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The Correlation Between Bitcoin and US Stocks is Reduced by Increasing Sentiment

December 19, Chicago, Illinois On December 19, 2017, in Chicago, Illinois, a computer screen at the Cboe Global Markets exchange (formerly… [+] known as CBOE Holdings, Inc.) displays the price of Bitcoin cash and its futures.

The exchange started trading Bitcoin futures for the first time in the United States last week. Since the beginning of the year, the price of one bitcoin has increased dramatically, rising from $1,000 to a recent high of almost $20,000. (Image: Scott Olson via Getty Images)

The link between bitcoin and stocks has all but disappeared. This correlation examines how closely the price of bitcoin tracks the movement of American stock values.

Why has the correlation’s value fallen so dramatically? Why is this a crucial concern for investors, exactly? These are the primary issues I cover in this article.

The short answer to the first query is that the correlation’s value has decreased as a result of growing emotion. The brief answer to the second issue is that correlation is significant since, generally speaking, a drop in correlation dampens future returns. This situation is, however, only transitory.

The VIX and similar dynamics of correlation

The collapse of the 90-day rolling correlation between bitcoin and U.S. stock indices like the Nasdaq and S&P 500 to almost zero has drawn the attention of cryptocurrency investors. It has been two years since these correlations have been this low.

The crypto derivatives analytics company Block Scholes makes this conclusion by pointing out that the 2021 trough happened in between two peaks, one in April 2021 and the other in November 2021.

Despite being complicated, Bitcoin BTC price moves follow a predictable pattern.

The volatility index, or VIX, a significant indicator of stock market mood, is a crucial component of sentiment. Notably, the VIX showed the same broad trend as the link between bitcoin prices and stocks in 2021.

The VIX dropped to a low of around 15 in July 2021. Between two peaks, one of which happened in February and the other in December, there was a VIX-trough.

Application Of Behavioral Pricing Models To Bitcoin

Traditional asset pricing models have been unable to adequately explain changes in the price of bitcoin. This is primarily a result of the models’ disregard for psychology and feeling.

In contrast, behavioral asset pricing models add psychology and mood to the conventional asset pricing framework. These models, which have proven effective at explaining bitcoin price fluctuations, are the subject of some of my study.

There are various attitude indicators, including the VIX and a net bullish index based on an American Association of Individual Investors poll.

When applied to bitcoin returns, behavioral asset pricing analysis reveals the existence of at least three key drivers of the predictable component of price changes.

The first driver records data on the extent to which undervaluation affects bitcoin’s price.

The second factor is the price of bitcoin’s susceptibility to overall market mood, which is generally positive stock market sentiment. Herein lies the role of VIX.

The VIX normally decreases when investors grow more upbeat about equities, and it often rises when investors become more pessimistic.

The third driver is how market sentiment moderates the effects of the basic variables that affect the returns on certain stocks. The behavioral nature of this driver reflects how investor psychology affects how market fundamentals affect security prices.

Unpredictable news has an impact on actual bitcoin price swings as well.

Beta Sentiment

Some assets are believed to have high sentiment betas because their prices are more heavily impacted by market psychology than those of other assets.

These assets are typically difficult to arbitrage and difficult to appraise using fundamental analysis. The equities of nascent companies with engaging narratives, however they are not yet profitable, are the typical high sentiment beta assets.

Here is a point to remember. Changes in the price of bitcoin are comparable to those in high sentiment beta stocks. This is the conclusion drawn from the study of behavioral asset pricing.

The predictable component of the price of bitcoin is driven by at least three independent factors, which results in complex dynamics.

A statistically significant market beta effect, in which bitcoin values typically move in lockstep with U.S. stocks, is a component of the bitcoin dynamic. The predicted price increase is bigger the higher the market beta.

It’s crucial to realize that emotion significantly affects the market beta impact for bitcoin. The VIX often declines when sentiment improves, which also affects the market beta of bitcoin and, consequently, the anticipated increase in price. Correlation is an important part of beta in this regard. A decreasing correlation usually indicates a decreasing beta, and a decreasing beta usually indicates a decreasing rate of future returns.

