Putting Current Market Dynamics in Perspective

Equity Risk Management in Periods of Positive Equity/Bond Correlation
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Unusually good or bad return episodes in financial markets attract attention from the media when they persist beyond a few days and extend across a range of asset classes and market segments.  The financial media eagerly report these strong short-term moves as their coverage brings more viewers and related advertising revenue.  Investors need to assess whether these extreme return periods are signals that warrant a change in investment strategy or are they just part of the ebb and flow that brings return for taking risk?  In this blog, we attempt to put the negative performance of the first six months of 2022 for both stocks and bonds in global markets into perspective.  Our conclusion is that the recent range of returns we have been experiencing in equities is within the pattern observed over the last 50 years, and that the positive correlation of stocks and bonds is also something that has been common looking back far into financial market history, especially during periods of rising inflation. 

The most important feature of this recent period is the shift to a higher risk regime for bonds as inflation has emerged as a major concern.   Further, the increasing correlation between the returns of equities and fixed income raises the question of how much investors should depend on their fixed income allocation for portfolio risk management.  Investors should consider looking at alternative tools for managing equity risk, which is the dominant risk in their portfolios. Approaches are now available in ETFs and fund products that enable investors to directly reduce exposure to downside equity risk using rolled buffer protection strategies.  These strategies reduce downside participation for a term, such as 6 or 12 months, for a range of downside index levels established when the equity risk reduction strategy is implemented.  The cost of the risk mitigation is financed by setting a cap on a portion of the upside equity index returns.  The performance or “target outcome” of these equity risk reduction approaches is, therefore, contingent on the index levels for the buffer range and cap when the strategy expires or is rolled into a new downside protection range. 


Putting Returns for U.S. Large Cap Equities and Bonds in Context

As we look back on the first half of 2022, investors faced the fact that the S&P 500 Index delivered its worst performance through June since 1970.  The chart below appeared in the Wall Street Journal showing returns through the first six calendar months of the year back to 1970.  It was also noted that there have been only five prior years in the last 100 when the S&P 500 Index has fallen more than 15% in the first six months (1932, 1939, 1940, 1962, and 1970) with an average reversal of 24% in the second half of the year.  [1]



Exhibit 1: S&P 500 Index 1st Half Year Returns, 1970-2022


Source: Wall Street Journal, July 1, 2022, based on Dow Jones Market Data
Past performance does not guarantee future results. It is not possible to invest directly in an index.

The chart shows that the first half of 2022 was a sharply negative return period in the 50-year history of S&P 500 Index returns. What stands out, however, is the consistent positive return periods for the equities over these five decades, which supports the choice of equities as the dominant asset class allocation in investor portfolios.  Returns exceeded +10% in this six-month period in 17 of the 53 years, or almost 1/3 of the time.  There were also 17 years in the last 50 when first half returns were negative, but in only seven of these years (13%) were the returns < 10%.  So yes, the first half of 2022 was painful, but this magnitude of decline has occurred a few times in a 50-year period.  Therefore, this is the type of risk over quarterly or semi-annual time frames that equity investors should be willing to weather to reap the long-term positive returns for equities. 

Periods of low returns and high risk for U.S. large cap equities can persist for as long as a decade.  This happened in the 1970’s when we encountered high inflation. It occurred again in the 2000-2009 period which had two bear markets; the first in 2000 triggered by the bursting of the dot-com bubble, followed by the Global Financial Crisis in 2007.  During the decade of 2000-2009, the annualized return for the S&P 500 Index was -1.0%, compared to 13.6% over the 2010 – 2019 period. [2] Additionally, the annualized volatility of S&P 500 Index monthly returns was 16.1% from 2000-2009, much higher than the relatively quiet 12.5% volatility markets saw in 2010-2019.

The large decline in equities and bonds this year has been accompanied by an extremely high realized risk pattern of S&P 500 Index returns on a day-to-day basis with annualized volatility at over 24% as of August 5. [3]   Moreover, we may be at the start of a longer-term, higher risk environment in this decade. The volatility of the S&P 500 Index since the start of 2020 through mid-year 2022 has been 20.3% annualized, even higher than during the 2000-2009 decade.[4]  Some of this higher risk regime has come because investors are so uncertain about the state of the economy with new information hitting the marketplace daily, helping to drive the large shifts in prices.


