It may be time for investors to return to one of the oldest of portfolio management tools to cope with the new bear market.
That would be the traditional combination of 60% stocks and 40% bonds, which for years had been a marvelous recipe for strong returns with reduced risk. Steadily declining yields had provided a tailwind for both asset classes. When risky equities would falter from a worsening economy or financial disruptions, interest rates would decline, boosting bonds.
Once bond yields started to run out of room to fall, the basic raison d’être of the 60/40 portfolio was called into question, including in this column more than three years ago. Those objections grew more acute as inflation built up its head of steam while bond yields remained low, as noted here last year.
Still, it comes as a bit of a shock to see how badly the strategy has fared since then. According to a research note from Bespoke Investment Group, the 60/40 portfolio suffered a negative total return of 17.8% since the beginning of 2022, the worst start to a year since 1976 and the second-worst six-month showing since then. Not even the 2007-09 financial crisis was as painful for such a 60/40 portfolio, the advisory noted.
That’s because both portions of the portfolio have been losers this year. The iShares Core U.S. Aggregate Bond exchange-traded fund (ticker: AGG), which represents the broad taxable investment-grade debt market, had a negative 11.54% return from the beginning of 2022 through June 15, according to Morningstar, while the SPDR S&P 500 ETF (SPY) lost 19.92% over that span.
To the contrarian-minded investor, such dreadful results might suggest that a reversal of fortune for the traditional 60/40 portfolio might be in the offing.
To Adam Hetts, global head of portfolio construction and strategy at Janus Henderson Investors, the insurance provided by bonds in a balanced portfolio was always valid but became too expensive when yields fell to historic lows. Now, with yields jumping dramatically—the benchmark 10-year Treasury has more than doubled to a peak, thus far, at 3.48% this past Tuesday—that insurance has become cheaper, he said in a telephone interview.
The rise in yields may induce households to rebalance their portfolios, J.P. Morgan strategist Jan Loeys writes in a research report. Paltry bond yields below inflation meant they either had to save more to meet future goals, such as retirement, or take on more risk in stocks. So they upped their equity allocation to the highest levels in the bank’s data going back to 1952.
The dramatic drops in both stock and bond prices now make for higher prospective returns—about 5% for a 60/40 portfolio. All of which argues for rebalancing from still-high equity allocations toward more fixed-income securities, Loeys concludes.
Other strategists recommend tactical shifts in portfolios toward bonds based on rising risks that have become painfully apparent of late.
Guggenheim Partners global chief investment officer Scott Minerd fears the Federal Reserve is making a “grave policy error” in tightening policy excessively. The result could be a “precipitous collapse in risk assets” such as stocks and speculative corporate debt. As a hedge, the firm’s portfolio allocation flipped to emphasize long-term Treasuries, which would be expected to rally if fissures in the financial system worsen.
David A. Levy, who heads the Jerome Levy Forecasting Institute, told clients this past week that he “would not be surprised” if Tuesday’s high yields for Treasuries could mark the peak for the business cycle. The Treasury market already appeared to have discounted the Fed’s expected rate increases and had also become oversold in disorderly trading, he added in a research note. Unusually, risk-free government securities also failed to benefit from the turmoil in risk markets, which he didn’t think would persist.
More-aggressive and faster monetary policy could mean bond prices will bottom (and yields peak) ahead of a trough in stocks, contends John Higgins of Capital Economics. Tighter monetary policy may bring forward the peak in yields but could also result in weaker economic growth and, in turn, corporate profits falling short of analysts’ consensus expectations. That scenario would hurt stocks but likely boost bonds.
Janus Henderson’s Hetts says the equity side of a 60/40 portfolio should emphasize quality, which can have either growth or value factors (like most strategists, he doesn’t offer individual names). Notwithstanding the risk of recession, he also likes cyclical companies but ones with secular advantages, plus technology, except those lacking profits and at risk of losing funding.
On the fixed-income side, Hetts emphasizes mortgage-backed securities, where yields have risen dramatically. That lessens the usual risk with MBS—prepayments. Homeowners are unlikely to refinance older 3% loans while costs of new ones have doubled this year to 6%.
There is a silver lining in the decimation of bond and stock portfolios, Hetts adds. Reallocation and rebalancing portfolios present the opportunity to book tax losses while upgrading holdings.
That may include a reconsideration of the venerable 60/40 balanced portfolio.
Write to Randall W. Forsyth at [email protected]
