Thinking in Probabilities
A framework to navigate the wall of worry in the markets
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Hello readers,
We’re about 6 months away from the next Presidential election in the United States. There is ongoing war in Ukraine and in the Middle East. President Biden just signed a bill that could lead to a nationwide ban of the popular Chinese social media app, TikTok. The SEC continues to sue large and important crypto companies. The US Treasury is currently spending to the tune of a $1.7 trillion budget deficit (!). AI is advancing at a blistering pace.
Said another way — a lot is going on in the world right now. Lots of uncertainty. And nobody has perfect information.
Of course, we also just had the 4th Bitcoin halving and we’re in the middle of the latest crypto cycle. Naturally, everyone wants to know if they should be buying, selling, or sitting on their hands.
That’s probably why you’re reading this.
So I thought it would be a great time to share a post on “thinking in probabilities” while applying frameworks and mental models to the current state of the markets. The goal of this post is to find some clear thinking as we gear up for the mania that may (or may not) come to the crypto markets in the coming year +.
Topics covered:
Probabilistic thinking
The election cycle & the SEC
Liquidity cycle
Geopolitics
Conclusion
Disclaimer: Views expressed are the author’s personal views and should not be taken as investment, legal, or any other advice.
Probabilistic Thinking
Mastering the ability to “think in probabilities” is a superpower for investors, entrepreneurs, business leaders, and anyone who has to make important decisions with clear eyes. In this section, I’ll share a basic approach, and then we’ll work through a number of open questions as it pertains to the current crypto cycle.
The Framework:
Prepare a list of potential outcomes for the decision at hand.
Assign a probability to each outcome.
Make a decision based on probabilistic thinking.
Example:
Let’s say you bought some Bitcoin at $15k because you read “did we bottom yet” in December of ‘22.
You’re up 320% on your $15k Bitcoin purchase, but you still have some dry powder to deploy. It feels weird to buy more Bitcoin now because it’s up so much already. But you also think Bitcoin could outperform stocks moving forward.
What do you do?
One way to approach this is to look at past cycles and price action to apply probability to certain outcomes. For example, let’s assume your research lead you to conclude that there is a:
45% chance that Bitcoin will hit $85k this year (35% increase from today) and $100k next year (60% increase from today).
45% chance that Bitcoin dips to $50k (another 20% drop) before resuming the bull run.
5% chance Bitcoin drops to $22k (70% drop from all-time high, cycle is over)
5% chance Bitcoin hits $150k this year (140% increase from today)
So you believe that scenarios 1 and 2 are most plausible and you’ve equally weighted them as such. But you also believe there is a chance of more extreme outcomes.
Now. If you were to apply this to portfolio management, it might look like this:
Buy more BTC. You’re happy to get a 35% gain this year as you do not think the S&P 500 will create those types of returns.
Buy more BTC. If we dip another 20% it’s ok because you believe the bull run will resume, and you can buy more at cheaper prices.
Sell BTC. The cycle is over. Inflation is persistent. Rates are going up. A recession is imminent.
Buy BTC. We’re currently in a classic bull market correction and on our way to a blow-off top this year.
By these (wildly over-simplified) estimates, buying is the best option for 95% of outcomes. All of a sudden the decision seems much more simple.
Keep in mind that I’ve made this unrealistically straightforward for the purpose of illustration. This is not investment advice. We all have different time preferences, wants, needs, responsibilities, and risk tolerance so please always do your own research.
My job is simply to provide you with a framework by sharing insights into my own process.
Now let’s apply the framework to some other factors that could impact the current market cycle.
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The Election Cycle & The SEC
Let’s say that you:
Are worried about how Politics will impact the crypto industry in the US.
Believe that either Biden or Trump will be the next President.
View Trump as “good” for crypto (new SEC Chairman, new leadership at the FDIC, banking subcommittees, etc.) and Biden as “bad” (more regulation by enforcement by the current regime with the courts deciding the fate of the industry).
You might apply the following weights to the potential outcomes:
49% chance that Trump wins.
43% chance that Biden wins.
8% chance someone else wins.
*per CNN polling as of 4/28/24
Now. If we were to apply this to crypto portfolio management, it might look like this:
Buy. The highest probability is that Trump will win — a positive outcome for the crypto industry in the US.
