Before the introduction of Bitcoin in 2009, the financial world saw the Stock Market as one of the best options to invest money in. However, after the boom of cryptocurrency in the past few years, the crypto market has emerged as a direct competitor to the stock market when it comes to available options for investors to invest their money in. And we are not even talking about individual investors; we are talking about institutional investors as well who have put resources aside to invest in cryptocurrency specifically because it looks like a more lucrative option for them to gain financial benefits.
One thing that was later observed by money was that while these two markets seemed to be separate entities with no relation to each other at the beginning, with time, they appeared to be correlated to each other in a way that when one market showed fluctuations or movements in the upward or downward direction, the different market followed. More specifically, we are talking about whether there is a correlation between the crypto market and the stock market.
Investors and analysts alike have been submerged in finding the answer to the question of whether a correlation exists between those two markets and how the movements in one market influence the other. If there is a positive correlation between them, then it suggests that the two markets move in tandem with each other. Suppose there is a negative correlation between them. In that case, the vice versa scenario will occur where the two markets will move in opposite directions to each other, meaning that if one market is moving in an upward trend, then the other is moving in a downward direction, and vice versa.
The reason why we are looking to find a correlation between these two different market options is that it holds significant importance for investors and financial institutions to find a connection between them. It can help them make informed decisions regarding their next investment strategies, risk assessments, and diversification of their financial portfolio.
Before delving into the intricacies of their relationship, let’s first establish a clear understanding of the players involved:
- Cryptocurrency Market: This decentralized market operates on blockchain technology, facilitating the exchange of digital assets like Bitcoin, Ethereum, and countless others. The characteristics of high volatility and rapid price fluctuations have attracted significant interest and investment in the crypto market in recent years.
- Stock Market: This traditional market serves as a platform for buying and selling shares of publicly traded companies. While established with a longer history and robust regulatory frameworks, the stock market also experiences periods of volatility and fluctuates based on various factors like economic performance and investor sentiment.
Analyzing the Correlation Between the Crypto Market and the Stock Market
To understand whether these two markets correlated, we will look into the historical data available for both investment options. From the historical data available, it certainly looks like a rollercoaster ride that witnessed periods of high correlation, low correlation, and even divergence at some stages. To understand these dynamics, we will divide the period into different eras and analyze how markets reacted in those specific eras.
Early Days (2009-2016)
In our exploration of the correlation between the crypto market and the stock market, we will focus on the S&P 500 index, which tracks the performance of 500 major companies listed on US stock exchanges. The widely followed index of the S&P 500 will serve as the benchmark for comparing the performance of Bitcoin, providing valuable insights into their relationship.
The reason why we are selecting Bitcoin here is because the Altcoins and the rest of the crypto market usually tend to follow the direction Bitcoin is taking on the crypto charts. In the early years of cryptocurrency, it was still an unknown entity to many, and those who even knew about it didn’t know whether it would grow significantly in the upcoming years.
As evidenced by the chart shown below, we can see that the stock market is moving at its own pace. In contrast, the crypto market is not making any major dent in the price chart, therefore indicating no correlation between these two markets in the early years.
Rise of Altcoins and Institutional Interest (2017-2020)
From 2017 onwards, a trend started to emerge after the crypto market matured and diversified with the introduction of new altcoins. We can see on the chart in the above section and the one shown below that both Bitcoin and the S&P 500 started to move in tandem with each other.
The reason why a correlation started to exist between these two was due to the increased media attention and mainstream adoption of cryptocurrency, which saw investors pooling their resources and investing them into the crypto market who were also active in the stock market.
Additionally, the bull run of 2017, which saw Bitcoin’s price skyrocket, coincided with a strong performance in the stock market. These events fueled speculation that the two markets were becoming increasingly linked.
In periods of significant market downturns, like the January-September 2018 and March 2022 crashes, both Bitcoin and the S&P 500 experienced price declines. However, the impact on Bitcoin was considerably more severe, often resulting in drops several times larger than the S&P 500’s losses. For instance, a 10% decline in the S&P 500 saw Bitcoin witnessing a 50% plunge in its value at the same time. The heightened volatility in Bitcoin often spills over to other cryptocurrencies or altcoins, causing them to follow suit.
2021-Present
The past few years have seen a complex evolution in the relationship between the crypto and stock market. While there have been instances of short-term correlation, particularly during periods of economic uncertainty like the COVID-19 pandemic, the overall trend suggests a decoupling. The above chart is taken from the article posted on the Investopedia website that shows the recent trend between Bitcoin and the S&P 500 index from November 2022 to November 2023.
Several factors contribute to this decoupling:
- Increased institutional adoption: As more institutional investors enter the crypto market, their trading strategies, influenced by traditional financial practices, can lead to short-term correlations with the stock market. However, their long-term investment horizons and diversified portfolios suggest a reduction in overall dependence on the stock market’s performance.
- Maturity of the crypto market: The crypto market has grown significantly in size and complexity, establishing its unique dynamics and drivers of price movements. This independence makes it less susceptible to fluctuations in the stock market.
- Regulatory landscape: The evolving regulatory landscape surrounding cryptocurrency can also contribute to decoupling. Uncertainties and changes in regulations can lead to independent volatility in the crypto market, further distancing it from the stock market.
