Does the Stock‑Bond Correlation Really Matter?

Contrary to most investors’ intuition, this commonly cited measure actually may not explain much about the relative performance of stocks and bonds.

Why do some investors care so much about the correlation between equities and Treasuries? Presumably, many believe the historically negative stock-bond correlation reflects the degree to which bonds will effectively hedge against a significant equity market sell-off, as happened in the 2008 global financial crisis. Yet, taken literally, the stock-bond correlation generally says little about the relative performance of stocks and bonds – arguably what investors actually care about.

Investors’ focus on the stock-bond correlation is understandable. Intuitively, a negative correlation between equities and bonds – which has been largely true of U.S. equities and Treasuries since the late 1990s – would suggest that bonds perform well when equities sell off, whereas a positive correlation would be evidence that bonds are not an effective hedge against equity risk.

In fact, however, this is not true.

To see why, one must first understand what a correlation is, and what it isn’t.

The meaning of correlation

Correlation measures the commonality in the deviation from trend for two series of returns. If both series tend to be above or below their respective trends at the same time, then they are positively correlated. Conversely, if the variables are generally on opposite sides of their means at the same time, they are negatively correlated. This can be shown mathematically in the correlation equation below. x and y represent two time-series (say, stock and bond returns) and the terms (xi- x) and (yi - y) represent each variable’s deviation from its own trend, or average return, over the measurement period.

What the correlation does not measure, however, is the relative performance of the two time-series. For example, it’s entirely possible for one time-series to have a positive trend and another to have a negative trend – and for the two series to be positively correlated. This is likely “counterintuitive” to how most people interpret the correlation measure. As such, the correlation tells us nothing about the actual returns of each series and hence the stock-bond correlation may say very little about the relative performance of stocks and bonds.

Figure 1 illustrates a real-world example. It shows cumulative returns over cash (represented by 90-day T-bills) of both Treasuries and U.S. equities during the recession that lasted from December 1969 to November 1970. During this period bonds returned 10.9% over cash while equities returned -7.0%. Hence, bonds provided diversification for equity investors during this turbulent period.

Figure 1 shows a graph of cumulative equity and bond excess returns over cash from December 1969 through November 1970. During this period, bonds returned 10.9% over cash, while equities returned negative 7.0% 

What is intriguing, however, is that the correlation between equities and bonds was positive, at 0.4, measured over the same period as the recession, using daily data. How is this possible? Simply put, bonds tended to be above their (positive) trend at the same time equities were above their (negative) trend, and vice versa. If investors had relied only on the correlation measure, they may have erroneously inferred that bonds and equities both performed poorly during the 1970 recession.

The upshot: Investors should care less about how the returns of assets deviate from their trends and more about the trends themselves – particularly when we are considering how bonds will perform in an equity market drawdown or in recessionary periods.

Might this simply be a one-off anomaly? It seems intuitive that if equities tend to fall in recessions and Treasuries rally, that they must be negatively correlated over the period. In fact, however, this is generally not the case.

Figure 2 is a table of stock-bond correlation in returns in the first half of recessions. It examines seven recessions, the first being December 1969 to June 1970, through the last one, whose term was December 2007 to September 2008. The numbers, detailed in the table, show how correlation shows little information about the relative performance of stocks and bonds 

Figure 2 shows the in-sample (daily) correlation between stocks and bonds and the performance of each asset class in the first half of every U.S. recession since 1970. We chose the first half of recessions because this is when equity drawdowns tend to be largest, as stocks generally recover in the second half of recessions. Rows in red correspond to periods when the relative return of each asset class is counterintuitive to the sign of the correlation, whereas blue denotes periods in which the returns are “intuitive” with the sign. For example, in the 1981–1982 recession, the in-sample correlation was 0.41, yet equities returned -11.2%, while bonds returned 12.9%. Hence, the sign of the correlation was counterintuitive to the relative returns.

In fact, in five of the seven past recessions, relative returns were counterintuitive to what the sign of the correlation implied. This result shows that the correlation provides little information about the relative performance of stocks and bonds.

What is key from an investment perspective, however, is that bonds provided needed diversification to equity risk in six of the past seven recessions. And this was true regardless of the sign of the stock-bond correlation. The sole exception was 1973, when Treasuries returned -3.5% during the recession’s first half (but ultimately produced positive nominal returns by the end of the recession).

Looking at correlations is too narrow. Average returns are what matter and the correlation is silent on returns. Bonds have historically hedged equity risk in recessions because returns have been positive, not necessarily because correlations have been negative. So, does the correlation matter? In our view, not really.

For more on the stock-bond correlation, please see our Viewpoint.” For a more technical treatment of the topic, please see “Stocks, Bonds and Causality.”

Jamil Baz is a managing director and head of PIMCO’s client solutions and analytics team. Steve Sapra is an executive vice president on the client solutions and analytics team. German Ramirez is a quantitative research analyst on the client solutions and analytics team. All are based in Newport Beach, Calif.

The Author

Jamil Baz

Head of Client Solutions and Analytics

Steve Sapra

Client Solutions & Analytics

German Ramirez

Quantitative Research Analyst



Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. Different proxies for the stock and bond market would produce different performance results.  The scenarios highlighted do not represent all possible outcomes and the analysis does not take into account all aspects of risk. It is not possible to invest directly in an unmanaged index. 

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Investors should consult their investment professional prior to making an investment decision.

This material contains the current opinions of the manager and such opinions are subject to change without notice.  This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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