This is all you need to take away from the article...
> Bond mutual and exchange-traded funds now own 17% of all corporate bonds, up from 9% in 2008, according to the ICI. In periods of market stress, more-concentrated mutual-fund ownership tends to mean larger price drops, the IMF said last year.
It used to be the case that stocks, bonds and other commodities like gold has inverse correlations. Or in other terms, when stocks were down, bonds and gold were up....
This lead to the Efficient Frontier from Markowitz where you would choose a risk level you were comfortable with and then build a portfolio of "uncorrelated assets" to get you optimum return for your risk level.
The issue now a days is that this no longer makes much sense as when things go wrong everything is correlated almost to a degree of 1. Or in other terms, when the shit hits the fan, everything (Gold, stocks and bonds) all go down together.
TL/DR the old advice about investing in both bonds, stocks and gold for diversivication of risk is at best much less pronounced than it used to be and at worst just bad advice as they are now positively correlated.
Is there similar data for longer periods of time? Seems like it be interesting to see that correlation in periods that include some recessions or am I completely off the mark?
Figure 2 illustrates five-year correlations between
monthly U.S. stock and U.S. bond total returns over
five-year intervals since 1926 (17 distinct, nonoverlapping periods). While the long-term average
correlation between these two asset classes has
been 0.25, the figure shows that correlations over
shorter windows vary widely from this average,
with a range of 0.72 for the five years ended 1975
to –0.54 for the five years ended 2005.
Lets not be silly here -- of course not everything ends up with a correlation of exactly 1 during crashes. It is an exaggeration demonstrating a general trend.
In 2008, bonds AND stocks fell because of all-out panic where individuals dumped everything and tried to go into cash. The only thing not falling were US Treasuries since that is where all the capital ended up.
In 2015, we have a different issue -- a lot of the market is controlled by algos which, upon seeing instability, sell and go to cash. This causes a valley for all asset classes except the safe harbours (US Treasuries...maybe gold.)
But the claim was not "everything is correlated almost to a degree of 1". The actual claim was "when things go wrong everything is correlated almost to a degree of 1". Look at the data from 2008, not 2009-2015.
If you look hard enough, you will find specific periods with any values of the correlation. Portfolio is about long-term strategy. That is not to say that I disagree that asset classes became more correlated lately.
Well, my point was that tosseraccount's evidence that the claim was wrong did not in fact apply. I was not actually asserting that the claim was true (though I believe it is), merely that the evidence cited against it was irrelevant because it was the wrong time period.
The quote was about corporate bonds and TLT is a US treasury ETF. I hold TLT in my portfolio as it one of the only ETFs I can find that tends not to move in tandem with absolutely everything else.
> It used to be the case that stocks, bonds and other commodities like gold has inverse correlations
Where are you getting this information, on which the whole comment is based? It has always been very volatile and stocks and bonds have almost never been "uncorrelated assets". They change sign very frequently. Here's a research report from PIMCO [1] that shows the change in sign of the correlation to be 29 times in the past 90-odd years.
I found several resources online confirming OPs statement when I googled "stocks bonds inverse correlation". Also, while only anecdotal, my father had told me that rule as well, and he spent about a decade in the pit trading commodities on the CME in Chicago (hogs, corn, soy, with some t-bills for good measure).
I am sorry, I provided a research report in the link. I think it makes more sense to follow that rather than a person's word who traded commodities, commenting on bonds-stocks correlation for a decade without empirical data.
The bottom line is, there are many periods of time when stocks and bonds are inversely correlated and many times when there is a positive correlation. That's the whole point.
> The bottom line is, there are many periods of time when stocks and bonds are inversely correlated and many times when there is a positive correlation. That's the whole point.
This is a gross simplification. Historically, to the 1930s, stocks and bonds were inversely correlated. Only recently has that behavior not held true (around 2008, according to the very PIMCO paper you cited).
To put it simply, it all comes down to interest rates. The only reason stocks and bonds are no longer inversely correlated (in my opinion) is the Fed's QE efforts. Historically, funds would move between stock and bond asset classes based on market sentiment (stocks when bullish, bonds when bearish).
