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.


  1. kharris

    Your intro argues that debt and equity exist in different worlds. Much of your text recognizes that they don’t. Your conclusion argues both ways. The fact is that more than the growth outlook is involved in decisions the value of both stocks and bonds. One market does not have to be working on a different set of assumptions than the other to in order for prices in both markets to rise or fall at the same time. Duration needs, pension legislation, differential impacts of inflation on debt and equity – they can all play a role. Foreign inflows can lift all domestic asset classes, either directly, or as foreign demand for one asset class changes relative value calculations. Changes in monetary policy can mean more or less liquidity than had been expected, having similar impact on both markets.
    Over and over, I see the argument that “stock investors think this, but bond investors think that” as an explanation for both markets heading higher or lower at the same time. To a significant extent, bond investors are stock investors, and vice versa. We need to think harders than “so somebody must be wrong” when stocks and bonds move together.

  2. Jim Picerno

    I agree with you…to a point. Yes, stocks and bonds don’t exist in separate financial and economic vacuums, as per my point about swimming in the same data pool. But the fact that both markets sometime move in the same direction doesn’t necessarily mean that both markets are right. If there’s no significant difference between stocks and bonds, as you seem to suggest, there wouldn’t be much reason for owning both at the same time. But as history shows quite clearly, there is a difference. Stocks and bonds are driven by different forces, which is why diversification makes sense.

  3. Anonymous

    We’re upside down. My point was not that market are always right, or necessarily right at any time. My point was that the assertion that investors in the two markets are thinking different things, so that one group is necessarily wrong, makes little sense. Investors are fallable, individually and as a group. But when stocks and bonds go up or down together, resorting to the notion that investors in each market are distinct and must be thinking different things is not useful.
    In my original response, I didn’t say you were a full-fledged member of the “somebody has to be wrong” camp. I said you veer into that sort of thinking, them back out. From what you wrote – “One market is wrong; one is right” – I think that’s pretty obvious. Not good.

  4. Jim Picerno

    I confess: I do think the stock market is wrong, which is to say that I think the market’s dismissing the potential for the economy to slow further and take a bite out of earnings. Guilty as charged. Then again, I’m not exactly sure that inflation is dead and buried, which raises questions about the appropriate yield on the 10 year. In short, your point is well taken. It’s a fuzzy world out there, and getting fuzzier all the time, at least for some of us.

  5. Abobtrader

    I have commented on your piece and a similar piece in the Economist (Buttonwood column) on a FX trading chat site. Here is my take:
    In my view, there is no great divergence. What is clear is that the market is now significantly less concerned over inflation than it was in the first half of the year. This is an absolute positive for equities.
    While there are question marks over economic growth we need to keep in mind where the we are coming from: it wasn’t so long ago that market players started talking about stagflation (high inflation and low growth). High inflation and low growth is a double negative for for equities. The bond market also treated the scenario as a net negative, perceiving the inflation risk as more than offsetting the downside risk to growth (all things being equal bonds would normally rally on poor growth news). While concerns over growth clearly remain (and may be growing), inflation is the stronger poison to bonds and equities a like, and so as this risk has become more dilute, equities and bonds have both rallied. With reduced probability of excessive continued tightening by the Fed, the market has renewed its appetite for risk, and this could be in part what is being reflected in a lower emerging market bond spreads.
    On the statement that’each asset class is driven by different trends’: I think this statement is questionable. Not only is inflation a major driver of equities and bonds (in the same direction), but moves in the bond market directly influence the equity market (yields are important in determining the present value of equities). On the topic of diversification, it can pay to look at the bigger picture. The chart below is from an old Morgan Stanley publication and highlights that on average the correlation is actually positive. This is what you would expect: lower yields (from higher bond prices) are good for stocks. So in some respects bonds and equities are actually a substitute for one another.
    Why the negative correlation in recent years then? Well, remember that equities first crashed through 2001 and the Fed (in large part in response to this) sent rates tumbling down to 1% by mid-2003. Equities, supported by low interest rates, have smartly recovered as the market has moved away from a ‘deflation’ scenario (in 2003, yields in the bond market plumbed fresh lows) toward a more balanced picture. I believe, the equity crash and policy response is is the exception rather than the rule (either way, we are through that phase now) and that a positive correlation between bonds and equities makes perfect sense going forward.

  6. Jim Picerno

    In response to Abobtrader’s comments, let me state what I believe: yes, inflation impacts all asset classes. That said, it impacts asset classes at different times, in different ways, and in different degrees.
    Ditto for other variables that influence asset class returns and risk.
    If this wasn’t true, there wouldn’t be any point to owning more than one asset class. But as history clearly shows, there is value in owning multiple asset classes over time. I might add as well that the definition of “asset class” needs to be clarified in discussions. I prefer a conservative definition. That is, small cap stocks aren’t an asset class, at least not a materially different one from large cap stocks. Stocks writ large are an asset class; bonds are another one; commodities a third; and so on.
    In some cases this gets blurry and/or confusing. Treasury bonds should be considered a separate asset class from corporate junk bonds, and both are different asset classes from inflation-indexed Treasuries. Why? Because the differences generally outweigh the similarities. The reverse is arguably true when talking about large-cap v. small-cap stocks.
    In any case, let me close by citing a few correlation statistics. The following reflects monthly total returns for four asset classes: stocks (S&P 500), bonds (Lehman Aggregate Bond Index), REITs (DJ Wilshire REIT Index), and commodities (DJ-AIG Index). Here’s the upper and lower band of trailing 36-month correlations for the following combinations going back to March 1986 for stocks, bonds and REITs, and March 1991 for commodities:
    Stocks/commodities: 0.3 down to -0.25
    Stocks/REITs: 0.8 down to 0.0
    Stocks/bonds: 0.6 down to -0.4
    I could go on with more empirical evidence, comparing even more “asset classes,” but for now I’ll leave it here.
    In sum, diversification is alive and well in the various asset classes. Not all the time, not everyday, but in the long run it’s there. The reason is that different asset classes are driven, in the long run, by different variables, inflation being only one.

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