Jurrien Timmer (03:06):

It’s like, “Mr. Johnson, you need to come to the meeting.” But his passion was charts. And so I learned a lot from him how the markets fit together. He would just draw on the chart physically, going back to the ’60s and explain the 1968 speculative blow off. And I use that today. Because we have the meme stocks and there are a lot of similarities. And that period was not well documented and so the oral history was extremely valuable.

Preston Pysh (03:39):

What would you say some of the critical variables were that he would look at? Was it currency and interest rates that he would be particularly paying attention to as the bigger, broader waves in the market to understand how everything else would be getting bumped around? Cue us into maybe some of the bigger, broader brush stroke.

Jurrien Timmer (04:01):

He would look a lot at the internals of the market. So are small caps confirming large caps? Or what are the breadth numbers? Tops and bottoms. Do you see the greed and fear show up in the markets? Did you see the capitulation watching the money flow? And obviously all the other elements that you just described weave into that. Obviously my background is actually a bond person because before Fidelity, I worked in New York for a Dutch bank running a bond desk for them. We would execute … Back then they were Euro bonds for the Belgian dentist. Maybe you’re too young to remember that, but that was a whole thing in the ’80s and ’90s. And that was a very valuable learning experience because if you want to understand the stock market, you really need to understand interest rates. And obviously the FED plays a very valuable or very important role in that. But interest rates is probably the backbone, is probably the most important thing you can know when you’re trying to understand the stock market, because that interest rate goes right into the discounted cash flow model and it’s a very big variable. Most people think about earnings and obviously earnings ultimately will drive the market. But the interest rate side of it is a very valuable component as well.

Preston Pysh (05:21):

You often hear, especially with younger investors, that back in the ’80s we had the 10 year treasury at 16%, but what’s often missed or not put with that is what the inflation rate was, right? So you were dealing with 100 basis or 200 basis points spread back then, even though the nominal yield was, call it 16%. Today, when we’re looking at these spreads right now, it’s astronomical. We’re dealing with a 10 year around 2% and inflation prints of 7% for a negative 500 basis point spread. Which you tell me, you lived this, but when I’m looking at that, I’m saying that’s crazy. Especially when you’re comparing it to any type of historical context for anybody alive right now, this spread seems to be a somewhat eyes popping out of the head kind of moment. How are you interpreting it?

Jurrien Timmer (06:11):

You’re referring to real rates, which is really an extremely important driver. And historically, generally speaking, real rates are positive to varying degrees. And that’s probably how it should be. But you do have periods where real rates have been negative. And one of my many, many charts that I’ve created, I look at kind of the length and stability of a business cycle going back to the 1800s. And what I found is that the longer the cycle lasts and the more stable it is, those tend to have modestly positive real rates. And that’s very important because if real rates are too positive, it kind of chokes the economy. But if they’re too negative, it can create basically misallocation of capital or other instabilities in the markets. And we look at today … If you look at the CPI, obviously a 7% bond yield is at 1.8, real rates are minus 500 as you pointed out.

Jurrien Timmer (07:11):

The TIPS market tells a little bit of a different story, and we can talk about whether the tips market is manipulated by the FED, which owns 29% of it. But the market’s expectation of inflation is that it’s not going to stay at seven, but it’s going to moderate. And that’s probably, I think, a reasonable outlook just because of base effects. But even then the five year, five year forward TIPS breakeven is 2.1 and the 10 year yield is 1.8 or so. So you still have negative real rates. And a year ago they were a lot more negative. They were about minus 100. And you have to go back really to obviously briefly the early ’80s. That was a really crazy time with the Paul Volcker FED really slamming the breaks on inflation, but those were very short episodes.

Jurrien Timmer (07:56):

But to look back in history for a more sustained period of negative real rates, you have to go back to the 1940s. And there are definitely some parallels with the World War II 1940s period of financial repression and today’s climate. In 1942, the US joined or mobilized to join World War II. The FED was not yet independent at that time. That happened in 1951. That was the Treasury-FED Accord. So the FED was basically tasked by the treasury to monetize the debt. And the debt to GDP went from about 35% to 116% in the span of three, four years. So a very, very rapid increase in debt. And the FED basically capped short yields and it capped long yields. The T bill at three eights, I think, and the 10 year or the long bond at two and a half percent. And inflation ran at 5%, 6% and in some years, a lot higher than that.

Jurrien Timmer (08:54):

And the FED to be able to protect that yield cap basically increased or grew its balance sheet tenfold from 1942 to 1946. So that was a very significant period of financial repression. If you were a bond investor back then you would’ve gotten two and a quarter percent CAGR, compound annual growth rate, from 1942 to 1951, which is when the FED gained independence. And you would’ve earned about 300 basis points of negative real return. Fast forward to today, very similar story. Although there might be a fork in the road now with the FED at least planning on raising rates by about 200 basis points, which the FED raised rates at one point during the ’40s, but it was only by, I think 50 basis points from one to one and a half percent. So maybe we have a fork in the road now, but you have to go back to the ’40s to find a period where you have this rapid increase in debt because of the pandemic, of course. And then the FED not explicitly monetizing the debt, but certainly being on the bid side of all those treasuries being issued.

