Updated: Mar 31, 2019
A Measurement of the Sustainability of Bull Runs
While the equities market has valuation metrics such as Price-to-Earnings ratio, Earnings per Share, Return on Equity, and many more, it is difficult to find an appropriate valuation metric for cryptocurrencies in a space where there are no earnings, equity, dividends, or any of the other metrics normally used in traditional valuation analysis. There are however a few crypto metrics that we can use as a complimentary piece to create our own crypto valuation metric known as the NVT Ratio.
What is the NVT Ratio
The NVT Ratio, formally named Network Value to Transactions Ratio, is a measure of the dollar value of a cryptocurrency transaction activity relative to its network value. You can think of it as a “Crypto P/E Ratio”. In traditional markets, the P/E Ratio values a company by comparing the company’s share price to its earnings per share. Alternatively, you can compare the company’s market cap by the total earnings of the company. This is where there are some similarities to the crypto markets. While we are still unable to derive earnings of a cryptocurrency, we do have a market cap we can utilize within the ratio to represent the price. The market cap represents the network value of the cryptocurrency. Instead of measuring the “price” against earnings (which we don’t have), the NVT ratio measures price against the utility of the cryptocurrency. For bitcoin, that would be its utility as a store of value and medium of exchange which can best be measured through the daily volume of on- chain transactions on the blockchain. We utilize only on-chain transactions since most trading activity that occurs on exchanges are mostly speculative and have no value in determining the actual utility of a cryptocurrency. This ratio is then taken one step further to be “smoothed” by using a 28 day moving average (14 days prior, 14 days post) of this ratio to come up with the final product. With so much data being used a moving average is necessary to help minimize the outliers and day-to-day fluctuations. Therefore, the NVT Ratio looks as such:
What this ratio tries to detect is whether the cryptocurrency in question is overvalued or undervalued. The higher the ratio, the larger probability that at the current transaction volume, price will not be able to sustain its current levels. Where at the opposite side of the spectrum, a lower ratio can be indicative of price sustainability at current levels.
Modifying the NVT Ratio
One major issue with the current NVT Ratio can be show in Figure 1 below. Utilizing a 28-day moving average of the ratio as a whole, the ratio provides a considerable lag compared to any significant price movement. The ratio reaches its peak well through a correction. Therefore, is unable to be used in a timely manner to use within a trading strategy. It’s only use would be to confirm that the cryptocurrency is indeed in a correction.
To resolve the issue and allow for the NVT Ratio to be used within a trading strategy in real-time, analysts at Cryptolab Capital summarized that utilizing a moving average for only the denominator, the daily transaction volume, and using the daily network value would get rid of the considerable lag time with the traditional NVT Ratio. After testing numerous moving averages, the 90-day moving average for transaction volume provided the most accurate comparison to the price. So, the (New) NVT Ratio is calculated as the following:
As you can see in Figure 2, the NVT Ratio now lines up near perfectly with major price movements, specifically the ’13 bull run and subsequent correction and the ’17 bull run and the subsequent correction we are experiencing currently.
Using the NVT Ratio in You Trading Strategy
Just like any analysis strategy, whether it is for cryptocurrencies or traditional markets, you should never use just one metric to make decisions on what and when to trade. The NVT ratio should be used as just one tool in your overall trading/ investment strategy. The following are just a few ways you could utilize the NVT Ratio:
1. Indication of a Highly Speculative Value - When price growth and NVT Ratio are both steep, the market value or price is increasing at a more rapid rate than the transaction volume. This is most likely caused by higher speculative trading on exchanges rather than actual on-chain usage. Within a highly speculative market such as crypto, it is common to see a high NVT Ratio for assets that are in a high growth stage due to a perception of a premium valuation based on future potential.
2. Detecting “Bubbles” - Predicting a bubble, or better yet the apex of a bubble is almost impossible. However, the NVT Ratio is useful for determining whether price growth is sustainable. If price growth is paired with a high NVT Ratio, there is a reasonable expectation that the current network value is not sustainable at the current volume levels. The thing is, for sustainability to be attained, explosive price growth needs to be followed up by an increase in utility. You will need to watch whether the NVT Ratio is able to return back to normal levels (indicating sustainable growth) or continues to increase along with the price (indicating a possible bubble). If the NVT Ratio is unable to return to normal levels, a reversal in price could signal the beginning of a major correction until the NVT Ratio is able to return to normal levels (as shown in Figure 3)
3. Confirmation of Sustainable Price Growth - If price growth is paired with a low NVT Ratio, as it was for much of 2017 during its bull run, it is reasonable to conclude that the price growth is sustainable at those levels. Only once the NVT Ratio reaches the dangerous level do you see any meaningful corrections. But as show in figure 3, price growth resumed in July ’17 and September ’17 once the NVT Ratio returned to a normal level.
4. Recovery from a Correction - Using the NVT Ratio in bear markets is slightly difficult than in bull markets. During corrections, a low NVT Ratio can tell you that the current volume levels are sufficient for supporting a higher network value or price. At these levels, once price is able to find its bottom, growth will be sustainable for the short term and a rise in the NVT Ratio in correlation with the price growth will still be within the normal level indicating sustainability.
Bitcoin’s Current NVT Ratio
Bitcoin’s massive 2017 bull run was paired with an equally massive run for the NVT Ratio. The subsequent price correction from its apex in December ’17 was also paired with a massive drop in the NVT Ratio, from nearly 300 to its current level just above 60. Looking back over the course of Bitcoin’s history, the NVT Ratio has only been below 60 just a handful of times:
July ’13 - right before the 2013 bull run
April ’14 – right after the initial correction in 2014 as price attempted a recovery
January ’15 – at the lowest price since the 2013 bull run 4. March – May ’16 – in lead up to parabolic bull run of 2017
This current NVT Ratio cannot tell us when we will see the end of this current bear market. However, at such a low level we can determine that the on-chain transaction volume is there to support the next bull run.
Inefficiencies of the NVT Ratio
With all that said, the NVT Ratio is not perfect. The first weakness of the metric is in the accuracy of the on-chain transaction volume. Blockchain.info can provide an estimate of the daily volume numbers but those are just estimates. Since Bitcoin uses an unspent transaction output model where records are maintained of both spent and unspent outputs, it’s nearly impossible to have an accurate count of which transactions were spent and which weren’t.
Another weakness is in the use of only on-chain transactions. Yes, it is imperative to remove the speculative volume on or between exchanges. However, with the implementation of the Lightning Network, which is an off-chain scaling solution, transactions on the Lightning Network will not be counted in the on-chain transaction volume numbers but should be included in the NVT Ratio calculation to accurately measure the utility of Bitcoin. To make sure these transactions are included we will need to either find a way to estimate or calculate the off-chain transaction volume from Lightning Network or find another metric than transaction volume to measure the utility of the Bitcoin Network.
No metric, whether in cryptocurrency or traditional markets, is a perfect indicator for valuation. However, the NVT Ratio can provide a relatively decent indication of overvaluation and when used in an encompassing trading/investing strategy that utilizes both fundamental and technical analysis can be an extremely useful tool. Hopefully, some of the inefficiencies of the NVT Ratio will be improved upon over time. It’s worth reiterating that the crypto markets are still in their early stages and even early in terms of attempting to create and validate valuation metrics for this new asset class. It will require more time, data, and modifications to develop a reliable metric within all market cycles. For now though, introducing the NVT Ratio into your trading/investment strategy should help you understand the crypto markets and make more informed decisions.