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Might Crypto be a Hedge After All?


Chief Strategist at Interactive Brokers

Stocks are having another rocky week, yet cryptocurrencies seem to be doing OK.  Could it be that they are actually acting as a hedge against stock market risk?

In the very short term, the answer might be yes.  As I write this, bitcoin is up just over 3% for the past week while the S&P 500 (SPX) is down about 0.9% over that span.  Items that rise when others fall are wonderful hedges.  But one week is hardly a meaningful timespan.  We want hedges to display that sort of behavior over a longer time span, not just a random week.  If we look at year-to-date (which admittedly is only 2 weeks at this point), we see bitcoin trading -9.6% while SPX is -3.3%.  That is the worst type of hedge – something that moves in the same direction, only more.  We need to step back and see if there is a rationale for considering bitcoin – and by extension other cryptos – display hedging behavior over an extended period.

First, let’s define what we consider a good hedge.  For starters, we like to see a hedge that inversely correlates, or at least decorrelates, with the item being hedged.  Shorting SPX futures against a stock portfolio of SPX stocks is a wonderful hedge if done properly.  One would go up while the other goes down.  But those hedges are from the same asset class.  Investors often desire hedges that are in another type of investment.  Over the past year bitcoin has indeed displayed a near-zero correlation with SPX even as both rose over that period.  The reason for the decorrelation is a problem, however.  Bitcoin had two major dips after a long period of rising prices over the past year – a very sharp drop in May and a longer one that has persisted since October.  Meanwhile, SPX continued to generally rally over those periods.  Those drops in bitcoin created the decorrelation, not a systematic time when one rose and the other fell.  And over a 2-year period the correlation is actually quite high, with an R^2 of about 0.85 when we compare log values.  Remember, both have moved sharply higher since the March 2020 covid crisis, and somewhat in lockstep prior to the incidents mentioned above.  The same applies to a 5-year period as well.  Things that move together are not hedges, just different choices.

One might ask how it works over an even longer-term.  Measured since 2009 when bitcoin was created, the correlation is even higher!  This shows a monstrous problem for hedgers.  Bitcoin came into being during a period of asset price inflation. Stocks have moved steadily higher since the end of the global financial crisis along with a wide variety of risk assets while riding a wave of nearly ever-present monetary accommodation.  Quite frankly, we have no historical precedent for how bitcoin and other cryptos might act if we enter a sustained period when central banks actively drain liquidity.  Those tend to be difficult times for investors, and riskier assets tend to underperform safer ones.  And yes, I believe that cryptos are riskier assets.

I assert that opinion based on statistics.  Over almost any time period, bitcoin has displayed far more historical volatility than SPX.  The 365-day historical volatility of bitcoin is currently 64.5 vs. a 250-day reading of 10.8 for SPX (remember that bitcoin never closes, while there are about 250 equity trading days in a year).  Even with bitcoin showing less volatility over recent days, its 14-day historical volatility is 36.9 vs. SPX’s 13.7 over that time.  It would be irrational to consider hedging by using an item that is 3-6 times more volatile than the asset one is attempting to hedge!  And by the way, bitcoin is less volatile than its peers.

On a day like this, when bitcoin is slightly higher and SPX is lower once again, it is tempting to think that bitcoin is acting like a hedge against one’s equity investments.  One day does not make a trend.

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