Bitcoin’s lack of correlation with the broader economy has proved a mixed blessing for the cryptocurrency. It has ensured an erratic and confusing price movement. The flip side is that bitcoin has, sometimes, acted as a haven for investors interested in an asset class that is independent of the turmoil that afflicts stock markets. (See also: The Market Is Crashing. Please Explain What All Of These Words Mean.)
But the situation is fast changing.
As bridges are built between cryptocurrencies and mainstream economy, events in one asset class may possibly begin affecting those in the other. The simultaneous crash in bitcoin price and equity market valuations last week set off a flurry of analyses investigating precedents to establish a correlation between both events. The available proof is inconclusive and, subsequently, the derived results are uncertain.
What Do Analysts Say?
Analysts have cited investor appetite for risk as the main reason to connect both markets.
The analysts at Datatrek, a research consultancy, analyzed three holding periods of 10 days, 30 days, and 90 days for bitcoin and S&P 500 dating back to January 2016. The current whipsaw in bitcoin prices has a 79% and 52% correlation to daily S&P 500 returns. On a 90-day basis, that figure has a correlation ratio of 33%. According to the analysts, the previous correlation high was back in December 2017, when returns from bitcoin and the S&P 500 were in tandem 17% of the time.
Analysts say the rising popularity of bitcoin within mainstream society is mainly responsible for the correlation. “Since investors have only one brain to process risk, they will make similar decisions about cryptocurrencies and stocks when they see price volatility in the latter,” they wrote.
The Volatility Index (VIX), which measures and moves in tandem with volatility in equity markets, is inversely correlated with bitcoin price, according to the folks at Deutsche Bank. They analyzed data from the beginning of December and found that the price of a single bitcoin increased as volatility decreased.
Analysts at Morgan Stanley and Wells Fargo reiterated the investor risk theme.
In a CNBC appearance, Chris Harvey from Wells Fargo said institutional investors were interested in knowing more about the volatility and risk associated with cryptocurrency markets. “They don’t understand whether it will be a systematic risk,” he said, and predicted that there might be a selloff in the stock market, if the bitcoin bubble bursts. The reverse could also hold true, and a selloff in the equity market could add “fuel to the fire” and result in a corresponding decline in the cryptocurrency markets.
Morgan Stanley analysts contend that bitcoin could represent the highest risk/return available in the current market to institutional investors. In simple words, this means that they transfer risk from relatively stable equity markets to bitcoin and vice versa to maximize returns.
What Should Investors Do?
At least two of the three analysts above cited institutional investors as a major factor driving correlations between equity markets and cryptocurrency markets. That makes sense when you consider that they account for a major chunk of trading in stock markets.
According to a 2010 report by Tabb Group, they accounted for as much as 88 percent of overall trading volumes. (That estimate includes high frequency traders). That share can only have gone up with growth of the HFT ecosystem. (See also: Has High Frequency Trading Ruined The Stock Market For The Rest Of Us?)
The entry of institutional investors into the bitcoin ecosystem will likely bring transparency, price stability and liquidity. More importantly, it will bring a certain amount of predictability to the knee-jerk price movements that have characterized bitcoin markets.
But it might be a while before that happens. Bitcoin and cryptocurrency markets are still largely opaque and dominated by individual traders. Bitcoin futures, introduced on CME and Cboe last year, have failed to draw large traders as evidenced by low trading volumes. There are too few institutional investors equally invested in cryptocurrency markets and equity markets for there to be a sound correlation between the two markets.
Not surprisingly, Morgan Stanley’s analysis showed that the correlation between bitcoin price and equity markets during the last 14 months was 0.4. (A correlation of 1 implies synchronicity in price movements). Datatrek’s research also came up with similar conclusions. The firm wrote that the correlation “seems to rise when US stocks falter and disconnects when equities rise”.
Government regulation might make a difference. “Regulation will bring speculation out (from the markets) and introduce more liquidity and less volatility,” said Chris Harvey from Wells Fargo. (See also: SEC Chair Testified About Cryptocurrencies At Congressional Hearing.)
Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns small amounts of bitcoin.