Bonds are negatively corrected with stocks! Not?
Ok, for all you Art History majors out there. For years, folks thought that bonds were a good compliment to stocks because when one went up the other was likely to go down. Ergo, they were considered negatively correlated. Spread your money between the two and you were diversified.
Apparently, that's no longer the case. For the first time since 2000 stocks and bonds are positively correlated.
Does that mean bonds are bad? That depends. ST (maturities under one year) bonds which carry no interest rate risk (they don't crash in value if interest rates go up) are paying the highest interest rates in decades (almost 6% for CDs). So yes, I have money invested in ST Treasuries.
Do you think I'm going to tell you any more...share my secrets? Suck it.
The Trusted 60-40 Investing Strategy Just Had Its Worst Year in Generations
Higher interest rates and inflation are upending millions of Americans’ retirement planning. Wall Street’s boilerplate mix of stocks and bonds isn’t cutting it anymore.
Correlation of returns for the S&P 500 and long-term Treasury bonds
Chart shows correlation of returns for the S&P 500 and long-term Treasury bonds. The correlation between the two has risen to its highest levels in more than two decades.
Over their 50 years of marriage, Dave and Kathy Lindenstruth adopted a time-honored Wall Street strategy to safeguard and grow their retirement nest egg: a mix of 60% U.S. stocks and 40% bonds known as the 60-40 portfolio. Now, it is failing them.
“There have been some days more recently where I’ve looked at my portfolio and gone ‘oh, crap,’” Dave Lindenstruth said.
Though the Lindenstruths added even more bonds to protect against losing their principal as they aged, their holdings are still down 14% from the highs of late 2021. Higher interest rates are hurting prices of both stocks and bonds these days.
Millions of Americans find themselves in the same situation as the Lindenstruths. For generations, financial advisers touted the 60-40 strategy as the single best way for ordinary people to invest. The idea is simple: owning stocks in good times helps grow your wealth. When stocks have a bad year, bonds typically perform better, cushioning the blow.
Some analysts say the crux of the portfolio’s success—bonds’ tendency to rise when stocks fall—generally happens when inflation and interest rates are relatively low. They argue that expectations for a prolonged period of higher rates and lingering inflation will weigh on both stocks and bonds, fostering a market environment that looks much different than in recent decades.
Wall Street’s biggest asset managers now focus on the pitfalls of what volatile markets can do to an unprepared portfolio in their marketing materials. Financial advisers are fielding an onslaught of calls from their clients to dump stocks and pile into cash—while some advisers are recommending assets not typically sold to individuals like commodities and private asset markets.
The tried-and-true 60-40 portfolio lost 17% last year, its worst performance since at least 1937, according to Leuthold Group analysis. Even with a 14% gain in the S&P 500 helping the strategy recover in 2023, stocks and bonds have moved in tandem, more over the past three years than any time since 1997, Standpoint Asset Management analysis shows.
It is supposed to work as follows: Stocks often fall when the economy slows. Unemployment surges, consumer spending wanes and corporate profits suffer, all hurting shares. Bond prices tend to rise in those circumstances, with investors hiding out in the safety of debt’s fixed payments. The Fed historically cuts interest rates during a recession to spur lending, business activity, and promote job growth. That increases the price of older bonds with higher coupons and lowers their yields—the annual rate an investor can expect to earn if they bought a bond today.
Bond math seems complicated, but when you boil it down, it can be illustrated in fairly simple terms. Companies issue bonds at the market rate—let’s say it is 3%. When the market rate rises to 4%, the 3% bond continues to pay bondholders their regular interest payments, or coupons. But if they want to sell that bond, they will receive only a discounted price that in turn gives the purchaser the market rate—in this case, something like 85 cents on the dollar. A bond with a 3% coupon sold at 75 cents on the dollar would yield something around 4%.
Conversely, an investor who buys a bond at the market rate of 4% and then sees the rate fall to 3% will be sitting on a windfall that can be harvested in a sale. A holder of a 4% bond, now in a 3% market, might fetch well over 100 cents on the dollar—enough to bring their yield down to 3%.
