Bitcoin is a Perfect Diversification Asset for Institutions


Matt Hougan, the vice president of research and development at Bitwise Asset Management Inc, expects the correlation between Bitcoin and the broader financial market to remain low, which may allow Bitcoin to appeal to institutional investors as a proper diversification asset whose price movement is immune to traditional market swings.

According to research findings published by professors Lawrence Trautman and Taft Dorman of the Western Carolina University, wild price fluctuations of Bitcoin allow the asset to be a prime candidate for “portfolio construction at the institutional level.”

Correlation Between Bitcoin and Stock Market is Low

There exists a remarkable similarity between Bitcoin price movements and that of Dow Jones and S&P 500. Similar to the equities market, the total market capitalization of the crypto markets slumped from the 2017 peak, with Bitcoin registering lows at $6,000 in the first quarter of 2018. This temporary correlation fueled speculation on whether there is a permanent correlation between these two assets of fundamental differences.

The performance of equity markets depends on the state of the economy. John F. Wasik, a behavioral Finance columnist at Forbes, suggested that inherent macro-economic conditions such as inflation and an overpriced market could contribute to the stock market slump. In contrast, the slide of Bitcoin and crypto markets was a correction. Last year, Bitcoin prices surged to $20,000 lifting altcoins. Fueling the crypto slump were “regulatory and risk” concerns that saw China place a firewall restricting its citizens from accessing and speculating on Bitcoin prices. This was on top of the US security and Exchange Commission (SEC) failure to approve Bitcoin ETFs and Reserve Bank of India’s (RBI) ban of cryptocurrency deflating investor confidence and price.

Stock Market and Bitcoin Z-Scores

This difference of price drivers is part of the reason why Matt Hougan believes correlation will remain suppressed. Statistical simulations demonstrate that Bitcoin correlation with the stock market is on average positive but below 0.5. To clearly understand, the details lie in what statisticians call Z-Scores. Z-Scores are absolute values that links the degree of correlation between two assets. A higher Z-Score points to a positive correlation between the two assets under test. A negative reading on the other hand signals an inverse correlation. Bitcoin and the S&P 500 has a 0.14 correlation while Bitcoin and VIX are inversely correlated with a Z-Score of -0.66. VIX is a fear index measuring the market volatility. A lower VIX number mean stock market investors expect low volatility.

Bitcoin and Altcoins Direct Correlation

While there is a diminishing correlation between Bitcoin and traditional markets, Bitcoin and altcoin prices tow. Empirical evidence show that altcoin prices soar when there is a boom in Bitcoin. Gains are even pronounced in liquid coins as Ethereum, DASH, Ethereum Classic with 0.64, 0.59 and 0.62 Z-Scores respectively. But, during periods of uncertainty, Bitcoin dominance rises as altcoin prices drop. Aside from same sector correlation, Bitcoin prices tend to outperform in tumultuous economies or when there are political uncertainties. A case in point is in Iran. There, Bitcoin’s demand as a store of value continues to draw unprecedented demand driving prices above market rates.

 

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