Is Bitcoin A Better Hedge Against Market Corrections Than Gold?

By November 8, 2018Bitcoin Business
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Summary

Bitcoin has remained unusually calm and less volatile while the S&P 500 has entered correction territory.

This has given life to the thought that Bitcoin can be used as a hedging instrument to avoid catastrophic market events.

Bitcoin has inherent characteristics that might turn investors away from using it for hedging purposes.

Gold has been a "go to" hedge at times of market corrections. Has gold lived up to its potential this time around?

Overview

The S&P 500 index entered correction territory last month as the index dropped more than 10% from its recent high of 2,940. While this is not an unknown phenomenon, investors are already considering alternative investment opportunities and the focus has shifted to hedging instruments that would purportedly resist the downward pressure of a market correction or a bear market for that matter. Bitcoin has been in the spotlight of late as the price drop of the cryptocurrency has been far less in magnitude in comparison with stock markets.

This is not the first time in which Bitcoin has been thought of as an alternative investment. However, to form an evidence based conclusion on Bitcoin’s ability to weather stock market corrections, historical data should be analyzed carefully.

Market corrections and Bitcoin price movement

In this section, I have focused on two recent corrections of the S&P 500 index for comparison purposes. Market data related to the current correction has not been included as it would distort the calculations by including a developing market movement.

Including data of market corrections prior to 2015 would be a misrepresentation as well since Bitcoin was not being considered as a mainstream investment vehicle back then.

Correction period

S&P 500 return

Bitcoin price change

January 26, 2018 – February 08, 2018

-10.2%

-32%

May 21, 2015 – February 11, 2016

-14.2%

2,628%

(Source – Yardeni Research & Coindesk)

These results are contradicting and a valid argument cannot be established based on these data alone as Bitcoin has been positively correlated to the S&P 500 index during the market correction earlier this year but has been significantly uncorrelated to the S&P 500 downturn in 2015.

Focusing on the current market correction, Bitcoin has been able to weather the market storm acceptably.

The S&P 500 is down 6.3% from its high recorded in September and is emerging from the correction territory. Bitcoin, during the same period is down 3.43% so far, which represent a drop of much smaller magnitude in comparison with the broad market index. This calls for an analysis of Bitcoin’s ability to weather market storms.

Analysis of Bitcoin as a hedging instrument

Bitcoin has remained less volatile during the current market correction in comparison with its drastic price movements this year.

Bitcoin price movement from September 7 – November 7

(Source - Blockchain)

Better yet, the lowest Bitcoin fell at any point during this period is 6.3%, whereas the broad market fell more than 10% at one point in time. This can be explained by the Z-Score of 0.14 between Bitcoin and the S&P 500 index.

While these figures look attractive on the face value, a deeper study should be conducted to identify whether Bitcoin has indeed been resisting the downward market pressure of the broad stock market index.

Apparently, number of confirmed Bitcoin transactions carried out in the same period has directly coincided with the stock market movement.

Number of confirmed Bitcoin transactions per day from September 7 – November 7

S&P 500 movement from September 7 – November 7, 2018

(Source – Coindesk and Yahoo Finance)

This implies that the number of transactions completed in Bitcoin has improved on days the stock market gained and declined as the stock market shredded its gains. While it is true that there has been an overall increase in the number of transactions completed from September to November, this has clearly varied with the directional movement in the S&P 500 index. While, this is not sufficient to form an opinion on the correlation between the two variables, the incorporation of a second relationship does the trick.

Bitcoin price is showing a positive correlation to the number of confirmed transactions carried out in a single day, which can be identified by studying the below charts.

Number of confirmed Bitcoin transactions per day from September 7 – November 7

Bitcoin price movement from September 7 – November 7

(Source – Coindesk)

There is a clear positive relationship between the number of confirmed Bitcoin transactions and the Bitcoin price. I have summarized below the two relationships identified and discussed.

  1. Number of Bitcoin transactions completed on a day has a positive relationship with the broad stock market direction.
  2. Bitcoin price has a positive relationship with the number of confirmed Bitcoin transactions.