Now, with an excess of cheap funds available (thanks QE!), both asset classes are being inflated artificially.
>Historically, to the 1930s, stocks and bonds were inversely correlated
Not true. In 1927, the correlation was around 0.18. The correlation was close to 0 in 1928 and it was 0.4 in 1929.
>Only recently has that behavior not held true (around 2008, according to the very PIMCO paper you cited).
Again, not true. From 1965 to 1995, there were only a handful of years when stocks and bonds were negatively correlated. See figure 1 in the research report from PIMCO if you want to find this.
"it all comes down to interest rates" is exactly right. The various markets align themselves around the risk free interest rates. Note that QE has central banks buying bonds so they are pushing yields down and prices up. They do this when they have exhausted their control over the short term interest rates and they're trying to flatten the entire yield curve.
Bonds with higher risk (states, municipal, various corporate) will tend to track the federal bonds with some higher yield due to the higher risk you're taking. The amount of risk you're taking is a function of the state of the economy since in a bad economy e.g. corporations are more likely to default (overall). So one could say that yields going down are indicative of increased risk except they often lag. The phenomena we've seen over the last several years has yields going down while the perception of risk is that the risk is reduced. People considered the risk to be highest during the financial crisis and dropping since. So stocks have sky-rocketed because yields are down and the perception of risk has lowered. At the same time bonds went up because yields are down due to QE and low short term interests (that's just math).
The stock market is a form of a risky investment. While some stocks have a yield directly in the form of dividends others supply it in the form of growth. The price of a stock today vs. some expected price in the future is similar to the yield on bonds. If the risk did not change and bond yields are down one can expect stocks to go up. Now obviously stocks are very much influenced by people guessing how much growth is in there but at the same time given some fixed guess there is a price that correlated to some return %... Stocks are also influenced by volatility as people tend to want to get a better average return if the outcome is very volatile.
So at the end of the day, all investment options "correlate" (negative or positive depends on what you measure) with each other because if there was a single investment that had a better return for the same risk then there would be an arbitrage opportunity. At the same time they respond differently to changes in the perceived risk because the riskier assets are a lot more sensitive to risk (duh)...
EDIT (some more thoughts):
Inflation expectations also influence the relative pricing of bonds and stocks. That's because stock prices will tend to go up with inflation (as corporate revenue will tend to track inflation almost by definition).
The really tricky bit is that the economy as a whole is I think a chaotic system. A butterfly flapping its wings in China can send oil prices down in the US. So it's hard to say something like these things used to correlate and therefore they will always correlate in some non-trivial way. (EDIT: esp. when thinking about things like growth, inflation and even policy which are the core things that move these other assets around)
While investors look for gold and bonds as a response to falling equities, they're actually just trying to find 'safety'. That doesn't tell anything about which asset they'll necessarily choose.
Take the EM crisis we've been experiencing. Yes, everything going downhill, but many EM investors bought USD as a 'response'. If USD has problems, maybe certain commodities go up. It's hard to tell.
> everything (Gold, stocks and bonds) all go down together
That's not possible. At the very least, cash cannot "go down" along with everything else. If everything is down then, by definition, cash is up because you can now buy more of everything with the same amount of cash.
There was a massive loss in wealth across most asset classes during the last crash without any significant price deflation, so I feel like this is empirically not true.
Yes, if you held cash in 2007, you beat the market, but you weren't wealthier than you were the year before.
If you sold everything in 2007 and re-bought in 2009 you're substantially wealthier now than you were in 2007. So in that way, cash appreciated (relative to assets) during the crash of 2008.
During that time period the numbers in your bank account didn't get any bigger. But if that were the sole qualification for "increasing wealth" then the folks constantly worried about deflation are totally wrong!
I was using consumer-goods purchasing power as an estimate of wealth. It is obvious that if you can time the market you can make more than if you can't time the market.
However, until someone seriously suggests keeping a significant fraction of your investment portfolio as cash (preferentially to e.g. bonds) as a hedge against market crashes, I don't think it makes sense to classify cash as an investment instrument.
