Morgan Stanley identified 12 trades to protect you from a stock market meltdown

Reuters / Russell Boyce

• Bonds are losing their attractiveness as a way to diversify an equity portfolio, according to cross-asset strategists at Morgan Stanley.
• They examined several other asset classes to find the cheapest alternatives that historically do not correlate with stocks' trading direction.
• The strategists found 12 alternative trades that could help investors offset an equity market sell-off.

It's not news anymore: bonds don't yield what they used to.

The 60-40 equities-fixed income portfolio was a go-to for investors to maximize returns and reduce risk. But with inflation on the rise and interest rates creeping higher, investors are increasingly questioning the role of bonds as a way to diversify their portfolios.

"Over the last 25 years, bonds have been an effective portfolio diversifier," Wanting Low, a cross-asset strategist at Morgan Stanley, said in a note on Sunday. "However, they are struggling to do so now. Given where global bond yields stand currently, the ability of bonds to offset an equity market sell-off is diminishing now."

By Low's estimate, an investor with a traditional 60/40 portfolio would need the 10-year yield to fall by at least 100 basis points, increasing its price, to offset a 10% decline in stocks. Right now, yields are headed in the opposite direction: the benchmark 10-year yield on Monday rose to 2.98%. It last hit 3% on January 8, 2014.

Low and her colleagues set out to find alternatives to bonds that can help global investors diversify their portfolios, and created a correlation-valuation or COVA model.

Trades that made the cut on correlation, or how connected they are to global stocks, had to meet three criteria: low or negative correlation to global equities, stable correlation, and low or negative downside beta to global stocks (meaning they tend to rise when the market tanks.)

To assess valuation, they considered the 20-year percentiles of the price/book ratio of equity sectors to the All-Country World Index, the real effective exchange rate of currencies, and the three-month implied vol of volatility instruments.

"Contrary to popular belief, not all assets which provide diversification benefits are expensive," Wanting said.

"In fact, we find that sectors like staples,utilities and telecom and value versus growth equities are cheap relative to MSCI ACWI and have negative correlation to global equities. UST-Bunds 10y and long vol strategies in UST 10y, US HY and USDJPY are cheap assets with a negative correlation to global equities."

Here are the assets that scored best:

Morgan Stanley