Let’s start today’s chat with today’s US equity market selloff: actually, it wasn’t all that bad. It only felt jarring because the recent past has been so remarkably quiet. A few statistics/thoughts here:
- The S&P 500 declined 0.82% today.
- We have not had a 1% day (up or down) on the S&P since June 25th, and even with today’s choppy action that streak continues.
- There were no 1% days in all of Q3 2018, only the 6th time since 1958 when any calendar quarter saw such little daily price volatility. We’re well into 2 standard deviation territory here…
Of the 5 other zero 1% day quarters, only one is recent (Q4 2017). The other 4 were in the 1960s. For comparison purposes, the average Q3 has 13 days where the S&P 500 moves +/- 1%.
- Foreign equity markets fared much worse today, with the MSCI Emerging Markets index down 2.5% as of the 4pm New York close and the MSCI EAFE Index down 1.2%. As we have highlighted all this year and repeatedly this week, these are asset classes to avoid just now.
Now, let’s shift our focus from a single day to what matters more: the changing relationship between US bonds and stocks. Today’s price action was a microcosm of how these two asset classes currently interrelate. Lower bond prices meant lower stock prices. A positive correlation.
While that makes sense in the context of the current market narrative, it is important to understand how different it is from the last 2 decades. Some data to consider:
- Through the end of last year, the 20-year historical correlation between total annual returns on the S&P 500 and 10-year US Treasuries was negative 0.66.
- That level of negative long-term correlation is a record back to 1928.
- The major driver of this inverse relationship: two major equity bear markets (2000-2002, 2008) with corresponding bond market rallies.
Since history so deeply colors current investor positioning, this shift from strongly negative correlations to a now-positive relationship is a potential market blind spot. Twenty years of bond gains offsetting stock declines is deeply ingrained in investor psychology. The current environment is essentially brand new, and sharply so.
Two thoughts on this:
- There has only been one year since 1928 when a typical 60/40 portfolio of S&P 500/10-year Treasuries was lower for the year because bond market losses swamped equity gains. This was in 1994, when Treasuries were down 8.0% and stocks posted a 1.3% total return. Net result: a 2.4% decline.
Could 2018 be another such year? Right now, Treasuries are down 8% in 2018, and the S&P is +10%, both on a total return basis. Net result: still +2.8%, but very far from a stock-only portfolio. And it will not take much of a move lower for stocks or higher for yields to push 2018 returns into the red. Even if US stocks remain up on the year.
- In April we published a note advocating for lighter bond allocations (“80/20 is the new 60/40” was our tagline) and we continue to believe in that position. If investors must hold to 60/40 or similar allocations, then shortening duration makes sense.
Not to end on a down note, but we also worry that the correlation reversal outlined here could lead to more equity market volatility in 2019 and beyond if yields continue to rise. We are coming off a 20-year cycle where bonds have been a perfect hedge for stocks even during vicious bear markets. For example:
- From 2000 – 2002, the S&P 500 was down an aggregate 38%. A 60/40 portfolio was only down 10.6%.
- In 2008, the S&P posted a 36.6% negative return. A 60/40 portfolio was only down 13.9%
Without such a hedge – today’s action is a prime example – will investors (retail or institutional) still allocate as much capital to US equities? To our thinking, the answer is “No”.