Equity/Fixed Income Correlation Switching Back to Positive

Another feature of the financial markets in 2022 has been the challenge of using diversification to manage risk.  Equity markets outside the U.S. have fallen in a similar fashion to U.S. equities.  The S&P Global Broad Market Index Ex-U.S. posted a -19.1% return in the first half of 2022, just 1% higher than the S&P 500.  MSCI EAFE and MSCI Emerging Markets indexes were also down -19.8% and -17.3% respectively.  Equity bear markets are known to exhibit higher correlation across equity indexes and see reduced benefits from diversification.  It is unusual, however, that fixed income has not provided much risk reduction. The Bloomberg Aggregate U.S. Bond Index delivered one of its worst first-half performance periods in 2022 as well, falling -10.3%.  A simple 60% S&P 500 Index/40% Bloomberg Aggregate U.S. Bond Index portfolio rebalanced at the beginning of 2022 would have fallen -16.14% (assuming no further rebalancing), exposing investors to potential for significant losses.  With bond yields still at the lower end of their 30-year range, there is concern this positive correlation between stocks and bonds will continue. 

In a recent article in the Journal of Beta Investment Strategies, I looked at the long-term correlation of large cap U.S. stocks and fixed income using the Stocks, Bonds, Bills, and Inflation (SBBI) monthly return data set that goes back to 1926.[5]  This data set was originally complied by Roger Ibbotson and Rex Sinquefield in 1976.  It is now called the SBBI database and is distributed by Morningstar.[6] Exhibit 2 below shows the rolling correlation, updated monthly over 36-month time periods, between U.S. Large Cap Equities from the SBBI database and a Fixed Income Composite.  This Fixed Income Composite was constructed by combining the SBBI Corporate Bond total return series (50%) with a maturity of approximately 20 years with equal weights to the SBBI 20-year and 5-year U.S. Government bond return series rebalanced on a monthly basis.

Exhibit 2

Rolling 3-Year Correlation - U.S. Large Cap Equities & Fixed Income

Jan 1929 - June 2022

Source: SBBI Data Base, Morningstar Inc.
Past Performance does not guarantee future results.

The average correlation of this very long-term, rolling 3-year time series was 0.154 for the entire 95-year period and 0.171 for the most recent 50-year period. From this historical perspective, we can see that the pattern of low to negative correlation that had been in place for the last two decades is no longer consistent with longer-term financial market dynamics.  Over the past two decades, fixed income yields have been low and declining.  The asset class of fixed income has also been a powerful tool for risk reduction because of both its lower risk to equities and its diversification potential due to its low/negative correlation. 

Although the volatility of fixed income investments remains lower than equities, their diversification properties can be quite variable and at low levels for decades at a time.  In particular, the phenomenon of equities and fixed income moving more in concert is something that has been a dominant theme of financial market history for many years in the last century.  Looking back over the correlation metrics in the Exhibit for the period of 1965-1995 and during the 1930s and 1940s, we see the predominance of positive correlation, more like what we have observed for the first half of 2022.  The first of these periods was also one with higher rates of inflation and generally high levels of bond yields.  In the most recent 3-year period, correlation has moved up to the positive range again and was 0.14 as of June 2022.  In short, the trend very likely due to higher positive correlation.  Looking at the 18-month and 12-month periods ending June 2022, equity/bond correlation was 0.38 and 0.49, respectively.  These are shorter periods with limited monthly return observations, but they do signal that changes could be afoot, even over longer horizons.


Time for More Direct Equity Risk Management Approaches

Investors can look to alternative ways of managing equity given the risk of a continuation of rising bond yields and the uncertainty associated with the diversification power of fixed income.  One of these approaches is to reduce equity index downside participation with put option strategies that are financed by selling away a portion of upside returns.  The returns of “buffer protection strategies” can now be analyzed using indices, and exchange traded funds (ETFs), mutual funds, insurance funds, and other wrappers have return objectives that incorporate the features of buffer protection approaches.  Common features of buffer protection strategies are the use of put options to cover a range of downside returns, based on the level of an equity index at the time that the strategy is implemented (e.g., 0% to -10%, 0 to -20%, or -5% to -30%) for a particular horizon, such as 12 months.  The put options used for downside protection are paid for by selling call options, which caps upside growth potential.  When the options expire at the end of 12 months, the put options pay off if the index has fallen within (or beyond) the buffer range, or they expire worthless.  At that point, a new 12-month buffer protection strategy is put in place.  These types of strategies have historically had similar risk profiles to a 60%/40% equity/bond allocation, measured by beta or the standard deviation of monthly returns. [7]

