Welcome to our new series, Node Notes, where we’re spotlighting topics from our bi-weekly research piece, The Node Ahead. If you want to read the full piece, you can check out our blog or sign up to receive The Node Ahead straight to your inbox. This edition of Node Notes is an excerpt from Node Ahead 49.
Why we pay attention to correlation in the market
One of the most compelling aspects of bitcoin as a financial asset has been the low historical correlation it has with other asset classes. Correlation is a statistical measurement from -1 to +1 that reveals how assets move in relation to each other. A positive correlation between two assets means every time one asset increases in value, the other asset also increases. The closer the correlation is to +1, the similar the magnitude of the change is. A negative correlation implies that when one asset increases in value, the other asset decreases in value. A correlation of 0 means there is no relationship between the two assets.
How correlation is used in portfolio management
Correlation is often used in portfolio management to measure the amount of diversification among the various assets within a portfolio. But why does diversification between assets matter? Because the more diversified a portfolio is, the more it can be optimized for any given level of risk. If you could add an asset to a portfolio that increases diversification, you could expect a similar return with less overall risk in the portfolio (even if that asset itself is risky).
For example, the most common way to diversify a portfolio of stocks is to include bonds, as the two have historically had a relatively low degree of correlation with each other. Investors also often use commodities such as gold to increase diversification for the same reason. But now there is a better way to diversify a portfolio, and that’s with bitcoin.
Bitcoin’s correlation with the stock market
BTC has spent most of its existence uncorrelated to the stock market. From 2011 to 2019, bitcoin had a correlation with the S&P 500 of 0.03. That’s as close to zero as it gets. To put that in perspective, that’s significantly less correlation than bonds or gold have to stocks, meaning that during its first decade of existence, bitcoin provided greater diversification benefits to a portfolio than traditional assets. And the kicker of it is, during that time, bitcoin was the best-performing asset by a wide margin.
Source: Glassnode, Yahoo Finance
Source: Glassnode, Bloomberg
For any investor with a low time preference, bitcoin has historically provided incredibly high returns and essentially no correlation with traditional assets. That’s the dream investment for any portfolio manager. And this isn’t just theoretical. Studies done by Yale, Fidelity, Ark, and others have all shown that because bitcoin has historically been uncorrelated with other asset classes, adding bitcoin to a diversified portfolio dramatically increases the expected returns without necessarily increasing the overall risk of the portfolio. Even Blackrock, the world’s largest asset manager, released a mathematical study on the impact of bitcoin in a portfolio in 2022. The results show that even for conservative investors, a 12.5% allocation to bitcoin statistically optimizes a portfolio. Another way of saying that is that any portfolio that doesn’t include bitcoin isn’t optimized on a risk-adjusted basis.
Like everything else in our world, the correlation between bitcoin and stocks changed in March 2020. When COVID hit, there was a sharp contraction in the economy and deep uncertainty about the virus’s severity and length. This caused a liquidity crisis in the market, which simply means there was a simultaneous lack of cash (or easily convertible-to-cash assets) across many businesses and financial institutions. As a result, investors and businesses began selling anything they could in order to generate liquidity. This, in turn, led to a sharp fall in not just the stock market but across all asset classes. Assets that typically have a low correlation with each other such as oil, gold, US treasuries and bitcoin, all fell simultaneously because investors suddenly needed cash. During a liquidity crisis, the correlation for all assets trends towards 1.
Fortunately, liquidity crises don’t last forever. For several months during 2020, bitcoin experienced a higher level of correlation with stocks and other assets, but by the end of the year, that correlation had dropped back to historical norms.
Source: Glassnode, Bloomberg
Bitcoin’s correlation to stocks remained relatively low in 2021 but spiked again in 2022 when the correlation of all asset classes increased in lockstep just like in 2020. The reason this time wasn’t a liquidity crisis, but the drastic change in the Fed’s monetary policy in response to growing inflation. After a decade of near zero interest rates, the Fed gave its public forecasts in 2020 in which it told the market it wouldn’t raise interest rates until after 2023. However, starting in March 2022, the Fed raised interest rates 10 times. That drastic pivot to tighter monetary policy was the cause of the bank crisis earlier this year. It also led to just about every asset class falling in value as market participants had to adjust to the new reality. BTC fell alongside stocks, gold, and even bonds.
As a result, bitcoin’s correlation spiked once again starting in March 2022. Similar to 2020, bitcoin’s correlation remained high for several months but then slowly began to decouple from the stock market towards the end of the year. That decrease in correlation has continued throughout 2023 to the point where bitcoin’s correlation to stocks is now back close to 0.
Source: Glassnode, Bloomberg
Since the start of the year, BTC is up 75% compared to 16% for the S&P 500 and 4% for gold. All the while, bitcoin’s correlations to all other assets have fallen back to historical norms (BTC’s correlation with the S&P 500 last month was 0.08), making bitcoin once again a dream asset to add to any portfolio.
The data proves that, over the long term, bitcoin has a very low correlation to traditional assets. Since 2011, BTC’s correlation to the S&P 500 is 0.12, and that’s including the two abnormal spikes in 2020 and 2022. The data also shows that during periods of financial stress, bitcoin’s correlation does have a tendency to rise. However, these periods are often short-lived and correspond with moments in time in which every other asset class also experienced an increase in correlations. For anyone with a time horizon longer than a few months, bitcoin is a valuable tool that can increase the diversification and returns to any portfolio.
Disclaimer: This is not investment advice. The content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content is information of a general nature and does not address the circumstances of any particular individual or entity. Opinions expressed are solely my own and do not express the views or opinions of Blockforce Capital or Onramp Invest.