Stock/Bond Correlations are Upside Down

  • Rising rates occur as business prospects improve. Often the best time to buy stocks is when the economy is recovering from recession, and rates are rising.
  • Today’s bond yields are so low, they could double and still be in the lowest decile of their long term history. Stocks actually have positive correlations when yields are low, and the correlations don’t turn negative until yields rise to around 6%.
  • Investors advised to abandon fear that rising rates pose threat to stock performance.
  • Efficient frontier now shows that bond managers can cut their risk by buying stocks!

DON'T FEAR RISING YIELDS

Few portfolio managers who learned the trade between the 1960s and 1990s seem to have become comfortable with the odd capital market dynamics of the last 15 years, in which the assumed negative correlation between interest rates and stock prices has been stood on its head*. Unfortunately, we don’t know when this anomaly will pass, having found asset class correlations even more difficult to forecast than individual asset classes themselves.

Still, there’s no reason to expect an imminent change in the positive relationship between stock prices and bond yields. Stock investors should abandon the common fear that rising bond yields pose any near-term threat to stocks.

At least 16 significant stock market rallies over the last 60 years have been accompanied by rising Treasury bond yields—with two of them occurring in just the last three years. With today’s 10-year Treasury yield only 7 basis points above a record low, we would be surprised if most intermediate-term stock market rallies of the next several years weren’t accompanied by rising rates.

*A side effect (possibly unwanted) of this change is that it has shone an exceptionally bright light on the timing of tradi- tional asset allocators’ shifts between stocks and bonds. In the absence of superlative timing, the “downside participation” and “R-squared” of almost all asset allocators has suffered compared to earlier eras.

RISING INTEREST RATES DON’T PROHIBIT RISING STOCK PRICES

The Fed has proposed holding a zero interest rate policy into 2014. We doubt they will be able to maintain that stance in the face of a strengthening economy and rising inflation pressures. Once the No- vember election is behind us and the political posturing abates, we would expect to see rates begin to rise. Rates should move up as conditions improve and demand for capital increases. In fact, within the Economic/Interest Rates/Inflation portion of our Major Trend Index, an increase in prevailing interest rates will be viewed as a positive because it would be indicating the economy is decidedly better.

Today, the yield on the ten year Treasury bond is 1.91%, the lowest level seen on our 1926 to date histogram as presented in the BenchMarks publication. As the economy continues to strengthen, rates will ultimately go higher. The bond market is now at the end of its long secular bull market, which saw ten year Treasury bonds fall from a peak yield around 15% in 1982 to the current low level. The next significant move in interest rates WILL be higher.

The following chart and accompanying table on the next page show that indeed it is possible to have a rising stock market in conjunction with rising interest rates. In fact, 32% of all weeks included on the chart were periods when stocks were rising along with interest rates. The chart below tracks the weekly closing price levels of the S&P 500 dating back to 1955, and the yield on the ten year Treasury bond. We identified 12 periods in which interest rates rose in tandem with stocks. These periods are identified by the dashed lines on the chart.

Even during the prolonged 1982 to date secular bond bull market move, there have been cyclical bear markets for bonds, in which interest rates rose. We typically identify five major cyclical bear bond mar- kets during this period (1983-1984, 1987, 1994, 1998-1999, and 2005-mid 2007). Three of these periods also saw stocks rise. In addition, during a mini bear bond market (rates rising in 1996), stocks also moved higher.

CURRENT CONDITIONS

As we have been saying for several months, the economy is improving, and it may well surprise in- vestors just how strong the recovery is. During times of recession, interest rates typically come down as demand for capital tapers out. Rates are then lowered to attract borrowers. With rates low, corporations are lured back and begin borrowing, and spending. The economy starts to improve, as does demand for capital. In response to rising demand, interest rates move up.

Therefore, early in an economic expansion, when business prospects are just getting good, interest rates start to rise. This is often a good time to buy stocks.

