The Relationship Between Stocks and Bonds

In April’s article “What to Make of The Flattening Yield Curve,” we discussed the Federal Reserve’s current rate hike cycle and the impact it was having on the bond market. We then took annual 10-year Treasury Bond data as a proxy for longer-term bonds and evaluated what a “bear market” in bonds looked like. We concluded that a bear market in bonds is nothing like a bear market in stocks. This makes sense as bonds are a much less risky investment than stocks. Ultimately, a bear market in bonds is a short to intermediate period with flat to slightly negative returns.

The three periods we highlighted were 1955-1959, 1967-1969 and 1977-1980. In each of these periods, stocks, as represented by the S&P 500, produced positive returns, more than offsetting any declines in 10-year Treasury Bond returns. However, that does not mean that there were not years where both stocks and bonds produced negative results.

In the first quarter we saw both stocks and bonds post negative returns for the first time since October 2016. A recent Vanguard commentary decided to look further into the relationship between stocks and bonds. Using the MSCI USA Index as a proxy for U.S. stocks and the Bloomberg Barclays U.S. Aggregate Bond Index as a proxy for U.S. bonds, Vanguard evaluated the monthly data for the past thirty years plus the first quarter of 2018.

Over the 363 months, U.S. stocks lost value 126 times and U.S. bonds lost value 112 times. Naturally, the average decline in bonds was much less than stocks – 0.70% versus 3.34%. There were 47 occurrences when U.S. stocks and U.S. bonds declined in the same month and on 25 occasions they both posted negative returns over a three-month period. Fortunately, the median return for the 12 months following a decline in both U.S. stocks and U.S. bonds was 12.17% for stocks and 8.18% for bonds.

Why All the Talk About Bonds?

The brief equity market correction in the first quarter was primarily attributed to concerns about rising interest rates. In general, when interest rates go up stock valuations go down. But as Vanguard points out; that does not mean the next 12 months will necessarily be bad. In fact, both stock and bonds had positive median returns following months with simultaneous declines.

Today we are seeing rising interest rates affect certain parts of the market while others remain unscathed. Below is a table showing the year-to-date returns of some of the major U.S. ETFs.

 

 

 

Illustrated above by AGG, we find that bonds have produced negative returns for the year, while stocks, represented by IVV, have recovered from the first quarter and are now positive for the year. But if we break down the equity markets further, we find some discrepancies. High dividend paying stocks (HDV) are down 3.92% for the year and growth stocks (IVW) are outperforming value stocks (IVE) by 9.47% year-to-date. Ultimately, stocks in growth cycles remain nominally affected by the interest rate environment. May of these companies are technology companies. Technology is now almost 26% of the S&P 500. The average weighting of the technology sector is just below 16% going back to 1990.

Some investors are concerned about the re-emergence of technology within the overall equity markets. It has undoubtedly driven market valuations higher. But unlike the bubble produced in the late 90’s, this time technology companies are profitable. The greater conclusion to draw from this year’s performance is that rising interest rates are creating relative opportunities in dividend paying stocks and value stocks. In fact, per Ned Davis research we have seen the median price/earnings ratio of sectors in the S&P 500 drop from over 26 to under 20. This illustrates that the undercurrent of the market is a lot stronger than the waves on top of the water are showing. If economic trends continue to be positive and inflation remains in check, rising interest rates have repriced much of the stock market to more attractive levels.

As always, I welcome your feedback and questions.

Jeremy Nelson

[1] Vanguard: The link between stocks and bonds: Will history be our guide?

Advisory services offered through Sowell Management Services, a Registered Investment Advisor. The views expressed represent the opinion of Element Wealth. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Element Wealth’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

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