These days, the Federal Reserve has continued raising rates, hurting bond prices and lifting yields. And while stocks and bonds have moved in opposite directions for much of the past 23 years, the three decades prior—when higher interest rates were the norm—saw them often moving in tandem.
“Central banks have come out and said that rates will be higher for longer,” said Dan Villalon, global co-head of portfolio solutions at Greenwich, Conn.-based AQR Capital Management. “The end of that environment is nowhere near.”
Investing in a mix of stocks and bonds is an idea rooted in the bedrock of modern Wall Street, the modern portfolio theory for which the late economist Harry Markowitz won the Nobel Prize in 1990. Among its biggest proponents: Vanguard founder John Bogle, who tended to lean more 50-50, like the Lindenstruths. Bogle’s aim wasn’t maximizing returns, it was allowing investors to sleep at night.
“I spend about half of my time wondering why I have so much in stocks, and about half wondering why I have so little,” Bogle told the Journal in 2015.
While retirees typically want more than a 5% return, many are happy with the pure safety of a 5% return on cash, at least for now. One place investors have been flocking—money-market funds, which mostly invest in ultrashort-term (and ultrasafe) Treasurys, or park cash at the Fed. Investors have been lured by rates above 5% after years of little income, sending assets in those funds to a record $5.7 trillion.
Traders work on the floor of the New York Mercantile Exchange in New York on Sept. 15, 2008, the day investment banking firm Lehman Brothers collapsed—a key moment in the financial crisis that led to the worst recession since the Great Depression in the 1930s. PHOTO: SETH WENIG/ASSOCIATED PRESS
The 60-40 balance has at times garnered great gains for investors.
In 2008, when the housing market crashed, Lehman Brothers collapsed, and Congress bailed out the financial system, bond prices soared as investors raced to park their money in the safety of U.S. Treasurys and the Fed slashed rates. Investors with a 60-40 mix would have beaten those holding just stocks by 23 percentage points, according to Leuthold. The mix also beat holding just stocks in 1917, the year the U.S. entered World War I; 1930, during the Great Depression; and 1974, when soaring energy prices, double-digit inflation and the resignation of Richard Nixon fueled stock declines.
Roger Aliaga-Diaz, chief economist of Americas and global head of portfolio construction at Vanguard, said the 60-40 portfolio tends to deliver 6% annual returns and works particularly well in a recession, despite painful transition periods like last year.
“The problem isn’t higher rates, it is when they are rising rapidly like in 2022,” he said. The central bank hiked rates 11 times since March 2022, the fastest pace in four decades, bringing them to a 22-year high. A gentle climb in Treasury yields can reflect a healthy economy and provide investors with more income. But when rates rise rapidly, it can destabilize markets, giving companies little time to adjust to elevated borrowing costs and spurring investors to rethink the value of stocks.
Periods of anemic economic growth, low inflation, or Fed intervention to stem extreme financial stress have caused stocks and bonds to break from their divergent pattern before.
After the 2008-09 financial crisis, near-zero rates and monetary stimulus from the U.S. government helped keep yields low while bonds and stocks moved in tandem. But those years look like outliers relative to history. Between World War II and the Fed crushing inflation in the early 1980s, which required raising rates to near 20%, investors lost money holding bonds when accounting for inflation. Bonds also tended to rise and fall alongside stocks during that period, meaning they offered less protection if stocks fell.
Now, many feel 2022’s battering of both stocks and bonds could be the start of a protracted slump. Inflation remains nearly double the Fed’s target and the economy is humming, which many expect to presage a prolonged period of higher rates. Government spending has surged since the pandemic, increasing the supply of new Treasury bonds to levels Wall Street isn’t sure it can handle.
And some regular large buyers have stepped back from the market. The Fed is paring the bondholdings it accumulated as part of its economic stimulus efforts. New regulations constrain big banks’ government bond purchases. Japan, America’s largest foreign creditor, earlier this year cut its U.S. bondholdings to the lowest level since 2019.