Keeping a significant fraction of your investment portfolio as cash (it's typically actually very short term T-Bills), to buy up assets during a crash is actually something lots of people do.
Weren't you? You could've bought more houses and companies that you could before. I guess it depends how you define wealth but if I can afford 5 houses and 2 companies one year and then 8 houses and 3 companies next year I would think I am wealthier :)
Through this post and others of yours, I've become a fan of your financial insight. Any recommendations on financial literature that unpacks this further?
So given the huge push towards buying index funds and the general Bogleheads approach, does this just mean Main St. investors are setting themselves up to be trampled again when equities drop if bonds follow suit?
Is there even a good hedge available for Joe Investor and his 401k?
Why isn't the fact that lots of baby boomers are getting older and retiring or getting close to retiring any part of this story?
If bonds are the safer choice for retirement investments (compared to stocks, while cash makes no interest/dividends or gains in value, these are the only 3 choices), then clearly lots of older people who are retiring are going to be buying into bond funds. Hence, huge upswing in bonds held by ETFs and mutual funds, since that's mostly what working-class people have access to through their employers or in their other reduced tax retirement accounts.
As the global economy slows, borrowers will cease to earn enough to service their debts. And the amounts are astronomical: $57T new debt at 17% debt-to-GDP ratios.
Link to McKinsey GI report on "Debt and (not much) deleveraging":
> In the U.S., household, corporate and government debt amounted to 239% of gross domestic product in 2014, the Bank for International Settlements estimates, compared with 218% in 2007.
I am not an economist, but it seems to me that if you're going to write an article suggesting that the bond market is "intimidating," "vulnerable as never before," and "increasingly subject to volatility," you would not want to conflate personal credit card debt, junk bonds, and other private debt instruments with what is widely considered the single safest investment in the world, a bulwark of stability in the wake of the economic crisis of 2008 — U.S. Treasury bonds.
Given the spike (now receding) in the U.S. budget deficit since 2000, it seems likely a big portion of this supposedly alarming bond growth is in Treasuries, no?
The only "bulwark of stability" is cold, hard cash. The US government may not default, but that does not mean you will not lose money. If you bought US bonds at a high price/low yield (like right now :-)) chances are you won;t be able to sell before maturity because the price will go down, and if you hold them to maturity, the inflation will eat the measly return US bonds offer right now.
and if you hold cash, as you mean, the physical asset, it costs you money. (bank vaults arent cheap) so no only does inflation eat away at it, so does the monthly cost.
yes. The constant threat of a big dominating presence of the authorities in the market, causes two-way flows to decline. You cannot rely on your macro skill set anymore to analyze the market direction, as anything you do is subject to policy maker event risk. Therefore faster money (read, speculators), who are the major providers of liquidity, stay away. It doesn't help that banks' risk taking, historically a big source of liquidity too, has been curtailed by regulation, but that is not the only story. It's also about the drunken elephant stomping all over the market known as QE/zero rates policy. So paradoxically, as the stock of bonds is ballooning, the liquidity is shrinking.
It was always the fact of course that the front end of the yield curve had policy event risk in it, but then you also had the shape of the curve which the market could use to intimidate the policy maker (too steep = a signal that the market was unhappy with policy). Today, the Feds have decided not only to guide the short end, but also to put the rest of the curve where they want it, and that's the underlying source of the problem.
Basically, the market is rigged. Nobody likes to bet in a rigged market.
> Bond mutual and exchange-traded funds now own 17% of all corporate bonds, up from 9% in 2008, according to the ICI. In periods of market stress, more-concentrated mutual-fund ownership tends to mean larger price drops, the IMF said last year.
This is way better than 17% of all corp bonds being controlled by hedge funds. Being levered money, HF selling would be way more disruptive to the marketplace than mutual fund selling.
Some people don't seem to understand that there is a ceiling on macro economic debt financing as a driver of economic growth. Once someone or some company has pulled forward all their future consumption and earnings with zirp-level interest bond issuances, credit cards and mortgage notes, there's not much more they (or the economy) can do.
