“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain
The main job of the professional investor is risk management. My opinion on this may not be popular or sexy among those hoping for the elusive grand slam returns, however I believe it is strong risk management that enables clients to remain invested in markets during the inevitable rough patches. Risk management, including portfolio diversification are the counterweights which prevent investors from bailing at the worst possible moments. Over long time horizons, it is time in the market which produces results and unleashes the magic wonders of compounding. You’ve got be in it to win it.
In most cases, investors get paid something for taking risk. It is the duty of the professional to estimate the probability of that future payoff and the corresponding magnitude of the expected gain or loss. If done correctly, investors should achieve positive results over time coupled with an acceptable amount of volatility. As professional investors, we consistently observe both the market environment and the available investing options to make our best judgement, “Is it worth it… is it worth the risk?”
Conventional wisdom holds out that diversification is good because we cannot predict the future. Many investors buy bonds because they believe if stock prices were to decline, bond prices would then increase, and vice versa. But sometimes this is not the case. Sometimes – actually fairly frequently, both stock and bond prices move higher together. With this in mind, I came across a recent Wall Street Journal article by Mark Hulbert, “Stocks and Bonds Are Up at the Same Time. No Worries.”, and felt it conveyed an optimistic message more in line with my current thinking, but contrary to recent market sentiment. Please see below.
Stocks and Bonds Are Up at the Same Time. No Worries.
Conventional wisdom says this is a bearish sign for equities. History says otherwise.
By Mark Hulbert
August 4, 2019
Much ink has been spilled recently about how unusual it is that both stocks and bonds have performed so well this year—and how it’s a bad omen for equities when they do.
In fact, it is neither particularly unusual nor an omen.
It’s easy to see why many are worried, given stocks’ and bonds’ reputation for moving in opposite directions. Stocks typically rise when the economy is firing on all cylinders, but that also puts upward pressure on interest rates, which in turn causes bond prices to decline. And just the opposite is often the case when the economy is weak.
Therefore, so the argument goes, stocks and bonds can’t both keep going up together forever: One of them is living on borrowed time and must eventually fall. And, some argue, since the bond market is substantially larger than the equity market, and less susceptible to irrational exuberance, the smart bet is to believe the story the bond market is telling: The economy is actually weaker than it appears, and stocks will fall back to Earth from their recent highs.
Yet a review of the stock and bond markets over the past century provides little support for this argument. Consider all six-month periods since 1926 in which both the S&P 500 (including dividends) and long-term U.S. Treasurys gained at least as much as they did in the first half of this year. Based on data from Morningstar, there were nine such occasions. (I counted any overlapping periods as just one.)
In the wake of those nine six-month stretches, the stock and bond markets didn’t tumble—in fact, they continued to rise on average.
Over the subsequent 12 months, the dividend-adjusted S&P 500 gained 20.1% on average, about double the historical average. In none of those nine cases, furthermore, was the S&P 500 lower in 12 months’ time. Long-term bonds also performed well over the 12 months following these nine occasions, gaining 13.9% on average.
To be sure, many of those prior cases occurred in the 1980s and 1990s, and current economic and monetary conditions are far different. Still, given the Federal Reserve’s monetary-easing policies of recent years, it would be a mistake to assume that lower interest rates and a rising bond market automatically mean that economic trouble is coming down the pike. On the contrary, stock-market investors have grown to prefer lower rates more than they worry about economic weakness. So, as long as the weakness isn’t too severe, investors will likely keep buying stocks—which means equities may very well continue moving in unison with bonds.
Of course, that kind of correlation isn’t permanent. Long-term investors shouldn’t give up on the bedrock financial-planning principle of diversifying between the two asset classes to reduce risk and volatility.
In fact, the stock-bond correlation has always fluctuated widely when measured over the short term, and the recent high correlation isn’t even close to being a historical record.
Consider the correlation coefficient, which ranges from a maximum of 100%— if stocks and bonds move up and down in lockstep with each other—to a minimum of minus 100% if the two move completely inversely to each other. When calculated on the basis of the trailing five calendar years, the coefficient historically has fluctuated between minus 97% on the low side to plus 98% on the high side. The most recent correlation is “just” 57%.
The lowest correlation coefficients coincide with major stock bear markets. Since 1926, for example, the lowest came at the bottom of the 2007-09 bear market, during which stocks plunged and bonds soared. There is every reason to expect a similarly low coefficient at the next bear-market low. That means that the real value of being diversified between stocks and bonds is realized during a stock bear market.
Unfortunately, there is no way, based on the recent bond-stock correlation, to predict when that next stock bear market will begin. But you’ll be happy you own some bonds when it does.
A final word on markets. I wouldn’t characterize my current view as overly optimistic but rather prudentially cautious. What this means is that client portfolio equity allocations are invested either at, or just below target allocations. I do believe the bull market in U.S. stocks has more to run, however much of the low hanging fruit has been picked, and so it appears future returns will likely be coupled with higher than usual market variability. Over the next 12-24 months, I wouldn’t be surprised if we eventually entered a blow-off top phase, similar to the bull run-up between 1998-2000 as monetary conditions make their way to becoming easier, while popular market sentiment seems biased towards TINA (There Is No Alternative).
With that said, the risks are becoming more apparent having grabbed headlines and seeped into current psychology. The U.S./China trade war isn’t going away and could be with us into the next presidential election, while the global economy is undoubtably slowing. The Fed seems to have made both a policy/communication error during its last meeting (not dovish enough), which has further hurt sentiment and created confusion regarding future monetary policy. Corporate profit growth has decelerated, which essentially means investors who want in, must chose to pay more per share of a company to own a piece of its future earnings. And lastly, Hong Kong is a wild card and is also a big issue of concern. The pro-democracy/anti-Chinese extradition protests are gaining moment and have received much more press lately. From afar, the situation appears more dangerous by the day, with a lot at stake for Hong Kong, China, Taiwan, Asia and really the rest of the world. The world is watching China, and so are we.
Justin Kobe, CFA
Founder, Portfolio Manager & Adviser
Pacificus Capital Management