My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5 percent equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: Inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history’s 2.5 percentage point excess return or the 5 percent premium that most investors expect? As Peter Bernstein and I suggested in 2002, it’s hard to construct a scenario that delivers a 5 percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day.
Bonds And Diversification
If 2008–09 teaches us anything, it’s the truth in the old adage: “The only thing that goes up in a market crash is correlation.” Diversification is overrated, especially when we need it most. In our asset allocation work for North American clients, we model the performance of 16 different asset classes. In September 2008, how many of these asset classes gave us a positive return? Zero. How often had that happened before in our entire available history? Never. During that bleak month, the average loss for these 16 asset classes—including many asset classes that are historically safe, low-volatility markets—was 8 percent. Had that happened before? Yes; in August 1998, during the collapse of Long Term Capital Management (LTCM), the average loss was 9 percent. But, after the LTCM collapse, more than half of the damage was recovered in the very next month!
By contrast, in the aftermath of the September 2008 meltdown, we had the October crash. During October, how many of these asset classes gave us a positive return? None. Zero. Nada. How often had that happened before in our entire available history? Only once … in the previous month. How bad was the carnage in October 2008? The average loss was 14 percent. Had so large an average loss ever been seen before? No. As is evident in Figure 4, October 2008 was the worst single month in 20 years for three-fourths of the 16 asset classes shown. For most, it was the worst single month in the entire history at our disposal.
The aftermath of the September–October 2008 crash was, unsurprisingly, a period of picking through the carnage to find the surviving “walking wounded.” As Figure 5 shows, the markets began a sorting-out process in November/December 2008. Some markets—the safe havens with little credit risk or liquidity risk—were deemed to have been hit too hard, and recovered handily. Others—the markets that are sensitive to default risk or economic weakness—were found wanting, suffering additional damage as a consequence of their vulnerability to a now-expected major recession. The range between the winners and the losers was over 3,000 basis points, nearly as wide as in the crash months of September/October, but more symmetrically around an average of roughly zero.
By the time the year had ended, bonds were both the best-performing assets and among the worst-performing assets. Consider Figure 6. The best-performing market on this list was long-duration stripped Treasuries—an asset class used in many LDI strategies—rising over 50 percent in that benighted year. The worst-performing asset is a shocker. It’s an absolute-return strategy—represented as a way to protect assets in times of turbulence—that takes short positions in stocks and long positions in bonds! In a year when the bond aggregates rose 5 percent and stocks crashed 37 percent, this strategy leverages that winning spread. Investors used these convertible arbitrage hedge fund strategies as a source of absolute returns, a safe haven especially in a severe bear market, and got an absolute horror show.
Of course, it was unhelpful that the Convertible Bond Index went from 100 basis points below Treasury yields to (briefly) 2,400 basis points above Treasury yields. Nor was the brief SEC prohibition on short-selling over 1,000 different stocks helpful. Now, as the convertible arb hedge funds deal with their clients’ mass exodus, the convertible bonds are looking for a new home; after all, even if these hedge funds are disappearing, their assets are not.
In 2008, the markets demonstrated that bond categories can be far more diverse and less correlated with one another than most investors previously believed. Indeed, in 2008, that was arguably even more true for bonds than for the broad stock market categories.