Buy. Despite the hostility of the White House, FDIC, SEC, and Banking Subcommittee (Elizabeth Warren) toward crypto, the industry is winning in the courts — which is the reason we now have a Bitcoin ETF and 320% price gains off the cycle lows.
Buy. RFK Jr. is the only viable alternative candidate and is pro-crypto.
In this case (once again, over-simplifying), buying is the best decision in 100% of the potential outcomes.
The Liquidity Cycle
As a reader of The DeFi Report, you know that crypto asset prices are tightly correlated to liquidity cycles and the business cycle.
Let’s say you’re worried that:
Inflation is persistent.
Rates could go up.
Risk assets (crypto) could sell off.
You apply the following weights to the potential outcomes:
40% chance that rates go up this year.
40% chance that rates remain the same this year.
20% chance that rates drop.
Applying to portfolio management, it could look like this:
Buy.
Buy.
Buy.
Why? Over the last year, we’ve learned that the Fed is not so much at the wheel anymore. The Treasury is. And they’re pumping liquidity into the system to finance budget deficits — over $1 trillion deficit through March of this year!
Data: Bipartisan Policy Center
This money is making its way into risk assets and is artificially propping up the entire economy. The Fed raising interest rates will not change this. It’s also why almost nobody predicted a strong economy + a big year for stocks and risk assets in 2023 and into 2024.
We’re now 6 months out from the election, and interest and military expenses could increase the budget deficit even further this year. Therefore it seems more likely than not that this trend of more fiscal spending will continue for the rest of the year — creating a tailwind for financial markets and risk assets such as crypto.
Geopolitics
With Wars raging in Eastern Europe and the Middle East (with potential for escalation), you may be worried that geopolitics will roil the oil and stock markets, bringing on recession. What happens if Russia backs Iran in the Middle East? What happens if the TikTok ban is just the beginning of a cold war with China?
There are a million scenarios we can spook ourselves with, but the reality is that financial markets are historically quite resilient to periods of conflict and war.
Data: S&P CapIQ, Bloomberg
While nobody wants to see more war, what is one inescapable reality of war? More money printing! And what does money printing do to financial assets? I’ll let you answer that one yourself.
Conclusion
I hope this over-simplified framework helps you think through where we sit in the current cycle as well as the wall of worry that markets could ultimately climb in the second half of this year.
Based on all of the data we track (both onchain, off-chain, and macro), we believe we are early to mid-cycle.
The recent pull-back is on par with what we would expect given:
Profits taken from 6 months of strong price action.
Tax harvesting & general selling to pay taxes.
Inflation rearing its ugly head again and spooking the market in the short run.
Turmoil with the Japanese Yen devaluing sharply against the dollar.
Public sector deficits ($1.7 trillion!) = private sector surpluses. This is the big picture of what is driving markets in our opinion. We’re in a period of fiscal dominance and so we are less concerned with inflation, rate expectations, and monetary policy from the Fed.
It’s worth noting that historically, crypto cycles see the majority of the price action in the second half of the cycle. Therefore, the party hasn’t really started just yet in my opinion.
Of course, crypto is risky and volatile. Nobody has a crystal ball. Please do your own research.
What could derail our forecast?
If inflation were to meaningfully increase, forcing the fed to signal aggressive rate hikes, we would expect to see a market sell-off. Why? Expectations. The market expects rate cuts later this year. If we see increases, this will create turmoil and a repositioning in the market.
Note that the Fed has its FOMC meetings yesterday and today. For what it’s worth, the market is anticipating no change to the current Fed Funds target rate of 5.25-5.5% — and potential rate cuts not until September.
Nobody is expecting rate hikes this year.
Stay tuned as we’ll continue to update you with more “cycle awareness” reports using onchain data in the coming months and quarters.
Take a Report.
And Stay Curious.
Disclaimer: Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment advisor and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice. The content contained in the report is derived from both publicly available information as well as proprietary data sources. All information presented and sources are believed to be reliable as of the date first published. Any opinions expressed in the report are based on the information cited herein as of the date of the publication. Although The DeFi Report and the author believe the information presented is substantially accurate in all material respects and does not omit to state material facts necessary to make the statements herein not misleading, all information and materials in the report are provided on an “as is” and “as available” basis, without warranty or condition of any kind either expressed or implied