Bitcoin Gets Ready for a New Type of Hedge

Of all of the many clever things Mark Twain is alleged to have said, one of my favorites, especially these days, is: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

In the turmoil that is 2020, many market “truths” have morphed into myths. And many trusted investment adages no longer make sense.

One that continues to puzzle me is how many financial advisers still recommend the 60/40 portfolio balance between equities and bonds. Equities will give you growth, the theory goes. And bonds will give you income as well as provide a buffer in times of equity decline. If you want to preserve capital into your old age, we’re told, this is the diversification strategy for you.

That doesn’t hold any more.

Diversification itself is not on trial here. Whether you subscribe to chaos theory or just enjoy a balanced diet, diversification is a pretty good rule of thumb when it comes to a healthy lifestyle (except perhaps when it comes to marriage).

It’s the why of diversification when it comes to investments that we need to think about.

The idea is that diversification spreads risk. What hurts one asset might benefit another, or at least not hurt it quite so much. An asset could have unique value drivers that set its performance apart. And a position in low-risk, highly liquid products allows investors to cover contingencies and to take advantage of other investment opportunities when they arise.

All that still largely holds. What needs to be questioned are the assumptions that diversification should be spread between equities and bonds.

One of the main reasons for the equity/bonds allocation split is the need to hedge. Traditionally, equities and bonds move inversely. In an economic slump, central banks would lower interest rates to reanimate the economy. This would push up bond prices, which would partially offset the slump in equities, delivering a performance superior to that of an unbalanced fund.

Since the crisis of 2008, that relationship has broken down. In fact, as the chart below shows, equities (represented by the S&P 500) have outperformed balanced funds (represented by the Vanguard Balanced Index) in terms of rolling annual performance over the past 20 years.

Why? First, central banks no longer have interest rates in their recession-fighting toolbox. While negative rates are possible, they are unlikely to reanimate the economy enough to turn around a stock market falling on recession expectations.

And, as we have seen this year, the stock market can keep rising even in an economic slump. Driven by lower interest rates and a flood of new money chasing assets, equity valuations became untethered from expected earnings a while ago.

So, there’s no reason to expect equities to have a pronounced down year, and no reason to expect bonds to rise when they do, as long as central banks maintain their current policies. And it is difficult to see how they can exit their current strategies without causing significant harm to borrowers (including governments). Where, then, is the hedge?

Another reason to hold a portion of bonds in portfolios is to have a guaranteed income. That has been taken off the table by record low interest rates. And as for the “safe” aspect of government bond holdings, the sovereign debt/GDP ratio is at all-time highs. No one expects the U.S. government to default on its debt – but that is more a question of trust than financial principle. Continuity of trust is perhaps another assumption that needs examining.

You might have heard this before: Government bonds used to provide risk-free interest. Now they provide interest-free risk.

So, why are financial advisers still recommending a bond/equities balance?

Another potential reason is as a hedge against volatility. In theory, equities are more volatile than bonds as their valuation depends on a higher number of variables. In practice, however, bonds are often more volatile than equities, as this graph of the 30-day volatilities of the TLT long-term bond index and the S&P 500 shows:

So, the justification of the 60/40 equity/bond split no longer has a meaningful argument to stand on, either as an income provider or as a hedge. Even just adjusting the ratio is missing the point. The underlying vulnerabilities for stocks and bonds now overlap.

What’s more, there’s no reason to expect things to go back to the way they were. Even without a divided government in the U.S., it will be difficult to implement sufficient fiscal expansion to keep the economy afloat on a sustained basis. It is more likely that expansionary monetary policy will become the new normal. This will keep bond yields down, equity prices stable or rising, and deficits ballooning.

This…