The link between stocks and bonds: Will history be our guide? -Vanguard

For the first time since October 2016, investors have experienced negative returns over a three-month period in both the domestic stock and bond markets. This outcome is hardly unprecedented, and the losses for both asset groups—less than half a percent—weren’t that significant. But investors may fear that the long-held belief in the inverse relationship between stocks and bonds will not hold up during sudden and extreme volatility.

Taking a historic look at the relationship between stocks and bonds

We looked at the monthly returns for each asset class for the last 30 years (plus Q1 2018) 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 to see how often investors with only U.S. holdings would have opened their month-end statements to see a loss of value in both asset classes.

For those 363 months, the U.S. stock market lost value during a one-month period 126 times¹, while the U.S. bond market lost value 112 times. While investors were almost as likely to see their bonds down in value as their stocks in any given calendar month, the severity of the decline was drastically different between the two asset classes. During this three-decade-plus period, the monthly average when the stock market declined was 3.34%, while for bonds it was only 0.70%.

Simultaneous declines not always associated with market events

Over those 30 years and 3 months, there were 47 occurrences when the U.S. broad stock and bond indexes lost value during the same one-month period, and on 25 occasions over a rolling three-month period. It’s important to note, however, that these simultaneous declines were not isolated to one type of economic event. They occurred:

• During both rising-rate environments (1994, 2004–2006) and falling-rate environments (1989–1992).
• During periods of robust market returns (six times during the late-1990s tech boom²) and economic catastrophe (six times during the global financial crisis³).
• When the U.S. economy was the focal point of panic (three times in 2000, during the “tech wreck”) and when non-U.S. markets were the center of an economic scare (three times in 2015, during concerns about a possible “hard landing” in China).

While the simultaneous short-term declines of stocks and bonds shared little in common with respect to catalysts, one thing they shared was the potential for outperformance afterward. In fact, during this 30-year period, the median return for the 12 months after a simultaneous decline was 12.17% for stocks and 8.18% for bonds.

How may popular hedging strategies hold up in the future?

Using the Vanguard Capital Markets Model® (VCMM),⁴ we analyzed various economic indicators to project how future outcomes can vary for investors. After completing 10,000 possible outcomes for the next ten years, we highlighted the lowest 10% of the quarters where global stocks were the worst-performing for each scenario. We then observed how a number of popular hedging strategies performed during these specific quarters in all 10,000 simulations.

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of March 31, 2018. Results from the model may vary with each use and over time. For more information, please see the important information below.

Employing this forward-looking approach, it appears many of the promoted inflation hedges, such as commodities and REITs, can add additional volatility to the portfolio through unpredictable (and likely positively correlated) returns, while interest rate hedges, such as cash and short-duration strategies, failed to capture the full benefits of diversification during the simulated stock market weakness. The strategies that provided the highest average return—the highest likelihood of positive returns and the greatest upside potential—were high-quality fixed income⁵ of longer duration from U.S. and international issuers.

Discipline and long-term outlook key to client conversations

Of course, no one can say which of the possible paths we’re likely to embark on over the next ten years. While this stock-bond inverse relationship held in a large majority of the observations we examined, there were periods when it didn’t. These periods of simultaneous decline should not lead you to abandon an investment strategy built for the long term, because plenty of reasons remain to believe that the inverse relationship between stocks and higher-quality fixed income should hold for investors over time.

That’s why it is important to have ongoing conversations with your clients about maintaining their discipline and long-term outlook when it comes to navigating volatile markets.

We would like to thank Investment Analysts Hank Lobel and Edoardo Cilla for their contributions to this article and in particular with respect to the Vanguard Capital Markets Model projections.

1 Measured by observing rolling quarterly returns from January 1988 through March 2018; benchmark for U.S.-based stocks was MSCI USA Index; benchmark for U.S.-based fixed income was Bloomberg Barclays U.S. Aggregate Bond Index.

2 Defined as the calendar years 1995–1999.

3 Defined as the period between October 2007 and March 2009.

4 The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. For more information about the model, refer to Aliaga-Diaz et al (2016).

5 While tax-exempt fixed income was not specifically tested in our simulations, we believe their performance would fall between investment-grade credit bonds and U.S. Treasuries of comparable maturities. This is because of slightly higher credit risk associated with state/local government obligations compared with the full faith and credit of the U.S. federal government.

Notes:

• IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
• Summary statistics of 10,000 VCMM simulations are based on respective asset class performance during the worst 10% of global equity performance for each simulation. Projections are as of March 31, 2018, in U.S. dollars before costs. The global equity portfolio is defined as 60% U.S. equity and 40% global ex-U.S. equity. The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard’s Investment Strategy Group. The model forecasts distributions of future returns for a wide array of broad asset classes.
• The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
• The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
• All investments are subject to risk, including the possible loss of the money you invest.
• Investments in bond funds are subject to interest rate, credit, and inflation risk.
• Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
• Foreign investing involves additional risks including currency fluctuations and political uncertainty. These risks are especially high in emerging markets.
• Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
• Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
• Currency hedging risk is the chance that currency hedging transactions may not perfectly offset the fund’s foreign currency exposures and may eliminate any chance for a fund to benefit from favorable fluctuations in relevant currency exchange rates. A fund will incur expenses to hedge its currency exposures.
• Although the income from the U.S. Treasury obligations held in the fund is subject to federal income tax, some or all of that income may be exempt from state and local taxes.