One Simple Chart Showing Why Declining Bond Yields Matter for Equity Allocation

The story of 2014, and so far in 2015, is that yields have continued to fall contrary to most economists' expectations. This matters to equity investors because the appropriate asset allocation in a falling yield environment is much different than the best allocation in a rising yield environment. If yields are expected to rise, because economic growth is about to accelerate for example, a cyclical allocation would seem to make sense. If one has a cyclical equity allocation, but yields actually fall, one would have a much diminished probability of outperforming their equity benchmark.

So here we are still in a persistent falling yield environment that seems to be reinforced every week with lower yields. In this scenario, the best equity allocation would be to overweight counter cyclical stocks relative to cyclical stocks.

As the chart below shows, when yields fall (blue line, right axis, inverted) counter cyclical stocks outperform cyclical stocks (red line, left axis). Since the beginning of 2014 counter cyclical stocks have outperformed cyclicals by 11% and it would appear that even more outperformance is in order to catch up with the most recent decline in yields.