May 15, 2003

April was a pretty darn good month for stocks. The S&P500 was up almost 10%, the NASDAQ 9.2%. April was also pretty darn good for bonds. Funds than invest in longer-term bonds were up about 2%. It was even better for high-risk bonds: emerging market bond funds like the Fidelity New Markets Income fund [FNIMX] which is in a couple of our model portfolios was up 6.8%. Junk bonds were up over 5%.

Bonds and Stocks walking arm in arm? Aren’t they supposed to move against one another? 

Lately, bonds and stocks have been moving up together. This has surprised some since bonds and stocks have moved in opposite directions in recent memory. Since the market peak of March 2000 stocks have lost money with some brief run-ups, while bonds have largely made money with some brief pullbacks. In statistical terms, the behavior of stocks and bonds over recent years is called low correlation.

Low correlation means not moving in the same direction at the same time. Investments that move together are highly correlated, or positively correlated. The S&P 500 is highly correlated with the Vanguard Total Market index, since they own almost the same weights in many stocks. The S&P 500 is perfectly correlated with the Vanguard S&P500 fund. The S&P 500 is very correlated to the Dow, as they move together, but not as correlated with the Dow as with the Vanguard total stock market index. The S&P500 is less correlated with a small cap value fund than a large cap growth fund because the S&P 500 index is still fairly heavily weighted in larger cap growth stocks. One of the biggest problems with investors portfolio in the late 90s is they owned a bunch of highly correlated investments. This was great when they all moved up, bad when they fell.

Investments can also be uncorrelated. The temperature in New York City is totally uncorrelated to the S&P500 – the two move completely independent of one another. Uncorrelated is the ideal in investments, but it is very rare. All stocks worldwide are positively correlated – when the market is up sharply in the US, value and growth stocks, small cap and large tend to be up, as will most major sectors like energy, utilities, healthcare, etc. Even foreign stocks will move with the market. This is why an all-stock portfolio is always fairly risky. There is reason for this situation, the world economy tends to move together, earnings tend to be good or not good all around, and investor enthusiasm tends to be a worldwide phenomenon.

Contrary to the recent three years, bonds are usually correlated to stocks, but less so than various stock categories are to each other. In recent years bonds have been negatively correlated to stocks in some cases. Negative correlation with investments is rare. It means when one goes up the other tends to go down and vice-versa. This is different than uncorrelated, which means no positive or negative correlation, just no relation at all, like how much rain falls each day in the Amazon and stock prices. Negative correlation generally happens when you sell an investment short. A fund that shorts the stocks in the S&P500 is perfectly inverse or negatively correlated to the vanguard 500 fund, when one goes up the other goes down in near perfect tandem. This is why the dumbest portfolio in the world owns the Vanguard 500 fund and a fund that shorts those same stocks – you wind up making nothing no matter what happens, but paying fees on both (and much higher fees on the short fund)

One of the main goals of diversification is to put your money in several asset classes that are not highly correlated to one another. Doing so lowers overall portfolio risk because when one investment zigs, the other may zag, or at least zig in a different way. 

The negative correlation of bonds and stocks in recent years has been a boon to the diversified investor who owns both; losses in their stock portfolio have been partially offset by gains in the other. We’ve benefited from this in our model portfolios over the last year.

Famed investor and second-richest American Warrant Buffet coined the term ‘diworsification’ to mean investors half-backed need to own too many investments – adding lots of junk to what would have been a few good choices. If I were as good at picking stocks as Warren Buffet I probably would only own a handful myself. For most people diversification is important. Diworsification has a different meaning for us, it means investments start all moving in synch, removing the risk reduction you get from diversifying. 

The main reason we’ve had such low correlations between asset classes like bonds and stocks, and even certain types of stocks and other types, notably smaller cap value to larger cap growth, is that asset classes were mispriced: bonds were cheap because nobody wanted to own them when stocks were going to the moon. You could get a 6% yield with no default risk in government bonds while stocks paid closer to 1% in yield with lots of risk and valuations that left for little upside. Large cap growth stocks were trading at huge valuation multiples compared to smaller cap value stocks, even adjusting for their relative safety being large and higher growth rates.

The valuation discrepancy has been largely removed from the market, now more or less most assets are properly priced relative to one another. This does not mean one area of the market wont get hot and outperform, only that it doesn’t have to happen to correct a valuation wrong.

These last few weeks may have been the strongest ones for our model portfolios because of this new Diworsification in the market – everything went up. We’d rather see the portfolios take smaller moves, because it just as easily could have been all to the downside. Now we must worry about what will happen if categories that were acting semi-independently, areas like small cap value, REITs, bonds, Junk bonds, foreign small cap stocks, emerging markets, all start moving together. Then investing can get just as dangerous as having an undiversified portfolio.