As of October 2023, the 90-day rolling correlation between Bitcoin and the S&P 500 is only 0.05, indicating a weak and inconsistent link, which suggests that the two markets are currently operating with a degree of independence.
Factors Influencing the Correlation
The correlation between the crypto market and the stock market is dependent on various factors that can be categorized into three different groups:
Macroeconomic Factors
- Global Economic Growth: A flourishing economy can be a very good catalyst for increased investor confidence, which would cause a good influx of investments being made in both crypto and stock markets. Conversely, a period of economic slowdown or recession can greatly dampen the investor’s sentiment, and they would be inclined to pull their investments out of the market, especially risky assets like cryptocurrencies, which can negatively impact both markets.
- Interest Rates: Interest rates have been a great indicator for determining the general market sentiment. Changes in the interest rate can influence how investors view the current financial market and determine whether or not they are attractive investment options for now. Rising interest rates can make traditional assets like Bonds more appealing, which would mean that people would pull their investments from risky assets like crypto and put them into conventional investment resources, which, as a result, would decrease the correlation between these two markets.
- Geopolitical Events: Major geopolitical events like wars, political instability, or trade disputes can cause major uncertainty in the financial market, and investors generally like to avoid taking such risks, which can lead to increased volatility in both crypto and stock markets. The degree of correlation can depend on how the specific event affects investor sentiment and the perception of risk in different asset classes.
Market-Specific Factors
- Institutional Involvement: As more institutional investors enter the crypto market, their trading activity can influence the market’s behaviour and potentially increase its correlation with the stock market. The reason for the increased correlation can be attributed to institutional investors often employing similar trading strategies across different asset classes.
- Regulations: The regulatory environment surrounding cryptocurrency can significantly impact its correlation with the stock market. Uncertainty or negative regulatory developments can lead to increased volatility and a decoupling of the two markets. Conversely, clear and supportive regulations can foster greater institutional involvement and potentially increase the correlation.
- Technology and Innovation: Technological advancements in blockchain technology and the development of new crypto applications can attract investors and fuel growth in the crypto market, which can lead to increased market capitalization and liquidity, potentially making the crypto market less susceptible to short-term fluctuations in the stock market.
Investor Behavior
- Risk Tolerance: Investors with higher risk tolerances may be more drawn to the potential for high returns in the crypto market, even if it entails greater volatility and less correlation with traditional assets. Conversely, risk-averse investors may prefer the relative stability of the stock market, even if it offers lower potential returns.
- Investment Strategies: Investors with diversified portfolios across different asset classes, including both crypto and stocks, may experience lower overall volatility. However, the degree of diversification can also influence the correlation between the two markets, depending on the specific allocation and weighting of each asset class.
- Market Sentiment: Public perception and sentiment towards cryptocurrencies can play a significant role in influencing their price movements. Positive media coverage and increased mainstream adoption can lead to increased investor demand and a potential rise in correlation with the stock market. Conversely, negative news and scandals can dampen sentiment and lead to a decoupling.
Implications and Future Outlook
The dynamic relationship between the crypto market and the stock market presents both challenges and opportunities for investors and the financial system as a whole. Here are some of the key implications and potential future trends:
For Investors:
- Diversification: The low correlation between the two markets can provide valuable diversification opportunities for investors seeking to spread their risk across different asset classes, which can prove helpful in mitigating portfolio volatility and enhancing overall returns.
- Enhanced Risk Management: Understanding the factors influencing the correlation can help investors make informed decisions about their asset allocation and risk management strategies. Following such steps are particularly important for managing risk during periods of heightened volatility or changing regulations.
- New Investment Opportunities: The emergence of new crypto applications, such as Decentralized Finance (DeFi) and non-fungible tokens (NFTs), presents unique investment opportunities with potentially different risk profiles and correlations to traditional assets.
For the Financial System:
- Increased Institutional Adoption: As the crypto market matures and regulations evolve, we can expect to see increased institutional adoption. The increased adoption will likely lead to a more stable and less volatile crypto market, potentially fostering deeper integration with the traditional financial system.
- Emergence of Hybrid Assets: The development of hybrid assets combining features of both traditional and crypto assets could lead to a more unified financial ecosystem with increased efficiency and transparency.
- Regulatory Challenges: Regulating the rapidly evolving crypto market remains a significant challenge for policymakers. Finding a balance between fostering innovation and protecting consumers will be critical for ensuring the long-term growth and stability of the crypto ecosystem.
Conclusion
Currently, it isn’t easy to ascertain whether the crypto market and the stock market will stop correlating with each other. The previous trends have shown us that most people use the stock market as an indicator to devise their crypto-related strategies. While this theory doesn’t hold in some scenarios, the previous indications have shown us that these markets have moved in tandem with each other on several occasions.
However, suppose we are to analyze the recent trends. In that case, the correlation factor between those markets is very low, which means that devising your crypto strategies while looking at the performance of the stock market isn’t a viable strategy anymore.
Note:
This article was written to analyze the relationship between crypto and the stock market and is, in a way, intended to be taken as investment or financial advice. We would recommend our readers do their due diligence as the crypto market is a risky investment option that requires doing your due diligence, which means conducting technical analysis and adequate risk assessment.
