Why Stocks and Bonds Aren’t Inversely Correlated
Most investors would agree with the view that stocks and bonds are inversely correlated. The reason we hold both in our portfolios is that we expect on to be going down while the other is going up. In some cases this is true. For example there are times where we can clearly see investors selling off stocks at any price, causing those to go down, and buying up bonds with insulting yields, causing those prices to go up.
However we can’t always expect this to happen. Other than investors trading back and forth, stocks and bonds can be driven by different factors and may go in the same direction at the same time. One simple example is falling interest rates. If interest rates go down, bond prices must go up. But stock prices could go up too for various reasons including companies getting access to cheaper leverage, consumers borrowing more, or even from interest rates falling less than expected and signalling that the economy is stronger than investors previously though.
There are many other reasons that they could move in the same direction. For example, if your portfolio is heavy in government bonds rather than corporate bonds (which many bond indexes are), then those are driven primarily by things like the strength of the governments finances or, in the last few decades, expectations for central bank action based on economic measures.
Stocks, on the other hand, are driven by the strength of the corporate income statements and balance sheets which could look very different from those of the government. It’s entirely possible for corporations to be profitable and have lots of cash while the government struggles (see: today). And even if the economy and consumer spending are declining, corporations could have growing profits for some time. After all some of the most profitable companies are those that are slowly losing their touch.
Unfortunately this doesn’t help predict the market. Any analysis based on one factor is too simple to be accurate, but adding more factors just creates uncertainty since we don’t know which ones will affect the market at what time. The only solution is a sensible asset allocation and long-term commitment that allows you to make a profit regardless of what happens in the markets.