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One of the main reasons for Bitcoin’s popularity at the beginning was its quality of being an uncorrelated asset. However, since 2017, the growing awareness from institutional investors and retailers has induced a correlation between the cryptocurrency market and stocks. Indeed, in 2017 the market value of digital assets was only $620 billion, but it rose to around $3 trillion in November 2021.
Currently, we have been witnessing a strong correlation between Bitcoin and stocks. According to recent IMF research, as usage has grown, there has been a considerable rise in the correlation between crypto assets and conventional investments like stocks, which limits the benefits of perceived risk diversification and increases the risk of financial market contagion.
The trigger point of cryptocurrency and the stock market correlation dates back to the recent COVID pandemic. Cryptocurrency assets like Bitcoin and Ether did not correlate with the main stock indexes before the epidemic. They were considered to aid with risk diversification and serve as a hedge against fluctuations in other assets. After the enormous central bank crisis reactions in early 2020, everything changed. Due to the easy state of the world economy and increased investor risk appetite, both the price of cryptocurrencies and US stocks increased.
“The cryptocurrency Bitcoin has been a great gauge of investors’ risk threshold for equities,” says JC O’Hara, Chief Market Technician at MKM Partners.
For example, In 2017-2019, there wasn’t a significant correlation between Bitcoin and S&P500, and they had no particular correlation. Their daily correlation coefficient was only 0.01, but during 2020–21 it increased to 0.36 as the assets moved more in lockstep, rising or falling together.
In developing market economies, some of which have led the way in adopting crypto-assets, it is also clear that there is a higher correlation between cryptocurrencies and equities. For instance, in 2020–21, there was a 17–fold rise compared to the preceding years in the correlation between the returns on the MSCI emerging markets index and Bitcoin, which stood at 0.34.
Stronger correlations imply that Bitcoin has been behaving riskily. Contrary to what we previously believed, its correlation with stocks has risen above the correlation between stocks and other assets like investment-grade bonds, gold, and major currencies, indicating limited risk diversification benefits.
The likelihood of investor sentiment spreading between those asset classes is increased by the increased correlation between cryptocurrencies and stocks. In fact, the number of spillovers from Bitcoin returns and volatility to stock markets increased dramatically in 2020–21 compared to 2017–19.
As you can see in the above image, the same price pattern started in 2018, and since 2020 we’ve witnessed more similarities in price trends. Lately, S&P 500 Stocks tanked again, with the S&P 500 falling into bear market territory as investors have spurned riskier assets. All these signals point out that the correlation between the stock market and Bitcoin is increasing over time, and we can use it as a tool to predict the market.
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