Preston Pysh (10:01):

So, I mean, they were effectively implementing yield curve control. They weren’t referring to it as that. When we look at where we’re at right now, they’re saying they’re going to raise rates. I suspect that maybe in March they will. But I think we’re going to get to yield curve control pretty quickly here in the coming two three years. I’m curious if you would agree with that. And then what would that look like if you do agree with that?

Jurrien Timmer (10:25):

Certainly the main conundrum in the bond market right now is that yields still are so low, right? So the FED is removing itself fairly quickly now via first the taper, now the turbo taper. That will be done in March, and then presumably they will start hiking rates in March at a pretty fast clip until they get to probably around 2%. At least that’s what the market is saying via the FED funds future curve or the Euro dollar curve. They’re saying that the terminal point for this FED cycle will be around two. The FED’s dot plot has the endpoint closer to two and a half, but I mean, it’s not a huge difference. But the question is at this point, the long end of the bond market remains very well controlled. The question is why is that? Is that demographics? Is that baby boomers always solving for income? And you can connect the dots all the way into the stock market for that as well when you look at valuations.

Jurrien Timmer (11:22):

Maybe it’s just the fact that the economy has become so financialized that the economy is just highly levered to low rates. And already the average mortgage rate is now above 3%, about three and a half percent. So there’s been a fairly quick increase in that. So maybe the market just recognizes that long yields can only go so high before it starts to essentially slow down the economy. And that will get us to kind of the inversion of the yield curve quicker. And so maybe the FED does not even need to do yield curve control, but I would say if the 10 year really shot up well beyond 2%, and my fair value, if you will, is around two, two and a quarter. So I don’t think long yields would go much higher than that anyway, but lets say that the 10 year goes to 3%.

Jurrien Timmer (12:14):

At that point, I could see the FED maybe getting into a more explicit form of financial repression, which would be through yield curve control, presumably. So I could see it, but maybe the markets are just doing all the heavy lifting for the FED and the FED won’t even have to go there. But it’s interesting, I’ve studied the Japanese cycle quite a bit. The US around 10 to 15 years behind Japan in terms of the overall demographic trend. We’re not going to end up as bad as they are in terms of the outright shrinkage of the population, but demographically the age dependency ratio, growth in the labor force, all heading in the same direction. And as you know, in Japan yields are around zero. The Bank of Japan’s balance sheet is I think 128% of GDP.

Jurrien Timmer (13:04):

So the FED is only at 36%. So the FED still has a long way to go to get to the Japan levels. But the Bank of Japan owns half the debt stock in Japan and it’s buying half the flow. And so it’s not maybe explicit yield curve control, but the Bank of Japan is a very large player and it basically has tamed the bond market into submission. The volatility of the long JGB, the Japanese government bond, is three. Whereas the annualized volatility of the US long bond is 11. So there is no yield, there’s no volatility. There are days where the JGB market doesn’t even trade. The Bank of Japan is really the only player there. And so it wouldn’t shock me at all if five to 10 years from now the US is in the same boat. And whether the FED has to do it explicitly or whether market forces we’ll do it for them, we’ll have to see.

Preston Pysh (13:58):

When we look at the current cycle that we’re talking about right now, the trends when you’re looking at the yield curve inversion kind of suggest that maybe around the summer timeframe into the fall is when that inversion might happen. Is that the timeline that you’re kind of looking at, or do you find that too hard to even forecast?

Jurrien Timmer (14:16):

When I look at the curve, and obviously the three month to 10 year remains very steep because the FED has not begun lifting rates yet. And the long end is pretty stable at around 1.8, 1.9 or so. But the twos to tens curve obviously is flattening pretty dramatically. I think it’s around 60 basis points. And it’s actually interesting that the two year note is still as low as it is. It’s just a little bit above 1%, even though the FED funds curve is pricing in about 200 basis points of hikes over the next two years. So you would think the two year note would fully reflect that, but it doesn’t for some reason. And maybe the bond market just assumes that the FED will not be able to do all the 200 basis points, but the twos to tens is around 60 and flattening fairly quickly.

Jurrien Timmer (15:04):

And so at some point, if the market perceives that the FED is not going to stop at, let’s say, four or five hikes and not even at eight hikes to maybe go to nine, 10 or 11, which is kind of what we had in 2018, where the market was completely chill for two years while the FED was hiking rates very, very consistently. And then the FED was perceived to go just a bridge too far. And then the market fell. Had a pretty sharp correction of 20%, which was very short lived and it caused the FED to pivot. But still, maybe there’s an element in the market that thinks that the FED is just talking very hawkishly and letting the markets do their work for them, but that they don’t actually have to see it through all the way to the end. And I think that’s a very important open question because right now financial conditions are tightening, but they remain quite loose.

