Correlations Are Rising. Should You Be Worried?
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To investors,
The 60/40 portfolio became the standard portfolio allocation for investors on the premise that these two assets were negatively correlated. When stocks go up, bonds go down. When stocks go down, bonds go up.
But what happens when this correlation breaks down?
The rolling 60-day stock and bond correlation has officially hit the highest level since 1999. The current correlation is approximately 0.7, which has not been seen in the last two and a half decades.
The most obvious reason this is happening is that inflation/supply-side risks have become the dominant market driver in the short term. We have disruptions in the Strait of Hormuz, regional infrastructure has been degraded, and oil prices have surged higher.
These issues create higher inflation expectations. We can’t return to negative correlations until inflation expectations come down. In the meantime, there are four main ramifications to watch for:
Bonds can’t be relied on as a hedge
Market volatility will increase
Downside risk is amplified
The Fed has less options at their disposal
My big takeaway from this situation is that investors are getting hit with a double-whammy. First, they are confused why public equities keep ripping higher as part of the AI trade, which is tempting them to chase momentum and pour more capital into the popular stocks. At the same time, investors are watching bonds, the perceived hedge in their portfolio, lose its ability to protect them against a public market downturn.
Another way to think about it is that bonds are becoming ineffective at the exact moment that investors potentially need them most. Now, if you are like me and believe stocks are going much higher, you may not care about the higher correlation between stocks and bonds.
When everything is going up together, investors are becoming very rich on paper. The returns are intoxicating. People start believing they are a genius. Few people care about hedges, risk, or correlations.
But as we know, there will be a day when those things matter again.
No one knows if it will be days, weeks, months or years. But markets run in cycles. There are good times and bad times. Although I am a believer in innovation, technology, public stocks, and bitcoin, I still acknowledge that portfolio construction, especially non-correlations, are a timeless idea for a reason.
Bonds have been a horrible investment for some time. Equities have been on an incredible tear at the same time. So when both assets start moving in lockstep, that may be the time to pay extra attention.
Hope everyone has a great day. I will talk to you next time.
- Anthony J. Pompliano
Founder & CEO, ProCap Financial (Nasdaq: BRR)
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Worrying. There’s no worrying in investing!