This is a strong pattern. When net bullishness based on the AAII poll is utilized instead of the VIX, the same overall pattern manifests itself.

It is interesting to note that as investor optimism decreases, the correlation between changes in bitcoin price and changes in US stocks increases. This is so that investors can concentrate more on the fundamentals when they are pessimistic.

On the other hand, during euphoric, upbeat times, bitcoin investors seem to get sucked into the frenzy. Importantly, rising confidence reduces the impact of all statistically significant fundamentals, not just equities, on future bitcoin price increases. This is why a drop in the VIX lowers predicted bitcoin returns in the future.

Fundamentally speaking, there is still a tenuous link between crypto assets and the real economy. Not only does sentiment affect how much the fundamentals contribute to bitcoin’s future returns.

The VIX has an effect on the undervaluation-related driver as well. In particular, the undervaluation effect is lessened by a decline in the VIX.

Investors’ responses to news are an expression of sentiment. The caption of the image at the top of this article provides an illustration and refers to the launch of bitcoin futures on the CBOE in December 2017. The same argument holds true for recent exchange-traded funds for spot bitcoin filed by banking institutions.

Investors should avoid drawing the conclusion that changes in the price of bitcoin are currently independent of the mood in American markets. Instead, mood was what reduced the link between bitcoin and stocks.

Behavioral Model Experiments Successfully

Consider what transpired from March through July this year while keeping all of this in mind. The price of bitcoin on March 7 was 20,207. Bitcoin reached a high of $30,367 on July 11 compared to March. Notably, the VIX experienced a sharp decline during this time, dropping from a peak of 25 to under 15, the same level it had attained in July 2021.

These coordinated movements fit the behavioral pricing model used to describe bitcoin returns. The model was created using a sample of data that was collected before 2021.1 Importantly, this suggests that the model’s fundamental components function outside of samples.

It is not surprising that the correlation between bitcoin and stocks has fallen over the past 90 days given the recent decline in the VIX.

Bitcoin: A Protective Measure Against Inflation and Market Unpredictability?

The fact that the correlation between bitcoin and stocks is almost nonexistent is seen as quite encouraging by many bitcoin supporters.

One justification for this idea is because supporters believe bitcoin will become a hedge against inflation and conventional market instability as its price swings become independent of stock market fluctuations.

Consider how bitcoin performed in relation to gold and stocks over the previous 24 months, when the CPI increased at a pace of 6% annually, to evaluate this claim.

The S&P 500 gained 0.3% throughout this time, while the price of gold increased at an annual pace of 3.3%.

However, the price of bitcoin decreased at a 2.1% yearly rate. During this time, when U.S. inflation was higher than at any point in the previous four decades, gold and stocks were stronger assets.

In terms of mitigating market volatility, the S&P 500’s maximum price to minimum price ratio during these 24 months was 1.3. This indicates that, in terms of instability, the S&P’s highest price was 30% higher than its bottom price.

The ratio for gold was 1.1, which is a little lower and provides a respectable hedging. Consider bitcoin. It had a fairly high ratio of 3.8, so it wasn’t exactly a hedge against instability.

Perhaps citizens of high-inflation nations like Argentina and Nigeria will discover bitcoin to be a respectable hedge against domestic inflation and established market volatility.

Even so, gold has been a superior investment over the last two years than bitcoin since it has experienced both a higher rate of growth and less volatility.

Regarding the notion that a negative correlation between bitcoin and stocks is advantageous, there is a further problem. This concern relates to the notion that increasing the number of low- or zero-beta securities enhances portfolio diversification. In this case, there are two points to be made.

First of all, the too concentrated portfolios of investors are the only ones to whom the diversification argument applies. How to diversify is a concern for investors who are not currently doing so.

Second, properly assessing the trade-off between lower risk and lower expected returns is necessary when utilizing bitcoin to promote diversity.

Keep in mind that when bitcoin decouples from the stock market, its predicted return decreases; in July 2021, the correlation between bitcoin and stocks was quite low.

Key Learnings

Remember that mood will eventually deteriorate and the VIX will rise once more.

When this happens, investors will pay closer attention to fundamentals, the correlation between bitcoin and stocks will rise, and so will the predicted rate of bitcoin appreciation.

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