A scary month for stocks — but will bitcoin benefit?

October is fabled for stock market volatility and 2018 was no exception. With millions of dollars wiped out of equities over the past four weeks, the drop has even invited comparisons with the 2008 crash.

Back then, Bitcoin was just an idea, but in the intervening decade it has grown to lead a new asset class with a two hundred billion dollar market cap. As it has expanded, analysts have continued to speculate on potential correlations with other markets — and the most recent drop has reignited the debate over how bitcoin would react to a severe stock market crash.

A positive correlation?

Historical data on recessions shows that as markets fall, investors usually seek to reduce risk, selling off speculative assets as the mood turns defensive. This would suggest a positive correlation between Bitcoin and the larger movements of the stock market: — a thesis confirmed by a cursory look over the price action of the last year.

As stocks soared in late 2017, bitcoin followed, and eventually went parabolic, reaching its all-time-high around $20,000 on December 17th, shortly before the S&P 500 reached its zenith on January 27th. After the ascent, both markets settled into similar downturns, and eventually found floors in the first few days of February.

Chart showing the coincidence of dips, with Bitcoin (BLX) in blue and stocks (S&P 500) in orange.

Since May, however, any correlation that might have existed seems to have weakened, and Fundstrat advisor Tom Lee has suggested that there is only a limited relationship between the prices of stocks and bitcoin. As Lee told CNBC’s Trading Nation: "[Bitcoin] 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. 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."

While the movements of the S&P 500 might bear little correlation, studies from Deutsche Bank and CBOE have found that as volatility decreases in the stock market, the price of bitcoin increases.

This is shown through correlation with the Volatility Index (VIX) – A so-called ‘fear gauge’ which measures investors’ expectations of future stock price fluctuations to indicate the level of risk present in the markets at any time.

Chart showing the coincidence of peaks and dips, with Bitcoin (BLX) in blue and Volatility Index (VIX) in green.

When fear and risk enters the stock market, the VIX starts to rise, and bitcoin starts to fall, demonstrating an inverse correlation and suggesting that bitcoin might have little safe haven appeal. This trend is also visible in a cryptocurrency correlation matrix compiled by mathematician Basil Bayati, which shows a ‘moderate negative correlation’ between VIX and Bitcoin.

A correlation score of zero indicates no correlation between the two assets. A score of one indicates perfect correlation, and a score of -1 is perfect inverse correlation. BTC and VIX show an average correlation of -0.31 – a weak negative correlation.

The bottom line

When the bitcoin network launched in January 2009, the first entry in the transaction register —the genesis block — included the following text: "The Times 03/Jan/2009 Chancellor on brink of second bailout for banks."

These short few words — taken by many to show loss of faith in the traditional markets — hark back to the original design of bitcoin as a peer-to-peer, deflationary, interference-free asset.

As a relatively new independent market, it’s perhaps natural that any correlation with other markets remains tenuous. But, these relationships might be expected to develop as more bridges are built between cryptocurrency and the mainstream economy, or indeed if the mainstream economy was to completely unravel.

Speaking on the Unconfirmed podcast, Cofounder of Messari Dan McArdle said that while bitcoin might not hedge against a typical recession, should such an event become very severe, then bitcoin is likely to play a considerable role: "If we just get a light to moderate recession that doesn’t bleed over into a currency crisis, then I think bitcoin would be sold down like any other risk asset [..] but where I think it dissociates is if the recession gets bad enough to turn into a currency crisis, or if the recession itself is triggered by a sovereign debt crisis."