What is the Stock-to-Flow model and why is it criticized?

Main

• The Stock-to-Flow model predicts the value of bitcoin based on the stock-to-production (SF) ratio. The author of the model, the anonymous author of PlanB, created a model based on his calculations for precious metals such as silver and gold.
• Stock-to-Flow is based on an attempt to prove that the price of a commodity will increase due to its shortage caused by an increase in the ratio of stocks to production.
• Experts criticize the Stock-to-Flow model for miscalculating assets, on the basis of which the forecast for the growth in the value of bitcoin was calculated as its deficit increased due to halving.

Who proposed the Stock-to-Flow model and when?

Stock-to-Flow model proposed by an anonymous analyst PlanB in the article Modeling Bitcoin Value with Scarcity (“Modeling the Value of Bitcoin with a Limited Supply”), published in 2019.

About himself, the author reports that he was an institutional investor with 25 years of experience, and previously worked in the financial and legal fields. PlanB is also interested in investment strategies and blockchain analysis. IN another publication the trader mentions that he managed multi-billion dollar assets. It is not known for certain who PlanB is.

How does the Stock-to-Flow model work?

The model is based on the idea of ​​the researcher Nick Szabo, according to which precious metals and collectibles are in constant shortage due to the high cost of their creation. This is the approach PlanB used for Bitcoin.

For an asset, the SF parameter is calculated, which is equal to the ratio of the asset’s stock to the inflow. This is the reciprocal of the increase in supply. The reserve corresponds to the full volume of reserves, and the inflow is equal to the volume of annual production or production.

Consumables, ferrous metals, and commodities have a low stock-to-flow ratio, while rarer items and precious metals have a high ratio.

Goods and materials with low SF are not rare. With the growth of prices for them, producers will significantly increase production and eliminate the shortage. For rare objects, it is difficult to increase production, or it is associated with high costs.

The author applies the concept for gold and silver, which were mined at 1.6% and 4.5% of the reserve. An increase in the demand for these metals will lead to an increase in the cost, since there is no way to significantly increase production and meet demand.

At the time of publication of Stock-to-Flow, the issue of bitcoin was 17.5 million, and the inflow due to mining was 0.7 million per year. The SF of the first cryptocurrency was 25. The inflow is determined by the block reward. Initially, it was equal to 50 bitcoins, but every 210,000 blocks, or about once every four years, payments are halved. This event is called a halving.

The block reward reduction determines the inflow and SF values. PlanB calculated the monthly SF values ​​for Bitcoin from December 2009 to February 2019 and got 111 points.

The graph uses a logarithmic scale that clearly visualizes values ​​from $10,000 to $100 billion. The time until the next halving is shown using a color gradient. Dark blue represents the month in which the block reward decreased, and red represents the month following the event.

According to the model, PlanB predicted that the market capitalization of bitcoin after the 2020 halving will be $1 trillion, and its price will exceed $55,000.

How do phase transitions complement the Stock-to-Flow model?

The author supplemented Stock-to-Flow with the concept of phase transitions, which eliminates the time factor. Substances undergo transformations, which gives them new properties. For example, there are four phase states of water: solid, liquid, gaseous, and ionized.

The US dollar has also undergone transformations: a gold coin; banknote backed by gold and unsecured banknote. Its properties differed significantly in different phases.

PlanB applied the concept to Bitcoin. The author compares the first cryptocurrency with water and the US dollar, which have different properties in each phase. Perceptions and applications of bitcoin have changed over time.

The attitude towards the first cryptocurrency was transformed smoothly, however, PlanB identified four phases:

• Proof of concept. The first phase began with the publication whitepaperfollowed by the launch of the Bitcoin network.

• Payment instrument. The beginning of the phase is associated with bitcoin overcoming the cost of $1, after which its gradual acceptance as a means of payment on the Internet began.

• Digital Gold. After the first bitcoin halving, its price approached the cost of an ounce of gold. These events led to the transition to the third phase.

• financial asset. The over $1B/day transaction volume that took place after the second halving marked the transition to the fourth phase. The latter characterizes the massive adoption of bitcoin in the financial sector.

In one of other works PlanB identified four clusters (groups of points) on the Stock-to-Flow model chart, which correspond to the phases of Bitcoin invented by him. PlanB’s initial forecast suggested an increase in the value of the cryptocurrency to $55,000.

When the SF parameter of BTC becomes equal to that of gold, Bitcoin will move into the fifth phase. This will lead to an increase in the value of the first cryptocurrency to $288,000, and its capitalization will be $5.5 trillion. According to the analyst’s assumption, the forecast can be realized until 2024.

How does the Stock-to-Flow Deflection indicator work?

Subsequently, the Stock-to-Flow Deflection technical indicator was developed that shows the relationship between the price of bitcoin and its value, found using the corresponding model. The parameter values ​​are calculated for the entire period of existence of the cryptocurrency.

If Stock-to-Flow Deflection takes a value less than one, then Bitcoin is undervalued. If the parameter exceeds one, a fall in the value of the cryptocurrency is predicted.

Some traders use this indicator when trading. They buy bitcoin if its value is lower than the estimated one, and open short positions when the first cryptocurrency, according to the indicator, is overvalued.

Why is the Stock-to-Flow model criticized?

Several years have passed since the publication of the concept, during which it could not be fully realized. Strix Leviathan Investment Director Nico Cordeiro thinksthat the Stock-to-Flow model is fundamentally wrong, because arbitrary data for gold and silver were chosen in the calculation of SF.

The analyst suggests that PlanB may have fitted the data to best fit the model. As a result, it was possible to obtain a linear dependence in logarithmic coordinates for gold, silver and bitcoin. The critic draws attention to the lack of correlation between the capitalization of goods and precious metals, expressed in US dollars, and the increase in their production.

Cordeiro has calculated SF for gold over the past 115 years. Its results demonstrate the lack of connection between the capitalization of the precious metal and the calculated parameter. The value of all gold reserves fluctuated from $60 billion to $9 trillion with an almost constant SF value of 60.

The critic’s study notes that the price of the precious metal increases primarily when the purchasing power of the US dollar falls. Due to inflation, the value of the American currency has decreased 25 times since 1915, which explains the increase in the value of gold.

According to Nico Cordeiro, Stock-to-Flow is based solely on historical data. There are prerequisites for this, since according to the simulation results, by 2045 the cost of one bitcoin will exceed $235 billion.

Stock-to-Flow has also been criticized by Huobi analysts. In their opinion, the latter does not take into account macroeconomic factors, such as the normalization of the Fed’s monetary policy and an increase in the discount rate.

What is the future of the Stock-to-Flow model?

PlanB was able to predict the rise in the value of the first cryptocurrency to $55,000. Moreover, it supplemented the original model. At the same time, although the model is supposed to be used for other assets besides cryptocurrency, most of them have a low SF parameter.

By 2022, many professional cryptocurrency analysts have stopped using Stock-to-Flow. Even the creator of Ethereum, Vitalik Buterin, joined in the criticism. He noted that the model does not work well in this period of time. According to Buterin, all models that predict an inevitable increase in the value of assets are harmful.

The author of Stock-to-Flow and its supporters agree that the exponential increase in the price of bitcoin will stop. PlanB acknowledges that the model may become less relevant in the future. However, it still assumes an increase in the value of bitcoin due to undervaluation and scarcity.