Introduction
The NFT market is facing its first-ever bear market after the crazy NFT summer run-up. In the first article of our series, we investigated the performance of Blue-Chip NFTs. In this article, we will continue our analysis by looking into the macro trends that drive the price changes in the NFT market.
The most valuable NFT projects exist on the Ethereum blockchain. Ethereum processed more than $246M in trading volume over the past week. Trades in the market are largely denominated in ETH. As the value of ETH dropped down to $1K from its all-time high above $4K, NFT valuations have suffered from this crash.
During times of uncertainty, spikes in speculation, and pump and dumps, we can use data to spot the signal from the noise and make data-driven decisions. In this article, we will look into the correlation between ETH and NFTs.
How are NFT and ETH Market Caps Calculated?
In general terms, Market Capitalization is a metric for analyzing the USD value of a company, NFT collection, or cryptocurrency. This metric is based on the current share price of the asset and its total number of outstanding shares. Since both stocks and cryptocurrencies are fungible assets, the market capitalization of these types of assets is calculated by multiplying the total number of outstanding shares by the current market price of one share. For example, if a cryptocurrency has a total of 1M shares and a share price of $20 per share, its Market Cap would be 1M * $20 = $20M.
In non-fungible tokens (NFTs), each NFT in a collection might have a different value because of rarity and other dynamics. The NFT market is also composed of ERC1155 (Semi-fungible) tokens. To account for both cases and provide an accurate representation of the total value of an NFT collection, NFTGo.io calculates the share price as the maximum value between the NFT collection's floor price and its latest traded price. This mechanism gives us the ability to factor out the high-value NFTs from the collection and account for their greater value.
Why is Market Cap Important?
Market Capitalization plays a critical role in evaluating the potential upside of a project. Market capitalization is an indicator of how much an investor is willing to pay for the NFTs in a collection. Although the average price of an NFT collection can be either overestimated or undervalued, market capitalization is a more accurate way of determining the total value of the NFT collections.
Before investing in an NFT project, it is critical to pay attention to the Market Cap of the company along with the floor and average price. Market capitalization is a representation of a project's risks and value. Each of these dynamics
impacts how we can strategically invest in NFTs:
1- Risk Management
Risk mitigation and portfolio diversification are critical components of a successful NFT investing strategy. Managing risks and being aware of the possible scenarios can guide investors in making better decisions amid market pumps and dumps. Similar to how when a storm hits, an oak tree with a stronger trunk and root structure is less prone to getting severely damaged than a sapling, a high-market cap NFT project is generally less volatile relative to new and low-market cap projects. This metaphor illustrates the critical role of market capitalization in risk management. Soon in this article, we will illustrate the volatility of some of the NFT projects in different categories.
2- Value
The current state of the market determines market capitalization. This metric can help investors gauge how other investors are valuing the NFT. The current value of the NFT collection helps traders and investors identify high-value projects.
The Correlation Between ETH and NFTs
The dizzying sell-off after aggressive liquidations has caused the ETH price to shrink drastically. The NFT market is primarily denominated in ETH, almost all NFT trades are done by ETH or its wrapped version, WETH.
The Rebased ROI of NFTs and ETH
The ETH market cap has gone down from the early December 2021 highs at roughly $550 billion to less than $130 billion in June 2022. For NFT valuations to catch up with the drastic decrease in their denominated currency ETH, they'd need to dramatically enlarge equally. However, NFTs have not been immune to the ETH market crash. Both the ETH market cap and the NFT market cap have been falling together during the last three months.
The chart below illustrates the rebased ETH and NFT market cap returns from the start of the period up until today. In a rebased chart, both values start as 100, and going above 100 accounts for increases, and going below 100 displays decreases from the initial value. The shared downtrend for both ETH and NFTs displays their strong correlation.
Another interesting data point from the chart is the NFT market's resilience compared to ETH in the current bear cycle. While ETH has gone down by more than 50% from its initial market cap, the NFT market has only decreased by 30%.
Why Did NFTs Crash Less Than ETH?
It is worth considering that NFTs are a very small and niche subset of speculative markets. NFTs merge culture and art with finance and trading and provide a decentralized way of connecting creators with fans. ETH is orders of magnitude more mainstream than NFTs. There are also huge funds with high leverage in the crypto markets that have been drastically liquidated over the past few weeks. All of these dynamics have been playing out together to cause a bigger decrease in ETH's market cap. NFTs are a very small market in comparison with ETH. The chart below illustrates the market size of the two assets.
