In-depth analysis of the correlation between NFT and ETH

Author: NFTGo

Introduction

Since the crazy surge last summer, NFTs are facing the most significant market calm period in history. In our first article, we investigated the performance of blue-chip NFTs, and this article will continue to explore the macro trends driving price changes in the NFT market.

In the past week, there has been over $246 million in trading volume on Ethereum, with transactions primarily priced in ETH. As the value of ETH dropped from historical highs above $4K to $1K, the valuation of NFTs was also affected during this crash. In such an uncertain and speculative period, we can leverage data to find signals amidst the noise and make data-driven decisions. In this article, we will examine the correlation between ETH and NFTs.

How is the Market Cap of NFTs and ETH Calculated?

Generally, market cap is a metric used to analyze the dollar value of a company, NFT collection, or cryptocurrency. This metric is based on the current stock price of the asset and its total circulating supply. Since stocks and cryptocurrencies are both fungible assets, the market cap of these types of assets is calculated by multiplying the total circulating supply by the current market price per share. For example, if a cryptocurrency has a total of 1 million shares and each share is priced at $20, its market cap would be 1 million * $20 = $20 million.

In NFTs, due to rarity and other dynamic factors, each NFT in a collection may have a different value. The NFT market is also composed of ERC1155 (Semi-fungible) tokens. To accommodate these two factors and provide an accurate representation of the total value of an NFT collection, NFTGo.io calculates market cap based on the maximum value between the floor price of the NFT collection and its latest transaction price. This way, we can exclude some of the highest-priced collectibles, reflecting the total value of the collection.

Why is Market Cap Important?

Market cap plays a crucial role in assessing the potential upside of a project, and it is one of the important indicators for investors to measure the willingness to pay for NFTs. While the average price of an NFT may be overvalued or undervalued, market cap can more accurately determine the total value of NFTs. Before investing in an NFT project, it is essential to pay attention to market cap, floor price, and average price. Market cap represents the risk and value of the project, and these dynamic factors are crucial for strategic investment in NFTs.

1- Risk Management

Reducing risk and diversifying the portfolio are key components of a successful NFT investment strategy. Risk management and forecasting risks can help players make better decisions in a speculative market. Similar to how a sturdy oak tree with strong roots stands firm against a storm compared to a small sapling; high market cap NFT projects typically exhibit less volatility compared to newly issued and low market cap projects, highlighting the critical role of market cap in risk management. This article will explain the volatility of different categories of NFT projects.

2- Value

Market conditions determine market cap. This metric can help investors gauge how other investors value NFTs, assisting traders and investors in identifying high-value projects.

The Correlation Between ETH and NFTs

The dizzying sell-off following aggressive liquidations led to a sharp decline in ETH prices, while the NFT market is primarily priced in ETH, with almost all NFT transactions conducted in ETH or WETH.

Re-evaluating Investment Returns of NFTs and ETH

The market cap of ETH has dropped from a peak of about $550 billion in early December 2021 to less than $130 billion in June 2022. Over the past three months, both ETH and NFT market caps have declined together.

The chart below shows the adjusted returns of ETH and NFTs from that period until today. In the adjusted chart, both market caps start at 100, with values above 100 indicating an increase and below 100 indicating a decrease from the initial value. The common downward trend of ETH and NFTs demonstrates a strong correlation.

Adjusted ETH and NFT Market Cap Returns Over the Past 3 Months

Another interesting data point in the chart is that during the current bear market cycle, the NFT market has shown strong resilience compared to ETH. While ETH has dropped over 50% from its initial market cap, the NFT market has only declined by 30%.

Why is the Decline of NFTs Less Severe than ETH?

It is worth considering that NFTs represent a very small subset of the crypto market. NFTs integrate culture, art, finance, and trading, providing a decentralized way to connect creators and fans. ETH is several orders of magnitude more mainstream than NFTs, and there have been large funds with high leverage in the cryptocurrency market that have been significantly liquidated in recent weeks. All these dynamics contribute to a greater decline in ETH's market cap, as illustrated in the chart below comparing the market sizes of these two assets.

Comparison of Market Cap Sizes of ETH and NFTs

The cryptocurrency market has undergone several iterations and cycles since 2009, and over time, these digital assets have become one of the mainstream methods of trading and investing. Large funds and market makers invest heavily in top crypto assets like Bitcoin and Ethereum. Compared to NFTs, cryptocurrencies are a mature market sector within the blockchain ecosystem.