“If you’re blindly relying on the old regime of 60-40, just be a little careful,” said Michael Hartnett, Bank of America’s chief investment strategist, at Grant’s 2023 investment conference. “This decade today, I don’t think there’s a lot in it.”
So what are the alternatives? Some financial advisers suggest being more deliberate about specific stock-and-bond holdings, even if investors’ overall framework remains similar. That could include choosing money-market funds over bonds, or replacing some part of their S&P 500 allocation with international stocks or shares of smaller companies.
Others recommend looking beyond stocks and bonds altogether to more complex investments, often ones that are riskier and charge higher fees. Real estate has long been a popular option for individuals with some spare cash. Some advisers have suggested adding exposure to commodities or corporate loans.
Wall Street sells exchange-traded and mutual funds with those strategies. But it also offers a vast pool of so-called alternative investments often used by pensions or other institutions: hedge funds, for example, or private equity and credit.
Eric Crittenden, the chief investment officer of Scottsdale, Ariz. asset management firm Standpoint, runs a mutual fund that uses hedge-fund style investing. His all-weather strategy follows macroeconomic market trends using algorithmic models, betting on or against various assets through the derivatives market. The derivatives market allows investors to speculate on the direction of an asset for less upfront cost than buying it whole.
Just because bonds protected portfolios against stock-driven losses for much of this century, doesn’t mean investors can always count on them, according to Crittenden.
“That was goldilocks. It wasn’t normal, it was an anomaly,” he said.
His portfolio is doing what it does right before calamity, he said. It is betting interest rates and the dollar will go higher, expecting energy prices to rise and betting against stocks and bonds. So-called trend-following strategies tend to outperform during tumultuous market environments, like 2022.
Another popular twist is the risk-parity portfolio. The strategy—pioneered by AQR among other firms—tweaks its stock-and-bond holdings based on how volatile each asset has been recently, putting more cash toward whichever one is less erratic. The idea is that the asset that is less volatile is therefore less risky, and should be a better bet going forward. That approach still struggled during last year’s lockstep moves in stocks and bonds.
Villalon’s team at AQR found that traditional stock investments along with alternatives like corporate bonds, private equity and real estate suffer in periods when rates are high. A better alternative is cash-efficient hedge-fund strategies they say, such as those using derivatives to bet on the direction of things like commodity prices or currencies, or ones that wager against stocks.
Derivatives offer a much cheaper way for those funds to bet on the direction of markets, but they need to hold cash in case their bets go awry. With rates near zero, that money sat idle, but now it is earning rates above 5%, providing an extra boost to their returns.
Many hedge-fund strategies have performed unevenly since 2008—Villalon and managers of other funds say their benefits will be starker as markets become more turbulent.
“When inflation is the primary risk driving headlines, stocks and bonds tend to move together,” said Villalon. “The world doesn’t go from crazy to calm overnight, so these trends tend to persist.”
Others say 60-40 is still a good bread-and-butter approach for the average investor—just don’t expect the same stellar returns you may have gotten used to over the past decade or so.
“If anything, higher yields provide better balance to a portfolio and should ballast against stocks,” said Lori Heinel, chief investment officer of State Street Global Advisors, which manages roughly $3.5 trillion as one of the world’s largest asset managers.
For Heinel, 60-40 looked much less attractive a few years ago, but now provides investors with a solid foundation. State Street has begun to lengthen their Treasury holdings into longer-dated bonds to take advantage of falling rates and lock-in high interest payments.
“We don’t think 60-40 is dead,” she said.
Neither do the Lindenstruths.
Their portfolio comprises stocks of large U.S. companies along with shares of some smaller and international firms, and fixed-income assets including bonds, CDs and cash. As rates rose, their advisor helped them build a ladder of bonds that mature at different times. They have continued reinvesting their proceeds at higher rates as some of those bonds have come due.
“We rode out 2007, 2008, and 2011—we just kept investing and it worked out,” Lindenstruth said. “But if our portfolio gets any worse, there’s a point where I’ll get worried.”
Write to Eric Wallerstein at firstname.lastname@example.org