Do you own a house, car, or anything else with a note on it? Do you work for a company or government entity that has to finance projects? The value,loans, bonds, and other debt instruments add is absolutely massive.
You are talking about credit - financing infrastructure, tooling, other investments. Yes, the value is definitely there.
The problem is, most of the recent "innovations" do not add any value to the economy. What value did Credit Default Swaps (CDS) ever bring to the economy? How does high-frequency trading (HFT) benefit the society?
You're right in that some instruments don't really add value. They're a bet.
Credit default swaps for mortgages didn't even exist really until some smart speculators noticed that the bond market for mortgages was unstable (and full of deceit) and only needed a bit of default to create a cascading waterfall of default which nearly took down the entire financial system.
Honestly, CDR's were a good idea but it made no sense for the same banks to sell them that were also baking the mortgages. It would be like selling insurance on your own car. If you crash you are out a car and have to pay someone else! It would have made sense for banks to hedge their mortgages by buying CDR's from other investors. But then, that would have affected their bottom lines and they just plain got greedy.
HFT is debatable as many claim it creates liquidity. I'm not sure I buy that but I also wouldn't confuse HFT with financial instruments.
For instance, packaging mortgages into rated bonds of various risk tranches in the 1970's was a brilliant innovation which enable more people to qualify for loans as their risk was distributed and sliced up among many parties. Of course, that system broke down after being abused - but the initial concept still survives and is remarkable.
Other instruments like derivatives allow for affordable hedges, the ability to buy and sell at a future price you want or collect premium on that offer. They aren't just for speculators.
Genuine capitalism doesn't have a government controlling money supply, which is behind your 'exponential growth'. Instead of growing an economy, the truest capitalist is focused on freeing an economy
If you wanna name the socialistic Keynesian experience 'Capitalism', that's your call. I can't do it.
You don't use words the same way everyone else does. The most charitable thing I could say is that your take on Keynesian economic policy and 'genuine capitalism' is heterodox and stems from a non-mainstream ideology. There is no serious economist who would call Keynes a socialist, or socialistic, whatever that means, and the definition of capitalism does not proscribe government control of the money supply.
Here's an example: If you have a theoretical country that uses an average of 1MW of electricity, and it grows by 5% per year, that's exponential growth. If its usage grows by 50kW per year, then that would be linear growth (one type of polynomial growth). Note that in the first year of this, they both grow by 50kW of usage, but they rapidly diverge:
The difference is that 70 years later, the former will be require about 29MW while the latter will require about 4.5MW
Your comment was meant to be witty, but is actually just uninformed. Exponential growth is a well-defined mathematical concept [0] and distinct from other formulas of growth. And, to specifically address your comment, the exponent in exponential growth is time, so no you cannot just dismiss it as being "some exponent".
I truly do not understand your argument. First, nothing in my comment alludes to physics, except for maybe the involvement of time, which I can assure you is very much a concept in financial economics.
Second, financial economics is in no way unfamiliar with exponential growth. For instance, the compounding interest formula:
The formula implies constant wage, not wage growth. But it can model growth in savings. An example: I save $200 per week. I have $800 saved already. How much will I have saved in 3 weeks?
> Bond mutual and exchange-traded funds now own 17% of all corporate bonds, up from 9% in 2008, according to the ICI. In periods of market stress, more-concentrated mutual-fund ownership tends to mean larger price drops, the IMF said last year.
It used to be the case that stocks, bonds and other commodities like gold has inverse correlations. Or in other terms, when stocks were down, bonds and gold were up....
This lead to the Efficient Frontier from Markowitz where you would choose a risk level you were comfortable with and then build a portfolio of "uncorrelated assets" to get you optimum return for your risk level.
http://www.investopedia.com/terms/e/efficientfrontier.asp
The issue now a days is that this no longer makes much sense as when things go wrong everything is correlated almost to a degree of 1. Or in other terms, when the shit hits the fan, everything (Gold, stocks and bonds) all go down together.
TL/DR the old advice about investing in both bonds, stocks and gold for diversivication of risk is at best much less pronounced than it used to be and at worst just bad advice as they are now positively correlated.