Quantum Entanglement

"Reality is merely an illusion, albeit a very persistent one." - Albert Einstein

The universe presents us with perplexing phenomena that defy simple explanation. Quantum entanglement, where particles become so deeply interconnected that the state of one is inexorably linked to the state of the other, offers a fitting metaphor for today's market environment. This interconnectedness, reflected in the dichotomous image of good versus evil, light versus dark, captures the essence of our investment world today, where risk and reward, opportunities and challenges, are intrinsically entwined.

Today, digital assets present a paradox to investors, acting as both a potential safe haven against runaway monetary policy while simultaneously offering highly asymmetric, event-driven outcomes over the medium term. The complexity of these interactions is no less confounding than the mysterious behavior of entangled particles, and navigating this terrain requires a nuanced and sophisticated understanding.

In this quarter's letter, we investigate this duality and discuss why the current market environment presents a uniquely bullish setup for our Fund. By embracing the entangled nature of risk and reward, we aim to guide our investors through a landscape marked by uncertainty and opportunity.

You Survived the Bear, Now Ride the Bull

The Chances of “Zero” are Officially Zero

On June 15, the world’s largest asset manager, Blackrock, applied with the SEC to launch a Bitcoin ETF, a significant milestone and a testament to the staying power of the digital asset industry. Since the filing, the SEC has picked up another six applications for Bitcoin ETFs to review.

If you are still wondering if digital assets are just a “fad”: it is very unlikely that the crypto pool will drain as Blackrock dives in. It is also very unlikely that Blackrock would take this risk if 1) clients were not inquiring about crypto products and 2) they didn’t expect the product to move the needle for the $2.5 trillion ETF business.

“It has a differentiating value versus other asset classes, but more importantly, because it’s so international it’s going to transcend any one currency and currency valuation.” - Larry Fink, CEO of Blackrock

Bitcoin and the larger crypto market have proven resilient. Even through major downturns, the global interest and investments in this space have continued to surge. With this development, the trend will likely accelerate and a rising tide of institutional and retail capital alike will lift all boats (some boats much more than others).

One cannot help but wonder where next the capital will flow? Our bet is that smart money positions itself in more asymmetric bets with the potential for higher absolute returns. This does not mean that basic financial physics will change: 99% of startups (read: tokens) fail over a on long enough timeline. But the majority of future value created in this space will be outside of Bitcoin, and fortune will favor investors with the skillset and knowledge to navigate the lesser known corners of this still-nascent ecosystem.

Digital Assets Offer Safe Haven

The encouraging promotion aside, the once skeptical Fink makes an often-overlooked point about digital assets amidst a flurry of US-related headlines: digital assets are a stateless, borderless, global phenomenon. While interest rate-sensitive markets like housing, stocks, and bonds hold their collective breath for the next Fed rate decision, Bitcoin is up ~80% YTD as global liquidity aggregates look to have bottomed and have begun an upward trajectory.

Meanwhile…

• Rates: Even after an unprecedented spike in rate hikes, it's only now that we're beginning to see real yields edge into the positive. This suggests a prolonged period of high rates as the Fed attempts to untangle the knot of years of lenient monetary policy.

^{Source: St. Louis Fred}

• Credit and Bonds The pain inflicted on bonds has been palpable, and the road to recovery seems long and fraught. Look for signs of stress in sectors like commercial real estate and consumer finance. The longer that higher rates persist, the more the risk of refinance embedded within our economy grows. On the other hand, much of this stress should have metastasized by now, and the open question is whether companies are better positioned than expected precisely due to how much fixed, low-rate easy money they have received.
• Stocks are feeling the weight of an unfamiliar reality: a rising rate environment. This environment can significantly erode the value of interest-rate sensitive asset classes. The market today eerily echoes the patterns of the 70s—complete with high inflation, GDP growth, low unemployment, foreign conflict, and a community banking crisis. This was a decade in which the S&P 500 remained stagnant, a stark reminder for investors navigating the current landscape.

^{Source: Bloomberg}

• ‍Digital Assets: Meanwhile, blockchain has massively decoupled and has resumed its long-term secular growth trajectory.  It’s just hard to notice in the moment…

Digital Assets Have Massively Decoupled

For most of the history of blockchain assets, they had little to essentially no correlation to risk assets.  Using Bitcoin as a proxy for blockchain, the correlation with the S&P 500 over its first nine years of existence was 0.03. That was a huge part of the argument:  when you find a new asset class with incredibly high historical returns and essentially no correlation with typical assets – that’s the dream investment.

Unfortunately, excess leverage, sensationalism, and fraud caused this correlation to increase in 2022, and the digital asset ecosystem ran headlong into reality. As blockchain is in no way connected to interest rates, it should have a very low correlation to the main asset classes (stocks, bonds, real estate), which are all tightly driven by rates. Bitcoin’s correlation with the S&P 500 is back to normalized levels and we expect this to continue.

Capital is Rotating Down the Risk Curve

The US SEC vs Ripple Labs case concluded with a federal court granting partial summary judgment in favor of Ripple Labs, a landmark decision that instantaneously reshaped the regulatory narrative. 

