The best asset allocation since the Financial Crisis was simplicity - the 60/40 stock bond mix. Could this month mark the end of the line for the classic mix? We are getting close and have reached the tipping point. This does not mean that a core stock bond allocation is not a good decision; however, it is now time to look beyond the simple and think about broader diversification and yield choices; nonetheless, this is especially difficult when there is a common shock that increases all correlations. The problem is threefold, rates, credit, and diversification.
On an absolute basis, yield is extraordinarily low across the curve. There is no yield cushion form bonds and bond durations have extended significantly. There is more bond risk with each cut in rates by the Fed.
Additionally, the reach for yield through credit has been reversed with the slowdown in economic growth. There is now a much higher price with holding credit spreads. Credit benchmarks for both investment grade and high yield are down 10% in less than a month.
More importantly, especially with this week, there has been a breakdown in the negative correlation between stocks and bonds. Stocks fell and bond yields actually rose. The core premise of holding the stock bond mix has been the hedge benefit from holding bonds that have also gained in value over the market rally. The link of having bonds as a hedge may be broken. So far this month, some of the other diversification choices have fared worse than the core benchmarks. There have been correlation reversals in the past, but this week is a warning sign that all is not normal.
What is the choice for investors in a rising correlation market? The choice that may be most effective is tactical asset allocation in the form of trend-following. Holding a fixed allocation portfolio expecting normal correlation may be dangerous. Action and adaption in a changing world may be a safer alternative. A trend approach can move to safety and then to risk-taking based on price signals. Care has to be taken given the current high volatility, but active allocation decisions may offer the best protection when relationships of the past do not hold.
Additionally, the reach for yield through credit has been reversed with the slowdown in economic growth. There is now a much higher price with holding credit spreads. Credit benchmarks for both investment grade and high yield are down 10% in less than a month.
More importantly, especially with this week, there has been a breakdown in the negative correlation between stocks and bonds. Stocks fell and bond yields actually rose. The core premise of holding the stock bond mix has been the hedge benefit from holding bonds that have also gained in value over the market rally. The link of having bonds as a hedge may be broken. So far this month, some of the other diversification choices have fared worse than the core benchmarks. There have been correlation reversals in the past, but this week is a warning sign that all is not normal.
What is the choice for investors in a rising correlation market? The choice that may be most effective is tactical asset allocation in the form of trend-following. Holding a fixed allocation portfolio expecting normal correlation may be dangerous. Action and adaption in a changing world may be a safer alternative. A trend approach can move to safety and then to risk-taking based on price signals. Care has to be taken given the current high volatility, but active allocation decisions may offer the best protection when relationships of the past do not hold.
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