by Don Gould

The last two US bear markets – 2000-2002 and 2007-2009 – saw the stock market lose about half its value in each instance.  Investors with balanced portfolios – some mix of equities and fixed-income – fared much better than those invested mostly or entirely in stocks, for two reasons, one obvious and the other less so.

Stock vs. Bond Performance - Last Two Bear MarketsThe no-brainer benefit of having a balanced portfolio in a bear market is simply that the bond portion dilutes the overall exposure to a declining stock market.  The second and less obvious benefit falls into what we might term the modern portfolio theory (MPT) basket.  MPT basically says that overall portfolio risk is reduced when we combine asset classes whose returns move at least somewhat out of sync with one another.  In the two bear markets cited, while stocks fell, bonds turned in positive returns, and in general there is good reason to expect this outcome.10 Yr Treasury Yields

In an economic slowdown, corporate earnings expectations drop, and stocks follow.  At the same time, business loan demand subsides with receding growth prospects, leading to lower interest rates.  Recall that the price of existing bonds rises when the available rate on new bonds falls.  So in this instance, we have the holy grail of MPT: negative correlation between stock and bond returns, leading to more stable returns of the portfolio as a whole.

The question now is whether balanced portfolios should expect MPT benefits when the next bear market rolls around.  On this score, the outlook is not promising.  Consider that the 10-year US Treasury note yielded about 6% at the outset of the 2000-2002 bear market, falling all the way to about 3.6% by the end of the period.  By the time the 2007-2009 downturn commenced, the 10-year yield had risen back to about 4.5%.  When the US stock market bottomed in early 2009, the yield plateaued around 3%.

In the second case, bond yields started lower and their decline, not surprisingly, was less pronounced.  Consequently, as seen in the accompanying chart, bonds did less well in cushioning the impact of the 2007-2009 bear market than they did in 2000-2002.

Today the 10-year Treasury yields rests at 1.6%.  The scope for further reductions in this rate – in other words, the likelihood that good bond performance will meaningfully offset the damage done by the next bear market – is greatly diminished.

This is a sobering observation, to be sure, but better to be thinking about it now than in the aftermath of the next bear market, whenever that may be.  One conclusion is clear.  Effective portfolio diversification today must incorporate asset classes and investment strategies that go well beyond the conventional stock/bond balanced mix.