As more investors fret about the potential of a bear market in the not-too-distant future, interest in defensive strategies has been increasing.
While there are many diversification strategies, and it does not require actual asset allocation (it can be okay to hold more cash in troubled times), we will restrict ourselves to the ones investors tend to think of as defensive and diversifying asset classes:
- Foreign stocks
- 30-Year US Bonds
- 10-Year US Bonds
In today’s research note, we take a look at some of the asset classes that investors have turned to during past downturns (and used for general diversification) in order to see if any offer true protection from a big crash.
Historical Performance in Downturns
If we look at the 10 worst months for the stock market in the 30 years between 1986 and 2016 (using the S&P 500 as proxy), we see that these different asset classes react in different ways:
So we can immediately see some clear divergence between asset classes, which indicates that some may be less useful tools of diversification and crisis mitigation than some might think. Foreign stocks, commodities, and REITs all dropped along with the S&P 500 during its 10 worst months. So that may call into question the notion that foreign stocks really offer good diversification from US-specific market risk.
Perhaps more importantly, these results indicate REITs’ limited ability to hedge the broader stock market due to supposed limited correlation between their respective returns.
Federal bonds, T-bills, and gold all showed positive returns in down months, but none showed particularly impressive returns.
Batting Averages in a Crash
In a 2017 study, Cambria Investments compared the performance of these various asset classes in order to calculate a “batting average” for each in the worst stock market scenarios. A batting average can be thought of as a “hit or miss” measurement, so if the asset class appreciates in value when stocks drop (regardless of the scale of the divergence) then it is a hit, while assets that drop in value when stocks fall would be a miss.
Taking a look at these asset classes’ batting averages, we again find some quite interesting things:
Here again we gain some interesting insights. Again, foreign stocks do very poorly, dropping almost in lockstep with the S&P 500. REITs too have a 0% batting average. Commodities, on the other hand, did comparatively well; while we previously observed that commodities averaged down across the 10 worst stock market months, they were up during 4 of them.
Among the solid performers, gold and 10-year Treasury bonds had the same average return. Gold appreciated in 8 of the 10 worst months. Meanwhile, 10-year bonds appreciated in 6. T-bills are the only asset class with a perfect batting average, which is understandable given everything we know about government bond prices, but the return is quite miniscule.
Broader Batting Averages
We can also look at asset classes’ batting averages in a broader context of stock market performance. Taking the batting average of performance in all months in which the S&P 500 finished red (not just the top 10 worst months), we get a slightly different result:
While these results are not entirely different from those of the worst months, there are a couple indicators worth noting. Most interesting is the behavior of gold. Specifically, while in the 10 worst stock market months, gold was up in 8 of them (80% batting average), it has just a 55% batting average across all down months. In other words, gold does inordinately well in the worst months, but can be a poor hedge in lighter down months.
Also interesting is that foreign stocks and REITs show a bit of life when taking this broader data set. While foreign stocks and REITs share a 0% batting average in the worst months, across all down months for the S&P 500, they have a 25% and 35% batting average, respectively.
Investor’s Eye View
Putting all of this together, we can see that many of these asset classes do not make for good hedges against downturns in stocks.
Foreign stocks are something of a non-starter; capital markets are too interwoven than investing in a broad basket of foreign stocks will offer little to no protection in a downturn in the US stock market.
REITs have long been considered somewhat uncorrelated, but as more REITs enter the major indices, the more correlation emerges. While they may work slightly better in non-crash down months, they are still quite a poor hedge.
Commodities and gold are also not terribly helpful. Gold especially is strange in that it is excellent in a true crisis scenario, but quite mercurial in run of the mill down months. That makes gold a good candidate for a hedge if one expects a true crisis, but not just volatility or soft bear market.
Bonds of all kinds do well, as we might expect. While bonds other than T bills do not have perfect batting averages, they do better than most.
Taken together, investors should be wary when building their diversification strategies. Some of the common wisdom is not played out in the data. Invest with care.
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.