In March 2020, financial markets experienced a tumultuous roller coaster. If you log on to Coinmarketrate.com then you will be able to analyze the total losses of the cryptocurrency market. Global financial markets (stocks, commodities, cryptocurrencies) in some cases fell by more than a third, but recovered quickly.
The high correlation of Bitcoin with other asset classes was striking. What these correlations look like, what they mean and what can cause them, will be discussed in this article.
In financial markets, correlation is a statistic that measures the degree of movement of two assets relative to each other. In advanced portfolio management, correlations are used, which are calculated as a correlation coefficient, which should have a value between -1.0 and +1.0.
An ideal positive correlation means that the correlation coefficient is 1. This means that when one asset moves up or down, the other moves in the same direction.
An ideal negative correlation means that two assets are moving in opposite directions, while a zero correlation implies a complete lack of relationship.
For example, large-cap mutual funds usually have a high positive correlation with the Standard and Poor’s (S&P) 500 index – very close to 1:
Smaller stocks have a positive correlation with the same index, but it is not as high – usually about 0.8.
However, the prices of put options and the prices of the underlying shares, as a rule, have a negative correlation. When the stock price rises, the prices of put options fall. This is a direct and extremely negative correlation.
Bitcoin and Stock indexes (SP500, DOW, DAX, …)
Ever since traditional markets collapsed due to the global economic impact of the COVID-19 virus, bitcoin traders have noticed an amazing correlation between BTC and major stock market indices such as the Dow Jones Industrial Average (DJI) and the S&P 500 (SPX). All three charts have a similar downward trajectory:
The correlation of BTC with the S&P 500 reached the highest value in the last two years and amounted to 0.6. To classify this, here are the values of the various correlation quantities:
- 1 -> BTC and S&P move the same way
- 0 -> BTC and S&P move completely independently of each other
- -1 -> BTC and S&P are moving in opposite directions
Historical data
Based on historical data, it can be seen that the two asset classes show a higher correlation during major Bitcoin corrections. During the peak in July 2018 at around $8,100, the correlation was close to zero. However, when Bitcoin fell to $6,300, it immediately rose to 0.5.
When Bitcoin rose to $9,300 in early November 2019, the correlation with the S&P was 0.1. In mid-September, when Bitcoin fell to just over $6,000, the correlation rose to 0.3.
Simply put, a number of major drops in the recent history of Bitcoin have been reflected in the growing correlation with the S&P 500 index.
Bitcoin and Precious Metals: Investing in Gold
Bitcoin is mostly associated and studied as a commodity, especially in relation to gold. In fact, VTS is often referred to as “new gold” or “digital gold”. You can also find a corresponding comparison of these two assets here:
Correlation of Bitcoin against gold.
As tensions between the US and Iran escalated, gold reached its highest level in the last 6 years, and the price of Bitcoin also rose sharply. As a result, analysts are trying to overestimate the degree of connection between commodities and other traditional assets, with the long-term and short-term price actions of Bitcoin.
If you observe the historical development of Bitcoin and gold prices, you will notice a growing correlation over time. Comparing the correlation of prices in the period 2018 – 2019, it can be found that it increased from 60.3% to 70.8%. For the period from April 2013 to December 2019, it was only 46.5%.
The correlation of the historical returns of the two asset classes has also increased to the same extent. It is interesting to note that the behavior of the bitcoin price is becoming more and more similar to the behavior of the gold price as its market capitalization increases.
Possible reasons of correlation
Bitcoin investors talk about the reasons for such a high correlation. How can such different assets behave so much the same over long periods of time? How is this possible? In search of an answer to these questions, we have collected various explanations, which we present to your attention:
- The most obvious explanation for the correlations is that people have the same patterns of behavior during the crisis and, most likely, liquidate their speculative investments (stocks, cryptocurrencies) in order to get their hands on cash. When the economy is doing well, investors are willing to take more risks.
- Institutional investors have long entered the “Bitcoin trading platform”, and some have created their own trading desks. Here, the same algorithms are often used for HFT (high-frequency trading), which may explain the high correlation between BTC and stock prices.
- Another explanation suggests that the newly created cash from the Federal Reserve and central banks needs to be invested somewhere. This is also true, and in addition to stock markets, it can also be Bitcoin. As in the previous paragraph, here institutional investors will be largely responsible for correlations.
Of course, all these three explanations play a role. Unfortunately, we lack a number of data to definitively answer this question. However, we can assume that a combination of the above three explanations is responsible for the Bitcoin correlation.
Separation: a pipe dream or an imminent reality?
In addition to the reasons for the correlation between Bitcoin and other assets, there is, of course, another important question: will the Cue Ball one day be able to separate from other asset classes and go its own way?
There were several cases when the growing correlation between Bitcoin and the S&P 500 did not lead to a correction, as one would expect, given the available data. For example, in February or June 2019 – when Bitcoin continued to swing against the trend. But, so far, alas. Even today’s correction of the crypto market has not been without correlation with traditional markets.
Conclusion
Whether Bitcoin will separate from other cryptocurrencies and when it will happen is still unclear. Too many variables are currently determining not only stocks and Bitcoin, but also the entire global economy. The real crisis may still be ahead. Only when the dust settles after this crisis will we see where the Cue Ball will lead us in the long run.
We believe that most people will need a few more years to realize the huge advantages of cryptocurrencies as a financial investment. But when this happens, we will see the separation of BTC from other asset classes.
