Asset correlations are one of the thorniest concepts in modern finance that can confuse even the most experienced portfolio managers, especially in times of crisis. Bitcoin correlations surprised many this year, although in hindsight, what happened makes perfect sense. What the COVID-crisis taught us about Bitcoin correlations. 

Bitcoin has many faces: For some, the cryptocurrency represents a techno-anarchic society, free from government intervention and monetary manipulation. For others, Bitcoin is an investment vehicle that promises outstanding returns and offers benefits for portfolio diversification.

For investors, the latter two features are particularly attractive. Bitcoin’s risk-adjusted return, measured by the Sharpe ratio, has outperformed equities, bonds, real estate, and commodities in recent years. Bitcoin’s role as a portfolio diversifier is based on the asset’s low correlation with other asset classes. 

Links between asset performance are not always obvious 

Over the last eleven years since Bitcoin’s inception, the correlation between Bitcoin and the S&P 500 has been close to zero, meaning the returns of Bitcoin and the S&P 500 have moved independently. The same was true for other asset classes: Bitcoin was largely uncorrelated with real estate, bonds, and commodities. 

This changed in early 2020 when Bitcoin’s correlation with the stock market reached an all-time high. When stocks plummeted in March and April due to the COVID pandemic, the correlation between Bitcoin and the S&P 500 was almost one – meaning that the returns of both assets moved in the exact same direction.

It is typical that historical correlations suddenly change during crises. However, the causation is not always obvious, as unexpected events can suddenly affect assets that were previously uncorrelated. 

Last week, for example, the US-based suiting-specialist Brooks Brothers filed for bankruptcy protection. This could have an impact on wool suppliers, for instance, on manufacturers in Bangladesh or India – a correlation that is rather obvious. What is less obvious, however, is that one of these fabric producers may be a wealthy investor who holds equity in a London-based tech start-up. The investor’s sudden liquidity shortage could then delay a financing round and thus also drag down the tech start-up.

Although this connection is hypothetical, it could very well occur in the real economy. The point is that nobody could have anticipated, much less modeled, the connection between an American suit company and a London-based tech start-up – it’s not obvious, and often such hidden links only become apparent in times of crisis. 

Bitcoin’s correlation to stock markets will continue to decline

Such crisis effects also occur in crypto markets. Bitcoin liquidity is still relatively low, and if an investor with a large market share sees heavy losses in his stock portfolio, for example, due to the COVID crisis, he may sell his bitcoins to gain liquidity. The sudden increase in Bitcoin supply would then cause a drop in price, trigger the stop-loss orders of other traders, and unleash a downward spiral. 

This is exactly what happened in March and April, which is why the returns of Bitcoin and the S&P 500 correlated strongly. However, after the crisis, when the liquidity shock was overcome, Bitcoin recovered much faster than the stock market, and the correlations started to decrease again. 

Today, the correlation between Bitcoin and the S&P 500 is below 0.5, and it will flatten further in the coming months and return to its long-term average.

The argument that was valid before the crisis is thus also valid after the crisis: uncorrelated crypto-assets are beneficial for portfolio diversification. They do lose value during crises, but that’s equally true for other asset classes, because in times of crisis, all correlations go to one. What matters more is how an asset class behaves after the crisis.