The table below highlights the twelve periods dating back to 1955, in which the stock market moved up in conjunction with rising interest rates. This includes the most recent period dating from October 2010 to February 2011, when rates rose 127 basis points (from 2.41% to 3.68%) and the stock market had a 12.5% advance in just four months.

The biggest interest rate rise was dur- ing the period from February 1978 to November 1980 (45 months). Ten year Treasury bond yields rose from 8.04% to 12.80%, a very significant 476 basis point increase. Over this same time frame, the stock market roared to a 60.1% gain.

Prior to the recent 2010-2011 move described above, the shortest previous period occurred from January 1996 to July 1996. During that period, interest rates rose 152 basis points, from 5.54% to 7.06%. Over that time frame, the stock market moved up almost 7%.

The 1957 to date median 10 year T- bond yield is 6.03% (with the 1926 to date median at 4.19%). Assuming the ten year rate rose to the longer term me- dian, it would be a 228 basis point in- crease. Investors today would likely view that as a terrible stock market en- vironment.

However, a look back in time reveals that this type of interest rate increase could well occur as stocks move higher.

WATCH OUT IF BOND YIELDS TRIPLE!

The correlation between stock prices and bond yields has been highly variable over time, but both the level and polarity of the correlation is to some extent dependent on the level of bond yields. This is entirely rational, but often overlooked. Treasury yields rising from a 2% level simply do not present the same competitive return allure as yields rising from an already juicy 8% level.

The table below shows 1962-to-date correlations between stock prices and 10-year Treasury bond yields at each bond yield decile. Aside from the seventh decile (yield levels of 7.07% to 7.68%), the change in correlation is perfectly “monotonic”; i.e., the stock/bond-yield correlation declines (eventually turning negative) as the level of bond yields rises. Today’s 10-year bond yield is so low (at 1.91%) it could double and remain in its bottom decile of the last 50 years. At yield levels this low (i.e., 3.91% or below), the correlation between stocks and bond yields has been positive (and extreme) at +0.43.

Bond bears who are nervous about the impact of rising rates on their stock portfolios should take heart. The correlation “flip” doesn’t occur until rates move into the fifth decile at almost 6%! In other words, over the last 50 years bond yields have not provided a serious competitive threat to equities until they reach yield levels that are precisely three times today’s level (1.91% x 3 = 5.73%, the bottom yield level of the fifth decile). Based on this analysis, we think it might be premature for bond bears to begin dumping their stocks.

APPENDIX: RISK & RETURN ARE NOT WHAT (NOR WHERE) THEY USED TO BE

We’re not fans of the efficient frontier for the simple reason that stock and bond correlations are unstable. Nonetheless, the concept is useful to illustrate what would have been possible in a balanced portfolio after the fact, and can therefore shed light on the time-varying nature of capital market dynamics.

The southwest-to-northeast curve in the diagram below shows the rather conventional risk/return tradeoff existing between the S&P 500 and 10-year Treasury bonds between 1926 and 1996. But—as discussed previously—the period since 1997 has been an anomalous one in which the traditionally negative relationship between stock prices and bond yields has inverted. This period has provided a nearly flat risk/return tradeoff, with stock and bond total returns almost identical for the past 15 years. But the shift in stock/bond correlations has also had the impact of significantly reducing the volatility of a balanced portfolio.

In fact, the negative covariance of returns has been so great that the so-called “bond equivalent risk” portfolio for the past 15 years has actually consisted of 47% stocks and 53% bonds! The risk- reduction available from equities would seem lost on retail investors, judging by year-to-date flows of $120 billion into bond funds and $25 billion out of stock funds. And the implication for professional bond managers? If recent stock/bond correlations persist (and it is only bond managers who seem to believe they will), bond investors can cut their risk by putting up to 47% of their portfolios into stocks! (Perhaps bond managers—not retail stock investors—will power the S&P 500 to new highs!) If recent stock/bond correlations persist (and it is only bond managers who seem to believe they will), bond inves- tors can cut their risk by putting up to 47% of their portfolios into stocks! (Perhaps bond managers - not retail stock investors - will power the S&P 500 to new highs!)

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