Skip to content

Does the “correlation” break?

October 29, 2020

The relationship that exists between the movement of one asset in relation to the other is commonly referred to as the “correlation”. Analyzing these “correlations” is extremely important in designing an intelligent investment portfolio. In other words, for creating a balanced and diversified portfolio. The concept of correlations is no accident. For the definition it is important to go straight to the data. If we choose short periods of time, the information will be less reliable. However, when we need longer periods of time, the information is much more reliable. However, two assets may be correlated for a long time, but break that correlation in the future.

What is the correlation for Bitcoin? First, we need to sort out certain things. We speak of a perfect positive correlation (+1) when two assets are moving in the same direction. And we talk about a perfect negative correlation (-1) when two assets tend to move in opposite directions.

Read on: Anthony Pompliano: Decoupling Bitcoin and Stocks Proves BTC is the “Ultimate Safe Haven”

Does the “correlation” break?
Does the “correlation” break?

Stocks tend to move in the same direction. This means that stocks on the New York Stock Exchange (NYSE) tend to move in the same direction as stocks on the Nasdaq. And exchanges around the world tend to move together. In fact, all stocks tend to move the same. That is, they are all positively correlated.

In turn, the weakening of the dollar tends to increase the value of gold and oil. In this case it is a negative correlation. Of course we talk about trends. Obviously, it’s not about causality. In fact, a perfect correlation is very rare. Which means that in general, when we have a correlation, we almost always have an incomplete correlation.

It is important to understand the concept of imperfect correlation as many in the crypto community take advantage of this “imperfection” to confuse the matter.. For example. We know that the New York Stock Exchange has a positive correlation with the Nasdaq. However, this is a common trend. There are days or even months when both markets temporarily deviate from their general trend. These deviations are common for the simple fact that perfect correlations are very rare.

For example, suppose the Dow Jones and SP 500 close positive for a few weeks (or a few months) but the Nasdaq close negative. At the same time, gold and oil close negative. No one in their right mind would say that due to this atypical period, the Nasdaq is definitely decoupled from the stock markets and is now correlated to gold. Nobody with three fingers on a forehead would dare make such a statement.

There can be a much more reasonable interpretation. Investors may be cautious and only invest in defensive (non-cyclical) companies. And they are waiting for more optimism to invest in growth stocks (cyclical). This scenario hurts Nasdaq because this market has many (cyclical) growth companies.

Read on: Frozen? Bitcoin’s price correlation with other assets is not yet defined

From that point of view, it would be absolutely absurd to say that the Nasdaq is positively correlated with gold. Despite the coincidences. Risky assets typically do not correlate with conservative assets. However, in many cases, medium risk assets may advance while high risk assets retreat. This sometimes happens during times of cautious optimism. There is optimism, but enough to take great risks.

Another scenario. Of course, it is also possible that two normally correlated markets could temporarily break the trend due to a certain event. For example, the health sector can see a general decline. However, a pharmaceutical company can see a huge increase that goes against the general trend. For example, thanks to the approval of a patent. The market may collapse tomorrow, but if a company gets approval for a coronavirus vaccine, its stakes will go to the moon. It’s that simple. There is no such thing as a perfect correlation.

Now the bitcoin correlation. Like it or not Bitcoin is extremely incompletely correlated with the SP 500. Positive correlation. In other words, Bitcoin has more in common with stocks than gold in terms of correlations. It’s very easy to check. It’s just a matter of examining the behavior of the SP 500 over the past 10 years and comparing it to the behavior of Bitcoin price over the same period. Injured whoever hurts, the prime of the SP 500 coincides with the prime of Bitcoin. It is not an opinion. It’s a fact. The data is available and anyone can review it.

I repeat: “Imperfect correlation.” In the short term, we could even say that this correlation is so incomplete that Bitcoin actually behaves like an uncorrelated asset. However, during this crisis, the correlation with the SP 500 has increased. But I speculate that next year when we emerge from the crisis Bitcoin will break away from the SP 500 a little more and soon return to its old, uncorrelated nature. In the long run, however, the incomplete correlation with the SP 500 could persist.

Does that mean Bitcoin is a copy of the SP 500? Of course not. The last few weeks are proof of that. PayPal announced it would soon accept crypto payments and the news sparked a rally. This is similar to the example I gave earlier of a pharmaceutical company approving a patent. Good news can temporarily break the trend. I repeat: There is no such thing as a perfect correlation.

However, many are already announcing a turnaround when it comes to Bitcoin correlations due to price movements in the past few weeks. I’m afraid these are not very serious statements. Is one month of data enough to decide a final trend change? Of course not. In fact, it’s absurd. It is just too hasty.

One final comment on Bitcoin’s correlations. Many in the bitcoin community are obsessed with correlating bitcoin with gold. Any random similarities are used as definitive evidence of a correlation. And the proven correlation to the SP 500 hides like a shameful disease. Frankly, that doesn’t seem pathetic. Draw a reality that does not exist to fit a predetermined narrative. Bitcoin as a “safe haven”, the “digital gold”. The counterculture hero who will save us from the tyranny of fiat money. Why not study the data honestly?

Read on: The next big treasure: Companies are buying Bitcoin as a treasury reserve

We can fight propaganda with common sense. By analyzing Bitcoin in terms of risk / return, we can understand why investors view Bitcoin as a high growth asset. In a smart investment portfolio, it would replace highly volatile assets. If we visualized a portfolio in the form of a pyramid, Bitcoin would be at the top. Something about high-growth stocks (big tech). At the end of this pyramid, investors typically place the safest assets such as bonds, certificates of deposit, and stable currencies.

The most speculative vehicles do very well in times of high liquidity. That is, when there’s more optimism and money, investors take greater risks. This favors startups, technology companies and new projects. On the other hand, in times of tight liquidity, investors choose much more conservative (stable) assets. So it’s just common sense to correlate an asset as volatile as Bitcoin with riskier assets. Common sense.