š Ā Charts of the Week 1/12/2025
By Michael Allison, CFA
This week's first Chart shows that of the 27 drawdowns in the S&P 500 of greater than 10% since 1960, over half of them have been attributed to rising interest rates and rest to other factors. This week, we discuss the risk and return relationship between stocks and bonds and offer a middle ground that might provide more durable diversification for investor portfolios.
Understanding Stock-Bond Correlations: Navigating Market Conditions
The second Chart of the Week shows the historical correlation between stocks and bond. These correlations have a significant impact on portfolio performance, especially during periods of market stress. Whether they move together (positive correlation) or in opposite directions (negative correlation) shapes the risk-return dynamics for investors. Letās look at what drives these correlations and how portfolios can be structured to weather varying market conditions.
Negative Correlation: Bonds as the Ultimate Hedge?
Historically, during periods when stocks and bonds are negatively correlated, the returns for stocks have often been negative. These periods are typically marked by economic or financial crises where equities plummet due to heightened uncertainty or recession fears. Bonds, especially U.S. Treasuries, shine in such environments. As investors flee risky assets, they pour into bonds, driving yields down and prices up, resulting in positive bond returns.
However, negative correlation doesnāt always mean stocks are in free fall. There have been periods, such as during steady economic recoveries or disinflationary phases, where both stocks and bonds delivered positive returns despite maintaining their inverse relationship. In such cases, bond returns may come from falling yields as central banks ease monetary policy, while stock returns benefit from improving corporate earnings and low discount rates.
Take the 2008 Global Financial Crisis, for example. Stocks experienced a dramatic drawdown, but bonds provided stability, cushioning the blow for diversified portfolios. This dynamic was seen again in the COVID-19 market collapse in early 2020, where bonds once again acted as a safe haven. Conversely, the post-2008 recovery period saw both asset classes perform well, with bonds riding the tailwind of central bank easing.
Positive Correlation: Trouble in Paradise?
In contrast, periods of positive stock-bond correlation often signal trouble for traditional diversification strategies. Both asset classes can suffer simultaneously, as seen in 2022. Rising inflation and tightening monetary policy forced stocks and bonds to move in lockstep. Stocks sold off due to higher discount rates on future cash flows, while bonds struggled as yields soared (prices fell). Essentially, there was no place to hide.
Still, positive correlation isnāt always bad. In some instances, both stocks and bonds have delivered positive returns during periods of synchronized global growth and stable inflation. For example, during the late 1990s tech boom, both asset classes gained ground, though stocks far outpaced bonds. Positive correlation in this context reflects a "risk-on" sentiment, where investors feel confident taking on risk across the board.
Historically, however, inflationary environmentsālike the 1970s stagflation eraāwere particularly brutal for this dynamic. Rising rates to combat inflation hurt bonds, while stagnant economic growth dragged down equities. For portfolios reliant on the traditional stock-bond balance, these periods underscore the need for alternative solutions.
Hedged Equity: A Middle Ground?
Given shifting correlation dynamics, could a portfolio consisting of 50% stocks, 20% bonds, and 30% hedged equity provide better risk-adjusted returns than the classic 60/40 mix? Evidence suggests it could. Hedged equity strategiesādesigned to limit downside risk while capturing some upsideāserve as a buffer during volatile times. By diversifying across different risk premia, such portfolios aim to reduce drawdowns when both stocks and bonds falter.
Can It Be a āPortfolio for All Seasonsā?
While the 50/20/30 portfolio offers enhanced resilience, calling it a āportfolio for all seasonsā might be a stretch. Why? Market environments are highly unpredictable.
The 50/20/30 mix is more versatile than the 60/40 portfolio in todayās environment of heightened inflation and interest rate uncertainty. However, no single portfolio can perfectly handle every market condition. Adjustments over time based on macroeconomic shifts and valuation changes remain critical.
Key Takeaways
Negative Correlation Periods: Stocks often see negative returns, while bonds serve as a safe haven, delivering positive returns. Occasionally, both can deliver gains in certain recovery periods.
Positive Correlation Periods: Both stocks and bonds can suffer in inflationary environments, though synchronized growth periods may see positive returns for both.
60/40 vs. 50/20/30: The latter can provide better risk-adjusted returns by reducing drawdowns through hedged equity exposure but may underperform the 60/40 mix in prolonged bull markets.
All-Season Portfolio?: While the 50/20/30 mix is robust, no portfolio is immune to all market conditions. Flexibility and periodic rebalancing are essential.
In the end, understanding stock-bond correlations and their drivers is key to constructing resilient portfolios. The traditional 60/40 mix may still work in certain conditions, but adapting to the new market realities with alternative strategies like hedged equity can make a meaningful difference.
Sources:
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