Issue #59 - "Nowhere to Hide"

In the world of investing, one decision ultimately determines your fate: stocks or bonds?  Also known as asset allocation, studies show that the mix ratio of these two investment products drives more than 90%¹ of portfolio performance. 

One of the primary reasons for mixing these two types of investments is due to the fact that they historically behave differently from one another.  When stocks go up, bonds go down.  When bonds are up, stocks are down. 

For the statistically inclined, this is known as a negative correlation and is tremendously important as a means of diversifying a portfolio, a critical component of the safety of your investments.  This negative correlation is generally caused by the fact that stocks are considered risk ‘on’ assets, while bonds are considered risk ‘off’.  As such, when investors decide to take ‘on’ risk they move into stocks and out of bonds.  The mass selling of bonds causes their prices to drop, while the mass purchase of stocks causes them to rise.  Conversely, during market corrections stocks drop and bonds rise.  Or at least, that is the conventional wisdom according to academics.

However, anyone with market investment experience knows that investing on theory alone is a guaranteed way to lose money.  Given that both stocks and bond markets around the world are posting losses so far this year, it begs the question; are stocks and bonds actually negatively correlated?  If so, how strongly and does this correlation hold up in all economic conditions?

In this month’s issue of Innova Market Insights, we dive into asset allocation and correlation to help explain how our target portfolio is currently positioned and why our strategy has held up so well compared to its peers.

To lend or to mend

In 2013, PIMCO, the world’s largest bond managers, released a comprehensive analysis on the correlation between stocks and bonds.  According to this analysis, the correlation between stocks and bonds has been more positive than negative over the past 90 years..  More worryingly, the study demonstrates that there exists a “greater tendency for the correlation to spike up versus down”. 

A deeper dive into the data shows that economic conditions exert a huge impact on the strength of the correlation.  Of particular interest is that correlation is often negative during market corrections and during periods of falling interest rates.  As we enter a period of rising interest rates during which stocks and bonds become more closely correlated and bonds are expected to lose money, we have to question the merits of having bonds in the portfolio.  As such, if bonds are included in a long-term portfolio to provide diversification via negatively correlated investments, then bonds will not only fail to accomplish that but may also very well lose you money during this period of rising rates. 

The impact of rising rates on investors is discussed at length in Issue #56 – The Impact of Rising Rates on Investors. Currently there isn’t much relief on the horizon, so where should investors turn?

All that glitters is gold?

Gold is often touted as an economic hedge to protect you in tough times or during market crashes.  At least once per year, a client emails me some “investment guru’s” infomercial predicting the next big crash and trying to solicit purchases of their book/stock tips.  Frequently, the recommendation is to hold gold or gold producing stocks…

This example is yet another case in which investment axioms don’t always hold up. In 2008, the price of gold fell 25% during the crash, which is hardly a smooth ride!  My own research dating back to 1970 demonstrates that gold and the Canadian stock market share a 75% positive correlation; so including gold in your portfolio might make you feel good, but it isn’t doing much good to your portfolio. 

Related:  How Gold Performs During a Financial Crash

The road less travelled!

With North American stocks historically overvalued and bonds likely to lose money, it can be difficult for investors to make a buck!  As we have elaborated on a few occasions, we believe that opportunities lie in the roads less travelled: Emerging Markets and Chinese Equities in particular. 

My own research shows that international markets have exhibited some of the lowest correlations to Canadian markets, specifically when the exchange rate is factored in.  The recent (and upcoming) trade war talks have sent prices downwards in Asian markets. We believe this posturing will likely lead to the further liberalisation of the Chinese economy, which is something that we view as a positive for long-term investors in that market.

All combined, we believe there is a good opportunity to pick up long-term positions at a good value.

Of course, these positions are notoriously volatile.  It is not uncommon to see Chinese equity move up or down seven to ten percent per week, so this investment style is certainly not for the faint of heart.  We have attempted to ‘smooth out’ this volatility for clients by complementing the holdings with cash or high interest savings accounts.  In this manner, we are combining 50% cash (risk level 0) and 50% Chinese equity (risk level 10) to meet risk level 5 allocations as a way to diversify the risk of our ‘core’ Canadian and US holdings.

We believe this approach will deliver our clients the best possible return for their desired level of risk, given our market expectations.

We invite you to schedule a meeting in the near term to review whether or not this strategy is right for you.

Related:  Trade War between China & US doesn’t faze this star investor

Sources:

1. “Determinants of Portfolio Performance” BRINSON, HOOD, BEEBOWER.  1986/1995 https://www.cfapubs.org/doi/abs/10.2469/faj.v51.n1.1869
2. "The Stock Bond Correlation"  PIMCO.  http://innovawealth.ca/PDFs/2013.Pimco.Stock-Bond-Correlation-Analysis.pdf