Bitcoin white paper was published in response to the 2008 financial crisis), and there is only a limited amount of analytical tools that can be applied to the data to give us clues as to what lies ahead. The initial investment strategy behind Parkour Ventures I was based around two key models, the four-year Bitcoin halving cycle and the stock-to-flow valuation model, which we believe is the best pricing model that is currently available for assets like Bitcoin, gold, or silver that have a relatively fixed supply and predictable yearly production.
Another tool that can be useful is practical experience (Parkour traders owned Bitcoin in 2013 and managed and traded crypto for clients during 2017). Two periods that stick out to us as particularly relevant right now are the fourth quarter of 2013 & 2017, both bull market years in the halving cycle comparable to this year. Bitcoin returned 472% in 4Q 2013 and 181% in 4Q 2017. The 2013 and 2017 Bitcoin charts are interesting to us because they both included a “blow-off top” where the price of Bitcoin significantly deviated to the upside from the price predicted by the stock-to-flow model.
We believe the probability of this happening again is very high, and, at a minimum, the price will reach the predicted stock-to-flow price target for this cycle of $100,000 per Bitcoin. At certain times during the year, it is almost impossible to understand the greed and FOMO (fear of missing out) that kicks in during the end of the cycle. However, we have seen it twice now and know how to play this part of the cycle to maximize returns. Patience and conviction are crucial to making it through the volatility that also accompanies this part of the cycle.
Regulation and Institutional Adoption
Institutional adoption has been a major part of this bull run for cryptocurrencies. Dozens of companies have embraced crypto by accepting it as payment or holding crypto on their balance sheets. Bank of America recently joined the ever-growing faction of banks to offer cryptocurrency services and products to their clients by releasing a 140 page report entitled “Digital Assets Primer: Only the First Inning.” The report covers a broad spectrum of crypto topics from Bitcoin and stablecoins, to NFTs and DeFi. Even the most traditional and old school investors are finally coming around to crypto. Recently, the Houston Firefighters Pension fund became the first US public pension fund to invest in crypto. These institutional investors represent an entire new demographic in crypto. However, with these larger and more traditional investors also comes more scrutiny and regulation. Unlike the first generation of crypto early adopters, many banks and governing bodies getting into cryptocurrencies are less interested in being first and more interested in more safety and security in order to enter the space correctly. The rally in early 2021, in part fueled by companies getting involved in crypto, also brought with it heavy scrutiny regarding ESG concerns around Bitcoin mining and larger attention from governing bodies as they began to institute laws around cryptocurrency taxation and accounting. While regulation and governance was the cause for initial short term pain in the market, it will ultimately make it possible for a wider range of investors to own crypto. We are already starting to see this with the approval and launch of multiple Bitcoin ETFs in October.
It is important to look through the day to day noise in markets and focus on the major structural changes that are taking place behind the scenes. These tectonic shifts, like large institutions moving off a zero allocation to crypto, are the major forces that will drive the next leg up to our $100,000 price target and higher in the long-term.
Another example of the sometimes hard to see undercurrents that are moving crypto markets is the striking similarity between crypto adoption and internet user growth during the late 1990’s and early 2000’s. The following chart shows where we are on the adoption curves and demonstrates the likely growth (and investment gains) that are still ahead for patient crypto investors.
The slower-moving, yet impactful addition of institutional crypto investors has significant implications for the price predictions of cryptocurrency models like Stock-to-Flow. Historically, after the Bitcoin halving events that take place roughly every 4 years, the price of Bitcoin rises over the next 12-15 months as the market adjusts to the new supply and demand ratio created by the lower rate of new Bitcoins entering the market. While the institutional adoption of Bitcoin significantly increases demand, the regulation that comes with it also makes for a potentially slower moving market. This may lengthen the post-halving price discovery as the supply/demand adjustments are less drastic and occur over a longer period of time.
One of the tools we pay attention to that helps us determine where we are in the Bitcoin cycle is the Pi Cycle Top indicator. The Pi Cycle Top indicator uses the 111-day simple moving average (111SMA) & the 350-day simple moving average times two (350SMAx2) to predict when the price discovery phase of the market is coming to an end and the momentum of the market is fading. Historically, the Pi Cycle Top Indicator has been extremely accurate in predicting these local tops within +/-3 days. This is an indicator that should not be ignored. In order for us to reach another cross for the Pi Cycle Top indicator and a top in the market by the end of December, Bitcoin would have to trade over $500,000. We don’t think this is reasonable by the end of this year, but is another indication of the direction we are heading and another reason why it is likely for the price discovery phase to extend into next year.
