Black swan events and thesis
Recently, Eric Robertsen, head of research at Standard Chartered Bank, made a list of several black swan events that could happen in 2023. Bitcoin (BTC-USD) prices will drop another 70% to $5,000. And at the same time, gold prices will increase by about 30% (and full disclosure, I have no Bitcoin exposure, but I do have some gold exposure). His reasons are given below and I find them quite convincing:
Eric Robertsen noted in the note that given a number of factors, such as insufficient funds or bankruptcies resulting in more cryptocurrency service providers piling up, more investors will begin to develop cold feet and continue to withdraw their assets. According to him, this is likely to cause investors to focus on good old gold. Robertson predicted that the price of gold could rise to about $2,250 an ounce, an increase of about 30%.
The remainder of this article focuses on the implications of such a black swan event for Nvidia (NASDAQ: NVDA). Black Swan events are, by definition, difficult or impossible to predict, but produce consistent events, which I think is what NVDA is dealing with here in terms of Bitcoin exposure.
NVDA reported exposure to cryptocurrencies. But recently he stopped reporting about it. Management has repeatedly emphasized in recent quarterly earnings reports that cryptocurrency no longer has a significant impact on NVDA, while acknowledging that there are various mechanisms for potential impact. The following exchange from the Q3 2022 earnings report is a good example. The quotes have been slightly edited with emphasis added by me.
Question from Joseph Moore of Morgan Stanley: A miracle if you can talk about the impact of cryptocurrency in hindsight. Obviously it’s gone from your numbers now, but do you see any potential for deprecation of GPUs in the mining network, any implications going forward? And do you foresee blockchain becoming an important part of your business at some point down the road?
Answers from Jensen Huang (NVDA CEO):We do not expect Blockchain to become an important part of our business. There is always a resale market. If you look at any of the major sales sites, such as eBay, there are always used graphics cards for sale. This is because the 3090 someone bought today was upgraded to a 4090 they bought a few years ago, or a 3090 upgraded to a 4090 today. That 3090 could sell to someone and enjoy if it sells for the right price. So volume — the availability of second-hand and used graphics cards has always existed. And inventory is never zero. And when inventory is larger than usual, as with all supply and demand, that will likely slide down the price and affect the lower end of our market.
True, it is difficult to assess the impact. But still, I’ll work through the rest of this article. And my conclusion is that NVDA management probably underestimated the impact of the cryptocurrency crash. As you’ll see next, I’m still seeing big cryptocurrency impacts on both NVDA prices (reflecting psychological impact) and NVDA profitability (reflecting fundamentals).
Historical Perspective: The 2018 Cryptocurrency Crash
The last time we experienced a similar cryptocurrency crash was in 2018, as shown in the charts below. As you can see from the top panel, Bitcoin USD prices have fallen from ~$19k to ~$3.6k in about 1 year, down 81% YoY. And in tandem, NVDA’s annual operating income growth rates (on a quarterly basis) ranged from roughly +50% to -45%. At the time, NVDA said it was still exposed to cryptocurrency mining. Specifically,
quotes from NVDA’s own calculations: cryptocurrency-related sales were about $0.6 billion (about 5.7% of their total sales of $10.6 billion. While other independent analysts (such as Mitch Steves at Business Insider) provided a higher estimate of $1.95 billion in crypto/blockchain-related revenue at the time (about 18.4% of its total revenue at the time).
As mentioned above, NVDA has stopped splitting its cryptocurrency-related revenue. But in my opinion, its leadership is underestimating its impact today, as well as in 2018, for at least two reasons.
First, NVDA stock prices are still closely related to Bitcoin prices. Of course, correlation does not reveal causation. And ultimately, such a correlation is best interpreted as a psychological effect. But even so, psychological influences are just as important as fundamental influences in investing. From 2022 to now, Bitcoin prices are going through the same correction as in 2028. As you can see from the bottom panel of the chart above, Bitcoin prices have fallen from their peak of ~$65k at the end of 2021. for November) now up to ~$17.1K in about 1 year. Such a decline translates into a 74% year-over-year decline, close to the 81% decline seen in the 2018 episode. Meanwhile, you already know what happened to the NVDA stock price: it has corrected about 52% from its peak value in about a year in tandem.
The above related movements are also observed on a wider time frame as shown in the next figure below. This chart shows the correlation between Bitcoin price action and NVDA price action over the past ten years since 2014. As can be seen, the average correlation is a positive 0.26 in the past and a positive 0.183 in the current generation.
Second, NVDA’s earnings are also positively correlated with Bitcoin prices. The next chart shows the correlation between Bitcoin prices and NVDA’s diluted EPS on a quarterly basis. As you can see, the average correlation over the last ten years is an even stronger 0.408. Currently, the correlation hovers around 0.757, a fairly strong level.
But of course, correlation always equals causation. However, in this case, I suspect it’s a good possibility. As you can see from the next chart, this time I plot the correlation between Bitcoin prices and diluted EPS of QCOM and INTC on a quarterly basis. I know for a fact that these two chip makers have little or no exposure to Bitcoin mining. And indeed, their EPS shows little or no correlation with Bitcoin prices (on average 0.025 in the case of QCOM and -0.117 in the case of INTC).
Summary of risks and final thoughts
Please note that Robertsen’s 2023 black swan peak is when Bitcoin prices fall another 70% to around $5,000. And I find this plausible given factors such as insufficient funds, bankruptcies and the psychological shift of investors to more familiar safe assets like gold.
Such a black swan event could have a large and negative impact on NVDA prices due to a combination of physical effects and fundamentals, both important and intertwined in investment. Based on my findings, it is my opinion that NVDA management is still underestimating the impact of their cryptocurrencies as of 2018. Last year, BTC prices fell from ~$65k to ~$17k. a ~74% year-over-year decline and NVDA’s annual operating income growth rates (on a quarterly basis) went from ~50% expansion to a 16.5% contraction. According to a recent Reuters report, NVDA’s supply of crypto-mining chips still contributes significantly to its sales. At the same time, investing in NVDA also involves significant valuation risk at this point. Its FY1 P/E is around 48x, more than double AMD’s 20x and nearly four times that of INTC (14x) and QCOM (11x).
Despite all that, I don’t recommend getting involved at this point. The downside is simply too great with the combination of negative psychological effects of Bitcoin prices, earnings effects and also valuation risks.