The S&P 500’s devastating 8% drop in less than a month underscores today’s stock market risk. Despite the modest correction in late July and early August, the benchmark index has a valuation that’s 71% higher than its long-term average. And not everyone is convinced that the Federal Reserve will be able to avoid triggering a recession.
But what would a larger stock market correction—or a bear market—mean for crypto traders and investors?
The Case for a Crash
The stock market is notoriously difficult to predict. There’s a famous proverb that the stock market can remain irrational longer than you can stay solvent. In other words, it’s hard to pinpoint bear markets even when all the signs are pointing in one direction!
To see why today’s stock market is overvalued, look at the so-called earnings yield—or the inverse of the price-earnings ratio. The S&P 500’s earnings yield is just 3.62% today, well below the 7.24% long-term average and lower than the risk-free 3.96% yield that the 10-year Treasury bonds offer!
The S&P 500 index’s earnings multiple over time. Source: Multpl.com
The caveat is that only a handful of stocks account for most of the lofty valuation. The most obvious example is NVIDIA’s impact on the S&P 500’s valuation. By comparison, the Invesco S&P 500 Equal Weight ETF (RSP)—an equal weight index of 500 stocks—has a more representative earnings yield of 5.51%.
Stretched equity valuations suggest little investor appetite for bad economic news. So, not surprisingly, a weaker-than-expected July 2024 jobs report sent the S&P 500 sharply lower as investors reassessed the odds of a downturn. While stocks have recovered since then, there’s still lingering concern over a slowdown, and ultimately, a recession.
Is Crypto a Safe-Haven?
Many investors look toward precious metals like gold during bear markets. That’s because gold is typically negatively correlated during market downturns. In other words, gold prices usually increase when the S&P 500 index decreases. For these reasons, many investors turn to gold when they suspect a market downturn is right around the corner.
Gold prices increase when stock market prices drop. Source: GoldSilver
The thought is that cryptocurrencies like Bitcoin should react in the same way. Like gold, Bitcoin has a limited supply that makes it a scarce commodity. But unlike gold, you don’t have to pay to store physical Bitcoins—they exist in software form only. As a result, it stands to reason that Bitcoin is a superior version of gold if both are priced mostly on scarcity.
In reality, Bitcoin doesn’t offer the same level of protection through a negative correlation—at least most of the time. Bitcoin’s price dynamics appear more driven by speculation than a safe-haven status, resulting in a typically positive correlation with stocks.
Over the past five years, Bitcoin and the S&P 500 index have seen a highly positive correlation. In fact, since 2019, they have only shown a negative correlation four times, meaning Bitcoin probably won’t be a safe haven—in fact, it could crash itself!
How to Prepare Your Portfolio
The fact that the S&P 500 and Bitcoin have a positive correlation most often suggests that you should prepare your crypto portfolio like your stock portfolio. And, for many long-term investors, that means not changing a thing.
Short-term investors, such as retirees or active traders, may hedge their portfolios rather than ride out the volatility. For example, they might turn to Bitcoin put options to profit from a decline and offset losses in their long Bitcoin portfolio.
Of course, the most significant risk of hedging a portfolio is poor market timing—and any experienced investor will tell you that timing the market is a challenge! If you purchase put options too early, they could expire worthless and leave your portfolio worse off.
Deribit simplifies crypto derivatives trading. Source: Deribit
If you choose to hedge, Deribit is the most popular platform for trading Bitcoin and Ethereum options. But, of course, more experienced traders and investors may prefer to trade options on CME futures contracts via a conventional brokerage account.
In addition to using options as a hedge, you can prepare your portfolio by ensuring it’s properly diversified. If you’ve held Bitcoin through a large rally and it’s now one-third of your portfolio, you may want to consider selling some and buying other crypto assets. This periodic “rebalancing” ensures that no single asset downturn impacts your entire portfolio.
Capitalizing on Opportunities
A market crash might feel painful in real time, but savvy traders and investors recognize that it could also spell opportunity. According to Warren Buffett, investors should “be fearful when others are greedy, and greedy when others are fearful.”
Many short-term traders rely on volatility to generate profits. For instance, they may use mean reversion strategies to buy oversold or sell overbought crypto. And, in the event of a sharp market sell-off, there’s a much larger reversion to the mean.
Long-term investors often eye the same oversold conditions but with the goal of reducing their cost basis rather than taking short-term profits. By continuing to buy as the price declines, they “average in” and reduce their overall cost.
ZenLedger makes it easy to find tax loss harvesting opportunities in your portfolio. Source: ZenLedger
Bear markets are also an excellent time to harvest tax losses to offset your capital gains and up to $3,000 in ordinary income. Using tools like our tax loss harvesting spreadsheet, you can identify unrealized losses and lock them in after a significant decline.
The Bottom Line
The S&P 500’s brief and sudden drop sparked fears of a bear market. While asset prices have fallen slightly since then, valuations remain well above their historical average, which means a bear market is within the realm of possibility.
While some see crypto as a hedge against risk, history suggests that prices often follow stocks. So, if you’re concerned about a bear market, you may want to consider taking action to hedge against risk using options or other strategies.
If you trade crypto assets, ZenLedger can help you prepare for tax time. Our platform aggregates transactions across exchanges and wallets, computes your capital gains and losses, and generates the paperwork you must file yearly.
The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.