Jurrien Timmer (15:58):

The yield curve is flattening, but it remains positive. My expectation is that the headline inflation numbers will moderate. And I think it’s just the math of the base effects will likely make that happen. But if inflation moderates, not back to 2% where it has been over the past decade, but to 3% or 4%, and that causes the FED to then say, “We’re not going to stop at two. We’re going to go to three.” Because if you look at the natural rate R-star, which is a theoretical rate, that it’s not a market rate, but it’s a theoretical construct on the basis of labor force growth productivity. There’s some kind of risk premium in there as well. It’s actually fairly easy to retrofit the FED’s natural rate number through those three variables.

Jurrien Timmer (16:46):

But if the natural rate is somewhere around half a percent, and that’s a real rate and inflation moderates to let’s say three and a half percent, and the FED goes to 2%, guess what? That still leaves the FED well below neutral, and it will leave the real FED funds rate well below zero. So I think if that actually happens that way, that’s probably going to mean a soft landing for the markets and for the economy. But if the FED feels the need to move the go old post yet again a year from now, or what have you, because inflation is not coming back down, then that’s a whole different ballgame. And then the FED will have a lot more wood to chop.

Preston Pysh (17:25):

In this chart that you’re talking about … I know that you recently posted this in the past day that you’re talking about. So we’ll have a link to that in the show notes for people that are wanting to see that. You were a person that in my opinion was truly ringing the bell at the top of this market cycle. Assuming everything keeps unfolding in this direction that it appears that it is. Back in November, December, you were making posts. And I’m just going to read two of these posts from … Here’s one from the 7th of December. You said, “Earnings growth is slowing. The FED wants the taper. So what’s next? We are bound to get more choppiness. The same thing happened in 2018, 2016.” And you say, “Like the seasons, it’s a natural part of the market cycle.”

Preston Pysh (18:06):

On 2 December, you said, “Earnings have done all the heavy lifting for more than a year now. The combination of slowing, but positive earnings growth and a sideways down PE multiple suggests a flattening out of the bull market slope.” I remember looking at these posts. And these were just two examples. You had a lot of examples with a lot of charts. And I was like, “Hey, Jurrien’s ringing the bell here. And I don’t know that everyone’s paying attention.” But so far, I mean, you have nailed this. If you could just … And I know people hate this question, but if you could just say two or three or four things that for you are really important indicators to pay attention to that you think, “Hey, this thing’s starting to run out of steam.” I know you mentioned the two in 10 on the fixed income side, which I think is a really important chart, but what are those things that you’re paying attention to, to be able to make such a bold call like this?

Jurrien Timmer (19:00):

So generally speaking, there are three pillars to a bull market, right? There’s obviously earnings growth. You’re not going to have any bull market without earnings growth. Abundant liquidity tends to be a hallmark of a secular bull market or a cyclical bull market for that matter. But I think we’re in a secular bull market that started in 2009. Third one is just interest rates because that feeds directly into the denominator of the discounted cash flow model. And there’s other parts as well. How much of earnings are being paid back or returned to shareholders via dividends and now increasingly via share buybacks. And so the payout ratio in the US, which is around 75% is a very important driver. And that’s driven on the margin by buybacks. But last year, or really the last two years, was a period where it was nothing but tailwinds for the market, right?

Jurrien Timmer (19:51):

And so the S&P from the March 2020 low has gained, I think 116% to the most recent high on January 4th. Contrast that to the historical CAGR of 11%. So 50%, 60% per year is not normal. Obviously it came off of a massive decline so I’m not being completely fair here. But we had obviously the liquidity impulse from the fiscal side, the CARES Act, the fiscal stimulus. We had all the liquidity impulse from the FED through zero rates, sharply negative real rates, 120 billion a month of QE. And we had the 10 year trading at 1%, a half a percent, one and a quarter percent. And that feeds directly into the market. I always get, not annoyed, but people make bold pronouncements about bubble this. But I don’t see many people actually quantifying it, but you can actually quantify all of this through the DCF, the discounted cash flow model.

Jurrien Timmer (20:54):

That model has a lot of flaws as well, because there are so many variables that you can never isolate one thing. But my work suggests that a year ago, six, seven, eight months ago, the 10 year yield was about 100 basis points lower than where it should have been based on the financial repression from the FED through quantitative easing. That 100 basis points, when you plug that into the DCF, it elevated the PE by six points. That was a 25% inflation. Asset price inflation. I wouldn’t quite call that a bubble. But clearly asset valuations were inflated by about 25% directly from the FED. The good news is that a lot of that has reversed. Instead of six points too high, the PE is now two points too high, which is not the end of the world, but that liquidity tide has gone back out.