Cryptocurrencies have been around since 2009. These markets have gone through several iterations and cycles. Over time, these digital assets have become one of the mainstream ways of trading and investing. Large funds and market makers invest heavily in top crypto assets like Bitcoin and Ethereum. In comparison with NFTs, cryptocurrencies are a mature market sector in the blockchain ecosystem.
One way of quantifying how mainstream NFTs are relative to crypto is by calculating the ratio of the NFT market cap with a mainstream crypto asset like ETH. For example, on March 21st, 2022, according to YCharts, the market cap of ETH was $238.3B, NFTGo.io recorded the NFT market cap chart on that day at $19.3B. The NFT/ETH ratio for March 21st would be 19.3 / 238.3 which roughly equals 0.26. On the other hand, this number changed on December 5th when ETH was $498B and NFTs were at $9.8B. These changes in the NFT/ETH ratio can show how close NFTs are getting to the size of the ETH market cap over time. In this case, the point of the analysis is not necessarily to forecast a time when NFTs could get to a 1 ratio value, but to analyze the growth rate of NFTs relative to a mainstream asset like ETH.
The chart below shows the NFT/ETH market cap ratio from late March to June 2022. We can observe an increase in the NFT/ETH ratio. This ratio grew from under 0.1 to just above 0.1 up until the middle of June. However, the ratio has been on an uptrend since mid June. The NFT market continues to grow faster than the previous months and the ratio even reached 0.18. The growth of the ratio indicates a growth in the size of the NFT market relative to ETH and ultimately quantifies how mainstream NFTs are getting to some degree.
The ROI of NFTs and ETH on a Log Scale
Earlier we looked into the rebased ROI of NFTs and ETH. However, during the past 3 months, there have been significant price movements in both NFTs and ETH. To capture these drastic changes, we can use a log scale graph to accurately analyze the percentage ROI for changes of all sizes. The chart below shows the ROI of ETH and NFTs relative to their market cap at the start of the week.
We can observe that both ETH and NFTs are moving in the same direction. As ETH goes down, NFT prices start to fall as well, hence, their market cap drops. However, the changes in the ETH market cap are more dramatic than NFTs. By zooming into only the past week, we can see subtler movements from the NFT market.
Correlation Coefficients
The correlation coefficients of two data points give us insights into how dependent they are on one another. Studying the correlation of two variables allows us to understand the influential dynamics of each of the values.
A correlation coefficient close to 1 means a one-to-one relationship between the two values. In our case, it means that the NFT market closely follows ETH's market cap. Another case could be that the NFT and ETH market caps are subtly correlated. In this case, the correlation would be close to zero. We can use a scatter plot to illustrate the correlation between the NFT market cap and volume. Before we look into the results, the charts below show how each scenario of positive, negative, or zero correlation shows up in a scatter chart.
A scatter plot can also show the strength of correlation between two values, the above charts are all theoretical cases of perfectly positive, negative, or zero correlation. However, in the real world, these correlations can be weaker or even show side-ways trends.
The strength of these correlations varies depending on the cycle of the market.
The chart below illustrates the correlation between the NFT and ETH market cap during the past 3 months. The x-axis represents the NFT total market cap that grew to over $38B at its peak. The y-axis illustrates the Ethereum market cap during the same 3 month period.
However, as we broaden the time window to 1 year, the correlations are not always negative or positive. There have been times in the NFT market that the correlations were both negative and positive. NFTs have not been a straight follower of ETH trends. Bull markets specific to NFTs, huge sales, more Whales entering the NFT market, and the emergence of new Blue-Chips can all contribute to the NFT market becoming more independent from the ETH market.
Analyzing The Pearson Correlation for NFTs and ETH
The Pearson correlation is a formula used to analyze the strength of a linear association between two variables. This value (denoted by r) can be between -1 and 1. According to r's value, we can analyze the linear correlation between two variables:
Using Bitcoin as a Reference
Bitcoin is broadly considered to be correlated with ETH. As both cryptocurrencies represent a large percentage of the total crypto market cap and are the two most popular cryptocurrencies, they typically rise and fall together during market pumps and dumps. We can use the strong positive correlation between BTC/ETH as a reference for analyzing the strength of the NFT/ETH correlation.
