During the past few months, an interesting phenomenon occurred with the cryptocurrency market, one that could have major implications on how investors will allocate capital. If the broad public perception was that crypto is an uncorrelated instrument, things had taken a different turn and now we see the market fluctuating the same as stocks. For someone who’s looking to diversify a portfolio, this isn’t the best thing and because of that, we would like to remind you of some of the most important implications.
# No risk hedging
Up until a few months ago, some investors were using crypto as a hedge. That’s not the case anymore since the cryptocurrency part of the portfolio will perform in line with stocks. The whole point of hedging is to spread the risk so the overall asset basket will gradually rise over time. If assets are closely correlated, the value will rise when things are good and drop sharply when not. As long as the correlation will remain elevated, it is imperative to find innovative ways to integrate crypto into a portfolio.
# Investors leaving the crypto market?
Since crypto and stocks have relatively the same performance, investors are questioning whether they should focus on a single market? Since April, daily cryptocurrency trading volumes had been dropping, while stock markets outperformed by a large. We can assume the interest for crypto had been diminishing and the positive correlation might have been one of the many factors leading to this. Risk sentiment is the leading market mover and until that won’t change, we suspect both crypto and stocks will move in sync, generating a slight disadvantage for crypto.
# Price distortions
We are in 2020 and yet we continue to see price distortions like pump-and-dump. The positive correlation between crypto and stocks is mainly driven by emotional behavior and as a result, it leads to irrational market valuations. At some point in time, a reversion to the mean is bound to take place, catching some market participants unprepared. It is very important to analyze which tokens are overvalued and which are undervalued, based on historical valuations and change in underlying fundamentals.
Without such an approach, the end of exuberance will come with significant losses and frustration. Price distortions will continue to be the norm in the crypto space, but that does not mean we can’t take precautions and use them to our advantage. Are you prepared to deal with the positive correlation between crypto and stocks?