Jurrien Timmer (21:46):

Interest rates are normalizing. They’re getting closer to where they should be, which for the 10 year in my view is around two, two and a quarter percent. But at the same time, earnings growth is also slowing. Earnings grew 48% last year. They are right now expected to grow about 8%. That’s using just the sales at consensus estimates. So in 2022, it’s really just coming down to just earnings. And it looks like we’re going to have mid to high single digit earnings growth. We’re not going to have that liquidity buffer. We’re not going to have that super low interest rate tailwind. And this is why you’re seeing the rotation in the markets. Guess what? The meme stocks, which don’t necessarily have either earnings or stable earnings are not going to make it without earnings growth, because they don’t have that liquidity tailwind to drive them higher.

Jurrien Timmer (22:39):

So you’re seeing the markets actually … As much as the market feels like a rollercoaster, it’s actually very disciplined and very mathematical and very rational. And what you’re seeing with this rotation is the rotation from the small cap growers, nonprofitable tech, the retail favorites, SPACs, IPOs towards value. As rates rise, financials and energy tend to do well. And now I think increasingly we’ll see a rotation into quality. Consumer staples, utilities. Utility stocks are so boring. They have a 0.6 beta, which doesn’t get you very far in a secular bull market. But they have a dividend yield north of 3%. They’re growing earnings by 6%, 7%. That’s a 10% return right there. And in a market where … As you pointed out when you were highlighting some of my tweets, in a market where you no longer have all of those tailwinds, you’re likely to have a wobble.

Jurrien Timmer (23:33):

Because you have PE multiple compression, which we are already seeing. The PE based on 2022 earnings estimates is already down four points from the high, which is good. It’s a good thing. It should be happening because it was artificially inflated earlier. When the PE is compressing and earnings growth is slowing and the FED is tightening, that’s the period when you tend to see wobbles in the market. It’s not necessarily to start of a bear market. I don’t think we’re in a bear market. I think this is a mid cycle correction. And I think the FED will look at the yield curve for instance. And if the yield curve goes inverted, my guess is that the FED will back off. And I think the FED, the reason why they’re being so hawkish is they’re letting the markets do a lot of this stuff for them. So I think this is an environment, and we’ve seen this in the past. We saw it in 2010, we saw it 2004 I think. We saw it in 2018. The bull market was intact, but you can’t go up 50% per year, especially when some of these tailwinds are turning into headwinds. And so this is when you tend to see these kinds of corrections, but it doesn’t mean the end of the bull market. I think the bull market remains intact.

Preston Pysh (24:45):

Really? So you’re thinking that we could still make new highs in the equity market right now?

Jurrien Timmer (24:51):

Based on my mostly technical work, I think we’re in a secular bull market that started in ’09. So historically speaking, if you go back to the 1800s, S&P goes up about 10%, 11% nominal. It goes up about six and a half percent real. Within that very, very long, long history, you tend to see secular bull markets and secular bear markets. And when you look at, for instance, the ’80s and ’90s, which was a secular bull market, the ’50s and ’60s, which was another one, what they tend to do, and I recognize that the sample size is very small, but they tend to go up above average for about 18 years by about 18% per year, 14% in real terms. And if you just extrapolate those two cycles onto the current one, which in my view started in ’09, we’re going to end up … Or I shouldn’t say that. But we could see an S&P of around 8,000 in the next five years.

Jurrien Timmer (25:47):

So I think this bull market is intact. I think demographics has a lot to do with it. Millions and millions of baby boomers retiring, solving for income, not finding it in the bond market. But through the mechanism of this financial engineering in the stock market. So the big growers, big growth stocks buying back shares, increasing the payout ratio and returning the earnings indirectly because buybacks are not a direct return of shareholder cash, but indirectly you’re seeing kind of a cash yield on the S&P of around 3%, 4%. And that doesn’t sound like a lot, but it’s better than the 2% you get in the bond market. And I think that is the fuel for why we’re seeing valuations be elevated and why the return profile is elevated. So my sense is that that’s the secular backdrop, and I want to play the long game. I mean, obviously catching the cycles and adjusting the amount of exposures you have based on these various tailwinds or headwinds, I think is important. But that really long wave I think is really the most important thing. And I think we’re still in it.

Preston Pysh (26:55):

For that thesis that you’re describing to play out, it would really involve inflation to come back down into a 2% kind of range, or maybe even lower, and be able to hold itself there. Not just come down for a two quarter kind of blowout period. Because like you said earlier, it’s all about the discount cash flow calculation, right? And if we’re running inflation at 5% or 4%, these PE ratios cannot sustain themselves at what has been historically for the last 20 years in a very low … Well, maybe not 20 years, but since the 2008, 2009 crisis to be an extremely low interest rate of 1% or 2%. So you really think that they’re going to be able to get the supply chains and things like that under control, based on what you’re saying Jurrien?

