Trading Bitcoin’s Correlation Reversal with US Stocks

  • Bitcoin has a low correlation with Tech stocks and emerging market stocks.
  • However, there is an opportunity to profit from correlational reversals.
  • Correlational reversal is highest between the iShares US Tech ETF and the Russell 2000.

With bitcoin hitting an all time high of $68,000 in November, many cryptocurrency traders are wondering how they can accurately predict the start of the next cryptocurrency bear market. Traders want to sell a portion of their bitcoin at the top of the market and then buy back later when bitcoin falls.

So what is the trick for predicting the start of the next bear market? Well, one theory is that emerging markets stocks are a “risk” asset that act like a canary in a mine. When the canary chirps, the miners know they have to get out quickly or else a toxic gas will kill them. The same was the case in the 2008 crisis. Investors began to sell their riskiest assets first in order to get much needed liquidity. Emerging market stocks got sold off first as investors went into blue chip stocks and government bonds.

Therefore, one could ask which asset class is deemed riskier by investors - cryptocurrencies, emerging market stocks, or tech stocks? Will one of these asset classes be the canary in the mine that triggers a massive sell off and end to the “everything bubble” that we are witnessing in stocks, bonds, real estate and cryptocurrencies?

Unoriginal and Derivative

Consider the correlations between BTC and the iShares US Technology ETF, the Vanguard Emerging Markets ETF and the Russell 2000 Index. The iShares Tech ETF should represent the “tech” play aspect of BTC; the Emerging Markets ETF the “geopolitical” play; and the Russell 2000, as the poorest-capitalised stocks, representing the general play on high-risk stocks.

Comparing the 180-day rolling correlations for each of these comparisons reveals weak correlations. There is little to no relationship between how investors allocate their money between bitcoin, tech stocks, foreign stocks or domestic small caps. This may indicate that, currently, none of these asset classes are acting as a canary in the mine for all asset classes.

However, this hunt for a canary did reveal what appears to be an opportunity for investors; the sign of the correlation can flip seemingly at random. This means that BTC and tech stocks could be moving up together, before one suddenly sinks and the other skyrockets.

Leaning away from the computer screen reveals something interesting. Perhaps the error has been in focusing on the wrong derivative. It’s true that changes in BTC are hard to map directly with changes in other asset classes. This is equivalent to comparing first derivatives. But what about the second derivative? Could there be secrets to be unlocked there?

The answer seems to be tantalisingly close to “yes.”

Specifically, the correlation between BTC and the iShares Tech ETF seems to be a leading indicator with the correlation between BTC and the Russell 2000. In other words, if the BTC/iShares Tech ETF starts a move to flip its sign (i.e., whether the correlation is positive or negative), the BTC/Russell 2000 correlation will make the same move soon after.

Compare the timing of the peaks and the valleys in Figure 4. Consistently, a peak in the BTC/iShares Tech ETF happens a few days before a peak in the BTC/Russell 2000, and similarly a trough in the BTC/iShares Tech ETF occurs a few days before a trough in the BTC/Russell 2000 chart. (See Figure 4.)

A similar correlation does not exist with the BTC/Vanguard Emerging Markets ETF. (See Figure 5.)

Towards a Rationalisation?

To reiterate: the correlation coefficient between BTC and tech stocks, and BTC and small-cap stocks, swings around violently. However, when the correlation between BTC and tech stocks starts to go up, the correlation between BTC and the Russell 2000 also starts to go up. The reverse is true as well.

As an example: When the correlation for BTC/iShares US Tech is negative, that means traders are dumping BTC to buy $AMZN. Similarly, when the correlation for BTC/Russell 2000 is negative, that means traders are dumping BTC to buy $AMC. The lag we discovered here implies that traders will dump BTC for $AMZN first, then dump BTC for $AMC a few days later.

Whatever is causing a change in the correlation coefficient between BTC and US tech stocks, seems to affect BTC and American small-cap stocks at a delayed date. What explains this relationship? There could be several different avenues.

  1. To understand why the correlations move in tandem, consider the fact that the iShares Tech ETF and the Russell 2000 both track US-based companies, and the biggest BTC market is also in the US. Finding parallel correlations should be expected. (Recall that this relationship did not hold with the foreign “emerging market” index.) Thus, they are impacted by the same sentiments generally held by American traders: so when traders are feeling optimistic about America, they make similar trades between the large tech stocks and smallest American stocks, which may or may not be positively correlated with sentiments about what BTC means for the future of American companies. Perhaps more of these correlations between correlations exist with other US indices.

  2. Understanding why the change in correlations happens in relation to tech stocks first is slightly more challenging. Here is perhaps the most compelling interpretation: because tech stocks are more infamous than small-cap stocks, they are more likely to grab news headlines. This means investors will react to news by making moves with the headliners first, before doing the analysis to figure out what the implications are for small caps later.

  3. Consider also market volume. The iShares US Tech ETF tracks the largest tech companies. These stocks have some of the highest trading volumes, making these markets very liquid. The Russell 2000 stocks are, by virtue of being a poorly-capitalised market, much less liquid. This means that trades take longer to complete, which ,when coupled with the above two explanations, in aggregate, may explain the difference in timings for changes in correlations between US tech markets and the Russell 2000.

There is no long-lasting, predictable correlation between BTC and any other asset class. However, looking at the correlation among correlations may reveal some hidden truths. A most tantalising example is that between the correlation of BTC/iShares US Tech ETF and BTC/Russell 2000. The full reason for this correlation of correlations is yet to be understood fully. However, the existence of this phenomena is very intriguing and requires much more analysis and debate.

Nothing in this article constitutes professional and/or financial advice. The content is provided exclusively for informational and/or educational purposes. Nothing is to be construed as an offer or a recommendation to buy or sell any type of asset. Seek independent professional advice in regards to financial, tax, legal and other matters.

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