From the outset, Bitcoin price has lost half of what the S&P 500 index has lost in the considered time period but Bitcoin has never been able to have a movement that is distinctly independent from that of the stock market. In comparison with previous market corrections, the current market correction provides a better platform to evaluate the correlation between these two variables as Bitcoin was not susceptible to increased regulatory pressures, coin thefts or SEC denials in this period. One of these things or any other positive news would have resulted in a drastic price movement in Bitcoin, which would have been an outlier.

What constitutes a strong hedge is not essentially the magnitude of the price movement between two variables at a single point in time or during an event but rather the inherent characteristics of the two variables considered.

Admittedly, Bitcoin fails to meet the general expectations of a natural hedge as inherent qualities of Bitcoin are far too attached to the directional movement of equity markets. In addition, the decrease in number of confirmed Bitcoin transactions when the stock market started plummeting depicts the market sentiment and expectations toward Bitcoin. Markets expect Bitcoin to move along with equity markets and Bitcoin has failed to create an impression that is otherwise.

Moreover, investors prefer to use a financial instrument that is established, liquid and reliable in price movements as a hedging security. Bitcoin fails to remain reliable as there are unwarranted price movements of high magnitudes, which would make the use of Bitcoin as a hedging security a risk in its own right.

Analysis of Gold as a hedging instrument

Gold, being a precious commodity is considered by many to provide a natural hedge against stock market downturns. More importantly, gold is seen as a valuable commodity, hence a store of value.

The base case is that gold is uncorrelated to stocks and bonds whereas it has a negative correlation to U.S. dollar movements. Therefore, when the dollar falls, Gold is expected to rise on the other hand. During times of economic crises, the dollar tends to fall along with stock prices. Gold, a commodity that has a negative correlation with the dollar, tends to rise. While there have been times in which these three variables have moved in tandem, this has not wavered the investor confidence in gold as a hedging instrument, purely because of the historical performance of gold as a successful hedging instrument.

Gold price movement from September 7 – November 7, 2018

(Soure – longtermtrends)

Gold is up 2.5% as represented by the yellow line and the S&P 500 index, depicted by the red line is down close to 5% in the same period. During the craze of comparing Bitcoin returns to assess whether finally it has become the perfect hedge for stock markets, some investors failed to notice how gold lived up to the potential.

From an investor’s perspective, what is more relevant is using an asset class as a hedge to survive a downturn in another asset class. Investors who are long stocks would not mind gold prices increasing at the same time stocks do as long as gold prices go back to their inherent nature and start moving higher when the dollar depreciates against other currencies and stocks tumble. This is exactly what is happening at the moment. Analysts were eager to decipher why and how gold prices kept on rising in the last year while stocks were also inching higher steadfastly but investors with a focus on stocks should never leave out gold as a reliable hedge against market headwinds.

Conclusion

Bitcoin has so far weathered the storm that has hit markets but a closer look at Bitcoin and its intrinsic characteristics reveals why Bitcoin cannot be trusted as a reliable hedge against stock market downfalls yet. While the situation might improve if and when Bitcoin is identified and treated as an alternative asset class, gold is currently a better hedge than Bitcoin for market corrections. Bitcoin still has a long way to go and will probably become a strong hedge against market corrections if it can achieve below.

  1. Remain less volatile under normal market conditions, which would boost investor confidence in Bitcoin. Currently, traders love Bitcoin for this very nature as wild swings in price provide traders with the opportunity to profit in the short term. If Bitcoin is to become a proper hedge against stock market corrections, a flair of formidability should be displayed, which would not only attract institutions toward Bitcoin but also would discourage traders from betting on Bitcoin for short term profits.
  2. Develop intrinsic characteristics to sway away from being attached to the investor sentiment on stocks. Currently, investors tend to consider Bitcoin as a compliment rather than an alternative to stock market investing. If Bitcoin is to receive recognition as a hedge against stock market corrections, there should be reasons to believe that Bitcoin in its own right is an investment.

While the major use of Bitcoin is as a currency rather than a hedge against a downturn in any other asset class, this research was conducted to address the issue of Bitcoin being considered a hedge against stock market downturns. To conclude, Bitcoin is not by any means a better hedge than gold in times of equity market selloffs at present.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Bitcoin has remained unusually calm and less volatile while the S&P 500 has entered correction territory.

This has given life to the thought that Bitcoin can be used as […]