Managing Around a Changing Market

Marc Zabicki (00:00):

We have long held that markets often provide you with new variables that can cause you to think differently about asset allocation and security selection. There has been little doubt that this market has changed dramatically since authorities moved equity pricing from eighths to pennies. And we also believe market dynamics have changed materially since the Great Financial Crisis. It happens a lot. Investment conditions change and you have to adjust. In this latest edition of LPL Street View, we'll take a look at one of those conditions that has indeed changed. That is the recent shift in stock and bond market price correlations. We'll also suggest some remedies investors should consider, as we believe the recent shift couldn't be long lasting.

Marc Zabicki (00:51):

First, let's start with this. What does correlation mean? In statistics correlation refers to the relationship of two variables and indicates how closely those two variables move together. Perfectly positive correlation means that two variables move exactly together, statistically equal to the number one. And perfectly negative correlation, when two variables move in opposite directions results in a reading of minus one. For our purposes, we have calculated the correlation between stock and bond prices, and the average correlation of the last 30 years is 0.09, meaning stock and bond prices over this time are only slightly correlated. And we see from this chart that during some periods, correlations have been materially negative, here shown in red. However, in recent years we have seen the correlation has gravitated toward one as it did in the late 1990s. Why is this important? When stock and bond prices are negatively correlated or only slightly positively correlated, bonds can act as a buffer against volatility and downside price action in stocks, meaning bonds are a good diversifier for your portfolio.

Marc Zabicki (02:11):

When correlations are higher, bonds act as less of a diversifier as stock prices and bond prices may be more likely to move together. In terms of portfolio construction, we would prefer to see stock and bond prices moving with low or negative correlation in order to add optimal diversification to a portfolio. For the last few years, we have indeed not seen that, and we believe this correlation condition could indeed persist for multiple years. So what can you do about the more positive correlation between stocks and bonds? Well, the first thing to do is consider adding another asset class to your portfolio in order to boost the portfolio's diversification properties. Today, we believe considering alternative assets in a portfolio has become more important given the higher correlation between stocks and bonds. But that doesn't mean any alternative asset will do, as some private assets, namely private credit and private equity, have relatively high correlations with public stock and public bond markets.

Marc Zabicki (03:20):

They may provide a wider range of upside opportunities in a portfolio, but they may not be the best choice when aiming for added diversification. So what can you do in a market where stock and bond prices move more closely in unison? First of all, let's be clear, we believe bonds should still act as a diversifier for your portfolio. But to bolster diversification, we believe adding alternative asset strategies, such as market neutral, global macro, and long vol strategies may offer important portfolio construction benefits in a stock and bond world that is constantly changing. Thanks for listening, and as always, allocate wisely.