Jurrien Timmer (27:42):

It’s a great question. My sense is that inflation will come back down, but not to the levels that we were used to prior to the pandemic. The FED was obviously, as we know, chronically underachieving its inflation target of 2%. It was more around one and a half to 2%. I don’t think we’re going back to those levels. I think we might see three, three and a half, but I don’t think that is a cycle killer. If we go to 5%, 6%, 7%, 8%, totally different story, of course. But I think when you look at, for instance, the 10 year growth rate in the labor force or any demographic indicator, it pretty well explains where interest rates happen and likely are going. And so if we are going more in the direction of Japan, Japan gives us a perfect taste of what might lie ahead, then I think inflation and interest rates will stay low and maybe inflation will be above the level of interest rates, which means we’ll see negative real rates.

Jurrien Timmer (28:42):

Again, which we saw throughout the 1940s for a pretty prolonged period of time. But not to the level where it becomes highly unstable. So I do think that inflation is not going to explode or continue to explode higher. I do think it will normalize, but structurally you look at the labor markets, you look at real estate prices. Those are the two components that I think will keep inflation somewhat elevated, maybe by 100 basis points over what it has been. But to me, that’s not enough to end the bull market. But as you point out, there’s a very clear inverse correlation between the PE ratio on the S&P and the long term inflation rate.

Jurrien Timmer (29:25):

And I tend to use either a five year CAGR or even a two year just to smooth out those year over year base effects. So I think the stock market will survive that. But I think the bigger question is what happens to the stocks to bonds correlation, right? To the 60-40 paradigm. Because many, many, many, probably most investors are in some form of 60-40, because that has been the M.O. for the markets for the last 20 plus years. And so if inflation does become more structurally elevated, will that cause the 60-40 inverse correlation between the 40, the bond side, and the 60, the equity side, will it cause that to flip? And that of course is a big deal because if you’re an investor and you’re in this diversified balanced portfolio, you need to make sure that that 40 … We’re not obviously getting a lot of yield out of the 40.

Jurrien Timmer (30:19):

Nominal yields are 1.8. Real yields are negative. So you’re not buying bonds because they’re such a great value. And we know of course, mathematically that if you buy a bond and you hold it to maturity, the yield that you’re buying on the bond is your return. So right now, if you buy a 10 year bond at 1.8 and you hold it to maturity, you’re getting 1.8% nominal. And if inflation is going to be at three, you’re going to get minus 1.2 negative. So you’re not buying bonds because they’re such an attractive bargain, but people have been buying bonds and for good reason, because they are a diversifier. They zig when the stock markets zags. And generally speaking, that has been the case over the past 20 years. So if that were to change … And that’s not a prediction, but if that were to change and inflation would be presumably the force that would make that change, then we need to look elsewhere for real stores of value instead of bonds. So to me, that is the bigger implication for maybe a more structurally higher inflation than what we’ve seen.

Preston Pysh (31:26):

Jurrien, all I heard was Ray Dalio’s risk parity’s dead. I’m joking with you. I’m not putting words in your mouth. I’m just joking around. I agree with that. I think it’s going to have problems moving forward, but that’s my personal opinion. Fidelity has a PDF release to their clients in January of 2022, just recently, titled Bitcoin First. In it, it has … I’m going to read two quotes from this document. At the very beginning of the document, it says, “Bitcoin is fundamentally different from any other digital asset. No other digital asset is likely to improve upon Bitcoin as a monetary good because Bitcoin is the most, relative to other digital assets, secure, decentralized, sound digital money, and any improvement will necessarily face trade offs.” That’s the first quote, here’s the second quote. “Other non Bitcoin projects should be elevated from a different perspective than Bitcoin.” This is a Fidelity document. This is not something that we’re reading off of a blog from a person like me saying these things. I’m blown away. So it appears Fidelity really understands Bitcoin and they’ve understand it for a while. This isn’t a new epiphany. So why? How? What’s going on within the company for you guys to be publishing things like this?

Jurrien Timmer (32:45):

That paper was published by my colleagues at Fidelity Digital Assets. So FDAS we call them. And they know what they’re talking about. We were an early mover or an early adopter of Bitcoin. And now in general the blockchain more generally speaking. But we’ve been involved in this space for a while. I kind of went down the rabbit hole about a little over a year ago. I published a white paper as well, where I likened it to a digital form of gold. I mean, that’s certainly not novel. I mean, that’s how a lot of people think about this. I think the points that the paper makes are very well made because when you look at the trilemma of the scale and scarcity and security, you have to make trade offs.

Jurrien Timmer (33:32):

If you want to make Bitcoin more scalable, it’s going to be maybe not as secure or not as decentralized. And so I think the paper correctly distinguishes Bitcoin from other crypto assets or other digital assets. So Bitcoin is not the same as Ethereum. I think that there is a place for both, but I wouldn’t even count them as the same asset class. So to me, what I looked at when I fell down this rabbit hole is I ended up looking at a thousand years history, and I looked at the role that gold has played in the past and the role that Bitcoin can play. And Bitcoin is extremely unique. And I think that the paper sites that. Because you have both this scarcity component, this supply component, you also have this whole network effect. And that’s why when I look at kind of valuation for of Bitcoin … Most people that I read are looking at price, but they’re not looking at valuation.

