When Stocks And Bonds Go Down Together

High on the list of the greatest fears among investors is a scenario in which stocks and bonds go down together.

Last week, those fears were realized when the S&P 500 (SPY) suffered its worst week since January 2016, while long-term Treasury bonds (TLT) also declined.

Source Data: Pension Partners, YCharts

This was an unusual occurrence, to say the least. Of the 20 worst weekly S&P 500 declines since July 2002 (inception of the long-duration ETF), last week was only the second time long-duration Treasuries also finished lower.

Treasuries tend act as a safe haven during times of equity market stress, showing positive returns on average during the worst stock market declines. This tendency is amplified on the long end of the curve, as investors are often positioning for weaker economic conditions that coincide with falling interest rates. A precipitous drop in interest rates, of course, is the best friend of duration.

However, there are certain times when the very source of equity market anxiety is a rise in interest rates and potential inflation. During such times, you can see stocks and long bonds fall together. We last saw this briefly in 2013 during the so-called "taper tantrum"...

The taper tantrum would ultimately prove to be short-lived. For the remainder of 2013, while Treasury yields continued to rise, stocks surged higher. The S&P 500 ended up posting its best gains since 1997 (+32%).

In the past few weeks, we've seen stocks and bonds fall together, with a sharper decline in the S&P 500 than 2013.

Is this high correlation between stocks and bonds likely to continue in the months and years to come? Anything is possible, but I have my doubts.

If the equity declines persist, market participants will likely begin expect an easier Federal Reserve (currently, the market is anticipating 3 hikes in 2018). This will cause yields on the short end to fall, providing support to short-term bonds. On the long end, interest rates tend to move in step with growth and inflation. Most persistent equity declines are characterized by falling growth/inflation, and in turn, would suggest lower long-term bond yields.

Since 1928, the S&P 500 and 10-Year Treasury bonds fell in the same calendar year only 3 times (3% of the time), last occurring in 1969.

Source Data: Pension Partners, YCharts, Stern.NYU.edu/~adamodar

Will 2018 be the fourth time? Perhaps, but the odds seem to be against that outcome becoming the norm. Much more common have been years in which stocks and 10-Year Treasuries rose together (59% of the time) and years in which stocks and bonds moved in opposite directions (38% of the time).

After the recent declines in both stocks and bonds, there will be opportunists suggesting this is why diversification "doesn't work." Ignore them at all costs. Making long-term portfolio decisions based on short-term market outcomes is not a recipe for success.

If anything, today's environment calls for more diversification, not less. In general, the worse the reward/risk in an asset class, the less concentration risk you should choose to incur. With interest rates near historic lows and U.S. equity valuations near historic highs, having increased diversification in terms of asset classes, geographies, and strategies would seem to be a prudent idea in the years to come. If we could predict the future, we would know if such diversification would be helpful, unnecessary, or a drag on returns.

But since we don't know what will happen tomorrow, we diversify today.