Acapulco

On October 24th, Tropical Storm Otis defied forecasts, escalating from a minor disturbance to a Category 5 hurricane within hours, leaving Acapulco in ruins as recorded wind speeds eclipsed 200 miles per hour. No forecasting model, regardless of its sophistication, predicted such rapid intensification. The cause? An ocean temperature of 88℉ off of Acapulco's coast — a crucial factor that models, grounded in historical data, overlooked. Just as weather models failed to capture the dynamism of nature, financial models can sometimes miss the evolving realities of our world. 

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The point is historical context matters and probabilistic models assume stability. Unless you zoom out and acknowledge that the world is changing, you are destined to be lost at sea. Despite a choppy quarter for the fund amidst the backdrop of an increasingly volatile world, the long-term trend is in our favor and the fund remains well-positioned as a port in the impending storm.

Other Storms Brew Abroad and At Home

Since our last quarterly update the world continues its trend towards volatility of all kinds: financial, geopolitical, and social. The elephant in the room is a new conflict in the Middle East - one that is especially complex and deep-seeded – the waters in the Red Sea are much hotter than Acapulco’s oceanic hot tub. The risk of escalation is high, and the geopolitical and strategic considerations for the United States are particularly acute. As money managers, our primary focus is how it affects our portfolio and risk management framework.

When the markets opened the Monday after Hamas’ initial October 7th attack on Israeli civilians and soldiers, US Treasury bonds rallied, yields fell, gold was slightly lower, and oil slightly higher. Shortly after, the prospect of an Israeli counterstrike and the implications on US future debt issuance generated the opposite reaction across the board.

Right now, the data points to the US ratcheting up military and aid spending in an already unprecedented and dire debt regime. This creates economic, political, and ethical dilemmas for our leadership, especially pertinent remembering an election is now 12 months away. And don’t forget the context, our fiscal situation is already slated to become exponentially worse due to “higher for longer” rates.

The most worrying thing is that the US government doesn’t believe it is spending too much. According to their models, they can always print more money. This is what US Treasury Secretary Yellen had to say when she was asked if America can afford two wars.

Sky News: Can America, the West, afford another war at this time?
Yellen: America can certainly afford to stand with Israel and to support Israel's military needs, and we also can and must support Ukraine in its struggle against Russia. The American economy is doing extremely well.
Source Sky News

The most intriguing price action in the wake of all of this was in gold and crypto. All signs point to global stimulus, debt issuance, and money printing across major economies. With a Treasury that already planned to issue $7 trillion in the span of 12 months, when the last extended conflict cost taxpayers $8 trillion, it would make sense to not have abundant confidence in the dollar. If you are in this paradigm, asking yourself how to preserve your wealth, it’s probably not financial assets denominated in rubles, yuan, or dollars. Gold and crypto markets are starting to tell you this - you just have to listen. 

Speaking of sovereign debt bubbles…let’s check back in on the banks. You can almost hear the sweet sound of taxpayer bailouts. Think that $105B from Ukraine/Israel is steep? Bank of America just announced a $131B loss on their equity capital in the third quarter. Who do you think is on the hook for that?

The Digital Asset Markets

And that brings us to the digital asset markets, which for most of the quarter, were eerily calm. In our Q2 Letter we discussed the compelling outlook for digital assets heading into 2024. We made a few key points:

1. With correlations to traditional asset classes reverting to their means, digital assets are decoupling and investors should consider digital asset exposure as a diversification safe haven in the face of macro uncertainty.
2. Blackrock’s application filing for a spot Bitcoin ETF, along with Grayscale’s victory against the SEC, would likely lead to approval of multiple passive products designed to accumulate cryptoassets at institutional scale.
3. The Bitcoin Halving is less than 6 months away and the optimal positioning for more patient investors targeting the highest absolute returns is down the risk curve in digital tokens.

Let’s check in on these narratives now that a quarter has passed. 

First the correlation of digital assets to the S&P:

Shown another way, here is the performance of cryptoassets relative to banks and the broader market that has played out since our letter:

And now everyone’s favorite topic these days: crypto ETFs. On October 16, a report that the SEC greenlit a spot bitcoin ETF proposal by BlackRock — which Cointelegraph later acknowledged was incorrect — resulted in bitcoin’s market cap jumping approximately $40B in minutes, fueled by over $100 million in liquidations.

The approval and subsequent trading of Bitcoin Spot ETFs will be gasoline on the fire when put into context of the impending supply shock associated with the Bitcoin Halving in early Q2 2024. Institutional investors have been cautious about entering the crypto space due to regulatory uncertainties and concerns about custody. A spot ETF would offer them a regulated and secure way to gain exposure to Bitcoin. Speculation about inflows upon ETF approval have ranged from $150B to $300B.

Does anyone remember the first gold ETF’s debut in 2004?

On positioning around these catalysts - recall our sentiment from last quarter:

 “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.”

We wanted to put a finer point on this given Bitcoin’s continued outperformance versus the space. It is typical that the rest of the space lags Bitcoin’s move upward in the earliest days of bull markets. If history rhymes, the fund is on track to capture excess returns when the next bull market gathers steam.

We also introduced our readers to Stacks, a layer 2 ecosystem that builds on Bitcoin’s capabilities by adding a layer of programmability while maintaining reliance on Bitcoin’s secure Proof-of-Work consensus. Our rationale was as follows:

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

Here’s how Stacks responded to the fake ETF news:

As we transitioned out of Q3, we noticed a sudden shift in sentiment and activity as Bitcoin made a statistically notable move higher, once again spurred by exogenous macro factors colliding with internal catalysts. For some this may have been a surprise, but for those monitoring the underlying trends driving Bitcoin and the wider digital asset markets (and those reading our letters) it was expected. The Fund has recouped most of its Q3 losses in October. 

Recently we have witnessed a renewed sense of momentum. This resurgence is predominantly attributed to factors such as speculation surrounding crypto ETFs, a more receptive regulatory environment, and the growing recognition of crypto as an asset class uncorrelated to interest rates and global monetary policy. These sentiments are particularly pertinent amidst the backdrop of increasing macroeconomic uncertainty and the ongoing challenges in the fiscal and monetary spheres. The perfect storm.

Conclusion

The third quarter of 2023 painted the crypto landscape with an aura of calmness. Yet, delving deeper into the fundamentals reveals an entirely different narrative. Despite the quieter quarter, the year-to-date performance of the Fund has been robust, showcasing approximately a 33% return (as of October). Crypto has once again cemented its position as the world's top-performing major asset class in 2023.

A closer look at Ethereum's revenue exemplifies the strength of the crypto sector. It has skyrocketed from $35 million in 2019, the tail-end of a previous bear market, to a staggering $1.75 billion so far this year. Moreover, decentralized finance (DeFi) remained strong, exemplified by stablecoins settling almost $1.5 trillion in transactions during Q3, overshadowing the quarterly volume of credit card transactions processed by Mastercard. This strength in fundamentals, combined with the exciting prospects of potential catalysts such as the anticipated approval of a spot bitcoin ETF in 2023 and the upcoming bitcoin halving in April 2024, paints a promising picture for the future of crypto.

Much like the unexpected force of Hurricane Otis, the crypto landscape, while seemingly placid, is showcasing robust fundamental performance. To predict any dynamic system, whether meteorological or financial, both historical context and current indicators are vital. The data suggests that the crypto world, rather than waning, is a coiled spring poised for significant growth.

Onward and upward,

The MJL Team

Marcus Leanos - Chief Investment Officer

Sean McElrath - Chief Technology Officer

Domenic Salvo - Managing Partner