A decoration hangs on a Christmas tree outside the New York Stock Exchange (NYSE) on the last day of trading before Christmas in Manhattan, New York City, on Dec. 23, 2021. Andrew Kelly/Reuters
What do your stocks, house, car, lawnmower, and expensive jewelry all have in common? If things get financially desperate enough, you’ll sell them all. At first thought, one might assume that there is no real correlation between a lawnmower and a car, but in times of serious stress, they all have to go—at the same time! If you think your real estate is worth $500,000, maybe you’ll take $495,000, but what if you have to sell it in a month no matter what? How about a week? How about a day?
The typically recommended portfolio of 60 percent of your assets in equities and 40 percent (60/40 portfolio) in bonds has worked well for a long time. The data supports the idea, bonds have been in a bull market since the early 1980s, and yields have been headed down in kind. Most of the time when stocks go down enough, bonds often go up, and because of this negative correlation, it has made sense to have both in your portfolio; bonds acting as a safe haven from stocks and vice versa.
In 1982, with rates at 15 percent there was a lot of room for bonds to go up (rates down), but now in 2021 with the same rate at 1.4 percent it’s not the same. Rates can’t go down another 13.5 percent, sure rates can go down 1.4 percent to zero, or even negative, but there is no data to support a deeply negative interest rate. Moreover, the Fed is ending its bond purchase program (they are still buying bonds every month but have signaled they will decrease this purchase by $30 billion per month through the beginning of 2022, ending Quantitative Easing).
10-year-note yields have been on a steady decline since President Reagan tasked Fed Chairman Paul Volker with fighting the inflation of the 1970s. Screenshot via TradingView
While none of us know where the stock or bond market will go, most people have some risk exposure to the standard retirement concept of a 60/40 portfolio whether in their 401k, IRA, mutual funds, etc. This has become a fixture of the modern portfolio, but the massive weakness with this plan is that it is predicated on the negative correlation between stocks and bonds—but what happens to a retirement account if this relationship breaks down? What happens is the relationship changes to a positive correlation, stocks and bonds both go down at the same time. Inflation is the main reason rates will go up, but if the Fed were to raise rates to fight inflation it could ruin the economy. Consider a home mortgage where the debt on the property is $1 million, with a 30-year fixed mortgage at 3.5 percent the payment would be around $4,500, but if rates were to go to 8.5 percent the payment would go to a little less than $8,000, and very few Americans could afford this percentage change in their financial obligations. Inflation at the end of 2021 is higher than at any time since the 1980s, arguably higher (note the Boskin Commission).
Since 2005 the SP500 ETF, SPY & the long term bond ETF, TLT…then below in blue, the correlation between SPY and TLT. Numbers between 0 and -1 are a negative correlation and numbers between 0 and +1 are positive correlation. Screenshot via TradingView
Historically, stocks and bonds have had long periods of positive correlation since the 1980s when most portfolios were constructed. The effect of stocks down and bonds down on the Boomer generation would be devastating. So what is the answer? Real Estate? Hedge Funds? Commodities? Gold? Bitcoin? The problem is that all of these can go down if the economy as a whole really starts to struggle, but there is one asset class that will very likely do well if the rest of these struggle; volatility. The concept is simple, if things get messy then asset prices will swing much more violently, and historically volatility has almost always gone up when stocks go down.
True diversification is taking into account not just the current correlations but also how these correlations will change if prices change dramatically in the future. Volatility as an asset class can be an extremely valuable part of a truly diversified portfolio.
The SP500 vs the VIX. The Volatility index, VIX, tends to rise when the stock market goes down. Screenshot via TradingView
Noel Smith
Author
Noel Smith is a Managing Partner and the Chief Investment Officer of Convex Asset Management. As a member of the CME, CBOT and CBOE Noel has over 25 years of experience trading volatility, market making, and managing risk.