Correlation Is Volatile
However, we need to consider the role of different market cycles on correlation. In analyzing financial assets, it's worth keeping in mind that correlation is a cycle and context-dependent factor. The strength of the correlation or even the positivity or negativity of the association between two assets can vary over time. To illustrate this point, we have analyzed the Pearson correlation between the two pairs: ETH/BTC and ETH/NFT in four different time windows:
1- Long-term: 1 year
2- Mid-term: 3 months
3- Short-term
4- Recent: 1 week
The chart below illustrates the Pearson correlation between the two pairs in the past year. This chart illustrates how volatile the correlations between two speculative assets can be, even if the two are ETH and BTC, and they're in the same cryptocurrency sector. The negative correlation between two assets is a signal of their unique value propositions in the market. We can observe that the ETH/BTC correlation has been close to 1 more often than the ETH/NFT correlation. Using BTC's association with ETH as our reference, we can observe the independent movements of the NFT market relative to ETH.
Can NFTs Be a Hedge Against Crypto Dumps?
More than anything, close to zero correlations show independence from the other asset while assets with negative correlations are used as a hedge against other assets. A concrete example is hedging against the devaluation of the US Dollar by holding assets like gold. NFTs and digital collectibles at times have had the potential to be used as a hedge against possible declines in cryptocurrencies like ETH.
Crypto has been in a bear market since early 2022. But the NFT mania continued and projects like Otherdeed and Moonbirds were huge successes amid a Crypto bear market. The chart below shrinks the time window to 3 months.
The chart below illustrates the Pearson correlation between these two pairs during the past month. During this time window, the ETH and BTC correlation has been very close to 1 and almost stayed flat during these three months. However, even though NFTs started the period with a correlation close to 1, since June 13th, NFTs have been trending towards a negative correlation with ETH. Compared with the beginning of the month, NFTs have been recently shifting to a more volatile correlation. This could be caused by a couple of events specific to NFTs:
1- Blue-Chip collections and companies like Yuga Labs teasing new announcements
2- NFT NYC
But this is not always the case. As we shorten the time window and get closer to the current bear market, we can see stronger positive correlations between ETH and NFTs. Over the past week, the NFT and ETH market caps have been strongly correlated. This shows that NFTs have been following the ETH market more than the days of the mania. The findings of this chart suggest that the cooldown period of NFT Summer has been replaced with a slower pace of Blue-Chip NFTs launching new collections to expand their brand rather than airdrops with gas wars.
Will NFTs Survive This Crash?
In the past weeks, the cryptocurrency market has been hammered by the latest macro events. The great crash of $LUNA in early May was the prelude to the Crypto recession that happened as a response to an aggressive rise in interest rates by the US Fed.
The hangover from the Crypto market's bull cycle during the global pandemic has now transitioned to liquidation events and hedge funds losing their high-leverage positions. The average Crypto investor has also experienced an acute drop in their total portfolio value.
We saw that the NFT market is not immune to the bear wave that has already sunk the crypto market. It's worth noting that although NFTs have fundamentally different dynamics and value propositions than De-Fi and crypto, just like how the equities and crypto markets rise and fall off the cliff together, the same dynamics can impact the NFT market sentiment.
These strong correlations between ETH and NFTs present an opportunity to spot the dips and the high points of the NFT market. However, we observed that sometimes, the NFT market was uncorrelated with ETH. This shows that NFTs could be regarded as an independent asset class at times of organic hype for NFTs. As we also saw, the NFT market had less dramatic changes than the ETH market over the past week. This is primarily due to the leveraged positions in the ETH market and the liquidations that are raising the buying pressure. We saw that NFTs still have a long way to go to become mainstream.
This bear market might be the end for some NFT collections but many of them are recovering from the crash.
To get the latest insights about the NFT market's performance, be sure to check out the leaderboards on NFTGo.io.
Note: The above information is for informational purposes only. Investing in digital assets such as NFTs and cryptocurrency brings with it a high degree of risk. Please consult with a financial advisor before making any investment decisions. NFTGo.io does not provide financial advice and is not responsible for any losses incurred as a result of investing in digital assets.