In 2024, you hedge your stocks with stocks — not bonds

In 2024, diversification isn’t dead. But it’s certainly different from virtually any market environment we’ve seen in the past 30 years.

Harry Markowitz taught the world that diversification is the free lunch in the world of investing: by pooling together many securities, you can create a group that is less volatile than the sum of their individual parts. This helps investors triangulate their ideal mix of risk versus return. 

This approach holds true both within asset classes and between them. 

Owning a variety of blue chip oil stocks, some high-flying tech stocks, and a smattering of consumer-oriented stocks might not make for a very volatile portfolio at the aggregate level because what’s positive for one or two of these groups might be negative for the others (or vice versa). What will drive the overall portfolio volatility is the extent to which these groups move in the same or different directions, not the gyrations of the most wild single security.

Between asset classes, the traditional method of building a diversified portfolio is the 60/40, a mix of stocks and bonds. The simple explanation is that stocks do well when the economy does well: there’s a bit of symbiosis with profits and employment tending to trend in the same direction. And bonds do well when there’s an economic downturn and central banks are aggressively lowering rates to try to reboot activity. Bonds do well enough in the bad times that your downside has been protected — and you have money to invest back into beaten-down stocks when they’re cheaper.

But this is not the type of market environment we’ve been living in.

This year, diversification has not come from owning a mix of stocks and bonds. It has come from owning both “the stock market” and “the stocks in the market.”

Through Tuesday, the 13-week correlation between the weekly returns of the S&P 500 and the S&P 500 equal weight index has plummeted to 26% – its lowest level on record going back to March 1994. On average, this correlation has been 95%!

Meanwhile, the correlation between the weekly returns of the S&P 500 and long-term US Treasury bonds is sitting at 60%, well above the long-term average of -15%.

Bonds are now more positively correlated with the S&P 500 than it is with its individual parts, a phenomenon we have not seen since 1999 as the dot-com bubble raged.

Some interesting implications:

A portfolio that’s a 50/50 blend of the daily returns of the S&P 500 and its equal weight counterpart is up about 5% more than a 50/50 mix of the S&P 500 and longer-term US Treasury bonds. That’s not necessarily too surprising. Stocks should be higher-risk, higher reward.

But what is shocking is that the max drawdown (the biggest drop from an intermediate peak to trough) for the two portfolios is virtually identical – 5.35% for the all-stock version and 5.28% for the stocks plus bonds edition.

It was one thing for the S&P 500, its equal weight edition, and bonds to all be relatively highly positively correlated for much of 2022 and 2023. Elevated inflation was a big threat to bonds because of the Federal Reserve’s series of rate hikes, while the speed and magnitude of those rate cuts raised fears that the US economy would soon suffer a recession.

Now, even after spending a ton of effort unpacking the reasons why the stock market’s internals are so out of whack, I’m still at a loss to explain why this has coincided with a very positive relationship between the S&P 500 and bonds. Especially since the average constituent in the stock market seemingly is more in need of lower rates to bolster their earnings prospects much more than megacap tech, where the AI theme reigns supreme.

But one thing we “know” about markets like these (given that this marks an n=2 over the past 30 years) is that they’re extremely rare, and don’t tend to last for very long.