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Cryptocurrency Market Cycles

Cryptocurrency Market Cycles

You don’t want to buy crypto and see its value go down immediately. So, how do you know when to buy crypto and what do market cycles have to do with that?

If you happen to have been in cryptocurrency for longer, you surely remember the Bitcoin all-time high in late 2017. Bitcoin was the talk of the day and major news networks ran featured pieces on it for the first time. Of course, Bitcoin had been around before, but not until its run to almost $20,000 were major TV channels and newspapers paying it much attention. After that market cycle, much of the hype died down. That was, until 2020 and the start of a new market cycle. Since Bitcoin and every other major asset move in cycles, this lesson will focus on:

  • Why relative price changes and market cycles are relevant for investors
  • What market cycles are
  • An example of a Bitcoin market cycle
  • Crypto-specific factors that influence crypto market cycles
  • How to tell where you are in a market cycle

Why buying low and selling high is not investment advice

The oldest investment advice in the world is “buy low and sell high.” When you spot someone giving you that advice, it’s best to smile, nod, and agree because, on its own, this advice is useless. If it really was this easy, we’d all be doing it, and no one would ever buy the top or sell the bottom.

So, how do you tell what’s low, high, or a top/bottom? How do you not become one of those poor suckers that end up holding the bag?

We need a way to put low and high into perspective. Let’s take a well-known stock everyone would like to be holding, such as Amazon. Clearly, a price of under $100 looks fantastic now that the stock is trading above $3,000. But how could you tell in 2005 whether $30 was low or high? And is $3,000 now the top or not?

While there is no silver bullet and no definite way to answer these questions, investors can use two key tools:

  1. relative price changes, and
  2. market cycles.

How to spot relative price changes

We can display relative price changes in an asset by using a logarithmic graph instead of a linear one. Let’s stay with the Amazon stock as an example:

The first graph shows a linear graph, and we can clearly see the price explosion in the last few years. What happened before is barely relevant to the price today because it doesn’t even register as a blip in the long run.

Absolute changes in price

Percentage changes in price

However, the second graph paints a much different picture. On the vertical scale, price changes are displayed in relative terms. For instance, if the price of Amazon doubled from $7 to $14 around 2000, that 100% increase makes up the same distance on the Y-axis as a 100% increase today from $3,000 to $6,000. Looking at prices this way makes it easier to see price volatility and how (un)steadily the price of an asset has been growing. Consequently, we can observe how the price of Amazon stock was struggling around 2000, even though that’s barely visible on a linear graph. Equally, since 2018, $AMZN has grown from $1,600 to $3,200, but this 100% increase looks much less impressive than its incredible historical performance on a logarithmic graph.

Armed with a log graph, let’s investigate how market cycles are relevant to investors.

What is a market cycle?

A market cycle is a recurring price pattern in a market triggered by underlying fundamentals such as innovation or regulatory changes. For example, policymakers banning combustion engines might start a new market cycle for alternative propulsion methods such as electric cars. As a result of the policy change, more money will flow into the development of electric cars (and probably other methods), which should spur growth in this sector.

Market cycles occur because markets are an aggregate of human participants and humans are emotional. Humans don't react rationally to market changes, which is why certain patterns - market cycles - repeat. A market cycle is stimulated by fundamentals but influenced by the emotions of market participants. Even though market participants are aware of the existence of market cycles, most cannot counteract them for two reasons.

First, humans are by nature influenced by their emotions and find it practically impossible to resist acting emotionally. This effect is exacerbated if we're talking about a group of people over a longer period of time as opposed to a single person in a specific situation. Second, market cycles can only be identified conclusively in retrospect. Since market cycles are not a science but a recurring pattern, there is no definite method to determine a market's exact position in a cycle. Nevertheless, by being aware of their existence and with experience, you can make educated guesses about it.

What a market cycle looks like

The classic and most basic version of a market cycle pattern is this:

Four distinct phases characterize each market cycle:

  • Accumulation
  • Markup
  • Distribution
  • Markdown

A more detailed version would be the following:

market cycle psychology

As you can see, different emotions are typical for different stages in the market cycle. Let's explore each phase in more detail.

Accumulation

An accumulation phase follows a decline. In this phase, buyers start taking control of the market. Buyers in the accumulation phase are often insiders or those with good information. Experienced traders or contrarians that have seen several cycles, especially of the same asset, might also start picking it up. Another group may be contrarians or bargain hunters looking for new or undervalued assets and happy to hold on to them for a long period if need be since they believe in the asset's fundamental value.

Sellers may be those stuck with long positions that want to eliminate them over time and reduce their exposure. These participants might have bigger positions, so they cannot afford to dump their entire position in one go, which would tank the asset's price and incur an even bigger loss.