Jurrien Timmer (34:26):

And I think valuation is the most important thing always because a car could be at a high price or a low price, but what’s the value of the car? That’s the most important thing. And so that’s why I combined the stock to flow type model with the S curve model, where I look at historical S-curves, whether it’s internet adoption or mobile phone subscribers historically, and I just regress the number of addresses for Bitcoin against those historical S-curves. And Bitcoin is the only asset class that I know of where you have both that supply scarcity and that exponentially growing demand side. Ethereum has one, but it doesn’t have the other, although they’re certainly trying to go in that direction. But I think that the Ethereum skeptics would say that that may be the direction where they’re going into now in terms of managing the supply growth but that doesn’t mean it won’t change in the future. And of course, Bitcoin can’t be changed. It’s immutable. And so that’s why that combination of supply scarcity and exponential demand growth or exponential network effects, I don’t know of any other asset class that combines those two. So I think it’s a point that they make that is very valid.

Preston Pysh (35:34):

One of the complaints that you hear from a lot of people that are skeptical of the stock to flow model is that they say that it’s just supply. There’s no accounting for demand there. When I first saw you start posting about this and putting them on the same chart, which was the stock to flow. And then you mentioned the S curve was your demand model. I was just like, “Oh, I love this.” Because it kind of addresses that counterpoint that you often hear when people are talking about stock to flow. What variable are you using for this S-curve? Are you using just wallet addresses or some type of hash piece? What is it that you’re looking at in order to model that S-curve out?

Jurrien Timmer (36:13):

To your first point, the stock to flow model, I think, has been obviously, at least until recently, very accurate in explaining the price of Bitcoin. But I think over the long run, especially as the stock to flow model just keeps pointing exponentially to higher prices, it left me unsatisfied because there has to be more than the supply scarcity, right? If there’s not a demand for something, it doesn’t matter how scarce it is. It’s not going to have a value. Right? So I think that the demand side of the equation is I think by far the most important one. And I look at just the number of addresses with a value greater than zero, or you can use the value greater than $1 just to make sure you don’t have duplications. And I think with the value greater than a dollar, the number of addresses right now is about 40 million.

Jurrien Timmer (37:04):

And it continues to grow to new highs. And the math exercise actually is relatively simple. I looked at mobile phone subscriptions historically, and I looked at internet adoption historically. And I just regressed those two curves to the last 11, 12 years worth of demand for Bitcoin through the number of addresses. That spits out a formula. And then you can extrapolate and that’s always a dangerous thing to do, of course. But if you assume that the S-curve is how this works and that’s how Bitcoin will continue to grow, what you get is this exponentially growing curve that becomes more asymptotic over time. And it departs from the stock to flow, because the stock to flow on a log scale just keeps going up in a straight line, whereas the demand curve becomes more asymptotic. So I’ve been quoted as saying Bitcoin could see 100,000 in the next two years and that number just comes from the intersection of those two models because that’s the last time that the supply model and the demand model meet.

Jurrien Timmer (38:09):

And from that point on the demand model goes up. It still goes up at a lesser pace. And at that point, those two lines start to diverge for good. That’s really all it is. But there are a lot of examples of this. I’ve compared the whole network effect for Bitcoin to Apple Computer’s network effect. As Apple grows its revenues, its stock price goes up exponentially from that. It doesn’t go up in line. And this is Metcalfe’s law of course. Bitcoin is following in the same path. And so I think there’s some very robust logic to why Bitcoin should see higher values as the demand curve evolves. And maybe other digital assets will do better because they are more scalable, but at the same time maybe they’re less decentralized. And that’s why I would see …

Jurrien Timmer (39:03):

And I think my colleagues at FDAS probably agree that to me, Bitcoin is an asset class like a store of value, like gold. And the rest of the digital asset space is more almost like a venture asset. I put the rest of the digital asset space in the venture side of an equity portfolio like venture capital. But I would put Bitcoin on the bond side of a portfolio because to me, that’s where you have a real store of value in an era of negative real rates and financial repression. So they have similar volatility and all that stuff, but I would put them in opposite sides of a portfolio.

Preston Pysh (39:42):

We had a lot of questions online for you wanting to get into a lot of the regulatory stuff. And we’re going to pass over that just because of some of the restrictions you have working for Fidelity. And I just want to put that out there so people know that we’re not purposely avoiding the questions. There’s just some restrictions that Jurrien can get into it. So we’re going to skip over that. Terda Mester had a really interesting question here. He said, “Have there been any surprising market behavioral differences in Bitcoin as an asset class versus other asset classes that you’ve studied throughout your career?”

