How Something So Simple Became So Complicated

| About: SPDR S&P (SPY)
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Summary

On Tuesday, the Wall Street Journal took a crack at simplifying the most vexing dilemma facing portfolio managers.

It was a valiant effort, but ultimately the Journal discovered how convoluted things have become in the post-crisis world.

Let's take another crack at breaking this down.

Oh look, the Wall Street Journal just ran an article about stock/bond return correlations.

Who would have thought that was a topic worth talking about?

All sarcasm aside, the piece published in the Journal on Tuesday underscores an important point about the correlation discussion. Namely, you can start with the basics - that is, by reminding everyone that really all we're talking about here is the trade-off that makes 60/40 portfolios work - but try as you may, things will eventually get convoluted. There's just no way around it.

I'm starting to become more fascinated with how we talk about correlation than I am with the correlations themselves. It's interesting to me that something so simple and indeed so foundational, has become so distorted by post-crisis monetary policy that it's almost impossible to discuss without prompting at least one comment like the following:

Correlations can be reverse-imaged and then mirrored by quantum systems of Antebelluem PDEs. Static modeling with kinetic PDEs is based on motion-sensitive causality, and can or can not uncover hidden static variables generating inverse correlations, and identify situations where inverse relationships reverse.

That exceedingly amusing bit (from a reader) suggests that this is complicated or that the discussion is best left to mathematicians or rocket scientists. Consider that, and then consider this from the Journal:

Traditionally, government bonds have formed a cornerstone of investment portfolios. The classic asset allocation structure was to invest 60% of a portfolio in equities and 40% in bonds. Equities were supposed to deliver meaty returns, while high-grade debt would act as a buffer-rising in value when fears were high and stock prices fell.

Behold! The disconnect between how investors perceive the cross-asset correlation discussion and what that discussion actually boils down to. Quite the juxtaposition, no?

Ten years ago, everyone understood cross-asset correlations. At least at some base level. Pick up any beginner's guide to mutual funds. Invariably, a 60/40 fund discussion will be in there somewhere. Want the ultimate "set it and forget it" strategy? Put 60% in stocks (for growth) and 40% in bonds (for income) and let it run. When stocks (NYSEARCA:SPY) go down, the bonds (NYSEARCA:TLT) will buffer your losses. Nothing complicated about that, right? Well, that's cross-asset correlation.

So how did this become so convoluted that readers now feel as though cross-asset discussions are best confined to jet propulsion laboratories?

Well, part of the problem is central banks and the distinct possibility that markets will overreact to normalization.

Coordinated easing has catalyzed the years-long rally in risk assets and that raises serious questions about what will happen when the global easing bias disappears.

Now, ideally, the market will view policy normalization as a good thing. You know, "an appropriate response to improving growth prospects and rising inflation" - or whatever. In that case, you get rising bond yields and rising stocks (i.e. a negative stock/bond return correlation or, alternatively, a positive rates/stock correlation).

But, some worry that policy normalization in the US will trigger a crisis in emerging economies that have borrowed heavily in dollars.

There are also legitimate concerns about what a structurally strong dollar will mean for China and its quest to control the pace of the RMB devaluation.

Throw in the fact that the market is conditioned to expect dovish leans from central banks (no matter what they may say about prioritizing normalization), and the stage is set for investors to view rate hikes as risk-off events. In such a scenario, yields would rise (i.e. bonds would sell off) and stocks would fall. That is, the stock/bond return correlation would be positive or, alternatively, the rates/stock correlation would be negative. Summed up visually:

To be sure, this has happened before. But the problem this time around is that years of easy money policies seem to have lowered the threshold beyond which the correlation flips. Prior to the crisis, the tipping point at which higher yields meant lower stocks was around 5% on the 10. Post-crisis, that threshold seems to have fallen to about 3% (if the taper tantrum is any indication).

(Chart: BofAML)

As you can see, something ostensibly simple has been rendered complex by the post-crisis reality.

This complexity also makes it harder to judge how investors should read the following chart:

(Chart: Goldman)

Normally, the return to negative stock/bond return correlations would be a good thing (hence the green shading above).

But in today's environment we can't be sure. As the chart shows, return correlations flipped positive in August/September before snapping back negative when Trump was elected. Generally speaking, that should be a green light for investors to go back to the old tried and true 60/40 strategy - especially in light of the fact that now, Treasuries actually get you some yield. Here's the Journal (my highlights):

Now, with government bonds offering higher returns, some money managers are starting to buy Treasurys and other high-grade debt again as a hedge against market turbulence.

They include Paul O'Connor, who has started to rebuild positions in government bonds in 2017 after several years of largely avoiding using these securities as "shock absorbers" in the cross-asset portfolios he runs.

If 10-year Treasury yields go above 2.75% in the medium term, from about 2.49% on Tuesday, they will lure many more buyers, said Marie Owens Thomsen, chief economist at Indosuez Wealth Management. When yields rose in December, Indosuez was one of the firms that increased its exposure to sovereign debt.

See the problem here? Now that the "turmoil threshold" (if you will) is just 3%, folks like Paul and Marie - assuming they're running balanced funds that include equities - could get burned badly if yields reprice sharply. That is, if we get the paradoxical "risk-off" event catalyzed by the selling of safe havens. Here's the Journal again (my highlights):

But bringing government bonds back into a portfolio may be counterintuitive at a time when these securities are potentially in the line of fire. If inflation picks up in 2017 as many expect, bonds would be among the biggest losers, particularly if the Federal Reserve reacted by quickening its pace of interest-rate increases. Bonds tend to suffer when inflation and rates are on the rise.

Other investors are treading carefully when adding bonds, to ensure their hedge doesn't end up becoming a large loss-maker.

That last bolded passage pretty much encapsulates the dilemma facing money managers. The nightmare, summed up, is this: what if the hedge (bonds) becomes a "large loss-maker" and those large losses are viewed by equity investors as a risk-off event?

So ultimately, if you want to blame someone for turning an ostensibly simple idea into something with multiple embedded contingencies, blame central banks.

Don't shoot the messenger. Even if he is wearing a hat and dark sunglasses.

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.