The current turbulence in the economy is palpable. The soaring inflation, the dramatic rise in the cost of living, and the ongoing war between Ukraine and Russia are a recipe for financial turmoil. The direct consequence on retail is a mixture of irrationality, confusion, and fear. Further, this corresponds to an exodus toward risk-off as cash becomes the flight to safety. Meanwhile, all the fundamentals surrounding blue-chip stocks become, to some extent, redundant, as the necessity to hold cash in a recession becomes too attractive. Ultimately, the uncertainty leaves investors in a predicament as they try to distinguish between the assets that are oversold with the ones that are merely retreating to fair valuation. One useful method of gauging this is Logarithmic Regression.
Firstly, it’s important to disclose that all charts, including logarithmic growth curves, are purely indicators and should be perceived as nothing more than that. Benjamin Cowen, a popular Quant Analyst on YouTube, recognises its usefulness by showcasing it in his videos. Despite that, he never fails to remind his viewers that “all models are wrong, but some are useful”. Once you understand that, you can look at Logarthimc Regression from an objective, clear lens and gain important insights.
In its simplest form, Logarithmic regression is used to model situations where growth or decay accelerates rapidly at first and then slows over time. In addition, using historical data, a log chart can forecast and predict future prices. In the case of Bitcoin, its surge to ascendency in the last decade, coinciding with its network effects, makes a logarithmic chart a very useful indicator for establishing potential future growth. Similarly, other stocks and indexes can be used to provide an investor a clearer picture of its true valuation versus its price. Therefore, it can be helpful to cancel out all the noise during an economic crisis, such as the one we find ourselves in.
Above is the logarithmic regression chart of Bitcoin since its existence. At a glance, the clear trend is that the Bitcoin price has followed a pattern of up and to the right. However, when you look in more detail, you learn that the Bitcoin price has deviated a lot within the log chart. For instance, there are three yellow lines in the log chart: the middle line (Mid Deviation) is the fair value price of Bitcoin at that moment in time. Moreover, the top line, also known as High Deviation, is when Bitcoin is seemingly overvalued. And finally, the lower line (Low Deviation) constitutes an undervalued Bitcoin price.
So, what does the chart tell us? First and foremost, Bitcoin tends to spend only a small amount of time at its fair valuation price (Mid Deviation). The reason for that can be put down to a number of factors such as the current economic climate, policy decisions, and speculation and hype about Bitcoin. And the most important factor of all, it’s an indicator, not absolute, and therefore up for interpretation.
Furthermore, the log chart makes it very easy to identify Bitcoin’s previous bull and bear markets. For example, the previous bull runs in 2011, 2014, and 2018 all saw the price of Bitcoin briefly touch the High Deviation line. Conversely, Bitcoin’s bear markets in 2012, 2016 and 2020 saw the price go to the low deviation, with the Bitcoin price even going under it in 2021 after the outbreak of the pandemic. Now, as an investor you could try and buy at the lower line and sell at the higher line. However, if you were to follow this approach in the recent “bull run”, you would get burnt. In order to view the Bitcoin price action more closely, we need to zoom in further.
The kickstart of the 2021 bull market was keenly felt as the price surged from the low deviation all the way beyond the fair valuation. However, something unique happened wherein the price did not reach the high deviation point. For the most part, Bitcoin sat in fair valuation in 2021 before making its brutal descent to the lower deviation. Why could that be and does that mean bull/bear market cycles are over? It’s hard to tell, but one thing that is true is that Bitcoin is a lot larger in scale than it once was. For instance, Bitcoin surpassed $1 Trillion in market capitalisation in 2021 and therefore the additional money required to make the same movements in previous cycles is far greater. As this asset continues to mature and grow in size, it would be feasible to see more time spent in the fair valuation and less time under. With that said, if history is any indication, Bitcoin hovering under the low deviation (which it currently is) is a screaming buy signal as it very rarely spends a lot of time under before a quick resurgence higher.
To sum up, logarithmic charts are helpful tools but cannot predict nor pre-empt what the future may hold. As a result, it can be used to your advantage when looked at objectively and with a grain of salt.
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