The potential benefits of this more focused downside protection approach can be seen in the performance of Buffer Strategy Indices for the first half of 2022.  Exhibit 3 below shows the returns of some Buffer Strategy Indices compared to the S&P 500 Index, Bloomberg U.S. Aggregate Bond Index, and a 60% S&P 500 Index/40% Bloomberg U.S. Aggregate Bond Index allocation. Also shown are the returns of several individual Cboe S&P 500 Buffer Protect Index (SPRO) monthly series, which reflects the returns of a 12-month, 10% Buffer Strategy on the S&P 500 Index. Also shown are some of the Buffer Strategy Indices from MerQube, which provide protection for a wider and deeper downside range, -5% to -30% over a 12-month horizon, on the SPDR® S&P 500 ETF Trust (SPY).    We show performance of the indices rolled in June and December as well as a laddered approach with equal weights in indexes across the calendar month strategies. 

In the exhibit we see some variation in returns due to the timing of option expiration relative to the timing of the S&P 500 Index, but all three -10% Cboe S&P 500 Buffer Protect Indices (SPRO6, SPRO12, and SPRO) significantly outperformed the 60/40 equity/fixed income allocation in the first half of 2022.  The S&P 500 Index -20% return was beyond the range of these 10% buffer strategies, but each SPY Buffer Strategy Index return series had much lower participation in the first 10% of the equity market decline.  

Exhibit 3

Comparative Performance of Buffer Strategy Indexes versus Equity/Fixed Income Indexes

First Half of 2022

Source: S&P Dow Jones Indexes, Bloomberg, and Cboe.
Past performance does not guarantee future results. It is not possible to invest directly in an index.

The SPY Buffer Strategy Indices from MerQube, with deeper protection (from -5% to -30%), showed even stronger relative performance.  Although these strategies allowed the investor to experience a -5% loss for the 12-month timeframe covered by the index, the puts purchased for the deeper protection have less downside participation for the range of returns down to the -30% outcome.  For the first half of 2022 the MerQube U.S. Deep Buffer (-5% to -30%) Index rolled in June posted the best performance (-6.8%), while the similar index strategy that rolled in December recorded a -8.7% return, both well ahead of the returns of the S&P 500 Index, Bloomberg U.S. Aggregate Bond Index, and a 60/40 portfolio comprised of the S&P 500 Index/ Bloomberg U.S. Aggregate Bond Index.

The Buffer Strategy Indices also have lower betas and less upside participation relative to full exposure in the S&P 500 Index since there is a cap from the call option sold to finance the downside buffer.  However, investors understand the level of the cap when the strategy is implemented and therefore can incorporate it into their return expectations.  Most importantly, these strategies do not rely on fixed income exposure and expectations about the correlation of equities and fixed income.  Instead, investors receive a target or defined outcome that is entirely based on where the S&P 500 Index settles at the time the strategy is rolled out to the next period. 

Fixed income will always have a place in portfolios and its risk can be managed by customizing duration and credit exposure.  However, given the lessons of long-term financial market history, it makes sense to consider additional strategies to seek to lower the risk equity exposure.


The views, opinions, and content presented are for informational purposes only and reflect the current opinion of the writer as of August 22, 2022. Opinions and forward looking statements expressed are subject to change without notice. They are not intended to reflect a current or past recommendation; investment, legal, tax, or accounting advice of any kind; or a solicitation of an offer to buy or sell any securities or investment services. Nothing presented should be considered to be an offer to provide any Cboe Vest product or service in any jurisdiction that would be unlawful under the securities laws of that jurisdiction. The charts and/or graphs contained herein are for educational purposes only and should not be used to predict security prices or market levels. Cboe Vest has made every attempt to ensure the accuracy and reliability of the information provided, but it cannot be guaranteed. Past performance is no guarantee of future results

[1] Akane Otami, “Stock Markets Post Worst First Half of a Year in Decades,” Markets, Wall Street Journal, July 1, 2022.

[2] Joanne Hill, “Assessing Downside Equity Risk – A Tale of Two Decades,” Cboe Vest Blog, September 8, 2020.

[3] Annualized standard deviation of S&P 500 Total Return index, based on data from S&P Dow Jones Indexes.

[4] Op. cit.

[5] Joanne Hill, “The Dynamics of Risk: Implications for Asset Allocation Strategies,” Journal of Beta Investment Strategies, Spring 2022, pp. 57-68.

[6] Source: Morningstar Direct. "SBBI" stands for "Stocks, Bonds. Bills, and Inflation".  Past performance does not guarantee future results.

[7] Joanne Hill, “The Dynamics of Risk: Implications for Asset Allocation Strategies,” Journal of Beta Investment Strategies, Spring 2022, Exhibits 5 and 6, pp. 67-68.