In SMI’s October cover article, The Role of SMI’s Dynamic Asset Allocation Strategy in Light of Current Market Dynamics, we revisited the concern that led to the research/creation of DAA:
By 2012, the handwriting was on the wall regarding the ability of bonds to provide long-term portfolio protection. Radical new policies by the Federal Reserve and other global central banks had shrunk the majority of global government bonds to negative yields, and U.S. interest rates were also hovering at historic lows, barely above zero in the case of most shorter-term government debt.
Given the fixed mathematical relationship between bond yields and prices — prices have to fall as yields rise — there was virtually no long-term upside left in bonds, but there was plenty of room for bond values to decline if/when yields reversed and moved higher, back toward their historic norms.
For 30 years, declining yields had helped bonds provide the safety net investors relied on within traditional stock/bond portfolios. But with that safety net looking tattered, we needed a new approach. The search for an alternative to bonds as a means of protecting our portfolios drove the research that led to DAA.
That was written and released prior to the market’s recent October pullback. In light of that, I found this recap (subscription required) of the recent stock market slide by Barron’s Randall W. Forsyth to be pretty striking:
What roiled the stock market this past week wasn’t the short-term rate targets set by the Fed, but the longer-term yields set by the bond market. Treasury yields, in particular, have been on an upward march the past month for both fundamental and technical reasons. What’s more important is that the interrelationship between the bond and stock markets appears to be undergoing a basic shift.
Quite simply, the Treasury market no longer has the stock market’s back. That represents a “regime change,” in the words of James Bianco, head of Bianco Research in Chicago....
Since around the turn of the century, stocks and bonds have been negatively correlated; in other words, if equities would zig, bonds would usually zag. A drop in stocks and other “risk assets,” such as junk bonds, would raise expectations of lower interest rates, so Treasury securities’ prices would rise....
Like Sherlock Holmes’ dog that didn’t bark, the long end of the Treasury market didn’t see prices rise and yields slip while stocks were in full retreat Wednesday. The Treasury market sent yields down a bit on Thursday, while stocks continued their slide, but that is a far cry from the bond rally that once was automatic when stocks sold off.
That reliable relationship was critical to two popular investing strategies of the past two decades: the venerable 60/40 stock/bond portfolio and so-called risk parity, which leverages lower-volatility bonds to produce returns like riskier stocks.
A shift in the relationship would have major implications, which became apparent in the recent simultaneous backup in bonds and stocks. Billions of dollars in institutional portfolios, from pensions to endowments, are predicated on the recent history that a stake in high-grade bonds like Treasuries would protect them from a downturn in risk assets. It seems as if it’s different this time. (emphasis mine)
To summarize: until this month, the changing relationship between stocks and bonds that we foresaw roughly six years ago — and which led to the creation of DAA — hadn’t really shown up yet. That’s been due to the way global central banks have held interest rates so low for so much longer than anyone anticipated. Now that the Fed is finally taking its foot off and letting yields rise back toward their natural "market" rates, we’re starting to see the splintering of the old stock/bond relationship that was the driving motivation behind DAA when it was introduced in 2013.
There’s no question we anticipated the need for DAA would become acute sooner than has been the case. But the direct factors that spurred DAA’s creation are now showing up as the explanation to the latest stock market pullback in the mainstream investing press. If you’ve been tempted to dismiss the need for DAA, don’t. The market is firing warning shots to alert us to the need for its inclusion in our portfolios. Don’t ignore the warning!