One way to quantify the mainstream status of NFTs relative to cryptocurrencies is to calculate the ratio of NFT market cap to mainstream crypto assets like ETH. For example, on March 21, 2022, according to YCharts, the market cap of ETH was $238.3 billion, while NFTGo.io recorded an NFT market cap of $19.3 billion on that day. The NFT/ETH ratio on March 21 would be 19.3 / 238.3, approximately equal to 0.26. On the other hand, this number changed on December 5, when ETH was at $498 billion and NFTs at $9.8 billion. These changes in the NFT/ETH ratio can show how NFTs have approached the market cap scale of ETH over time. In this case, the focus of the analysis is not necessarily to predict when NFTs will reach a ratio value of 1, but to analyze the growth rate of NFTs relative to this mainstream asset, ETH.

The chart below shows the NFT/ETH market cap ratio from the end of November 2021 to May 2022. We can observe an increase in the NFT/ETH ratio. This ratio grew from below 0.02 at the end of 2021 to above 0.05 in just two months. The NFT market continued to grow, from 0.05 to now approaching 0.08.

NFT to ETH Market Cap Ratio Over the Past 3 Months

Logarithmic Scale of Investment Returns for NFTs and ETH

Earlier, we examined the reinvestment returns of NFTs and ETH. However, both NFT and ETH prices have experienced significant fluctuations over the past three months. To capture these drastic changes, we can use a logarithmic ratio chart to accurately analyze the percentage of investment return rates for various magnitudes of changes. The chart below shows the investment return rates of ETH and NFTs relative to their market cap at the beginning of the week.

Investment Return Rates of ETH and NFTs Relative to 30 Days Ago on a Logarithmic Scale

We can observe that both ETH and NFTs are moving in the same direction. As ETH declines, the price of NFTs also begins to drop, leading to a decrease in their market cap as well. However, the changes in ETH's market cap are more drastic than those of NFTs. By zooming in on just the past week, we can see more subtle changes in the NFT market.

Investment Return Rates of ETH and NFTs Relative to 7 Days Ago on a Logarithmic Scale

Correlation Coefficient

The correlation coefficient between two data points allows us to gain deeper insights into their dependency. Studying the correlation between two variables enables us to understand the dynamic impacts of each value.

A correlation coefficient close to 1 indicates a one-to-one relationship between the two values. In our case, this means that the NFT market closely follows the market cap of ETH. Another possibility is that the market caps of NFTs and ETH have subtle correlations. In this case, the correlation would be close to zero. We can use a scatter plot to illustrate the correlation between NFT market cap and trading volume. Before presenting our findings, the following shows how each case of positive correlation, negative correlation, or zero correlation would appear in a scatter plot.

Results of Scatter Plots with Different Degrees of Correlation

Scatter plots can also show the strength of the correlation between two values. The above charts represent theoretical cases of perfect positive correlation, negative correlation, or zero correlation. However, in the real world, these correlations may be weaker and even show consolidation.

The strength of these correlations depends on the market cycle.

The chart below illustrates the correlation between NFT and ETH market caps over the past three months. The X-axis represents the total market cap of NFTs, which peaked at over $38 billion, while the Y-axis represents the market cap of Ethereum during the same three-month period.

Correlation Between ETH and NFT Market Caps Over the Past 3 Months

However, when we expand the time frame to one year, the correlation does not always remain negative or positive. In the NFT market, there have been times when the correlation was both negative and positive, indicating that NFTs do not directly follow ETH trends. The unique bull market of NFTs, large issuances, the entry of whales, and the emergence of new blue chips can all drive the NFT market to be more independent of the ETH market.

Correlation Between ETH and NFT Market Caps Over the Past Year

Analyzing the Pearson Correlation of NFTs and ETH

The Pearson correlation is a formula used to analyze the strength of linear association between two variables. This value (denoted as r) can range between -1 and 1. Based on the value of r, we can analyze the linear correlation between the two variables.

Pearson Correlation Coefficient

Using Bitcoin as a Reference

Bitcoin is widely regarded as being strongly correlated with ETH. Since both cryptocurrencies represent a significant portion of the total cryptocurrency market cap and are the two most popular cryptocurrencies, they often rise and fall together during market cycles of buying low and selling high. We can use the strong positive correlation between BTC and ETH as a reference for analyzing the strength of the NFT/ETH correlation.

