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Unexpect The Expected To Uncover Opportunities

Since the financial crisis, the two major asset classes — stocks and government bonds — have shown a wonderful diversification effect. When stocks fell, yields on bonds generally fell (i.e. bond prices rose); as stocks rose, yields on bond rose (i.e. bond prices fell). We expect this inverse correlation relationship between the prices of the two main asset classes to generally hold, and so does the market. Yet as yields plumb to new lows, in many cases negative, it might be time to “un-expect” this and see what lies beyond.

Using the S&P 500 as proxy for the stock market as a whole and the US 10-year yield as proxy for the government bond market, the correlation between returns on stocks and bond yields has been around 0.50. What has been somewhat of a surprise for investors is that despite the diversification effect, both stocks and bonds have delivered significant cumulative positive returns over this period.

S&P 500 and US 10 Year Treasury Yield

So investors got the ultimate free lunch: positive returns on the two major asset classes, with built in diversification as well. Things turned out to be much better than expected. This windfall certainly was not expected back in 2009, and most pundits would have said that either stocks would have gone up or bonds, but not both at the same time, and certainly not by the magnitude they have. It’s been a great time to own financial assets.

Now the most direct explanation of this behavior that has benefited investors across both asset classes (and hurt those who fought the two massive bull markets – in stocks and bonds) of the last decade is that as all rates have been brought down globally by central banks, the effect on the present value of all cash-flows — real or imagined — has been bid up, hence raising asset values across the board.

It was thought that theoretically rates and yields could not, or should not, go negative and this bidding up of asset prices would meet a natural barrier as we got to the zero bound. But yields are negative on over $10 trillion of bonds, and today the 10 year German government bond yield went negative for the firm time in history. The net present value calculation that is fundamental to all asset valuation gets turbocharged as yields go more and more negative.

So in principle if there is no limit to the “negativity” in yields, then there is no limit to how much asset prices can be bid up in a positively correlated manner due to this technical and purely mathematical property of present value calculations (of course ultimately there has to be a limit on how negative yields can get, but we could still be pretty far from it while US yields are still positive).

This raises the question that if the proverbial mattress (where investors would rather park money instead of paying for the privilege of lending) did not exist in ample quantity, could we be looking at another leg up, or should I say “melt-up” in asset prices after another bout of overdue volatility and market correction?

Of course we know that even if this were to happen, it could well turn out to be a short-lived mirage, an act of borrowing from the future value of cash flows through the mechanism of the discount factor. This has been, and continues to be the most hated bond AND equity rally in a long time, and there are ample signals that investors are becoming increasingly sidelined, waiting for better “value”. This is a perfect recipe for an unexpected rally in both risky and riskless assets.

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