Why Stocks and Bonds Fall Together

Stocks and bonds fell together because the thing that hurt them was the same thing. When the problem is a slowing economy, bonds cushion stocks. When the problem is inflation and the rate increases that follow it, nothing in a conventional stock-and-bond portfolio is on the other side of the trade.

That's the short version. The longer version is worth knowing, because the same question is going to come up again, and the answer decides what your bonds are actually for.

What bonds are supposed to do in a portfolio

The reason a 60/40 portfolio exists is that stocks and bonds have, for most of the past 25 years, moved in opposite directions when it mattered. In a recession, earnings fall and stocks fall with them. Investors move to safety, the Fed cuts rates, and bond prices rise. The 40% in bonds goes up while the 60% in stocks goes down, and the portfolio's drawdown is roughly half what an all-stock portfolio suffers. That's what happened in 2008. It's what happened in the spring of 2020.

Book Five puts it this way: the diversification benefit exists at any correlation below 1.0. Stocks and bonds don't have to move in exactly opposite directions to help each other. They only have to respond to different things. For a long stretch, they did.

Why the usual relationship holds

Both assets are claims on future cash, and both are priced by discounting that cash back to today. The difference is what moves each one.

A bond's cash flows are fixed. The only thing that changes its price is the rate used to discount them. Rates up, price down. Rates down, price up. That's the whole mechanism, and it's arithmetic, not opinion.

A stock's cash flows aren't fixed. Its price moves for two reasons: the discount rate, same as the bond, and the expected earnings themselves. In a normal downturn, the earnings expectation falls (bad for stocks) while the discount rate also falls as the Fed cuts (good for bonds, and a partial offset for stocks). Two forces, pulling in different directions, and bonds come out ahead. That's the hedge.

What was different in 2022

Inflation. The Fed raised its policy rate from near zero at the start of the year to a range of 4.25% to 4.50% by December, the fastest tightening in four decades. Rising rates hit bonds directly through the discount rate, and the Bloomberg U.S. Aggregate Bond Index lost roughly 13%, its worst year on record. Rising rates also hit stocks through the same discount rate, while earnings expectations held up well enough that there was no flight to safety to offset it. The S&P 500 lost roughly 18% with dividends included.

Notice what didn't happen. The economy didn't collapse. Unemployment stayed low. Earnings didn't crater. There was no recession to send investors into Treasuries, and so the one force that usually makes bonds rise when stocks fall never showed up. Both assets were repriced by the same variable, in the same direction, at the same time.

Kind of downturn	What drives it	Earnings	Fed	Bond prices	Stock prices
Growth scare	Recession, credit stress, a shock to demand	Fall	Cuts	Rise	Fall
Inflation scare	Prices rising faster than the Fed will tolerate	Hold or rise	Hikes	Fall	Fall

Your bonds are built for the first row. 2022 was the second row.

The correlation that protects you in one kind of downturn can fail in a different kind. Know which kind your hedge is built for.

This wasn't a rule breaking. It was a regime changing back.

The negative stock-bond correlation that gets treated as a law of nature is about 25 years old. Federal Reserve research shows U.S. stock and bond returns were positively correlated through much of the 1970s and 1980s, when inflation was the dominant risk, and shifted toward the negative correlation we're used to starting around the late 1990s, once inflation had been tamed and growth became the thing markets worried about. The relationship depends on which risk is in charge. For a generation, it was growth. In 2022, for one year, it was inflation again.

So the honest statement isn't "bonds hedge stocks." It's "bonds hedge stocks against growth scares, and they've been the right hedge because growth scares have been the usual kind." That held more often than not even after 2022, and I expect it to keep holding most years. But a portfolio built on the assumption that it holds every year is carrying a risk its owner hasn't priced.

Why it hurt more than the arithmetic says it should have

Duration. The longer a bond's maturity, the more its price moves for a given change in rates. By 2021, yields had been so low for so long that investors reaching for any income at all had drifted into longer maturities, and bond funds carried more rate sensitivity than their owners realized. A rate increase that would have cost a short-term bond fund a few percent cost a long-term Treasury fund more than a quarter of its value.

The same thing happened on the stock side. The companies hit hardest were the ones whose earnings sat furthest in the future, the long-duration growth names whose present value depends most on the discount rate. A portfolio of long bonds and long-duration growth stocks looked diversified by asset class and was, in fact, one big bet on rates staying low.

What this means for how you build the portfolio

Not that 60/40 is dead. A strategy having a bad year isn't the strategy failing, and the growth scares bonds are built for will come again. Four adjustments are worth making, though.

Know what you're hedging. If your worry is a recession, bonds remain the right tool. If your worry is inflation, they aren't, and the honest hedges for that are shorter-maturity bonds, inflation-protected Treasuries, and the kind of businesses that can raise prices. Decide which risk you're more exposed to before deciding how much of each to hold.

Watch duration as well as allocation. A 40% bond allocation in short-term Treasuries and one in long-term bonds are different portfolios with the same label. Shorter duration gives up some yield in exchange for a much smaller loss when rates rise. In 2022 that trade would have been worth a great deal.

Look for hidden rate bets on the stock side. If your equity holdings are concentrated in companies valued on earnings ten years out, your stocks and your bonds share a driver, and your diversification is thinner than the pie chart suggests. That's the same hidden-concentration problem as five stocks that all depend on one theme, and the fix is the same: measure exposure by what moves it, not by what it's called.

Rebalance anyway. A year when both fall together is painful, but it doesn't change the discipline. The portfolio drifted, the targets are still the targets, and the rebalance that felt pointless in December 2022 was buying bonds at the highest yields in fifteen years.

What to do with this

Pull up your bond holdings and find each fund's effective duration; it's on the fact sheet. Multiply the portfolio's weighted duration by one percentage point. That's roughly what a one-point rise in rates would cost you, and it's the number almost nobody looked at before 2022.

Then ask the question the table above asks: which row am I built for? If the answer is the first row only, you've learned what your portfolio assumes, and you can decide whether you agree with it. What diversification actually means covers the general case; the yield curve article is where the rate expectations that drive all of this show up first.