Ethereum is in the Ether

I have a general policy about not writing about crypto prices hitting or missing arbitrary benchmarks, yet I was asked to weigh in on Ethereum. My aversion to crypto media comes from the fact that most content parades as analysis and does little to help others understand what’s actually going on. Most price determinants are manifold and complex so I don’t spin stories or make short-term predictions for the same reason I don’t try to forecast next year’s hottest fashion trends or predict when my two-year-old will be fully potty trained.

Economics and statistical training taught me to differentiate signal and noise, and this forbids me from contributing to crypto noise in the public sphere. As a financial researcher, I’m expected to be the source of facts, not hype. I’ve shepherded thousands of people through economics experiments and nearly all of them demonstrated irrationality. I even develop trading algorithms that tune into that very irrationality. But I’ll share what (if anything) we can learn from soaring — and crashing — Ethereum prices.

What do I mean by noise?

Price paths can be decomposed into random and directional components and long-term investors are interested in economic value through cash flows generated by an asset, rather than a succession of its random steps. Conversely, traders’ profits are in the noise.

The sports equivalent is betting on teams versus on the play-by-play: Teams consist of fundamental factors that prevail over time — skilled athletes with team chemistry, a veteran coaching staff, major TV deals — and noisy movements occur due to many random factors. A random price change is like a fluke event in a sports match — generally irrelevant in the long term.

But price itself does not resolve the cryptocurrency value question because value and beliefs about value are difficult to disentangle. It’s statistically unclear whether prices affect sentiment or the other way around because there is strong “bidirectionality” in cryptocurrencies. Higher prices increase positive sentiment, which further pushes up prices, creating a positive feedback loop that generates more speculative demand.

Efficient Markets?

A graph caught my attention in graduate school from a 1981 paper from Yale Professor Robert Shiller. He addressed the core question of whether markets are “efficient” in the sense that prices reflect asset value by juxtaposing “rational” and actual data.

The solid line waving about wildly is the S&P index price and the stable, boring dotted line represents the “rational price” calculated after the fact. We see that prices fluctuated much more significantly than they should have and that they seldom matched the rational price.

If the S&P index could look back and see itself, I imagine it would feel a bit like a guy watching a video of himself at a wedding, drunkenly hitting on the bride, picking a fight with the best man, and twerking Grandma during the cake-cutting ceremony. In comparison, the fundamental dotted line is the astute father of the bride, sipping scotch in his tuxedo and calmly observing the night play out.

The graph from his now-ancient paper shows the variability of stock prices, but the timeless message applies to cryptocurrencies today.

Fun(damental) Exercise!

How would you reproduce Shiller’s famous graph for Ethereum?

You could easily come up with prices (the solid line), but what would stand in for earnings and dividends (dotted line, fundamentals)?

If you’re struggling to give a clear answer, you’re not alone. It is this very lack of clear economic value that attracts scorn from financial academics, regulators, and Warren Buffett. When people say, “crypto is in a bubble,” they mean that prices are greater than the discounted net present value of the cash flows generated by that asset. Alternative “fundamental” measures have been proposed (e.g., network activity), but there is no escaping the fact there are no cash flows to unit holders, and thus no computable value using this basic yardstick.

From New Economy to DeFi

Ethereum positions itself as a “fail fast” blockchain servicing other decentralized applications (DApps) with so-called smart contracts. This, and other Decentralized Finance (DeFi) projects threaten traditional finance, and this excites people. However, economic gravity eventually pulls harder than speculative motives, especially when propelled by easy money and exuberance. Remember: the once-hyped AltaVista tanked, and perhaps Ethereum may likewise give way to presently undervalued projects with better fundamentals.

Because of its vast disruptive potential, Ethereum’s intrinsic value could be comparable to a technology titan, but it may also end up worth as much as a common tulip bulb. Price today only communicates how much a marginal trader paid for it, so basing an argument about the long-term value of an asset on its spot, future, or derivative price, especially surrounded by a frenzied market with poor price discovery, is a fool’s errand.

Citations

Shiller, Robert J. “Do stock prices move too much to be justified by subsequent changes in dividends?” (1980). American Economic Review.