Correlation is Unstable

However, we need to consider the impact of different market cycles on correlation. When analyzing financial assets, it is worth remembering that correlation is a cyclical and environment-dependent factor. The strength of the association between two assets, whether positive or negative, can change over time. To illustrate this point, we analyzed the Pearson correlation of two pairs: ETH/BTC and ETH/NFT over four different time windows:

1- Long-term: 1 year

2- Medium-term: 3 months

3- Short-term: 1 month

4- Recent: 1 week

The chart below illustrates the Pearson correlation of these two currency pairs over the past year. This chart shows how much the correlation between two speculative assets can fluctuate, even when those assets are ETH and BTC, both within the cryptocurrency space. The negative correlation between the two assets signals their unique value propositions in the market. We can observe that the correlation of ETH/BTC is closer to 1 than that of ETH/NFT. Using the correlation of BTC with ETH as a reference, we can observe the independent movement of the NFT market relative to ETH.

Pearson Correlation Between ETH/BTC and ETH/NFT Over the Past Year

Can NFTs Serve as a Hedge Against Cryptocurrency Downturns?

Most importantly, a correlation close to zero indicates independence from other assets, while negatively correlated assets are used to hedge against other assets. A specific example is using assets like gold to hedge against the depreciation of the dollar. NFTs and digital collectibles have been used to hedge against the potential downturn of cryptocurrencies like ETH.

Since early 2022, the cryptocurrency market has been in a bear market. However, the frenzy around NFTs continues, with projects like Otherdeed and Moonbirds achieving significant success during the cryptocurrency bear market. The chart below narrows the time frame to three months.

Pearson Correlation Between ETH/BTC and ETH/NFT Over the Past Three Months

The chart below illustrates the Pearson correlation between these two currency pairs over the past month. In this time window, the correlation between ETH and BTC has been very close to 1 and has remained stable over the past three months. However, even though the correlation between NFTs and ETH was close to 1 at the beginning of this period, since June 13, the correlation between NFTs and ETH has been on a downward trend. Compared to the beginning of the month, NFTs have recently been shifting towards a more unstable correlation. This may be caused by several unique events related to NFTs.

1- Announcements from blue-chip collections and new companies like Yuga Labs

2- NFT NYC

Pearson Correlation Between ETH/BTC and ETH/NFT Over the Past Month

But this is not always the case. As we shorten the time frame to the current bear market, we can see a stronger positive correlation between ETH and NFTs. Over the past week, the market caps of NFTs and ETH have been strongly correlated, indicating that NFTs are more related to the ETH market than during the bull market. The cooling period of NFTSummer has been replaced by the slow-paced expansion of brands through the launch of new series of blue-chip NFTs.

Pearson Correlation Between ETH/BTC and ETH/NFT Over the Past Week

Can NFTs Survive This Downturn?

In recent weeks, the cryptocurrency market has been impacted by the latest macro events. The massive collapse of $LUNA in early May was a precursor to the cryptocurrency downturn, resulting from the aggressive interest rate hikes by the U.S. Federal Reserve.

During the global pandemic, the bull market cycle of the cryptocurrency market has now transitioned into liquidation, with hedge funds losing high-leverage positions and cryptocurrency investors experiencing a sharp decline in the total value of their portfolios.

It is noteworthy that although NFTs, DeFi, and cryptocurrencies have fundamentally different dynamics and value propositions, similar dynamics can also affect the sentiment of the NFT market, just as stocks and cryptocurrencies rise and fall together.

These correlations between ETH and NFTs provide opportunities to discover the lows and highs of the NFT market. However, we observe that sometimes the NFT market is not correlated with ETH, indicating that when speculating on NFTs, they can be viewed as an independent asset class. We also see that the changes in the NFT market over the past period have not been as significant as those in the ETH market, primarily due to the leveraged positions and liquidations in the ETH market increasing buying pressure. Therefore, NFTs still have a long way to go to become a mainstream market.

This bear market may cause some NFTs to disappear, but more NFTs are recovering from the market collapse.

Note: This article is for research purposes only. The views and opinions expressed are solely those of the author and do not necessarily reflect or represent the views and opinions of NFTGo.io. Investing in digital assets (such as NFTs and digital assets) carries risks, and it is essential to consult a financial advisor before making any investment decisions. NFTGo does not provide investment advice and is not responsible for any losses incurred from investing in digital assets.