At the start of February, just before the great vol-quake, we highlighted that a curious correlation was emerging between the VIX - and therefore the broader market as would be confirmed just days later - and bitcoin. We referenced a recent note from Deutsche Bank according to which "cryptocurrencies are closely watched by retail investors, affecting their risk preferences for stocks and other risk assets." It continued:

Although institutional investors recognize that stocks and other asset valuations may have entered bubble territory (US equities’ average P/E is around 20x), they cannot help but continue their risk-taking. Now, a growing number of institutional investors are watching cryptocurrencies as the frontier of risk-taking to evaluate the sustainability of asset prices. The result is that institutional investors, who are supposed to value assets using their sophisticated financial literacy, analysis, and information-gathering strengths, are actually seeking feedback about the market from cryptocurrency prices (which are mainly formed by retail investors).

Adding to this, we pointed out the correlation that had emerged between bitcoin and the VIX...

... and added that "the correlation between Bitcoin and VIX can increase as more institutional investors begin trading Bitcoin futures."

Last year, cryptocurrencies experienced “melt-up,” a situation where prices surged, irrespective of fundamentals, because a flood of investors seeking capital gains outstriped supplies. If the current “triple-low environment” persists, and inflation rate and the likelihood of a recession remains low, we believe this “melt-up” phenomenon could spread to other products, creating massive asset bubbles.

Two weeks later, and just days after the first market correction in years which some say was presaged by the crash in cryptos just prior, none other than Bank of America's Chief Investment Strategist Michael Hartnett made the same, apocryphal for some, observation namely that "the next lead indicator is...Bitcoin."

Continuing this theme, last Friday "bond king" Jeff Gundlach spoke to CNBC and said that "if you want to know where stocks are going, watch bitcoin."

"Strangely, bitcoin seems to be the poster child for social mood and market mood," Gundlach said: "We had a vertical rise from Sept. 7 which was led and epitomized by bitcoin. Bitcoin started at about $4,500 and went up to about $20,000 or so."

"Bitcoin peaked out in mid-December and it crashed. That sort of presaged the volatility in the stock market," he said, noting the cryptocurrency has stabilized recently. "If stocks are going to take another tumble, I think it would be preceded by a bitcoin decline."

And the punchline: "Weirdly, I'm actually using the sentiment regarding speculative assets like bitcoin as a guide to maybe what the future will bring."

Which brings us to the 64,000 bitcoin question: are cryptocurrencies really a leading indicator for the entire market, as not only we, but some of the biggest financial luminaries now think?

The answer is, at best, limited: after all there is very limited historical data to use for statistical analysis purposes, and the correlation in peaks and subsequent drop be simply a case of spurious correlation. Still, some like DataTrek's Nicholas Colas see a distinct pattern emerging.

As Colas wrote in a letter to clients this week, "the notion that bitcoin is a “Stub” asset (the riskiest piece of a capital structure) in global capital markets is getting some traction lately." The idea, in a nutshell, is that crypto currencies are increasingly part of the financial mainstream (numerous haters notwithstanding) and their fortunes are inherently tied to the risk tolerances that support all assets. "Higher price correlations should therefore follow, even if bitcoin remains a very volatile asset."

These starting parameters prompted him to update his statistical work on the relationship between bitcoin’s price and the S&P 500.

This is what he found:

Short-term price correlations (measured in 10 day rolling averages) during the recent selloff in US stocks absolutely exhibit a high degree of linkage, but we need to call out a few caveats as well:

The 10-day historical correlations between bitcoin and the S&P 500 reached 0.79 on February 6th, right in the middle of the sharp decline in US stocks. For those of you with a statistical bent, that is an R-squared (coefficient of determination, rather than correlation) of 62%. Not bad for a one-variable model, to be sure.

This 10-day measure also shows that the relationship between bitcoin and stocks declined rapidly in the days that followed. By February 21st they had turned negative. As of today, the correlation was just 0.37.

It is also worth noting that 10-day price return correlations between bitcoin and the S&P have been high several times in recent years, and long before it was widely followed by the financial press. Examples include: February 22, 2016 (0.77 correlation), July 14th 2016 (0.80), April 21st, 2017 (0.81), and September 8th (0.80).

Bottom line: high short-term correlations between bitcoin and stocks are nothing new. (And one word of explanation: financial services professionals typically refer to correlations in percentage terms, even though they are obviously an index between -1.0 and +1.0. We follow that convention in our other work, but we find that bitcoin gets a lot of attention from math/stats people who are real sticklers about percentages reflecting R-squared data. In deference to them, we use their convention in this note.)

Now, over the longer term, there is a statistical story about bitcoin and US stocks being increasingly tethered to the same market appetite for risk. The data here:

We’ve included two charts below. One shows the 90-day correlation between the S&P 500 and bitcoin, the other highlights the correlation between US large cap Tech stocks (using the XLK exchange traded fund) and the crypto currency.

With this longer-term timeframe, you can see that bitcoin now shows a much higher correlation to US stocks than for much of the last 2 years (the graph starts in January 2016). The lift-off point was in August 2017 when bitcoin went from a history of almost complete non-correlation to a 0.10 correlation coefficient and (more recently) 0.25-0.30.

Statistically minded people will note that this translates only to a 6-9% R-squared. Markets people will look at the chart and say “the trend is not the friend” of considering bitcoin as a non-correlated asset going forward.

Since bitcoin is a technology as well as a crypto currency, a comparison between it and US large cap Tech stocks is also worth a look. The data shows essentially the same relationship between bitcoin and US stocks, although a modestly tighter fit during last Fall.

As Colas concludes, the upshot here is twofold:

Bitcoin seems to track US stocks when they fall (witness earlier this month) more than when they rise . That makes sense to us. A sudden shift in risk tolerances pulls capital out of all risk assets. The same thing happened with gold during the Financial Crisis, when the yellow metal was down in 2008 along with everything else.

. That makes sense to us. A sudden shift in risk tolerances pulls capital out of all risk assets. The same thing happened with gold during the Financial Crisis, when the yellow metal was down in 2008 along with everything else. Over time, bitcoin’s price will be set not by equity prices but by its own fundamentals. The long run correlations show that well enough, and it makes intuitive sense as well.

In other words, while major inflection points in crypto may indicate to a distinct shift in risk-mood, one which can then affect other risk assets, in the long-run the correlation become negligible, it will be up to bitcoin - and stocks, or rather central banks - to justify they prices, whether bubbly or crashy.