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Timing The Bond MArket

|Includes:iShares Core Total U.S. Bond Market ETF (AGG), GLD, IEF, TIP

Stock-Bond Correlation

Economic journalism has never inspired what historians refer to as "strict historical impartiality." Financial Analysts are as likely as any editorial page writer to misinterpret or misrepresent, intentionally or not, the past to suit their current view. A good journalist never lets the facts get in the way of a good story just as good analyst never lets past misguided market calls temper current recommendations. The accuracy of predictions is usually inversely related to the enthusiasm and conviction with which they are made. That's why I tend to shy away from making bold predictions. I'd rather look at the numbers and let them speak for themselves. Some analysts have agendas, numbers don't.

The stock-bond correlation, as measured by the mutual relationship between the broad Barclays Aggregate Index (NYSEARCA:AGG) and the S&P 500 (SPY), has ranged between negative .75 and plus .75 during the past 5 years. The latest rolling correlation is about -.1 over that past 12 months. So there is slight negative correlation between the two assets, at least for now. Let's use that number, -.1, as a proxy for broad bond market beta and plug it into a simple CAPM model to estimate the expected return for the all-encompassing bond market.

AGG Expected Return = RFR+ Beta* (ERP), where RFR equals the risk free rate, and ERP equals the equity risk premium. I use 3% and 6% as the long term averages of the RRF and ERP respectively. Here is what we get: AGG expected return = 3% + (-.1)*(6%) or about 2.40%. What's the actual price return of AGG during the past 12 months? 2.14% to be exact. Naturally you get to collect the coupons as well, raising the total return up to close to 4%. The point here is that correlation, when used properly, is a very powerful metric. If you believe that the AGG -SPY correlation will become more negative as the Fed normalizes, then you should expect to bonds to return less than in the recent past, assuming of course that estimates of the ERP remain unchanged.

Let's say that you believe upcoming Fed action will lower the ERP to around 4%, and then the expected price return on AGG will rise to 2.6%, assuming a steady correlation of -.1. Now let's really push out our assumptions and speculate that the future ERP may be -10% and the stock-bond correlation falls to -.5, like back in the 2007-2009 period. Now AGG should return closer to 8% before coupons!

Here is another handy tool. When is it a good time to buy U.S. Treasuries as part of a diversified portfolio? It may seem counterintuitive, but the best time is usually when the correlation with stocks is positive. The iShares Barclays 7-10 Year Treasury ETF (NYSEARCA:IEF) last had positive correlation with SPY in late 2010 and for most of 2013. During those periods, 10y Treasury yields peaked between 3.00% and 3.50%- obviously a good time to buy. When the correlation between IEF and SPY is positive, the US Treasury "flight to quality" and liquidly premium is basically offered for free! Right now, that correlation is about -.35 on a rolling 12 month basis. That means an investor is paying dearly to own U.S. Treasuries. It may be the right trade, but it isn't cheap.

(click to enlarge)Click to enlarge

The Grand Remonstrance

Investors are not known to bear adversity without complaint. Many endure good fortune with an equal measure of protest as well. Recall that back in 1641, a list of grievances was sent by members of the English Parliament to King Charles I. Apparently the manuscript, called the Grand Remonstrance, listed 204 separate complaints against the ruling King. Charles I famously dismissed the document and tried to arrest the leaders of Parliament. Eight years later, Charles I lost his head - literally. Today, we have an equal if not longer list of gripes and complaints against our very own stately and majestic institution - the Federal Reserve. It seems just about every mainstream economist, analyst, high profile and casual investor has a beef with the Fed's policies. The Fed is regularly peppered with unsolicited advice and demands from all quarters, and just like an ancient royal, seems to turn a deaf ear. It's hard to image an institution with a worse public image than the Fed. Hopefully we are blessed with a fresh pair of eyes and hands at the Fed with Ms. Yellen and she can turn the situation around before swords and axes are drawn

In the meantime, serious critics of Fed policy have little choice other than to invest in real assets like SPDR Gold Trust ETF (NYSEARCA:GLD) and iShares Barclays Tips Bond ETF (NYSEARCA:TIP) to protect themselves against a potential catastrophic monetary blunder. However even the famed Roman warrior Mucius Scaevola, who burned off his own right hand to prove his bravery, may balk at buying Gold after reading Executive Order 6102 issued in 1933. The Order, signed into law by FDR, required all U.S. Citizens to deliver all their gold holdings to the Government. Basically, Uncle Sam confiscated its citizen's gold. Could that happen again? Who knows? You can see Mucius thrusting his right hand into the flames in the lower right hand section of the attached image. It's a remarkable visual sketch when you consider just how many investors tend to get burned- not from bravery but from fright.

Conclusion

The stock-bond correlation can provide a meaningful signal about future expected broad bond market returns. Generally, a negative correlation between stocks and bonds may indicate that investors are being charged a premium for owning securities that provide diversification benefits. Such a premium can reduce expected future returns. When the correlation is positive, the diversification benefits of bonds, particularly U.S. Treasuries, are effectively offered for free and hence it is usually god time to buys bonds. Lastly, real assets like Gold and TIPs may not be the panacea you think it is to lean against the Fed. You can easily get burned, just like our Roman friend.

Disclosure: The author is long AGG, TIP, SPY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: written by edward talisse

Stocks: AGG, GLD, IEF, TIP