Information Cascading: Correlation between cryptos and stocks, and the bull & bear cycle
https://learn.bybit.com/investing/bitcoin-stock-market-correlation/
This article talks about the correlation between Bitcoin price and S&P 500 index. In the early years of Bitcoin, its correlation with the market was low, so many fund managers thought it was a great tool to hedge against market risks and added Bitcoin to their portfolios. However, in recent years, the correlation between Bitcoin and S&P 500 is increasing, especially after the pandemic. One potential reason behind that is there are a large group of investors investing in Bitcoin and stocks at the same time. If they think the economy will be good, they will buy both assets. If they think the economy is worrying, they will sell both assets.
Source: Bloomberg
As a crypto investor for two and half years, I observed the correlation is increasing. Before the pandemic, Bitcoin follows its supply-driven cycle. Due to Bitcoin’s mining production halving every four years, Bitcoin’s bull & bear cycle is also four years. However, during the pandemic, when the Federal Reserve decreased the interest rate to nearly zero and start quantitative easing (buying securities like treasury bonds, MBS, and cooperate and municipal bonds.) to release a large amount of liquidity to the market, every asset’s price was increasing to an all-time high, including housing, stocks, bonds, cryptos and NFTs. Not only the blue-chip assets were pushed to a high valuation, but the returns on bad assets (financially unhealthy firms or meme cryptos) were also higher than those blue-chip assets. That’s an information cascading effect. Since people trust the Federal Reserve when it decides to save the economy, the first group of buyers was financial experts/ fund managers- they know the effect of this decision on the markets. Then the experts bought in the dip in March 2020, and the market bounced. The media started to report this. That’s when the information cascading started. The early groups of retail investors saw the news and rushed into the market. (Eg. Me) After the early retailer investors made money from the bull run, they would tell their families and friends to urge them to get into the market. (I also did this) This brings the late retail investors who even never invested before into the market, pushing the bubble higher. Dogecoin and GME were two examples of the results.
Early this year, the Federal Reserve announced the plan to raise the interest rate and started quantitative tightening (selling securities like treasury bonds, MBS, and cooperate and municipal bonds.) to fight inflation. The reverse effect of the early information cascading effect started. Everyone was selling, from stocks, and cryptos, to real estate, which caused the bear market to start.
Summary: The decisions of the Federal Reserve started the information cascading, creating the bull run since March 2020 and the bear market since Jan 2022. Information cascading is everywhere in life, affecting the crowds and even the experts. The power of information cascading is just like what the greatest trader in the 20th century, Jesse Livermore said- when a trend started, it takes a lot of effort to end it.