I think one of the most frustrating comments I commonly see is "whatever if BTC tanks.. just diversify into alts". The fact is that alt-coins rise with bitcoin and fall with bitcoin. The thing is, it's actually shocking how correlated alts are with each other. I want to show:
- Most of the rise in alts is just beta, or correlation with Bitcoin. In other words, most of the gains in alts is equivalent to a leveraged position in Bitcoin
- Most of the perceived alpha in alts is actually highly correlated with beta as well. In other words, right now even the "extra" gains that alts are making is mainly because of the rise of Bitcoin.
- We should fear the rise of alts more than the rise of CME/CBOT cash settled futures. This is in spite of how a lot of people are saying how CME/CBOT futures will be manipulated by wall street to short Bitcoin.
Here, I've taken 6 fairly popular alts, and plotted the 30 day rolling correlation of their returns with Bitcoin. Also, I plot the 'mean correlation' in orange, which is the average of all 6 cryptos' correlations, and finally I've plot the 'Alpha' (the intercept, a, for y = a * x + b, where x is the return of BTCUSD and y is the return of the instrument).
I think it's pretty obvious that:
- correlation between alts and bitcoin has increased dramatically since 2015
- correlation between alts and each other has increased since 2015
- correlation increases during periods of volatility. In other words, the whole crypto market synchronizes in periods of high volatility.
- Alpha is increasing during periods of volatility. In other words, right now, alts are getting richer than BTC during times of big gains.
This has strong implications for risk management, because during periods of high volatility, the beta, or systemic correlated risk, is very high. One reasonable theory is that when volatility is high, the entire market trades on sentiment, buying all cryptos as bitcoin goes up, and selling all cryptos as bitcoin goes down.
It also has strong implications for those of us seeking a safe haven in case of a crash. So far we haven't seen a serious bear market after the great proliferation of alts in 2016 - 2017. There were few alts during the great bear market of 2014, and most of ones that were around were extremely illiquid back then.
Therefore, I posit two hypotheses: (1) alts will see a massive drop when Bitcoin drops, even more than a regular leveraged position in BTC, and (2) This will have the same effect as a debt crisis.
I believe the psychology of #2 will work like this: A lot of people are putting a ton of money into Bitcoin, and now with the bull run of alts, they are seeking greater returns. People know that alts are more risky, but they are mis-calculating the risk, because they think alts will be a safe-haven when Bitcoin crashes. The math and FOMO reinforce the feeling that alts gain more when bitcoin goes up, and they provide some de-correlated returns when bitcoin crashes. But I believe when we have the big crash, de-correlation will turn into just even larger dumps for alts.
For fundamental traders / long time holders, I think the most important number these days to look at is the float, or the number of outstanding coins actually hitting the market for any alt-coin. We already know pre-mine is a market diversity problem, because one big original holder can dump a lot. However, coins like BCH also have a serious problem because of the small float. "Circulating Supply" is very deceiving. What percentage of BCH haven't been moved at all from their pre-fork address? This smaller pool of traded coins just means that when the market tanks, the illiquid, lightly traded, and low-float coins are at higher risk for an overall risk-off period.
It's extra frightening when you look at the market cap of extremely new / vaporware coins. There's no way that new money will be able to stomach a 95% drop in a new alt-coin when the FUD returns.
Of course, nobody knows when the music will stop, so for now, risk on.
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