Crypto’s correlation problem
The story of the bear market, as told by correlations.
The genesis of the bear market
Before the current bear market, there was an immediately obvious problem in crypto: correlation.
Estimates peg average pairwise correlation of the top crypto assets at around 80% leading up to the selloff. So on any given day, we typically saw prices rise or fall in lockstep. The reason this happened was shifting supply and demand for the asset class as a whole — as opposed to any individual asset — a bearish sign that the masses remained uninformed as to the fundamental value of a digital asset. To them, an EOS is just a “slightly worse Bitcoin,” never mind the deep technological and practical differences between the two. This seems to explain why the days before the selloff were marked by low volatility and high correlation.
This is the mindset that generated a highly correlated market — and an asset bubble. If the mindset was that every ICO would produce the kind of wealth seen in the initial run-up of Bitcoin, certainly we can understand the irrational exuberance of the ICO boom. When we further contemplate that most investors lacked any of the necessary technical background to understand the nuances of digital assets, high correlations aren’t so surprising.
Correlation and market neutral investing
Correlation, within reason, isn’t a problem. On any given day in the stock market, blue chip stocks will move in roughly the same direction. This is an unavoidable consequence of the buying and selling of ETFs and mutual funds as demand comes into and washes out of stocks. What differentiates a good stock picker from a bad one is their ability to assess relative movements, so that on down days, they’re long stocks that sell off minimally and short the stocks that sell off the most.
With the ability to short, things become even more interesting, as a properly weighted combination of short and long positions can represent a market neutral portfolio — one that doesn’t care about the ups or downs of the stock market as a whole, only whether the stocks it’s long and short are good and bad, respectively. To be clear: you can take a view that Apple stock is good without taking the view that stocks are good and still make money. As we will see, the same is not true of crypto.
The correlation dance
The first issue in crypto leading into the bear market was that demand for each individual asset appears to have been inextricably linked to demand for the asset class.
Simply put, the masses were buying or selling “cryptos,” not Bitcoin, Ether, or Stellar. As these consumer masses began to see losses, they didn’t attribute them to any singular asset or event — neither the BCH hard fork, nor the SEC’s enforcement action, nor the overbought NVT ratio factored into the decision making. Without an understanding of the assets they held, the herd mentality took over and panic selling ensued. Panic selling, of course, leads to yet greater correlation and natural downside volatility.
The second issue — this one on the institutional side — was the inability to effectively run a market neutral strategy. Because many digital assets remained difficult to short, it was impossible for investors to allocate to any individual token without also committing to the asset class as a whole.
For this reason, investors without a way to hedge their beta were forced to sell their holdings in their entirety, leading to downward price pressure in assets that still commanded strong confidence from institutional investors and — you guessed it — increased average pairwise correlation in the asset class.
Are we there yet?
Eventually, the weak-handed retail investors will have all sold; the ICOs sitting on stockpiles will have liquidated them; and the reason to purchase digital assets will once again be grounded in their actual uses, not speculative mania. I believe watching the correlation dance unfold is the easiest way to spot the moment when the weak-handed retail investors have sold and the buyers driven by knowledge of the ecosystem and fundamental analysis of its potential enter once again.
Indeed, correlations have slowly but surely been breaking down over the last few days. And while there could be more bloodshed to come, it seems reasonable to posit that once fundamentals are running the show again, we can expect to see an end to the present bear market.
At time of writing, the market is finally starting to reflect changes in sentiment on a project-by-project basis, instead of moving in lockstep. Perhaps fundamentally justified price action will keep the community focused on building the killer applications that fuel the next bull run.
