El Bitcoin and the investment in growth stocks They have moved almost hand in hand this year. So much so, that most investors now believe that Bitcoin can only rise if the Nasdaq 100 (which is packed with tech growth stocks) does the same. In today's cryptocurrency training lesson we will see that the data suggests that the two things are not as related as we might think.
What is the problem with correlations?➗
It is understood that two assets are correlated if they rise and fall at the same time, and the "correlation coefficient" can help us see exactly the intensity of that relationship. Correlation coefficients can range between +1 (when two assets move by the same percentage and in the same direction) and -1 (when they move exactly the opposite). When the coefficient is zero, it means there is no relationship.
—2022/09/curso-formacion-inversion-cryptomonedas-18.pngExplanation of the Pearson correlation coefficient. Source: Wikipedia.
As you well know, diversification can help us stabilize our portfolios. Basically because if one or two of our investments go up while the rest go down, we will be better protected from large falls in our portfolio. And the less correlated your investments are, the better everything will work.
What correlation does Bitcoin have with the Nasdaq?
This year, Bitcoin's correlation with the Nasdaq has reached all-time highs. Using an Excel spreadsheet, we have analyzed the correlation coefficients between their weekly returns for each year since 2015 (blue bars), as well as the overall correlation from 2015 until now (gray dotted line). You can see that the correlation has been rising over the last three years, and is now well above its long-term average of 0,2.
Correlation coefficients of Bitcoin with the Nasdaq by year (blue bars) and over all time (gray dotted line).
Why has the correlation between Bitcoin and the Nasdaq increased so much this year?
In times of crisis, all correlations reach 1.
When investors are worried about the markets (as in the current situation) they do not discriminate when it comes to pressing the sell button. And the effect is compounded as overly leveraged traders are forced to sell their most volatile investments as prices plummet.
Markets move based on feelings.
The idea that Bitcoin, like growth stocks, are “risk assets” has become much more popular among mainstream investors this year. Bitcoin is mainly conceived as a new technology with great growth potential, which makes sense. As we have discussed in previous cryptocurrency education lessons, risk assets tend to do better when investors have more confidence in the market and the economy. This leads them to make greater investments to generate better returns, instead of playing it safe by trying to preserve the value of their wealth at all costs.
Does that mean that this strong correlation will continue?♾️
Not necessarily. There are two possible economic scenarios that could break Bitcoin's correlation with the Nasdaq:
(i) If inflation rises more than everyone expects, and continues for longer.
In this scenario, investors will buy growth stocks because they expect those companies to generate most of their profits in the future. But if inflation is really high, the present value of those profits is much lower, so they would be less willing to buy growth stocks.
Historical inflation in the US. Source: Visual Capitalist.
If inflation rises it would also force the Federal Reserve to raise interest rates even more aggressively, which would further hurt growth stocks. This is because analysts calculate the current value of a stock by discounting the future value of its earnings using a "discount rate." If interest rates rise, so does that discount rate, reducing the current value of the stock. Bitcoin, on the other hand, could do very well if inflation spikes: after all, there is a finite supply of coins, and the narrative could change quickly if investors see traditional currencies losing more and more in value. each month.
(ii) If economic growth plummets further than expected and drags inflation down with it.
In this scenario, the Fed would then be forced to shift gears and lower interest rates, stimulating the economy in an attempt to maintain employment. This scenario could also lead the central bank to expand the money supply by purchasing more government bonds. And while this could give growth stocks a bit of a boost, we think it would be fuel for Bitcoin. Bitcoin may not yet have proven itself as a hedge against inflation, but it has certainly shown us what it can do when central banks “print more money” with bond-buying programs.
During 2022, interest rates have been raised globally to alleviate the effects of inflation. Source: Mappingmemories.
We also have to note that Bitcoin has a much smaller market capitalization than the US growth stock market. Bitcoin is valued at only $385.000 billion, while the total market size of all Nasdaq stocks It is about 20 billion dollars. This means that it takes much less trading volume to move the price of bitcoin (up or down) than it does to move the Nasdaq. Therefore, if large buyers start buying Bitcoin for any reason, it could quickly become detached from the growth stock index.
What conclusion do we draw for our training in cryptocurrencies?
Regardless of what happens with the economy, it is important to remember that correlations are constantly changing. A tip for your training in cryptocurrencies; It makes sense to own growth stocks and bitcoin, rather than one or the other. Even if the correlation remains as it is, we still have diversification benefits from holding both in our portfolio.