This post is to share some observations that may be helpful to readers who, like me, depend to some degree on their investments and who were rudely surprised by the simultaneous steep decline in both bonds and stocks in the past year.
Bonds and Stocks Are No Longer Inversely Correlated
Back in the day before routine, massive Federal Reserve interventions, say before the 2008 Great Recession, there was a more or less routine business cycle. In an expansionary phase, GDP would increase, there was greater demand for loans, company profits would rise and so would stock prices and interest rates. When interest rates go up, bond prices go down. When the cycle rotated to the recessionary downside, all this would reverse. Stocks would go down, interest rates would decline and investors would flee to bonds, raising their prices.
Thus, bonds served as a good portfolio diversifier, since their prices tended to move inversely to stocks. Hence, the traditional 60/40 portfolio: 60% stocks, 40% bonds, with periodic rebalancing between the two classes.
This approach still worked sort of OK from 2008-2021 or so. The Fed kept beating interest rates lower and lower, and so bond prices kept (fitfully) rising. But at last we hit the “zero bound”. Short- and long-term interest rates went to essentially zero in the U.S. (and actually slightly negative in some other developed countries). Rates had nowhere to go but up, and so bond prices had no place go but down, no matter how stocks performed.
Trillions of dollars of federal deficit spending to pay out various COVID-related benefits in 2020-2021, along with supply chain interruptions, ignited raging inflation in 2022, which the Fed belated addressed with a series of rapid rate hikes and reductions in its bond holdings. The end of easy (nearly no-interest) money and the prospect of a recession knocked stock prices down severely in 2022. However, the rise in both short term and long term interest rates also cratered bond prices. The traditional 60/40 portfolio was decimated. Thus, in an inflationary environment with active Fed intervention, bonds are much less useful as a portfolio diversifier.
Both the stock and bond markets seem to be now driven less by real-world considerations and more by expectations of Fed (and federal government) reactions to real-world occurrences. Pundits have noted the “bad news is good news” effect on stock prices: if GDP dips or unemployment rises (which used to be considered recessionary bad news), the markets cheer, assuming that if any real economic pain occurs, the federal government will flood us with benefits and the Fed will lower rates and buy bonds and otherwise facilitate the renewed deficit spending. (See The Kalecki Profit Equation: Why Government Deficit Spending (Typically) MUST Boost Corporate Earnings for an explanation of why deficit spending normally causes a rise in corporate profits, and hence in stock prices.)
In 2022, there was practically no place to hide from investment losses. Petroleum-related stocks furnished one of the few bright spots, but that was partly a function of economies recovering that year from COVID lockdowns. There is no particular reason to believe that petroleum stocks will rise in the next market downturn. Oil and gas stocks, along with gold and other commodities, might offer a certain degree of diversification, but none of these can be assumed to normally rise (or even stay steady) when the general stock market falls.
Managed Futures Funds as Portfolio Diversifiers
It turns out that there is one class of investable assets that does tend to rise during an extended market downturn, while typically rising slowly or at least staying level during stock bull markets. That is managed futures funds. These funds observe pricing trends across a wide range of commodities and currencies and bond markets, and buy or sell futures to try to profit. If they (or their algorithms) guess right, they make steady, small gains. If there is a new, strong trend that they can buy into, they can make a lot of money quickly. Such was the case for most of 2022. It was obvious that the Fed was going to raise rates heavily that year, which would drive up interest rates and the value of the dollar versus other currencies, and would crush bond prices. The managed futures funds shorted the Euro and bonds, and made a ton of money January-November last year. Investors who held these funds were glad they did. Charts to follow.
The first chart here shows the total returns for the S&P 500 stock index (blue) and a general bond fund, BND (purple), for the past three years, ending Feb 13, 2023. (Ignore the orange curve for the moment). This chart captures the short but very sharp drop in stock prices in early 2020, as COVID lockdowns hit, but government aid was promised. Bonds did not greatly rise as stocks fell then, although after a bit of wobble they stayed fairly steady in early 2020. However, when stocks slid down and down during most of 2022, bonds went right down with them (purple drawn-in arrow), giving no effective diversification. Both stocks and bonds rose in early 2023, showing what is now a positive correlation between these two asset classes.
Source: Seeking Alpha
The next chart (below) omits the bonds line, showing just the blue stocks curve and the orange curve, which is for a managed futures fund, DBMF. The drawn-in red arrows show how DBMF only dipped a little during the COVID crash in early 2020, and it rose greatly in 2022, as stocks (blue arrow) collapsed. This shows the power of managed futures for portfolio diversification.
Source: Seeking Alpha
There was a surprising break in futures trends in November, 2022, as markets suddenly started pricing in an early Fed pivot towards easing in 2023, and so interest rates rose, and bonds and the U.S. dollar tumbled. All the managed futures funds took a sharp hit Nov-Dec 2022; some of them recovered better than DBMF, which kept drifting down for the next few months. Without getting too deep in the weeds, DBMF is an exchange-traded fund (ETF) with favorable fees and taxation aspects for the average investor. However, its holdings are chosen by observing the recent (past few weeks) behavior of other, primary managed futures funds, and trying to match the average performance of these funds. This average matching is good, because the performance of any single one of the major managed futures funds can be really good or really any particular year. However, as observed by Seeking Alpha author Macrotips Trading, the matching approach used by DBMF means it can be appreciably slower than other funds to adjust its positions when trends change. Some other, similar funds are EBSCX, PQTNX, GIFMX and AMFNX. These are mutual funds, rather than ETFs, with somewhat higher fees and higher minimum purchases, depending on which “class” of these funds you go with (A, C, or I). KMLM is another managed futures ETF, which tends to be more volatile than DBMF; higher volatility may be desirable for this asset class.
One Fund to Rule Them All
A recommended application of these managed futures funds is to replace maybe a third of your bond holdings with them. Back testing shows good results for say a 15 managed futures/25 bonds/ 60 stocks portfolio, which is periodically rebalanced.
What if there was a fund which combined stocks and managed futures under one wrapper? There is one I have found, called REMIX. It has an “institutional” class, BLNDX, with higher minimum purchase and slightly lower fees, which I have bought into. The chart below shows the past three years of performance for the hybrid REMIX (orange) compared to stocks (blue) and the managed futures-only fund DBMF. We can see that REMIX stayed fairly flat during the COVID blowout in 2020, and it rose along with stocks in 2021, and went roughly flat in 2022 instead of dropping with stocks (see thick drawn-in yellow arrows). The performance of REMIX is actually better than a plain average of stocks (blue curve) and DBMF (purple), so this is an attractive “all-weather” fund. A similar hybrid (multi-asset) fund is MAFCX, which has higher fees but perhaps slightly higher returns to date.
Source: Seeking Alpha
Caveat on Managed Futures
Managed futures put in an outstanding performance in 2022 because there was a well-telegraphed trend (Fed raising interest rates) in place for many months, which allowed them to make easy profits at the same time that stocks were crashing. But we cannot assume that managed futures will always go up when stocks go down. That said, managed futures will likely be reasonable diversifiers, since they should at least stay roughly level when stocks go down. The trick is to not grow impatient and dump them if their prices stagnate during a long bull stock market phase. Holding them in the form of a multi-asset fund like REMIX may help investors hang in there, since it should go up in a bull market (due to its stock component), while offering protection in a bear.
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