The accumulation phase is often characterized by a mixture of negative and neutral news with low trading volume. Depending on where exactly in the accumulation phase the asset is, the sentiment around it might be leaning more towards depression (still early), neutral (if it's a prolonged phase of sideways trading), or disbelief (late accumulation and trending upwards).

Markup

This phase marks the start of a bull market, where prices are rising or expected to rise. Demand exceeds supply during the markup and rising prices cause more noise in traditional and social media. The rising price attracts greater interest from new participants, while strong moves can also be supported by players shorting at the bottom and having to close their positions at a loss. Emotions in the markup phase become increasingly positive and culminate in euphoria at the top.

Markups are also strongly shaped by FOMO (fear of missing out) and greed, the longer the price run continues. Technically, the asset price is making higher highs and higher lows, and towards the end of this phase, the greater fool theory kicks in. More experienced participants can identify the signs of a finishing markup and start passing their assets on to a greater fool willing to buy at high prices.

Distribution

High volatility often shapes the top of a markup and the transition into a distribution phase. The asset is probably getting more attention from news coverage, and euphoria starts spilling over into greed and eventually fear as the demand becomes exhausted at high prices. Experienced participants are taking profits while buyers start bidding lower and become more distrustful of whether the price rally will continue. Finally, as technical indicators signal a market top, sellers become more aggressive, sending the price downwards. As people who bought the top have to close out their positions at a loss, downwards price pressure intensifies, and the markdown begins.

Markdown

Depending on the intensity of the markup, the markdown is shaped by more or less pronounced panic selling. Negative emotions prevail, starting with anxiety and capitulation, and anger as the price plummets to a low point. it is the mirror image of a markup, only with negative emotions and can equally end in the same kind of greed and exuberance on the part of short-sellers looking for ever-lower lows. Eventually, the market stabilizes and a new cycle begins.

Example of a cryptocurrency market cycle

Market cycles do not have a specific length. They are easier to identify on higher time frames but a market cycle might itself consist of several cycles that play out over smaller cycles and can only be seen on smaller time frames. An example of a market cycle was the Bitcoin bull market that ended in late 2017 at almost $20,000.

Bitcoin accumulated for almost two years, beginning in 2015, roughly the end of the previous markdown. Noticeable price appreciation began in 2017, with a parabolic markup all the way to the top. Bitcoin oscillated wildly between $15,000 and $19,000, before a prolonged markdown followed, lasting well into 2019 (and past the end of the chart). Market participants during that cycle will surely remember that all phases were followed by the emotions characteristic for such a cycle.

Looking at a logarithmic chart of Bitcoin visualizes its relative price changes and how Bitcoin has gone through several market cycles.

The initial cycle that peaked in 2014 yielded the biggest relative gains for investors. Bitcoin then went through a markdown and peaked for the second cycle as seen in the linear graph above. Currently, BTC is going through its third cycle and whether it peaked already or whether it is still in its markup phase is part of many discussions.

Crypto-specific factors influencing market cycles

Cryptocurrency markets are specific for several reasons. Firstly, they're extraordinarily volatile, which is probably caused by the asset's novelty and a lack of benchmarks to compare it to, leading market participants to overshoot in both directions.

Second, the cryptocurrency market is almost entirely driven by the price movement of Bitcoin. Pretty much every single other crypto asset (except for stablecoins) has a more or less strong correlation with the price of Bitcoin. Hence, why directional moves in the price of Bitcoin will equal those of other crypto assets unless there are very strong fundamental factors justifying otherwise. Those would often be negative, e.g., a cryptocurrency having massive problems and depreciating despite a rising Bitcoin price.

Third, market cycles of Bitcoin itself have (so far) largely happened in four-year cycles following the Bitcoin halvings. Bitcoins are issued through mining rewards, which were designed to incentivize early users to participate in the network. Miners are rewarded for their work with a subsidy in bitcoin. This subsidy is halved every four years, reducing the supply of Bitcoin until its hard cap of 21 million. Whether by accident or by design, this has resulted in four-year cycles, where the price of Bitcoin appreciates sharply in the 12-18 months after the halving, before finding a new equilibrium and the beginning of a new cycle.

Why does the Bitcoin halving result in market cycles?

Initially, there is an equilibrium between the supply and demand of Bitcoin. Demand from Hodlers matches the supply from miners.

EQUILIBRIUM: Buyers = Sellers + Mined Coins

The halving introduces a supply shock, resulting in the supply decreasing, with demand being equal. Supply from miners goes down but Hodlers demand just as many bitcoin. Since additional supply can only come from Hodlers, people unwilling to sell their bitcoin, upwards price pressure ensues, attracting new market participants. Bitcoin also seems to exemplify attributes of a Veblen good, a good whose demand increases with increasing price because it is perceived as a status symbol.

