Below we look at how bonds no longer protect against stock declines as confirmed by recent market volatility and the much-anticipated short squeeze in the volatility trade; we ask this: is your traditional portfolio safe?
We recently examined (and warned against) the dangers of the standard “risk parity” trade in which portfolios try to offset (or “balance”) their stock risk with a theoretically safer and uncorrelated allocation to bonds.
Many have understandably tried to temper their market fears by making tactical portfolio shifts into bonds. In recent months, over $2T in additional assets have shifted into passive and quant funds who favor such a risk-parity model.
We think that’s a bad idea, because we think today’s bond market isn’t what it used to be…Recent market signs make this lesson clearer.
As volatility in last week’s markets confirmed (and finally reappeared), modern portfolio theory and market reality are two different things.
Stated simply: bonds in today’s credit bubble do not “offset” stock risk, they add to it.
In short, to “balance” credits against equities is akin to balancing grenades against landmines.
Risk Parity or Risk Parody?
We recognize as well that this was not always so. We recognize that stocks and bonds traditionally behave differently and that bonds had once protected investors during stock market sell-offs.
Passively held yet diversified stock and bond portfolios, moreover, were (and still are) the bread and butter of the traditional advisory menu. From the standard RIA model and the advisor down the street to the big bank PWM teams, or the online juggernauts like wealthfront.com and betterment.com: everyone sells the same story.
60/40, 80/20 bond and stock portfolios (which take about 10 minutes to build) have been touted as the safest and best approaches to long-term investing.
This story, which we respect but no longer believe, won’t die easily. Not yet at least…
Furthermore, decades of performance support the traditional bond/stock allocation approach. But as we’ve also said ad nauseum, traditional markets are gone (thanks to central banks here and abroad).
Those who rely on traditional portfolio theory are, we thus contend, investing on borrowed time—though we admit it has been a really good time since 08.
Last week confirmed to investors all around America that if you were $1M in bonds and $1M in stocks, your combined portfolio saw NO offset, just losses. Period.
Bond Protection Vanished—This Happens
Stated simply, bonds were not protecting stocks. Both went down together.
This is not entirely new. We saw this in the 70’s and 80’s—mostly due to inflation. During that period, there were over 20 examples where stocks and bonds simultaneously fell for a period of more than 2 weeks.
In the 1990’s there were only three such examples.
Since 2000, however, we’ve seen no 2-3-week periods where bonds and stocks sold off together. In fact, in 2010, 2011, 2014, 2015 and 2016, when stocks went DOWN, bonds went UP. “Risk off” in stocks meant an allocation to bonds, and hence bond prices went up (and yields went down).
Thus, if you had a balanced, traditional portfolio of bonds and stocks during that period, your gains in bonds helped buffer some of the pains/losses you took in stocks. That was traditional portfolio theory working in practice.
NOT ANY MORE.
A Telling Change in Bond Correlations
Last week was a clear sign of the kink in the bond armor and hence portfolio construction. As we’ve been warning, investors running out of a burning stock market won’t (and didn’t) find safety in an equally burning bond market. In fact, last week’s bond market saw over $1.4T in bond market wealth destruction.
Why this sudden bond market change of character?
As we’ve been warning for a long time, the bond market is grossly distorted after years of low rate manipulation and massive bond purchasing by our rich uncle at the Federal Reserve.
The Global Debt Mania
Furthermore, the global debt bubble is just too big, and investors are starting to realize the credit markets are on thin ice. As we’ve argued so many times: the key word to describe modern markets and economies is undeniably obvious: DEBT.
In the last 10 years, the debt to GDP ratios of the G20 countries has risen from 70% to over 100 to 110% today. Dollar-denominated debt in Emerging Markets (created in the low rate mania between 2007-2017) is in the trillions. Do you think there’s any default, rate or inflation risk there?
Then, of course, there’s our own sovereign debt. The great and more recent budget explosion coming out of DC is just the latest in a string of years of can-kicking and debt-ignorance coming out of the Capital. Last year’s 2018 deficit forecast was $700B; today, we are looking at $1.2-1.5T. Crazy. Just crazy.
America literally lives off debt, not productivity. This is true from Main Street to Wall Street.
Is the Bull Dead? Not Yet…
So, are such debt generalities and last week’s specifics the signs of a “beginning of the end” for the global securities market? Is last week a harbinger of the perfect storm ahead? Is the bull on his knees?
Not yet. The bull never goes down without a fight, and this market has fight left in it. In fact, the steroids the central banks have given this bull make it one of the hardest to predict and kill, but die it eventually shall…
The truth is, we are in uncharted territory. There is simply no precedent for this kind of debt-driven crazy. Can central banks print another $15T of fiat steroids for ten more years, as they have done in the last 10 years?
How long can fantasy replace fundamentals? How long can the media, the pundits and the sell-side keep investor faith alive? Will scared money continue to see US markets as the lesser of all evils? Can the party go on?
As our subscribers know, we look at market signals more than just macro fascinations or central bank profligacy. As ugly as this bull is, we’ve never seen one this “jacked up” on debt rather than productivity, earnings or faith.
What to Watch?
We don’t watch the press or the politicians for market guidance. We are watching the bounces of the future’s curve, resistance line support and myriad other technical and fundamental indicators, and thus despite last week’s carnage (which we and our subscribers at Signals Matter avoided), we don’t smell the iceberg just yet.
What we do smell is wealth burning. Drawdowns like last week were no shock to many of us, but are easily forgotten by most when markets have enjoyed years of artificial “support” from central banks.
Markets are clearly heading toward greater risk, and for many investors, greater uncertainties. There are many making straight-faced cases for a DOW at 45000, while others are equally confident a great recession and drawdown is just around the corner.
To this, we can only say, follow the signals, not the pundits. Become a subscriber and know the difference between risk and uncertainty and invest as much or little, long or short, as your own risk profile makes you comfortable. We understand and signal to all investor types.
P.S.: The Volatility Trade—We Told You So…
Speaking of comfortable…remember those volatility sellers who smugly made fortunes selling the VIX while collecting premiums because they were so sure the VIX (“fear index”) could never go up? You know, guys who thought they were selling flood insurance to ignorant desert dwellers?
Well, last week just goes to show you that smug doesn’t always pay-off and that a big bad market wolf can humble years of performance in a single week.
Last Monday saw the single greatest one-day percentage move in the history of the VIX. Short Volatility ETFs, like Credit Suisse’s VelocityShares Daily Inverse VIX ST ETN (XIV), plunged like the Titanic. And then, like an homage to crazy, the XIV was down 81% after-hours, from where it closed (-15%) during Monday’s trading session.
That, folks, is a warning sign. Years of calm (artificially supported) markets lulled to complacency by central banks acting as one-big-fat bid and “super-hero,” have taken reason and caution out the equation and replaced it will greed.
Derivative jockeys out of Harvard and Wharton who have never lived through a market drawdown having been selling (and leveraging) the VIX to great bonuses. Why? Because they began to believe that markets only go up. Selling vol was a free-lunch to them.
Until the markets reminded them that nothing is free.
By Wednesday, many of these “vol sellers” had to be taken off the field on their shields. Gains that took years to easily amass, were gone in a day. For those who were so levered and smug, we at Signals Matter feel no pity, and neither should you.
Remember, if a trade, euphoria or quick fix seems too good to be true, it is. Stick to your common sense and your signals. By being patient, managing risk and waiting for tops to sell and bottoms to buy, the real wealth and fun is ahead of us, not behind.
In the interim, be careful out there.