Outside of the crypto space, the focus of the broader market during the third quarter was centered around the actions of the Federal Reserve and the Evergrande Debt crisis. For the past year and a half, the Federal Reserve has taken a very accommodating stance in supporting the US economy to assist in recovering from the COVID-19 recession. Through quantitative easing and low interest rates, the Federal reserve propped up bonds markets and contributed to historic rises in the stock market. However, the market has been wary of how and when the Federal Reserve will begin to taper and decrease monetary support. The two key metrics the Fed has been monitoring as indicators on when to taper are inflation and unemployment. While inflation has been running high for several months, employment rates initially lagged as the Delta variant slowed the reopening, and companies struggled to rehire employees. However, the last few employment data reports finally showed substantial further progress towards the recovery the Fed was looking for as the unemployment rate fell below 5% for the first time since February 2020.
This, in turn, triggered the Federal Reserve to announce their plan to begin tapering by the end of the year by gradually reducing bond purchases over the next 6-8 months, while also planning to begin raising interest rates in the second half of 2022. While this does mean a reduction in liquidity in markets, the resolution of the “how and when” the Fed will taper marks an end to a major uncertainty in the market that many investors have been wary of this past year.
Another major negative catalyst for markets was the Evergrande debt crisis. Evergrande is one of the largest real estate developers in China. Their business model relied upon aggressivelypre-selling properties in future developments to fund current ongoing projects. This allowed them to lever-up their assets and expand rapidly. As long as new developments and new pre-sales kept coming in, the company was able to sustain this model. However, when supply chain issues, related to Covid lockdowns, significantly delayed the pace of production, the music came to an abrupt stop. In the beginning of September, Evergrande failed to make an interest payment on their loans, and it was disclosed that Evergrande had over $300 Billion in debt. At the time, that debt was worth more than six times more than the company’s overall market-cap. The crux of the Evergrande story broke on Sunday, September 7th when traditional markets were closed. This led to a major selloff in crypto markets, as funds were forced to de-risk in anticipation of the far reaching effects of a possible default of a company of that size. Additional scrutiny was placed on crypto as it was rumored that the stablecoin Tether (USDT) was backed, in part, by Evergrande bonds and commercial paper. The size and scale of the Evergrande default led many investors to draw comparisons to Lehman Brothers and the 2008 housing crisis. However, over the next several days, Tether, along with several major US companies, stated that they did not hold Evergrande commercial paper and market participants began to see that crypto’s exposure to the Evergrande debt crisis was likely limited. Furthermore, Evergrande was able to sell-off a large stake in the company to a state-backed bank in order to raise funds to make the required payments. While Evergrande may ultimately be broken-up and many of its assets sold-off to other companies, it became clear that the effects of the debt crisis will be limited and primarily isolated to the Chinese real estate market.
One key thing to note about this sell off, was that it was primarily due to macroeconomic issues outside of crypto, and not related to any underlying problems with cryptocurrencies themselves. Because of this, once these macro fears abated, the skies cleared, leading to the large rally we have seen over the past month.
Open Interest, Derivatives, & Leverage Continues to Create Air Pockets
The leverage that is created by futures, in particular, continues to be a big factor contributing to the extreme volatility in crypto markets. Once again, September 20th turned into another “liquidation event,” as we saw another sharp drop in the Bitcoin price that snowballed into overleveraged longs having their positions automatically closed, or “liquidated” by exchanges. As the graph below shows, the open interest, which measures the aggregate size of all futures positions that are open on the perpetual contract, decreased by 30% in the course of an hour:
That is a big drop! When moves of this magnitude happen in the market, it often takes awhile for participants to gather themselves (and their portfolios) and to regain confidence in the uptrend.
Although this was a liquidation event for longs, the same set of events happens in reverse, as short positions are liquidated during sharp price increases. We think it is important to explain some of the inner-workings of the crypto market because it helps understand how market moves are often amplified by the leverage that is easily accessible to crypto traders. Also, if history is a good predictor, the fourth quarter should have shorts on their heels, as their positions are bought back by exchanges, which will likely trigger some short-squeeze fireworks that are always more pleasant for investors like us with a bullish bias.
On-Chain Data & Whale Accumulation
During tumultuous times in the market, an important thing to keep track of is the accumulation of long-term Bitcoin holders. One way to track this statistic is to look at the total volume of inflows and outflows of Bitcoin on and off exchanges. Because the blockchain is fully public and transparent, we can look at on-chain data to determine this information. If we see a high volume of Bitcoin moving onto exchanges, then this could be a sign that holders are looking to sell and realize profits. Alternatively, if we see a significant movement off of exchanges and into private wallets, this means owners are likely intending to hold their Bitcoin for longer periods of time, indicating high confidence in the price and future of Bitcoin moving forward. Furthermore, this also leads to a lower supply available on exchanges to trade, which can cause a supply shortage and thus larger movements in price when more buyers come into the market.
