Maybe We Shouldn't Have Drinks: The Power Of Pontification

| About: SPDR Dow (DIA)


Why pontificate and/or wax philosophical about markets?

Because that's how you get at the things that really matter.

Like a shift in a decades old correlation between stock and bonds returns.

I gave up a long time ago on the general public's willingness to develop, hone, and employ critical thinking skills.

There are a number of reasons why people don't like to think critically. They might be intellectually lazy, for instance. Or perhaps they're so wedded to their own ingrained beliefs that objectivity simply isn't possible. Or, in the case of markets, they'd rather read what someone else has to say about the assets they own (which might be a useful exercise if it didn't almost always end with the exaltation of analysis that agrees with their own and the beratement of anyone who happens to disagree) than they would take a few minutes to think about how markets actually work and why, on occasion, things go so horribly wrong.

Personally, I'm not sure why most folks on the Street have jobs. I've been reading sellside notes all day, everyday for years and if there's anything I've learned it's that the more specific an analyst is (i.e. the more explicit someone is about a call, be it on an individual name or on some macro thesis) the more likely it is that you could do just as well flipping a coin and basing your investment decision on the results (see here for instance).

Indeed the only real value add you're going to get comes from what the intellectually lazy disparagingly call "pontificating." It's pontification that leads the likes of Albert Edwards and Matt King to ask the questions that actually matter in the big scheme of things. And yes, when something happens like the bund tantrum of 2015 or the harrowing market collapse that unfolded a little more than four months later following the devaluation of the yuan, these folks are fully justified in taking an "I told you so" victory lap.

Of course instead of focusing on the outsized gains one could have made by listening to those who "pontificate" on what might turn a tail risk into a real-life black swan event (Nassim Nicholas Taleb's fund made $1 billion on the morning of August 24,2015), the naysayers will simply point to the fact that eventually things bounced back. Never mind the fortune you could have made had you spent just a few minutes focused on structural market threats and important trends instead of trying to determine whether Chipotle has some upside now that they've apparently stopped poisoning people.

And so, with that as the backdrop, let's talk a bit more about a trend that's played a critical role in shaping the performance of multi-asset strats. More importantly, let's talk about what happens if that trend reverses.

I've talked quite a bit of late about the correlation between stock (NYSEARCA:SPY) and bond (NYSEARCA:TLT) returns. Why have I spent so much time on this particular subject? Well, because in case you haven't noticed, it looks like we're entering a bond bear market. If that's the case, we really need to discern whether we can continue to depend on a negative correlation between equities and bonds to help buffer the rise in yields.

Here's a look at correlations going back some 50 years:

(Chart: Goldman)

You'll note that the correlation has been generally negative for quite some time. If we take a more granular look, we can see that a sharp repricing of yields tends to push the correlation into positive territory:

(Chart: Goldman)

We haven't seen the same dynamic during the recent sharp selloff in bonds. Why? Because as I explained in a previous piece, rising yields have been accompanied by expectations for higher growth (think Trump's fiscal stimulus). That's allowed equities to rally as rates have sold off.

But what happens if adding fiscal stimulus to an economy that's already short on slack ends up pushing up inflation more than it does growth? Well then it's very possible that stocks might have a more difficult time coping with sharply higher yields thus driving the correlation between equity and bond returns into positive territory.

That's a problem for multi-asset funds as the natural diversification bestowed by negative correlations disappears. It's also a problem for risk parity and vol. targeting strats (something I've discussed on quite a few occasions both here and with traders). If everything is moving in the same direction and that direction is down, there's no such thing as an "all weather" strategy - sorry Ray. Here's Goldman with a bit more in the way of color:

The shift to negative equity/bond return correlations in the late 1990s was one of the most important developments in asset allocation as it has improved diversification of multi-asset funds (both traditional balanced and those focused on absolute returns) and enabled vol target and risk parity strategies to take more risk within equities in recent years. It has also likely contributed to the strong performance and growth of the multi-asset fund industry in the last decade.

Higher equity/bond return correlation could weigh on risk-adjusted returns for more systematic risk parity/ vol target portfolios. After good performance since the crisis, especially risk-adjusted, performance has suffered since the summer (Exhibit 12). As equity volatility was relatively low during the summer, allocations to equity in these portfolios increased across regions (Exhibit 13). Passive multi-asset portfolios have generally done well relative to absolute return funds this year with most assets up, but we do not expect this to be the case going forward. Rather, we expect that bond-equity correlations will be a source of risk for these portfolios, more active risk management will be required to effectively hedge, and "risk free" bonds will now be more a source of risk than of return.

See, this is why I write about the things I write about; the reason I prefer to wax philosophical about markets rather than to pretend I know where shares of XYZ are going to be a year from now.

Here we're talking about the fate of a trend that's effectively underwritten nearly two decades of reliable diversification for multi-asset portfolios.

If you don't find pontificating on that to be worth your time, then you and I probably shouldn't have drinks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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