Ecoinometrics - Drawdowns are opportunities

If you see the glass half full, drawdowns aren't necessarily bad. Beware hopium ahead.

Oct 31, 2022

I'm not in the business of selling you the apocalypse.

No doubt the macro environment is challenging. As a consequence it might seem that this newsletter is constantly spreading doom and gloom. But I'm not trying to get you depressed, or panicked, or desperate about what might happen in the near future.

What I'm trying to achieve is give you a fair assessment of the current situation so that you can manage your risk appropriately.

That being said if you are fed up with the negativity, you can always flip the narrative on its head and look at drawdowns as opportunities.

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Done? Thanks! That’s great! Now let’s dive in.

Drawdowns are opportunities

Bitcoin is down 70%, Ethereum is down 68%, Amazon is down 45%, Meta is down 75%, the stock market as a whole is down 20%. And when people look at these kinds of charts they get depressed.

But if you take a long view, if you have a long term thesis on the assets you are investing in then you can look at this differently by just flipping the numbers.

One way to think about it systematically is that if you have a long investment horizon you most likely expect at least that whichever asset you are betting on will some day recover from this drawdown.

So a standard way of gauging the opportunity offered by this correction is to imagine the potential returns you will make if you buy today and sell at the exit of the drawdown.

Example, Bitcoin is currently down 70% from its peak. That means if you buy today, by the time Bitcoin is reaching again this previous all-time high you'll be up 232%. Said like that it doesn't sound too bad does it?

That doesn't mean you have to sell as soon as BTC makes a new all-time high of course. But you expect to make at least that much from taking a bet when everybody else is selling.

Another example is Meta. Facebook made a big bet that their future lies in building their own version of the Metaverse. The market doesn't like this pivot and the Meta stock is down 75%. But if you think that there are chances Zuckerberg can pull this off then if you buy the stock today you'll be up 290% by the time it recovers its all-time high.

I'm not saying you should do that, and I personally don't like the corporate version of the Metaverse, but hey, that doesn't mean Meta doesn't constitute an asymmetric bet.

Bitcoin and Meta aren't the only ones. Check out this chart for the range of current opportunities offered by this drawdown.

My point is that if you are looking past the struggle of the coming months / years you need to entertain the idea that taking position during a correction will simply juice your returns.

I mean just look at Amazon right? Unless you think the exponential trend is dead the odds are on your side this will recover and then some.

Actually now is a good time to look at something I’m hearing often about this “and then some”. Is it the case that the larger the correction the bigger the following bull market?

If that was the case, well you could use that info to make some guess as to where the next bull run should go.

So let's take a look at this relationship.

Some methodology first. A drawdown is just the period of correction between two consecutive all-time highs. In practice that means there are a lot of small drawdowns happening during a major bull market. What we really want to do for this analysis is ignore those small drawdowns. So that's what we are going to do. That leaves us with few data points to work with.

But on those we can calculate the ratio between the size of a major drawdown (all-time high to bottom) and the size of the bull market that followed (from bottom of the drawdown to next all-time high before a bear market).

Here is what we find…

Right, we find nothing. It is not generally the case that the bigger the drawdowns the stronger the following bull market. And if you were wondering, the reverse situation is not true either. It is not the case true that the stronger the preceding bull market the bigger the drawdown. There simply is no relationship between the two.

Honestly this is a theme in my work. On many occasions I hear the “people say that …” but when we look at the data we find very often that actually there is very little to support whatever people are saying or even worse the data contradicts what most people expect.

The latest example we looked at is the claim that the end of the zero-COVID policy in China (who knows when that will be) would automatically be a tailwind for global inflation.

Tl;dr If you are investing for the long term you obviously expected that we haven't experienced the last bull market.

That means is this bear market is nothing but an occasion to get positioned for the next 5 to 10 years.

The positive framework is to look at the current price in relation to how much return it will generate in the long run.

For Bitcoin:

Buying now will generate 230% return on exit of the drawdown.
Buying at $15k will generate 362% return on exit of the drawdown.
Buying at $10k will generate 588% return on exit of the drawdown.

Similarly for Ethereum:

Buying now will generate 200% return on exit of the drawdown.
Buying at $1,000 will generate 387% return on exit of the drawdown.
Buying at $500 will generate 880% return on exit of the drawdown.

Of course the total upside potential is much higher than that.

So I'll repeat the three strategic advice to follow in this bear market:

Make sure you are not going to be liquidated in a market meltdown. Those things happen. Needless to say, if you get liquidated your future upside is zero.
At this point of the correction wait for either a complete meltdown or the first start of improvements on the macro side before taking on new positions. This is where you reward to risk ratio will be the strongest.
When you finally take those positions, favour asymmetric bets. Life is too short to grind small wins for the next 40 years.

October recap

If you haven't seen it yet, Noelle Acheson just launched a newsletter where she breaks down the latest news in crypto through the macro framework. Since you are reading this newsletter, you'll certainly enjoy Crypto Is Macro Now.

Checkout the latest weekly edition over here.

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