Stock and Bond Correlation

9/6/2016 – Most investors have only a mix of stocks and bonds in their portfolios. This is because stocks and bonds have historically had a negative correlation. Since 2008, the SPDR S&P 500 ETF (SPY) and the iShares 20+ Year Treasury Bond ETF (TLT) has had a negative correlation of -43%. (Bull Oak Capital)

On days when the S&P 500 was down, Treasury bonds were more likely than not to help dampen those negative days. This is the whole point behind diversification. By not having all of your eggs in one basket, you reduce your risk by splitting your money between these two different asset classes. Remember, owning a stock is to own an equity stake in a corporation. To own a bond is to own a debt instrument. They are two completely asset classes that are supposed to behave differently. This behavior provides safety.

Stocks And Bonds Are Pricey

Since 2008, both stocks and bonds have provided impressive returns. In fact, TLT (the long-term Treasury ETF) has posted a more impressive return than SPY (the S&P 500 ETF).

SPY vs TLT Returns

All of this has been accomplished while still maintaining a negative correlation. The problem with the current scenario, though, is that both asset classes are now very expensive. The TTM S&P 500 P/E ratio is 25.29 (www.multpl.com). The 10-yr Treasury currently yields 1.55% and the 30-yr yields 2.24%. Remember, as bond prices go up, bond yields go down. The outlook for both bonds and stocks look bleak at best, at least under the current environment.

The Risk

In my opinion, the 2013 Taper Tantrum is an event that should be on top of every portfolio manager’s mind. During this phenomenon, bond yields spiked as the Federal Reserve reduced the amount of money it was feeding into the economy.  There was also a sharp reversal in the stock and bond correlation.

Correlation

Of course, the Federal Reserve stepped in quickly to quell any pricing concerns. The markets were cheaper back then and forward looking earnings expansions were reasonable.

However, in our current market environment, both stocks and bonds are expensive. The stock market is at its all-time high and the expectation that corporate earnings growth will continue is muted. Treasury yields are at historic lows and they are very sensitive to any type of interest rate movement. Furthermore, the Fed is expected to do very little to help accommodate asset price growth. in fact, they are expected to do the opposite by normalizing interest rates.

If your investment strategy is hinged on the idea that stocks and bonds will remain negatively correlated, despite the circumstances, you should probably rethink your reasoning. A market with rising rates would not help either asset class. A worse-case scenario is one where inflation were to pick-up. Under this situation, both stock and bond prices would be under pressure. The volatility of a standard 60/40 stock/bond portfolio would increase as the correlation of stocks and bonds increase.

That being said, this central bank-induced party may continue for quite some time. The Fed, the ECB, the BOJ, and other global central banks are very powerful entities. They may continue this NIRP/ZIRP policy for another month, another year, or even another 5 years. Who knows. But with both stock and bond prices at all-time highs, the risk/reward ratio is highly unfavorable. If interest rates do rise (Fed induced or not) or if faith in the central banks begin to wane, there is a lot of pain to be had.

The threat of an asymmetrical stock and bond selloff is too great to ignore. I believe it is wise to consider these risks more closely.

 

Ryan Hughes
Bull Oak Capital
Bull Oak Newsletter
9/6/2016


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While the information presented herein is believed to be accurate, Bull Oak Capital LLC (Bull Oak) makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in the document. Bull Oak is under no obligation to notify you of any errors discovered later or of any subsequent changes in opinions. Nothing herein should be construed as a recommendation to buy or sell any of these securities. It should not be assumed that any of the securities, transactions, or holdings discussed will prove to be profitable in the future or that investment recommendations or decisions Bull Oak makes in the future will be profitable or will equal the investment performance of the securities discussed herein. Bull Oak or its employees may have an economic interest in securities mentioned herein.