Even street vendors hedge risk.
Walk down the street, in any large city and you’ll see vendors that sell everything from sunglasses to plastic rain ponchos. Most likely, there isn’t a customer on any given day that would buy both items at the same time. That’s the point. When it’s raining, it’s easier to sell rain ponchos but harder to sell sunglasses, and vice versa. By stocking both – and diversifying the product line – the vendor reduces the risk of losing money on any given day.
Of course in modern portfolio theory, asset allocation replaces rain ponchos and sunglasses with stocks and bonds (and cash), to diversify a portfolio and provide a level of reduced risk. For decades, most investors have used some allocation of stocks, bonds and cash to manage the risk-adjusted returns in their portfolios, but over the past years, returns from many traditional asset classes have become highly correlated.
Market Realist – The higher correlation between stocks and bonds is eroding diversification benefits.
For years, bonds (TYD)(SYTL) have been considered the safer component that balanced out the risky stocks in investors’ portfolios. However, what’s rattling them lately is that this traditional relationship is disappearing due to the probable rate hike soon.
The graph above shows the correlation of the S&P 500 Index (SPXL) (LLSP), the long-dated Treasuries (TMF), and the Barclays Total Bond Market Index with one another. It considers weekly returns over the past ten years.
The S&P 500 has a relatively low correlation with the other two. The correlation between the S&P 500 and the long-dated Treasuries is -0.40. The correlation between the S&P 500 and the Barclays Total Bond Market Index is 0.10. The low correlation means that adding bonds to a portfolio containing only stocks is very beneficial.
However, stock and bond investors have been wary of the fact that interest rates will rise. High valuations in both asset classes only add to the problem. This outlook has caused a convergence in their performance. The correlation between the S&P 500 and long-dated Treasuries has risen to -0.20 this year, considering weekly returns. While this correlation is still negative, you can expect it to rise over the coming months. The Fed will likely raise rates by the end of the year.