How To Hedge The End Of The 100-Year Balanced Bull

Who’s afraid of a multi-asset drawdown catalyzed by a bond tantrum in 2018?

Nobody, right? Because drawdowns no longer happen. The entire world has turned into China. Selling is de facto illegal.

And hell, given how much Trump seems to look up to Xi (an ironic turn given all the anti-China rhetoric that was tossed about with reckless abandon on the campaign trail), who’s to say he doesn’t take a page out of the Politburo playbook and simply put half the market on indefinite trading halt in the event his precious equity rally is imperiled?

I’m just kidding. But the bit about the multi-asset drawdown and the possibility that a bond tantrum could disrupt balanced portfolios in 2018 is an important point. Remember, we’re in the midst of the longest bull run for a balanced 60/40 portfolio in a century:

And stock-bond return correlations have been negative for the longest stretch in 100 years:

So you’re getting the best of both worlds – a simultaneous rally in stocks and bonds and the diversification that comes with a negative return correlation.

The problem with that (well besides the fact that all good things invariably come to an end even as the gambler’s fallacy has a tendency to f*ck anyone who tries to predict the exact moment when things will turn) is that now, everything is stretched. Stocks, credit, and bonds. So it isn’t clear whether it makes sense to talk about “diversification” anymore. Here’s how we put it in November:

What does it mean to be “diversified” when everything is expensive?

That’s a good question. Does “diversification” help when everything is in a bubble? Maybe at the margin, right? I mean, “diversification” entails holding assets the returns on which are negatively correlated but when all of those assets are in bubble territory, the implication is that at best, returns going forward are going to constrained and at worst, returns will be negative. So while being diversified across a bunch of assets that are all expensive might help mitigate exposure to one of those assets plunging, the concept of “diversification” becomes more ambiguous in an environment where everything is overvalued.