The case focuses on whether XRP, Ripple's token, constitutes an unregistered security in violation of securities laws. The court, guided by the Howey test, determined that XRP sales to institutional investors were securities transactions and thus unlawful. Conversely, programmatic sales on exchanges did not meet the securities classification, introducing some regulatory clarity regarding secondary digital asset trading. 

Ripple's partial victory establishes a precedent for digital tokens beyond Bitcoin, potentially removing a performance overhang from large swaths of DeFi and Web3. " The anticipated appeal inches us closer to a Supreme Court renowned for resisting regulatory overreach. With that being said, it remains to be seen whether this will be overturned or face a conflicting judgement in another jurisdiction. 

^{Source: Coingecko}

In just the last 10 days since the ruling, we have seen DeFi-related assets surge in value, including within our portfolio. Either way, the market has indicated that the scales have begun to tilt toward emerging digital assets.

^{Source: Coingecko}

The inconsistencies within the current regulatory framework are conspicuous, suggesting impending new legislation in Congress. Although the initial legislation will likely offer marginal clarity, we believe the long-term pendulum of regulation is set to swing backin our favor.

The Biggest Catalyst in Crypto is Months Away

The number of new Bitcoins that miners receive as a reward is not constant; it decreases over time. Approximately every four years, the Bitcoin halving event occurs, cutting in half the number of new Bitcoins that miners get for processing transactions.

This halving event is crucial because it directly impacts the supply of new Bitcoins entering the market and the subsequent sell pressure that miners rely on to finance their ongoing operations. With fewer new Bitcoins being created, it means there's less selling pressure from miners trying to sell their rewards. When supply decreases, but demand remains the same or increases, it has historically led to an exponential increase in the price of Bitcoin. Importantly, non-Bitcoin related names tend to follow the upward trend in this market regime before exploding higher. These are the sorts of moves that we built the Digital Equity Fund to capitalize on.

Although we share the excitement related to the 2024 halving, we believe that positioning within assets further down the risk and liquidity spectrum provides a more asymmetric opportunity.

Meet Stacks

Stacks is a layer 2 ecosystem that builds on Bitcoin's capabilities by adding a layer of programmability (similar to Ethereum) while maintaining reliance on the Bitcoin validator set. The potential growth of Stax ecosystem is underscored by its current value of ~$1B relative to Bitcoin’s $613B market cap. For some context, Ethereum’s Layer 2 ecosystem is valued at approximately $60B relative to Ethereum’s $223B market cap. STX was distributed through the first-ever SEC qualified token offering in 2019 and has already decentralized.

Stack’s Nakamoto upgrade, expected to occur in Q4 2023, will have an enormous impact on the performance of the protocol and give rise to the first truly composable and efficient L2 in Bitcoin history.

Assuming clean value capture and tokenomics, Stacks (STX) is:

• In the early adoption phase
• Growing super-linearly to Bitcoin
• Generating revenue
• Generating positive unit economics for all stakeholders
• Unlocking $613B of previously untapped liquidity in DeFi
• Uniquely situated from a regulatory perspective

Untangling Risk and Reward in a Complex Market Environment

‍"The optimist thinks this is the best of all possible worlds. The pessimist fears it is true." - J Robert Oppenheimer

At the beginning of this letter we wrote about duality. Today it feels like there is principally a duality of perception amongst market participants. When grappling with multifaceted market conditions it is essential to evaluate markets independent of bias. Just as Oppenheimer's quote suggests, some may be viewing our current economic landscape with fear, expecting the worst of possible worlds. Conversely, others might interpret the same conditions with optimism, finding opportunity in the midst of adversity. Considering all the factors at play, while acknowledging the realities of the current market, we remain optimistic, steadfast in our belief that a balanced perspective will navigate us through these turbulent times. 

As you contemplate your 60/40 portfolio and see the S&P 500 inching closer to its zenith, the investment landscape for the next 3-5 years might appear uncertain. The Federal Reserve, for its part, seems intent on moderating the stock market's feverish pace, and with high interest rates putting a freeze on the housing market, bonds are a tempting but unsure bet amid economic instability.

This is what recent research from the world's largest asset manager suggests the optimal portfolio looks like right now:

"Exhibit 4 presents the results. Starting with a 60–40 equity-bond portfolio, which is produced with a risk aversion of γ = 1.50, the optimal BTC allocation BTC allocation is a large 84.9%! The remainder of the portfolio, 15.1% is split 60-40 between equities and bonds. Although BTC has an extremely large volatility of 1.322... the pronounced positive skewness leads to large allocations and dominates the utility function." – Andrew Ang, Tom Morris, Raffaele Savi, Blackrock Et Al

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We would go a step further, opting for an active multi-strategy approach designed to outperform Bitcoin.

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Onward and upward,

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The MJL Portfolio Management Team

Marcus Leanos - Chief Investment Officer

Sean McElrath - Chief Technology Officer

Domenic Salvo - Managing Partner