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Looking at the Bitcoin graph, and that of the stock market, including the Dow Jones and the S&P 500, you may have noted an interesting similarity. The stock market was growing to new heights rapidly, with even Donald Trump tweeting how it had risen 20 percent since his election. A little before these heights, Bitcoin had also surged up to its all-time high of $20,000 on Dec. 17.
Both markets then started to plunge, first, it was Bitcoin, whose price steadily dropped towards $6,000 before hitting a floor. The stock market fell a lot quicker, but the pattern looked remarkably similar, with them both finding a floor last Monday. The Dow Jones Industrial Average saw its biggest one-day point drop in history on Monday, and the S&P 500 had its worst day since 2011. Questions then started to spring up whether or not there was a correlation between the vastly different assets. And can we predict the future moves?
What happened to the stock
To determine if there is a correlation, one needs to address the reasons why the stock market is down and investors are seemingly selling off. John F. Wasik, behavioral finance Forbes columnist lists a couple of reasons why the Stocks have crashed. He believes that the general stock market was overpriced, and uses a gauge by Robert Shiller, a Yale economics professor, to assess that. He adds that volatility has returned, looking to the VIX index, and this is important in looking for the Bitcoin correlation.
Furthermore, interest rates are rising and there is a belief that inflation may be on its way back. What happens next? According to Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics, the computers (which make 90 percent of deals on the stock market) make their turn, calculating that even higher inflation is inevitable.
And why Bitcoin took a dip
These explanations as to why the stock market crashed are vastly different to the reasons why it was assumed that Bitcoin fell by almost 70 percent. The problem for Bitcoin, following an expected correction once it hit $20,000, was that there was a stream of damaging media reports, some of them unfounded and simply incorrect.
The confusion firstly in South Korea about a potential ban did its damage before it was eventually cleared up by the South Korean Government. Then, China announced it would be putting one more nail into Bitcoin’s coffin within the country by placing a firewall up to restrict foreign access to exchanges. There was even news out of India that was flagrantly misinterpreted, also regarding a potential ban, that saw Bitcoin plummet.
From these external events, there is no discernible relationship as to why the Bitcoin market and the Stock market fell at the same time. But looking deeper in terms of correlation graphs, you can see some sort of link.
Z-scores and fear gauge
One area of data which seems to show a sort of correlation is in a matrix of z-scores and p-scores. These correlation graphs are quite confusing, but the just of it is that if two assets share a z-score that is negative or positive, there is evidence of either a direct or inverse relationship.
In the graph below, the numbers are called z-scores. They represent the direction and strength of the relationship between the two sets of data. A higher absolute z-score means greater correlation, while a lower absolute z-score means less of a correlation.
Image source: Sifr Data
A simple glance at this correlation graph can show that the relationship between Bitcoin and S&P 500 is at a weak positive relationship. But, the correlation between VIX and Bitcoin -0.31 making it a moderate negative relationship.
The VIX is a so-called ‘fear gauge’ and indicates the level of risk that is currently present in the markets at any time. According to this graph, there should be an inverse correlation between VIX and Bitcoin, and this was demonstrated in an article on CBOE’s website that overlayed the VIX and Bitcoin price. So it is between the VIX and Bitcoin, not the Stock Market itself, where the correlation seems to exist. But then again, for the last three years, VIX Index outperformed Bitcoin in terms of volatility and in 2015-2016 the correlation was almost non-existing, it’s 2017 that matches the pattern.
"[Bitcoin’s] could easily look like a chart that looks like the S&P, because both had a parabolic move and then subsequently gave back some of these gains," Lee told CNBC’s "Trading Nation."
But that's where the relationship may stagnate. Lee added that "the connection between the two is really, really limited." He went on to discuss that the correlation, if any, may have been down to a more cavalier approach by investors who were also then buying cryptocurrency.
"In the past 12 months, not only did we have a strong rally in equities, we had a strong rally in cryptocurrencies. I wouldn't be surprised if those investors who saw risk-on assets everywhere outperforming globally were also buying cryptocurrencies."
“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.”
Correlation in the future?
Christopher Harvey, head of equity strategy at Wells Fargo, believes that perhaps there is a stronger correlation than has been stated previously, but he, like Lee and Datatrek analysts, is linking these relationships more to sentiment that empirical evidence. "On Monday [February 5] what we saw is all risk products sell off," Harvey said Wednesday on CNBC's "Fast Money." A hit on the market, in his opinion, can cause investors to panic and begin selling Bitcoin as well: "It sometimes adds fuel to the fire.”
Again, it is this idea that Bitcoin has crossed a threshold into the mainstream market too that could perhaps be causing this assumed correlation. Harvey, and others, talk of similar sentiment meaning a similar sell off across the two markets. Morgan Stanley analysts have also stated that perhaps traditional investors were transferring risk from the relatively stable equities markets into Bitcoin, and vice versa, showing again this crossover that could be amalgamating the markets slightly.
Marcus Poh, Trading Trainee at Octagon Strategy, also believes that the two markets are starting to intermingle somewhat as he states:
“As for it being indirectly related, I would say that BTC is considered to many as a hedge against currencies, similar to that of gold. Therefore, if the demand, recognition and acceptance of BTC becomes much larger, there is a chance it would be in a similar position to that of gold and the stock market.”
Fear breeds fear
Perhaps for now the idea of correlation between the Bitcoin market and that of traditional stocks is limited to the “fear index” because of cryptocurrency buzz in 2017 and the bull rally of investors. They cannot truly be plotted on a graph against one another, and have often deviated at key moments. For example, In August last year, the global economy took a major hit in the face of rising tensions between the US and North Korea, but the Bitcoin market remained unfazed.
But what could be concluded from this recent pattern across the markets is that investor sentiment can carry over from the stock market to the Bitcoin market. Because of a mainstream adoption wave that has seen Bitcoin accepted as an investable asset, there is the beginnings of a crossover.
Thus, when fear and risk enters the stock market for reasons outlines by John Wasik then the VIX also starts to rise. It has been shown that there is an inverse correlation between this and the price of Bitcoin which can be seen on an overlapping graph. None of these relationships or correlations, tenuous as they are, can really aid in predicting the markets, they can only prove that investment fear is not just isolated to the stocks. But as for now, Tom Lee sums it up in a bold, no nonsense manner:
"Cryptocurrencies have their own economy based on activity on that Blockchain. Equities have their own economy based on earnings per share multiples. The institutional overlap is essentially zero."