Cryptos and the market cycle — what the data tells us

This week, global equity markets suffered two of their worst days of the year, with major equity indices across the globe loosing up to 4% in a single day. In contrast, gold as a traditional safe haven showed a positive reaction. Quickly the question popped up, how would crypto assets behave? After all, crypto assets are the new kid on the block and have only reached critical mass in late 2018 and have not yet gone through a full market cycle of bull and bear markets. What investors want to know is, can cryptos help diversify a traditional investment portfolio during market downturns?

There have only been two other days over the past year when global equity markets dropped by more than 2% in a single day. So first, let’s take a look at these four days of extreme negative equity returns and see how other asset classes performed. Figure 1 shows our findings. As a proxy for crypto assets, we took five of the largest tokens by market capitalisation, namely BTC, ETC, XRP, XLM and LTC. We can see that indeed crypto assets seem to correlate with equity markets during these particular days, whereas government bonds and gold tend to rise as they are perceived as safe havens.

But does this mean that cryptos will always correlate with equities during extreme market events? To decide this, we require more data and we will also need to think about the theoretical connections between these asset classes. We split our analysis into three parts: 1) short term correlations 2) long term correlations 3) theoretical considerations.

Figure 1. Return comparison of traditional asset classes vs cryptos during equity downturns

Short term correlations

To understand how prices of crypto assets react to price changes in other asset classes, we use the correlation coefficient as our preferred measure. More importantly, we don’t just look at correlations at a single point in time, but over a period of time to see how they change during different market environments. As short-term indicator, we use correlation figures based on the past 30 days of returns, and we then calculate these for every day over the past year. Figure 2 highlights our findings.

During Q4 2018, correlations have been mostly swinging up and down around zero, which was due to the exceptional bull market in cryptos while equities moved only slightly upwards. In April/May we see a strong swing, which is due to a short-term rally in cryptos and subsequent decline, while equities tended to go sideways. Bottom line, short term correlations between developed market equities and cryptos can vary strongly over time from negative to positive. Despite these short-term dynamics, cryptos still provided decent diversification most of the time.

Figure 2. 30 days rolling correlations with developed equities

Long term correlations

When looking at the long-term picture, we expand the observation period from 30 days to 1 year to compute our rolling correlation numbers. As a result, single days or short periods of abnormal behaviour have less of an influence on the results. While the former analysis gives investors an idea how short-term events can impact the behaviour of asset classes to each other, this metric provides a longer-term outlook for investors who want to take a strategic view.

As figure 3 shows, the absolute correlation values are much lower here, ranging from -0.06 to 0.19. Over the past year, correlations have moved slightly upwards and currently range between 0.10 and 0.20. Despite this trend, the values are still very low. So, in the long run, cryptos seem to offer good diversification potential for traditional equity portfolios. While our focus here is only on developed equities, we can confirm similar results for correlations with government and corporate bonds as well as gold.

Figure 3. 1 year rolling correlations with Developed Equities

Theoretical consideration of price drivers

Empirical results are always useful to validate theoretical considerations and to learn from past behaviour. However, in order to ensure that our findings are robust, we would require much more historic data then currently available for most cryptos. Also, cryptos were and still are a retail dominated asset class. As institutional adoption increases and the market ecosystem grows, price behaviour will likely change due to factors such as 1) more diverse range of investors 2) deeper liquidity 3) adoption and maturation business models. So instead of relying only on empiric data, let’s try and think about the fundamental drivers of crypto assets and traditional asset classes.

The economic cycle

Equities and bonds depend on macro-economic factors such as economic growth, central bank policy, inflation, etc. Do these factors impact crypto assets? To varying degrees, they should. Take Bitcoin for example. Bitcoins wants to be a currency, potentially with gold-like characteristics. So, in the long-run, we would expect to see it correlate with risk-off indicators such as high inflation, rising interest rates, falling economic growth, etc. But Bitcoin is not there yet, it is still in its infancy in terms of adoption it does not yet hold safe haven status. Currently, its main driver seems to be the behaviour of retail investors and early adopters. Presumably, these investors might behave like every other human in history and will get nervous when they see their other investments, such as stocks, fall and might react by selling their cryptos, which should form part of their speculative portfolio. So, one could argue that Bitcoin and other currency tokens should suffer when we experience more extreme market corrections, at least in the short term. In the long run, we expect this to be less and less the case.

Looking at other tokens such as Ethereum or Eos, the story might be different. These tokens aim to enable the creation of platforms for decentralised applications (DAPPs), decentralised organisations (DAOs) and for the creation of smart contracts. They will depend on corporation using them and having a valid business case. Simplified, one could argue that a downturn in the economic cycle will also mean a downturn in business on their platforms, as companies will reduce Research & Development budgets, and hence a falling token price.

Finally, crypto assets still depend on financing and development from traditional investors. If the economy is in bad shape, there will be less capital available for such projects, which should have negative implications for tokens that require capital to grow their business plans, similar to traditional companies.

Long-term structural shift

Should crypto investors care about returns over a period of days or weeks? We would argue they should not. In our opinion, crypto assets have arisen as a structural development that is part of the digital economy of the 21st century. Growing areas of the traditional economy are being digitalised, and each of these areas becomes accessible to blockchain technology in one way or another. Based on this premise, we believe that cryptos are part of a megatrend that will continue to evolve over the next decade. For investors who agree with this line of thinking, it seems most prudent to invest in a diversified basket of crypto assets as part of a traditional portfolio, with an investment horizon of at least 3–5 years. This does not mean that one should not monitor market developments. But we suggest to ignore short-term price fluctuations and rather look periodically at fundamentals.

Idiosyncratic risks (good and bad)

This can be viewed as the opposite to macro-economic drivers that impact asset classes as a whole and determine their valuation. We believe that a large chunk of crypto assets’ returns are still driven by idiosyncratic events. This is simply due to the fact that the asset class and its ecosystem are still young. So even if equity markets should enter a cyclical downturn, single crypto assets can still break out to the upside based on developments such as regulatory changes, government policy changes, successful conclusion of major milestones and technical developments. Equally, during equity bull markets, some cryptos might suffer if they have to deal with major setbacks. The business models of cryptos are still in a strong growth phase, which makes them quite different from developed market equities, which is why we think that we see such low correlations when looking at longer time horizons, as shown previously.

To highlight the beneficial asymmetric risk characteristics of crypto assets, we conclude by showing the upside and the downside volatility for our five cryptos, as shown in figure 4 and 5. Upside volatility is much higher than downside volatility, which is good for investors. It means that positive return surprises tend to be more pronounced than downside surprises. In our view this highlight again the, on average, positive idiosyncratic risk opportunities of crypt assets.

Figure 4. Upside volatility