By Randy Swan
The average investor has good reason to be thinking defensively these days. The positive impact of last year’s U.S. tax cuts appears to be fading at a time when global growth is slowing and increased geopolitical friction is rattling the confidence of multinational corporations. Although nobody can accurately pinpoint when the bull market will finally end, warning signs are clearly flashing.
Unfortunately, most investors—including many bracing for the next bear market—appear ill-equipped to defend their portfolios from major losses.
Investment advisors have preached for decades that diversification provides adequate downside protection, and it can be achieved through a portfolio made up of 60% stocks and 40% bonds. This is why equities are viewed as a primary driver of capital appreciation while bonds are considered to be the safe harbor in a storm.
The past, however, is not prologue in our financial markets.
The pervasive cracks in modern portfolio theory have always existed, but they have reappeared in a much more pronounced manner over the past 18 months. In fact, there were several points in 2018 and early 2019 when stocks and bonds fell in unison. While this development runs counter to the negative correlation that has existed between the two asset classes since the late 1990s, it is not an anomaly.
According to research from UBS Asset Management, there have been prolonged periods over the past century when stocks and bonds exhibited a positive correlation. The correlation between the two asset classes was slightly positive at 0.16 from 1931 to 1955. The correlation then reappeared in 1968 before rising to more than 0.35 from 1970 to 1998.
It is equally important to remember that many assets became positively correlated during the global financial crisis, tumbling together when markets fell. Research conducted by my firm actually shows that in 2008, positive correlations exceeded 0.50 between various assets classes such as stocks, high-yield bonds, commodities and public real estate.
The reality is that the risk reduction from allegedly uncorrelated assets has always been theoretical. Risk is not directly and specifically defined by assets; it is merely expressed in historical standards. This means when markets tumble, investors should not bank on a mix of conventional assets—ranging from stocks to bonds to real estate—providing optimal downside protection.
Investors hoping to insulate themselves from catastrophic losses during the next significant downturn need to begin thinking differently about portfolio construction. In today’s environment, pursuing diversification through asset allocation alone is inefficient at best and ineffective at worst.
When assessing the asset correlation conundrum, however, it is also vital to take into account that today’s investing landscape is vastly different than the one that existed when Harry Markowitz invented modern portfolio theory in the 1950s.
Financial markets are now extremely dependent on government-driven, interventionist policies designed to keep securities prices artificially high. This is the case even though governments can only prop up markets for so long through fiscal stimulus, tax cuts and accommodative monetary policies. After a while, interest rates can go no lower and governmental debts can no longer be serviced.
To illustrate how much has changed in just a few decades, consider the ways America’s fiscal mess now undermines the long-held assumption that U.S. government debt is “risk-free.” Yet few investors dare to imagine the value-destructive panic that would ensue if this fiscal mess evolved into a true debt crisis.
This new world order means stocks and bonds may very well fall together—and hard—during the next bear market. If you look at the dire state of many central banks’ balance sheets and the unsustainable levels of government debt across the world, there is very little wiggle room for policymakers to prop up economies or risk assets when recession strikes.
The takeaway for the investing public should be clear: relying on a conventional mix of stocks and bonds is arguably riskier than ever. Preserving irreplaceable capital going forward will necessitate abandoning the status quo. A truly diversified portfolio designed for full market cycles requires a mix of strategies, especially hedging strategies, that are uncorrelated and offer distinct return patterns.
Randy Swan is the founder, chief executive officer and lead portfolio manager of Swan Global Investments, and the author of “Investing Redefined.