Edward Quince’s Wisdom Bites - The Perils of a Single Story: What Happens When Bonds and Stocks Bet the Same Way

For decades, investors have relied on a simple rule: when stocks zig, bonds zag. But what happens when that rule breaks? A deeper look reveals that the relationship between stocks and bonds is not a law of nature, but a "regime dependent" phenomenon that can flip, leaving unprepared investors exposed.

For much of the modern era, particularly since the 1960s, the correlation between stocks and bonds has been low or negative. This relationship is the bedrock of traditional portfolio construction, like the 60/40 portfolio. In a typical downturn, fear sends investors fleeing from stocks into the safe haven of bonds, pushing their prices in opposite directions.

However, this wasn't always the case. Before the 1960s, the correlation was often positive, meaning stocks and bonds moved in lockstep. This positive correlation can reappear during periods of high and volatile inflation, like the 1970s. When inflation is the primary driver of market anxiety, it becomes bad for both stocks (which face higher discount rates and input costs) and bonds (whose fixed payments are eroded).

This dynamic creates a significant challenge for investors. Research shows that diversification often fails precisely when it's needed most—during market crises. Correlations tend to increase significantly on the downside, meaning various risk assets all fall together, while decreasing on the upside—the opposite of what an investor would want.

The Takeaway: Don't take diversification for granted. Recognize that the stock-bond relationship is not static. The economic "regime"—whether it's defined by growth shocks, inflation shocks, or something else—matters immensely. An unexpected change in inflation expectations can push the stock-bond correlation into positive territory, undermining traditional hedging strategies. This insight calls for a more dynamic and humble approach to risk management, one that acknowledges the "full-sample correlation is an average of extremes" and prepares for a world where your safe haven might not be so safe after all.