That leads to a shortage in tradeable coins and a rapidly appreciating price, ending in a blowoff top, as in the bull market 2017 where there are almost no tradeable coins and Hodlers’ demand still outstrips supply. Only after this coin flow equalizes, and eventually reverses, does the price of BTC go down and find a new equilibrium.

How do you know where in the market cycle Bitcoin is?

Several models exist to predict the long-term price movement of Bitcoin. One of the most well-known and seemingly most accurate is the stock-to-flow model. It indicates Bitcoin should appreciate as it is characterized by inelastic supply, meaning in the long run, its price will be determined entirely by its demand.

The author also compared Bitcoin to seemingly similar goods such as gold to strengthen the model's credibility. While it is an interesting thought exercise, it's not based on scientific methods and uses doubtful statistical assumptions.

Another way to estimate Bitcoin's price performance, while not perfect but grounded in a sounder statistical foundation, is the Bitcoin Price Temperature. It measures the distance between the current price of BTC and its four-year moving average with the following formula:

(daily price – four-year moving average) / standard deviation of the price of the past 4 years

In simple terms, it measures how far away the price is from its long-term mean, so how abnormal the current price is.

Bitcoin temperature chart

Historically, Bitcoin has always topped out in a cycle at measures of eight or higher, although the author admits these are chosen randomly. Since past performance is not necessarily predictive of future performance, this model should not be regarded as gospel. It rather confirms the observation that Bitcoin has been moving in four-year cycles and, therefore, dollar-cost-averaging has been an excellent investment strategy. However, it does not claim to hold any predictive power.

You can see more on the Bitcoin price compared to standard deviations to the 4 year moving average in out Bitcoin Bubble Checker tool

Can the Bitcoin four-year market cycle change?

This is the subject of much discussion in Bitcoin circles. So far, Bitcoin has reliably reacted to its supply shock induced by the halvening by a sharp markup phase in the following 12-18 months. Equally, its hash rate, the computing power dedicated to mining new bitcoins, has been growing constantly and faster than normal during these markup periods. The question is whether future halvenings will affect the price and if the hash rate will keep growing.

On the one hand, miner profitability goes down with each halvening because miners receive a smaller subsidy every four years while having to invest more to stay competitive as the hash rate increases. However, so far, the price appreciation has kept Bitcoin mining profitable. In addition, Bitcoin miners also receive a share of the transaction fees. During markup phases, this share grows as more people start bidding for block space. Each Bitcoin block is capped by its block size in how many transactions it can support, but participants can bid for this block size and drive transaction fees up during times of increased network usage. Since the dollar value of BTC is going up, miners are receiving a growing share of their revenue from transaction fees. Still, it is debated whether this trend will continue as block rewards keep falling.

One theory is that market cycles might lengthen in the future. As the absolute size of supply shocks decreases, so might their impact. After the first halvening in 2012, the impact of the block reward decreased from a 33.3% increase on the total supply of Bitcoin to a 12.5% increase. In other words, the inflation rate decreased drastically. In 2016, the inflation rate decreased from 9.09% to 4.17% and in 2020 from 3.7% to 1.79%. Most BTC are already on the market, so cutting the subsidy will have a smaller impact in the future.

Eventually, the price will be perfectly inelastic and only driven by demand. At that point, Bitcoin's price may be entirely driven by the business cycle, although this also depends on its adoption rate as a store of value. Currently, Bitcoin is still seen as a risk asset, which is why it is highly volatile. If Bitcoin's market penetration grows, this perception might start changing, and with it Bitcoin's volatility (which should go down) and its market cycles. With bigger market penetration, it also becomes more likely that market participants start pricing in the halvening, and hence future halvenings have less of an impact than past ones. However, the contrary might also happen, and market participants may expect more price appreciation following a halvening, becoming a self-fulfilling prophecy.

Eventually, other factors will also start impacting the price of Bitcoin more, such as public perception of its environmental impact (whether correct or not), and the adoption rate of blockchain and distributed ledger technology as a whole. Currently, all other cryptocurrencies are more or less a function of the Bitcoin price. However, this might change in the future, if blockchains manage to scale and emancipate themselves from Bitcoin, which would result in their prices trading more according to their own fundamentals. Bitcoin itself could also still undergo a perception shift. For instance, successful adoption as a means of payment in several developing countries could conceivably lead to more such countries adopting Bitcoin as peer-to-peer payment network, which would likely affect prices as well.

Conclusion

While market cycles are fairly straightforward to understand, the fact that cryptocurrencies are a completely new asset class complicates matters. Investors should hence not simply extrapolate from past performance but try to understand the bigger picture of what could impact future market cycles.

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