Monday, June 8, 2015

Bonds hedge stocks but stocks do not hedge bonds





The normal or traditional view for asset allocation between stocks and bonds is that there is a negative correlation between the two asset classes. Bonds provide a safe hedge against a stock market decline. Unfortunately, the correlation between these two asset classes is not as stable as many think. It can move from deeply negative to positive. The bond hedge does not always work. In fact, holding bonds this quarter has been the risky strategy.

More importantly, there is not symmetry between extreme moves in stocks and bonds and extreme moves in bonds and stocks. Look at two extreme. In the first case, we look at the biggest down quarters for bonds. There is no pattern with stock returns during those periods. With bonds down, stocks could be up or down. In the second case, down stock markets will usually see bond gains. Bonds serve as a hedge during down stock markets, but stocks do not serve as a hedge for down bond markets.

A down bond market is a dangerous situation for any asset allocation.

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