Correlations Within The Context of Cryptocurrencies

Correlations Are a Useful Portfolio Diversification Tool in Traditional Finance

In traditional markets, portfolio managers use asset class correlations to help determine an investment strategy. Correlation coefficients assign a statistical measure for synchronicity between assets’ prices. A correlation coefficient greater than zero means a positive correlation, while a negative coefficient implies the opposite. Positive correlation is when two assets move up or down in price together, while negative correlation implies inverse movement. Cycling through assets based on their coefficients helps investors to balance their portfolios and try to maintain growth through economic cycles.

For example, the prices of stocks and Treasury bonds (T-bonds) are inversely correlated, meaning that one goes up when the other goes down. When consumers are spending and the economy is expanding, including stocks in a portfolio will likely help to ensure growth. During times of economic contraction, however, returns from stocks will likely decline because of decreased demand. In contrast, T-bonds’ yields typically rise because investors usually flock to the relative safety of government instruments during economic uncertainty. Therefore, incorporating bonds in the same portfolio as stocks would likely generate returns in recessionary times.

Investors can even exploit the absence of correlation between assets and economic indicators. For example, gold has low to almost-no correlation with equity markets, and for this reason is generally referred to as a non-correlated asset. Investors often use gold and other non-correlated assets as a safe haven against economic turmoil.

Correlation Between Cryptocurrencies and Traditional Assets

Early on in U.S. crypto markets, retail investors dominated the crypto trading ecosystem, but they lacked the heft and trading volume of institutional investors. As such, price movements for cryptocurrencies have not always followed a predictable pattern and can swing with investor whims.

The correlation theory works in part because it establishes a statistical relationship between different assets in an economy. But because cryptocurrencies are such a new asset class, it’s difficult to establish the correlation of cryptocurrencies to other assets within the broader economy. Not enough time has elapsed to establish predictable patterns of behavior between cryptocurrencies and traditional asset classes. Many cryptocurrencies also lack a clear enough use case in economics or financial accounting for many investors to develop a cogent thesis around them. The scarcity of publicly available data has further complicated their case and has led to cryptocurrencies being correlated to a wide range of assets, none of which have yet to be widely accepted by the investor class. Correlations contribute to narratives that explain shifts in asset prices but sudden price swings for cryptocurrencies can lack cause-and-effect explanations. Investors have latched on to correlations as a possible cause of crypto’s price volatility, but often without accompanying proof.

For instance, investors have repeatedly attributed surges in bitcoin (BTC) prices to bitcoin’s popularity in countries with runaway inflation, but there is little quantitative or qualitative evidence to support such assertions. Venezuela is an economy with severe hyperinflation but there are no digital tracks or fund inflows to prove that Venezuelans are responsible for bumping up the price of bitcoin.

Cryptocurrency prices are also said to be inversely correlated to stock prices, but the opposite has also been true. For example, after years of sideways movement, the price of bitcoin rose decisively toward its 2017 peak (of $20,000 USD) during the COVID-19 pandemic and 2020 presidential election in the U.S. That price trajectory corresponded with a rally in major stock indices at the same time.

Establishing Correlations Between Cryptocurrencies

There are more than 1,500 assets listed on cryptocurrency exchanges. The biggest assets have market capitalizations running in the billions of dollars, while those at the bottom have valuations that are just thousands of dollars. Attempting correlations with the latter group is difficult because low valuations make assets subject to extreme price volatility, and a lack of sufficient investment also makes their long-term viability questionable.

Among cryptocurrency assets with substantial valuations, correlation is an on-and-off affair. Bitcoin prices have set investor and price momentum in crypto markets for most of the last decade. Lately, however, as other cryptocurrencies have garnered popularity with developers and investors, that correlation has proven difficult to maintain. For example, bitcoin prices fell even as prices for Ethereum’s ether (ETH) rose to new heights in early 2018.

Do Asset Correlations Matter?

Asset class correlations are important only insofar as they help analysts complete the equation of a balanced portfolio, one that can withstand economic cycles and market movements to produce consistent returns. But, they are not set in stone. An asset may be negatively correlated to its broader economic context one moment and turn positive the next. As the cryptocurrency asset class continues to mature, the nature of their positive or negative correlation to more traditional asset classes will likely become more and more apparent.