What the Alleged ‘Stock-Bond Correlation Regime Change’ Means for Asset Allocation

Is a “generational paradigm shift” in stock-bond correlations underway?^[i] Some say so, arguing Treasury bonds no longer zig when stocks zag, with implications for investors’ asset allocations (the mix of stocks, bonds, cash and other securities they own). But data show this isn’t such a shock and doesn’t mean portfolio construction is forever altered. Let us explain.

While last year was difficult for stock investors, longer-term Treasurys trended similarly lower, unfortunately. And although Treasurys are flat to slightly lower this year as of mid-September, they have climbed alongside stocks at times—especially early this year. To many, this side-by-side movement counteracted long-standing thinking that bonds move against stocks, offsetting volatility—and it is largely the jumping off point for all these theories of a paradigm shift. Pundits now say a new market regime is taking hold—one where bonds no longer “hedge equity risk effectively.”^[ii] Hence, they suggest traditional blended asset allocations designed to cushion short-term volatility may be obsolete.

But let us examine the data using correlations—a measure of how similarly two assets move. In numerical terms, a correlation of 1.00 means the two variables move in lockstep over one-year rolling periods. A 0.00 read means no relationship, and -1.00 means they move in exactly opposite directions. Over the last year, as Exhibit 1 shows, the correlation between weekly stock and bond returns has crept into positive territory, reaching 0.35 this month, meaning they have been zigging and zagging the same way more often than not.

Exhibit 1: Stock-Bond Correlation Regime May Be Shifting?

Source: FactSet, as of 9/18/2023. S&P 500 and ICE BofA 7 – 10-Year US Treasury Index total returns, 1/8/1989 – 9/15/2023.

This is a sharp change from most of the last 20 years, when correlations were mostly negative—hitting -0.75 in 2012, when returns for stocks and bonds frequently diverged. While occasionally popping up into positive territory, their correlation wasn’t very tight in the 2000s and 2010s—never above 0.40. Maybe that seems to support pundits’ take. But consider: In the 1990s, it ranged from 1993’s low of 0.01—little discernable relationship between the two—to a high of 0.72 in 1997. For most of the decade, stocks and bonds more often zigged together than zagged against each other. The ebbing and flowing Exhibit 1 shows should call into question notions of a huge paradigm shift. Indeed, their correlation over the last three decades is -0.11—close to no relationship.

Sometimes stocks and bonds move together—or opposite—but generally speaking, they aren’t related. Which makes sense to us because they have different drivers. Stocks move most on the gap between political and economic expectations—largely how they influence earnings—and reality. Inflation and inflation expectations chiefly drive Treasury returns. No wonder they largely move independently from each other.

But at a higher level, correlation is just one measure of bonds’ effectiveness at cushioning against big stock swings. Another? Their degree of volatility. Exhibit 2 shows stocks’ and bonds’ average annualized returns and standard deviations over 5- and 30-year periods since 1926. Standard deviation represents the degree of fluctuation from average historical returns. So for example, bonds’ 3.9% standard deviation over rolling five-year periods means their annualized total return was usually within plus or minus 3.9 percentage points of their 5.1% average.

Exhibit 2: But Correlations Don’t Matter as Much as Stocks and Bonds’ Relative Volatility

Source: Global Financial Data, as of 12/31/2022. 5- and 30-year rolling returns from 12/31/1925 – 12/31/2022. Equity return based on the S&P 500 Total Return Index. Fixed income return based on Global Financial Data’s USA 10-Year Government Bond Index.

At less than half stocks’ five-year standard deviation, this shows bond returns varied far less over shorter time horizons—regardless of correlation. In other words, even if positively correlated with stocks, bonds still typically reduce short-term volatility—which is the point of blended allocations. That reduced swing helps facilitate cash flows, and it can ease one’s ride through difficult stretches. Even last year, the average daily percentage change (up or down) in bonds was 0.49% while stocks averaged 1.15%.^[iii] This doesn’t mean bonds will always mitigate short-term stock swings—they can be somewhat volatile, too, as we have experienced—but historically, overall and on average, they are likelier to than not.