Jurrien Timmer (40:15):

Well, certainly Bitcoin is probably more volatile. It’s interesting. The sharp ratio for Bitcoin, which is the annualized return over the annualized volatility over the past 10, 11, 12 years is actually the same as a 60-40 index. Not many people know this, but if something goes up 260% and has a volatility of 80, you are kind of getting to the same place, but in a lot more of a non-linear way. And I think part of that … I think a lot of people think of that volatility as a bug in the system and that it will smooth out over time as Bitcoin comes of age. I liken Bitcoin as a teenager. A teenager has great potential, but they can also wreck your car, right? So there’s kind of a binary side to that.

Jurrien Timmer (41:05):

But I think of Bitcoin as where gold was in the 1970s. It went from being money to being an asset class. And it went through price discovery. It was a teenager, it was coming of age. It was very volatile. It went up a lot, but it had huge, huge drawdowns as well. Bitcoin is doing the same thing, but it’s a little bit different because gold of course is a scarce commodity. That’s why it’s a store of value. But there can be some supply response in gold if demand is very high. Not a lot because you have to mine it and then all that stuff. But for Bitcoin, that supply response is even harder to achieve because of the pre-programmed slowdown in future growth. So the volatility I think in part is because a lot of people pile in.

Jurrien Timmer (41:51):

We know about the hoddlers but I also like to talk about the tourists that just come in and they’re buying it because it goes up and then they puke it out when it goes down. And so you have that very speculative aspect of it. But the other part is that you don’t have the supply response if demand goes up so therefore that increase or decrease in demand is completely translated into price movements. So it’s kind of a price inelasticity if you will. And that’s a very unique property and so I think it’s actually more of a feature than a bug. And it’s not something that will go away. I think the sharp ratio probably stays the same and both the numerator and the denominator go down as there’s more adoption over time. But I do think the volatility is something that will stay around.

Preston Pysh (42:37):

I like this question. When will retail be able to buy Bitcoin in custody through their Fidelity account?

Jurrien Timmer (42:44):

I don’t know, but I know that obviously we were disappointed that there’s not an ETF, a physically backed ETF coming, at least in the near term. We do think the market is ready for that. I think the asset class is mature enough at this point that it can happen and maybe it will. At Fidelity Digital Assets, we do offer custody and all that stuff for accredited investors. At what point it ends up in model portfolios, I couldn’t tell you. But it’s an asset that’s coming of age and it will become more mature over time. And so I think that’s just something that we’ll have to wait for.

Preston Pysh (43:24):

Is Fidelity digging into lightning at all?

Jurrien Timmer (43:28):

I don’t know the direct answer, but certainly the L2 side of overcoming the lack of scalability is certainly an important part of the whole conversation about Bitcoin and how it can be made more scalable, which of course is what other digital assets are already achieving. So I think it’s an important part of the conversation.

Preston Pysh (43:49):

When I looked at this volcano bond that they’re doing down in El Salvador, I found this to be just such a unique security in that half of it is going to be paid as a special coupon. And I think by setting this structure up, you’ve opened up this market to the fixed income space and not necessarily El Salvador specifically, but something that could be template and used in other parts of the world that nobody I don’t think has ever thought of a vehicle structure like this and how you got all this pent up capital and fixed income that’s earning a pittance in yield in my personal … I mean, negative yields. Deep negative yields that are chartered for only investing in the fixed income space. And now you have this really unique idea where half of the amount that’s raised is immediately converted into Bitcoin. It’s custody by that entity. And then at a five year period later, it’s just paid out as a special coupon to these fixed income investors. They now have direct access, not 100% performance, but half the performance right there built in, and they’re still within their charter constraints. Is this something that you think is going to be templated into other parts of the world I outside of EL Salva … You can extract El Salvador out of this completely and just kind of looking at the, the vehicle type that’s being used here.

Jurrien Timmer (45:19):

It’s certainly super fascinating. And it becomes a question of will a bond holder be able to stomach the volatility that might come from bonds like that? And it’s a conversation that I think a lot of corporates are having as well. I remember a year ago when I had published my white paper, I had many, many meetings with corporate pension plan CIOs, even some treasurers of Fortune 50 companies. And they were all super interested. They want to get involved, but the volatility is something that I think has kept a lot of investors away from the space. I mean, there’s other reasons as well. It’ll be an important test case to see how these bonds do. And I think obviously El Salvador is right there at the beginning of it. And as other countries presumably adopt a similar structure and we continue to live in this period of negative real rates, solving that problem in the bond market, I think, is a very worthwhile thing to do. Whether it’s exactly in this structure or not, who knows? Someone has to go first and try it and then we’ll see how it goes.

Jurrien Timmer (46:32):

But there’s a lot of money tied up in the bond market, earning a negative real return. And so any ways to overcome that either by going into another asset class, which to your point, not everyone can do. Investors often have to stay in their charter. That’s why European institutions buy bonds with a negative yield in Europe because they’re mandated to do so by the central bank. So being able to play around with the parameters within that asset class, I think is something that’s very innovative and be interesting to see how it all plays out.