As shown in the chart below, from May to July we saw inflows of Bitcoin onto exchanges, further contributing to the sell-off that occurred over the summer. However, recently, this narrative has flipped, and we are seeing significant outflows of Bitcoin to an extreme that we have not seen since November 2020 when the price of Bitcoin was still below $10,000. This is a further indication that the rally we have seen on the back end of Q3 is only getting started, as many long-term Bitcoin investors are filling their bags for the next leg up.
The Rise of Layer 1 Protocols and NFTs
Both Bitcoin and Ethereum can be considered Layer 1 protocols (L1s), providing the settlement layer for all transactions on the network. Bitcoin Layer 2 solutions (L2s), such as the Lightning Network on Bitcoin, or Plasma on Ethereum, deliver a way to increase transaction speeds while scaling the network and retaining the security of the base layer.
While Bitcoin uses blockchain technology for peer-to-peer transactions and allows nodes and messages to be attached to each transaction, Ethereum takes it a step further by using the blockchain to create a decentralized computer. Bitcoin may be used as a store of value or medium of exchange, while Ethereum uses smart contracts to interact with decentralized applications (dApps) built on the Ethereum blockchain.
The explosion of dApps has overloaded the Ethereum network, causing bottlenecks and high transaction fees that make many of them time-consuming, unusable, and expensive. The proposed Ethereum 2.0 protocol coming out in Q1/Q2 2022 addresses the need for a quicker solution, accelerating the shift to L2 technology.
The growing pains of Bitcoin and Ethereum scalability have increased demand for other L1 smart contract platforms. Since the rapid growth in dApps, more attention and capital has been flowing into alternative L1 chains, also known as “ETH competitors,” like Binance Smart Chain, Solana, Polkadot, Cosmos, Fantom, Cardano, and Avalanche to name a few. These other L1s have also grown in popularity, partially in response to the scalability issues encountered in the Ethereum ecosystem.
Now, L2s, which make Ethereum transactions more affordable and faster by executing them off the Layer 1 mainnet, are showing signs of rallying on their own. The explosive growth of L2s has captured a lot of value, bringing the native L1s that they were built on top of back into the spotlight with many hitting all-time highs in September and October.
Along with dApps and L2s, another major addition to the cryptocurrency space has been NFTs. An NFT is a piece of software code that verifies the property of a unique and non-interchangeable unit of data stored on a digital ledger, known as a non-fungible token. NFTs can be used to represent easily-reproducible items such as photos, videos, audio, and other types of digital files as unique items, while also providing verified public proof of ownership using blockchain technology.
NFTs are the perfect example of how the impact of blockchain technology is affecting regular people’s lives, and starting to go far beyond just the financial impact. NFTs have gripped the world’s attention by interacting with culture, music, sports and the media and are starting to become known as “CultureFi” or Culture Finance.
The NFT market has been a major driving force in the crypto industry since the beginning of the year and through the recent market correction. Brands like Coca-Cola, Visa, Asics, and many sports teams in the MLB or NBA are starting to create their own NFTs causing this trend to gain traction in the mainstream media. NFTs have started a digital, cultural renaissance.
On October 2nd, 2021, Parkour Venture Fund I acquired a CryptoPunk NFT. While many new NFT projects are difficult to value, CryptoPunks are the first NFT project minted on the Ethereum network, and therefore, will always hold a historic place in the origin story of the blockchain. We are the second owner of the unique 1 of 1 NFT. At Parkour we view the Punk as a leveraged play on Ethereum similar to a warrant or perpetual call option on Ethereum, while also giving us exposure to the ever growing NFT market.
Similar to the high valuations given to select paintings and art, NFTs are becoming equally coveted by high-net-worth collectors. More importantly, the NFT marketplace provides artists with a direct way to publish and receive credit for their creations without having to receive approval or acceptance from an art gallery or physical marketplace that often takes a cut of the proceeds. This is analogous to how blockchain is able to cut out the middleman in many financial transactions in the traditional banking system.
Furthermore, a secondary market is also created once the art leaves the artists’ hands and enters the marketplace. The NFT token-economics can be set up in a way that the artist also receives a percentage of each sale in perpetuity, earning the royalties that they deserve in a trustless and secure fashion through the smart contract. The NFT marketplace has reached a transformational stage that is changing the way artists are compensated for their hard work.
With the adoption of NFTs and new L1 protocols, institutional involvement, and the accumulation of long-term crypto holders, we believe Q4 2021 will be another historic period for the crypto market. Parkour is in a very advantageous position to continue to capitalize on these market moves and to intelligently invest in the ongoing crypto adoption we see across financial and cultural industries alike.