investment insights

    Cryptocurrencies’ rise and fall – when diversification fails

    Cryptocurrencies’ rise and fall – when diversification fails
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Key takeaways:

    • Cryptocurrencies offer the least diversification at times when it is most needed
    • Inflated projection-based SPAC valuations drop as growth expectations are revised downwards
    • In the current environment, we favour high quality cash-flow generating risk assets – differentiation is key
    • Asymmetric option strategies allow investors to gain from potential equity market rebounds while shielding portfolios from adverse market movements.


    Not-so-stable stablecoin

    Some recent market declines look reminiscent of the plot of The Emperor’s New Clothes, published in 1837 by Danish author Hans Christian Andersen. Revisiting the story may help to understand recent market volatility. The tale centres on a vain emperor persuaded by crooks that they have invented a special cloth only visible to intelligent people. The emperor parades in front of his subjects, who praise the clothes for fear of being considered foolish, until a child shouts “but he has nothing at all on!”

    Faced with the price fluctuations of some digital assets, investors might be forgiven for feeling like one of the emperor’s subjects over the last few years. While the blockchain architecture has exciting prospects in terms of authentication or contract management, it is harder to see the value behind some of the 18,000 coins in existence. Looking at Terra Luna, for example, the algorithmic stablecoin peaked at a valuation of around USD 40 billion, before collapsing to zero in mid-May, after several large investors pulled out.


    Chart 1.svg


    Cryptocurrencies are more correlated to stocks in downturns

    That something which featured “stable” in its very description turned out to be so unstable has somewhat dented the credibility of the ecosystem, while fuelling legitimate questions, such as whether cryptocurrencies really deliver on their advertised diversification benefits? For most of their time in the financial limelight, cryptocurrencies have followed a path of their own. In conducting a regression against the most common risk factors such as rates, spreads and equities since 2018, for example, we could explain only 17% of Bitcoin’s price movements. This apparent independence vis-à-vis traditional assets is further reflected by Bitcoin’s low correlation with the S&P, standing at a meagre 0.19 since 2018.

    However, looking at correlations with more granularity, it appears that the relationship between cryptocurrencies and traditional assets is vastly different depending on whether the stock market is upward or downward trending. The chart below shows the 30-day correlation of Bitcoin with the S&P500 since 2020 while distinguishing periods of growth (in white) and periods of contraction (in grey).

    The relationship between cryptocurrencies and traditional assets is vastly different depending on whether the stock market is upward or downward trending

    Chart 2.svg


    While being modestly correlated with the stock market overall, the graph reveals that Bitcoin is actually nearly twice as sensitive to the S&P500 in periods when it is falling. This is particularly apparent this year, with Bitcoin and Ethereum – the two largest cryptocurrencies by market capitalisation – down 55% and 68% respectively as I write this amid very challenging market conditions. Beyond their dire performance, the infrastructure supporting the ecosystem has also failed to provide liquidity, with several exchanges freezing recently. As such, we judge cryptocurrencies to have failed their first major bear market diversification test.

    We judge cryptocurrencies to have failed their first major bear market diversification test

    SPACs fall from grace

    Loose financial conditions have supported the emergence of inflated valuations and distorted markets in traditional financial assets too. Special Purpose Acquisition Companies (SPACs) allow faster and easier access to equity market funding than traditional Initial Public Offerings (IPOs). However, one important yet somewhat under-advertised feature of SPACs is that their light regulatory framework allows them to use valuations based on projected earnings, rather than the actual results demanded for IPOs. More often than not to the detriment of end-investors, SPAC sponsors and company owners fuelled a boom in transactions that lasted until mid-2021. Fast forward one year, and more than 10% of the stocks that merged with SPACs over the past two years have issued going-concern warnings, which means they could go bust in the next 12 months. For comparison, the implied default rate for the US high yield credit market currently stands slightly above 3%, which is aligned with its historical average over the last 25 years.

    More than 10% of the stocks that merged with SPACs over the past two years have issued going-concern warnings

    Favour quality corporates with high pricing power and asymmetric return profiles

    In an environment of financial tightening, investors are favouring stocks with a proven ability to generate cash flows, to the detriment of more prospective business models. This explains the recent outperformance of value versus technology names. We believe that analysing traditional metrics such as cash flow, leverage, liquidity, profitability, and taking a long investment perspective, remain sound investment principles. In equities, we retain a neutral exposure overall, with a preference for the US and UK among regions. We favour companies that enjoy high pricing power, and are hence better equipped to withstand a lower growth and higher inflation environment. We complement these positions with option strategies such as put spreads to mitigate our downside risk. In fixed income, we continue to be underweight, yet to a smaller extent, as high sovereign yields and wider credit spreads offer more interesting risk/reward propositions. We retain a focus on high-quality issuers, where default and liquidity risks are less of a concern. In terms of alternatives, we maintain our basket of diversified commodities, with a preference for industrial metals, which represent an inflationary hedge, and should be supported by large-scale energy transition projects. Lastly, in currency markets, despite its recent retracement, we maintain an overweight position to the dollar for its haven status as uncertainties linger.

    Important information

    This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
    It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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