Preston Pysh (47:07):

And this is my last question for you Jurrien. The conversations that you’re having with some of these players, I mean, we’re talking billions and billions of dollars at the disposal of each one of the entities. How has that progressed? Are they much more open to Bitcoin today than they were a year ago, than they were two years ago? Is this a linear interest or is this kind of an exponential interest? From your point of view, how would you describe that?

Jurrien Timmer (47:34):

I would say a year ago as Bitcoin was ratcheting up very rapidly and we published that white paper, I mean, I was having meetings every day with, again, CIOs of humongous companies in the US. And a lot of it was just curiosity and especially as Fidelity weighing in on the space with a hopefully objective, well thought out approach. I think that there was a lot of demand for that. But the caveats always generally were it’s too volatile and it still is. And part of the … I don’t want to call it FOMO, but with Bitcoin not having really gone up over the past year and in correction mode as we speak, there’s not as much of an urgency I think to say, “Oh my, we’ve got to be in this or we’re going to lose out.”

Jurrien Timmer (48:25):

And I think part of it also is the regulatory side. My colleagues at FDAS, I think … Don’t want to speak for them, but I think they would agree with me that some regulation actually is good or would be good because it will legitimize the space. And I think a lot of that will come actually from the stable coin side as well, which is also a critical component. And so a lot of big institutions are probably still waiting for those things to play out because we don’t really have a lot of new clarity on the regulation side. The volatility is still there. And I think with Bitcoin, not at this point at least going exponentially higher, maybe institutions have a sense that, “Okay, we don’t have to do this right now.” Because if you’re a CIO of a major corporate pension plan, you need to answer to your board.

Jurrien Timmer (49:15):

If you buy something that maybe you were earlier than you should have been, and then it’s down 50%, and then you have to explain that. So I think generally speaking, I think institutions would rather be a little late and have a little bit more of, not certainty, but a sense of that they know where it’s going. And I think the stable coin aspect of that is a very important part. And of course the FED just released a paper on stable coins and on central bank digital currency. I do think that that’s moving in the right direction and probably stable coins will become regulated as they probably should be. So that there at least there’s that sense of security that if you own stable coins, that you know what they’re actually worth.

Jurrien Timmer (50:00):

So I think we’re heading in the right direction. I’m sure the adoption is higher than where it was a year ago because I was kind of in those early conversations. But I don’t know where things go after that. But I think on the volatility side, on the regulatory side, we don’t have total clarity yet. And maybe we won’t for a long time. Maybe the volatility angle will never really be resolved because as I mentioned earlier, it’s probably more of a feature than a bug to the system.

Preston Pysh (50:31):

Jurrien, I just want to tell folks, if you’re not following Jurrien on Twitter, you need to do that now. I’m going to have a link to his Twitter account in the show notes. You are going to be hard pressed to find better charts than these charts that he’s putting out. Jurrien, is there anything else that you want to highlight or point people towards?

Jurrien Timmer (50:49):

I would just say, think about all these things hard before you get involved. I have people still walking up to me or friends that, “Should I buy Bitcoin?” And I say, “Well, you need to probably put 100 hours worth of work in it because otherwise you’re never going to hoddle Bitcoin when it goes down. And so only then will you have the conviction.” And the same thing is probably true for the traditional asset markets. Understand what drives markets. Earnings, liquidity, interest rates. And take a balanced approach. And what I always tell people, which is more for long term investors, which may or may not be your audience, but having a plan and then just executing on that plan are the two most important things. So having a portfolio, whether it includes Bitcoin or not, that is right for you, that you’re buying these assets for the right reason because your time horizon, your risk appetite, your goals, your financial needs. And then the hardest part is when you do see a drawdown, which we’re seeing in recent weeks, only then do you have the conviction to really stick with it and sticking with it is often the difference between making a decent return and not.

Preston Pysh (52:00):

Love that. Absolutely love that. So, like I said, I’m going to have some links there in the show notes. Jurrien, thank you so much for making time and coming on the show. I am just thrilled to be able to have this chat with you. I could talk to you all night about this stuff. So thank you for your time, sir.

Jurrien Timmer (52:15):

Thank you very much for having me. Appreciate it.

Preston Pysh (52:16):

If you guys enjoyed this conversation, be sure to follow the show on whatever podcast application you use. Just search for We Study Billionaires. The Bitcoin specific shows come out every Wednesday, and I’d love to have you as a regular listener. If you enjoyed the show or you learned something new, or you found it valuable, if you can leave a review, we would really appreciate that. And it’s something that helps others find the interview in the search algorithm. So anything you can do to help out with a review, we would just greatly appreciate. And with that, thanks for listening and I’ll catch you again next week.

Outro (52:50):

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