Correlations Within The Context of Cryptocurrencies


Asset class correlations help keep portfolios balanced, but crypto traders aren’t convinced that this traditional finance concept is applicable in their marketplaces.

Summary

The amount of correlation and influence between the prices of different assets in a portfolio is determined by the correlations between their prices.

Asset correlations are used by portfolio managers in traditional markets to help establish investment strategies.

But what is the relationship between cryptocurrency and traditional assets? Because cryptocurrencies are so young, there are a variety of conflicting narratives and hypotheses regarding whether the correlation is beneficial across cryptocurrencies or between cryptocurrencies and other asset classes.

Contents

Correlations Are a Useful Portfolio Diversification Tool in Traditional Finance

Asset class correlations are used by portfolio managers in traditional markets to help them decide on an investment strategy.

Correlation coefficients assign a statistical measure of asset price synchronization. A positive correlation is shown by a correlation coefficient larger than zero, and a negative correlation is indicated by a negative correlation coefficient. When two assets move up or down in price together, it’s called positive correlation; when they move in the other direction, it’s called negative correlation.

Investors can balance their portfolios and aim to maintain growth through economic cycles by cycling among assets based on their coefficients.

Stocks and Treasury bonds (T-bonds), for example, are negatively connected, meaning that one rises when the other falls. Stocks in a portfolio will likely aid to ensure growth when people are spending and the economy is expanding.

Stock returns, on the other hand, are expected to fall during periods of economic contraction due to lower demand. T-bond yields, on the other hand, normally climb as investors seek the relative safety of government assets during times of economic concern. As a result, combining bonds and equities in a portfolio would certainly generate profits during a downturn.

The lack of correlation between assets and economic indicators can also be exploited by investors.

Gold, for example, has little to no connection with equity markets and is hence referred to as a non-correlated asset. Gold and other non-correlated assets are frequently used by investors as a safe haven against economic uncertainty.

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Correlation Between Cryptocurrencies and Traditional Assets

Retail investors dominated the crypto trading ecosystem early on in the United States, but they lacked the clout and trading volume of institutional investors. As a result, cryptocurrency price swings have not always followed a predictable pattern and might swing based on investor whims.

Because it demonstrates a statistical relationship between different assets in an economy, the correlation theory works.

However, because cryptocurrencies are such a novel asset class, determining their correlation to other assets in the broader economy is difficult. There hasn’t been enough time for predictable patterns of behavior between cryptocurrency and traditional asset classes to emerge.

Many cryptocurrencies also lack a clear enough economic or financial accounting use case for many investors to build a compelling thesis around them.

The lack of publicly available data has muddled their case, even more, causing cryptocurrencies to be linked to a wide range of assets, none of which have yet gained widespread acceptance among investors. Correlations help to explain asset price shifts, but abrupt price swings in cryptocurrencies can be difficult to understand due to a lack of cause-and-effect explanations.

Correlations have been cited by investors as a probable explanation of cryptocurrency price volatility, but typically without supporting evidence.

For example, speculators have regularly linked price increases in bitcoin (BTC) to the currency’s popularity in nations where inflation is out of control, although there is little quantitative or qualitative evidence to back up such claims. Venezuela’s economy is suffering from severe hyperinflation, but there are no digital trails or fund inflows to show that Venezuelans are to blame for the rise in bitcoin’s price.

The price of cryptocurrency is considered to be inversely tied to the price of stocks, although the contrary has also proven true.

For example, during the COVID-19 pandemic and the 2020 presidential election in the United States, the price of bitcoin decisively soared toward its 2017 top (of $20,000 USD) after years of sideways fluctuation. This pricing trend coincided with a rally in major stock indices around the same time.

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Establishing Correlations Between Cryptocurrencies

On cryptocurrency exchanges, there are over 1,500 assets listed. The most valuable assets have market capitalizations in the billions of dollars, while the least valuable assets have valuations in the thousands of dollars.

Correlations with the second category are difficult to achieve since assets with low valuations are subject to high price volatility, and their long-term viability is also questioned due to a lack of sufficient investment.

Correlation is a hit-or-miss affair for bitcoin assets with high values.

For the better part of the previous decade, Bitcoin prices have established investor and price momentum in crypto markets. However, as other cryptocurrencies have grown in popularity among developers and investors, maintaining that linkage has become more challenging. In early 2018, for example, bitcoin prices declined even as Ethereum’s ether (ETH) prices climbed to new highs.

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Do Asset Correlations Matter?

Asset class correlations are only significant inasmuch as they aid analysts in completing the equation of a well-balanced portfolio that can weather economic cycles and market fluctuations while still producing consistent returns.

They are not, however, irreversible.

An asset’s correlation to its broader economic context can be negative one moment and then positive the next. The nature of cryptocurrency’s positive or negative correlation to more traditional asset classes will likely become more apparent as the asset class matures.