The stock market has been shrugging off recent signs of weakness in the economy and the bond market has been embracing the trend. One market is wrong; one is right. We have a suspicion about which is which, but then again if we really knew what was going to happen we’d sell everything, leverage our portfolio to the sky, and put it all on the winning asset class. Alas, we’re not quite sure what’s lurking around the corner, and so concentrated bets in a single asset class remain the stuff of dreams in a world where limited knowledge and surprise prevails.
Diversification, in other words, is the only game in town for mere mortals with imperfect insight into the future. But as compelling as multi-asset class investing is, sometimes it’s perplexing, and now is one of those times.
Both stocks and bonds have been running higher. Both markets have access to the same data, and both are drawing different conclusions.
Let’s start with the bond market, where the benchmark 10-year Treasury yield has dipped below 4.6% for the first time since February. In fact, the 10-year yield has been on a slippery slope for since July, when a 5.2% current yield prevailed early in the month. The catalyst for the decline is, of course, the ongoing stream of economic reports that show the economy is slowing. (The latest is this morning’s update on new orders for durable goods, which tumbled for the second straight month in August–the first back-to-back tumble in more than two years.)
The stock market swims in the same data pool as the bond market and yet equities have run higher in recent weeks. In fact, yesterday’s jump in equities brought the S&P 500 to its highest level in more than five years.
The fact that bonds and stocks are moving in the same direction may be frustrating for strategic investors looking for more independence from the two major asset classes. In fact, correlations go through cycles. As the chart below illustrates, correlations between the S&P 500 and the Lehman Brothers Aggregate Bond index have been rising since bottoming out in 2003 and 2004. Even so, measuring correlation by trailing 36-month periods shows that the diversification kick born of holding stocks and bonds is battered but far from dead. For the three years through last month, equities and fixed income still had a slightly negative correlation. (For the chart, 1.0 is perfect correlation, 0.0 is no correlation, and -1.0 is perfect negative correlation for performance.)

There’s a fundamental reason why owning both stocks and bonds has served as the foundation for a diversified portfolio over time: each asset class is driven by different trends. Sometimes those trends converge, in which case equities and fixed income march together. But such symmetry never lasts, and over time tends to be the exception. As such, we see the future bringing more asymmetry into the relationship between stocks and bonds. The only question is which asset class will blink first? We can afford to remain agnostic on the answer in part because we own some of each asset class. Diversification has its rewards, even if they’re not always obvious in the short run.