EXECUTIVE SUMMARY
- The S&P 500® peaked on Jan. 3, 2022, and recorded a 20% decline in the first six months of the year. Bonds declined at the same time, as the U.S. 10-Year Treasury yield more than doubled.
- The combination of falling stock prices and rising interest rates is historically uncommon. When the equity and bond markets decline simultaneously, defensive equity factors—which aim to provide protection during falling markets and participation in rising markets—become more relevant.
- We explore ways of utilizing defensive strategy indices in order to improve the risk/return profile of a traditional asset allocation.
Rising Rates and Falling Stocks
The S&P 500 reached its most recent peak on Jan. 3, 2022, and declined 20% through June 30, 2022. Were investors prescient, of course, avoiding losses would be easy: simply shift from equities to cash on or about Jan. 3, 2022. For those of us not gifted with omniscience, however, market timing is an inadequate solution.
As Exhibit 1 suggests, in the first six months of 2022, investors were beset not only by the declining stock market, but also by rising interest rates. (The S&P U.S. Treasury Bond 7-10 Year Index was off by -10.6% as rates more than doubled.) This represents a radical change of fortune from the rising stock and bond markets that characterized most of the past 40 years. It also has an important implication for portfolio construction. Historically, investors who were unwilling or unable to bear the full risk of the equity market could hedge by constructing a balanced portfolio of stocks and bonds. During the bull market in bonds that began in 1981, such defensive allocations did not require a major sacrifice in returns. If the bull market in bonds has ended, however, defensively minded investors might seek other ways of limiting their equity risk.
Exhibit 2 shows that some factor indices would have dampened the S&P 500’s volatility in the first half of 2022; some even outperformed the bond market. Our intent in this paper is to explore what we can learn from the history of these indices. Which factors are best suited to providing defensive outcomes?
