It is clear to investors that cryptocurrencies and stocks work on different dynamics and provide different magnitudes of profit. A balanced portfolio should consist of stakes in the crypto industry and the stock market. During the bitcoin Prices, however, it was earlier noticed that the crypto trends were very different and unrelated to the trends in the stock market. However, it has been observed that the interconnectedness between financial markets and virtual assets has increased.
The interconnectedness has gotten to a point where it has become a concern for investors, as its risk diversification benefits keep depreciating. Let us discuss this topic deeply and analyze the relationship between these two.
Post Pandemic correlation between Bitcoin and stock prices
Prior to the pandemic, it was observed that there was little to no correlation between the two. This allowed investors to invest in both, allowing the diversification of risks. However, the steps taken in response to the Early 2020 crisis by the central bank have shifted the dynamics of these two markets so that their prices surged together.
This happened because of better financial conditions around the globe and the higher risk acceptance rate among investors. The correlation coefficient between the prices of Bitcoins and Stocks has shot up from 0.01 to 0.36, as they followed similar market trends. This is how these two assets started showing similar market trends. Recent trends also suggest that Bitcoin is showing properties of a risky asset.
The correlation between stock prices and crypto prices has gotten stronger than the correlation between other assets such as gold, major currencies, and stocks. Similar market trends in all these assets lower the chances of risk diversification for portfolios with diverse investments, which was earlier regarded as a safe choice.
Spillover of emotions between the markets
The emotional spillover from the crypto market to the stock market and vice versa has gone up significantly in recent years. The spillover of volatility and price trends has also been observed between the global stock markets and the crypto market. The correlation between Bitcoin Prices and S&P 500 is such that the volatility of Bitcoin accounts for a sixth part of the volatility of the S&P 500.
It also accounts for a tenth of the variations observed in the returns provided by the S&P 500.
This implies that falling Bitcoin prices can lead to avoidance of risks by investors in the stock market, resulting in lower investments and vice versa. Similar spillovers were observed between the Stock market and stablecoins, such as Tether.
Worldwide concerns regarding the financial system
A co-movement of both the markets has been observed. This implies that shocks and anomalies in one market can be transmitted into the other one, which in turn is capable of destabilizing financial systems. The higher the adoption of cryptocurrencies in a country is, the higher is the spillage of volatility in the stock market from the crypto market. Thus, it is safe to say that buying cryptocurrencies to balance a portfolio if stock markets go down is no longer an optimal choice. Market shocks travel from one market to the other.
Therefore, if one market crashes, the other will crash as well. Thus, it can be implied that the two markets are very interconnected, and you choose your assets carefully, as one small glitch in the market can lead to severe changes in the market dynamics.
Bitcoins and other stablecoins have always helped investors with risk management during the Bitcoin Era, as investing in both crypto and stocks would allow investors to diversify their portfolios. However, due to the recent co-movement of the stock market and the crypto market, it has become clear that risk diversification is now less prevalent in portfolios containing both crypto and stock investments.
The spillover of emotions between these two markets can be responsible for the falling prices of each other, in case one of them falls. Market shocks have been observed to travel from one market to another, which implies that the financial systems are destabilized. The relation between the volatility and price variation of S&P 500 stocks and Bitcoin volatility has been established owing to the co-movement of prices after the pandemic.