Sure, why not have an extra day every 4 years? Yesterday stocks moved lower and bond yields fell a few bps. The 4Q GDP showed a 3.2% rate, revised down a tenth. This leap year will feature the all important PCE data, whoa! It will be important until the next important piece of data and on it continues. Government looks to have kicked the shutdown risk out a year.
Fedspeak continued the messaging of 'it's too soon to cut rates' post-FOMC narrative. NY Fed's Williams said:
“While the economy has come a long way toward achieving better balance and reaching our 2 percent inflation goal, we are not there yet.”
“I am committed to fully restoring price stability in the context of a strong economy and labor market.”
“As we navigate the remainder of this journey, I will be focused on the data, the economic outlook, and the risks, in evaluating the appropriate path for monetary policy that best achieves our goals.”
Given we have an extra day, a topic that seems to be coming up frequently of late is that of diversification and more specifically the role of bonds in an investment portfolio. Diversification works best when assets have negative correlations.
I was reminded of this in a
post by Joachim Klement where he discusses how it is possible that the correlations between stocks and bonds is what he calls "regime dependent", depending upon the expectations for GDP growth, inflation and interest rates. In his post he provides:
"But as long as stocks and bonds have a negative correlation, we can at last reduce this higher volatility in a mixed stock/bond portfolio. And bonds have a negative correlation with stocks, don’t they? Don’t they? …please tell me that stocks and bonds have a negative correlation in the long run because that is the foundation of stock/bond portfolios recommended by asset managers and banks everywhere.
Since the 1960s, the correlation between stocks and bonds has been either very low or even negative. This is the time when modern portfolio theory was born and when stock/bond portfolios became the workhorse benchmark against which to assess all other investment approaches.
But before the 1960s, the correlation between stocks and bonds was on average 0.5 to 0.6, much higher than any investor today expects it to be going forward. If the correlation between stocks and bonds is that high, the diversification benefits from investing in stocks and bonds are much smaller as these two asset classes increasingly move in lockstep.
Note that even since the 1960s there have been large swings in the 20-year correlation between the two asset classes. Notably, in the 1970s the correlation increased, before falling again in the 1990s.
Concluding that basically the fundamental premise of asset allocations could be questionable:
Depending on the regime you expect and the assumptions on correlation you make, the allocation to stocks and bonds will be very different going forward. In a world of high correlation between stocks and bonds, the allocation to bonds will likely be smaller, unless you also expect the equity risk premium to be smaller (which again depends on your expectations for growth, inflation, etc.). In a world of negative correlation between stocks and bonds, the allocation to bonds will be higher, unless you expect the equity risk premium to be larger.
Klement's writing reminded me of an article that turned into a book by Seb Page of T. Rowe Price called When Diversification Fails. In the article Page cites research showing the following:
Based on a precrisis data sample ending in February 2008, Chua, Kritzman, and Page (2009) documented significant “undesirable correlation asymmetries” for a broad range of asset classes. Not only did correlations increase on the downside, but they also significantly decreased on the upside. This asymmetry is the opposite of what investors want. Indeed, who wants diversification on the upside? Upside unification (or antidiversification) would be preferable.
Page's article focuses mainly on how diversification fails most notably at times when investors need it most, especially during crashes (i.e. "left-tail events"). His article shows that hedge funds and private assets do little to solve the diversification problem. Ultimately the article provides:
Unexpected changes to the discount rate or inflation expectations can push the stock–bond correlation into positive territory—especially when other conditions remain constant.
"In an apocryphal story, a statistician who had his head in the oven and his feet in the freezer exclaimed, “On average, I feel great!” Similarly, as a measure of diversification, the full-sample correlation is an aver-age of extremes. Conditional correlations reveal that during market crises, diversification across risk assets almost completely disappears. Moreover, diversification seems to work remarkably well when investors do not need it—during market rallies. This undesirable asymmetry is pervasive across markets. Our findings are not new, but we proposed a robust approach to measure left- and right-tail correlations, and we documented the extent of the failure of diversification on a large dataset of asset classes and risk factors. The good news is that tail risk– aware analytics, as well as hedging and dynamic strategies, are now widely available to help investors manage the failure of diversification."
XTOD: I (like most people!) have been skeptical of the 6, 5, or even 4 cuts priced in for the Fed, but now that we are priced to match the DOTS, I think further upside progress in yields will be much more difficult. First test is PCE tomorrow--I could see a scenario where we get 0.5 Core PCE and yields end lower on the day. The market understands that inflation popped in January-- we don't need PCE to tell us that.
I feel that getting to fewer cuts than the DOTS is a lot more strenuous than removing cuts in excess of the DOTS.
XTOD: $BOXX. It's not that simple. Strongly recommend Victor's piece. As a partner at LTCM Victor knows arbitrage and risk from the pointy end. His company ELM is now a leader in tax optimized beta investing. https://t.co/9P8Hql12oi
XTOD: NVIDIA and now BTC going parabolic. Incredible. The Federal GOV really should be taxing me more. Maybe they should start investing in equities to make up for the deficit? Now there’s an idea.
XTOD: More on privates! Agreed. I’ve acknowledged this many times (https://institutionalinvestor.com/article/2bstqfcskz9o72ospzlds/opinion/why-does-private-equity-get-to-play-make-believe-with-prices). My issues remain:
A) Once you say “I’m investing in volatile things but like not being told the truth as it makes it easier to stick with” I would’ve guessed the bubble would have popped and it wouldn’t work anymore. Clearly I’m wrong. Why I’m wrong is another question.
B) Our job (well many of our jobs) is to explain such things to people and to encourage them to do better not to simply accept “hey we do dumb false things as we are weak knee-ed panickers.” Too often the truism you describe is taken too far to become an excuse for not doing the right thing.
C) The very act of accepting this logic (hey volatility laundering is great!) almost definitely lowers future returns on the assets that provide the volatility laundering (you get paid for bearing a bug, you pay for a feature).
https://aqr.com/Insights/Perspectives/The-Illiquidity-Discount
XTOD: Press release: Barclays Bank PLC also served as liquidity facility provider to Blackstone.
Barclays sheds credit risk to private credit firm —> private credit firm needs bank liquidity support, gets it from Barclays. Banks continue to re-tranche themselves.
XTOD: How seriously should we take stats like these on secession? IMO, as seriously as we take intensifying polarization, growing acceptance of political violence, and rising expectations of civil war. More in today's post: https://demographyunplugged.com/p/what-were-following-secession-population
XTOD: “When you go back and study people producing things of real value, using their brain, they were smart, and they were dedicated, and they worked really hard, but they didn’t hustle, and they didn’t work 10-hour days, day after day. They didn’t work all-out, year-round. They didn’t push, push, push until this thing was done. It was a more natural variation. They had less on their plate at the same time, and they glued it all together by obsessing over quality.”
— Cal Newport
https://x.com/donnelly_brent/status/1762871236487471223?s=20
https://x.com/dampedspring/status/1762876919224082445?s=20
https://x.com/point7five/status/1762942716386980245?s=20
https://x.com/CliffordAsness/status/1762852350807466346?s=20
https://x.com/StevenKelly49/status/1762690790604616139?s=20
https://x.com/HoweGeneration/status/1762943410854359164?s=20
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