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Maybe it’s time for investors to go back to one of the older portfolio management tools to face the new bear market.
This would be the traditional combination of 60% stocks and 40% bonds, which for years has been a wonderful recipe for strong returns with reduced risk. The steadily declining returns had created a backwind for both asset classes. When risky stocks stumble over a worsening economy or financial turmoil, interest rates would fall, boosting bonds.
As bond yields began to plummet, the underlying reason for the 60/40 portfolio came into question, including this column more than three years ago. These objections became more intense as inflation increased its momentum, while bond yields remained low, as noted here last year.
However, it is a bit shocking to see how badly the strategy has gone since then. According to a research note by Bespoke Investment Group, the 60/40 portfolio showed a negative overall return of 17.8% since the beginning of 2022, the worst start of a year since 1976 and the second worst performance of six months since. The financial crisis of 2007-09 was not so painful for such a 60/40 portfolio either, the advisory noted.
This is due to the fact that both parts of the portfolio were lost this year. The
iShares Core US Bond
negotiable mutual fund (AGG), which represents the broad taxable market for investment grade debt, had a negative return of 11.54% from the beginning of 2022 to June 15, according to Morningstar.
SPDR S&P 500
The ETF (SPY) lost 19.92% during this period.
For the opposite investor, such dire results may suggest that a reversal of fortune for the traditional 60/40 portfolio may be in the spotlight.
For Adam Hetts, global head of portfolio building and strategy at Janus Henderson Investors, bond insurance in a balanced portfolio has always been valid, but became very expensive when yields fell to historic lows. Now, with yields soaring dramatically – the benchmark for the 10-year Treasury has more than doubled to a maximum of 3.48% last Tuesday – insurance has become cheaper, he said in a telephone interview.
Rising yields could push households to rebalance their portfolios, writes JP Morgan general Jan Loeys in a research report. Low bond yields below inflation meant they either had to save more to achieve future goals, such as retirement, or take more risk on stocks. Thus, they increased the distribution of their own funds to the highest levels in the bank since 1952.
Dramatic reductions in both stock and bond prices are now creating higher yields – around 5% for a 60/40 portfolio. All of this argues for a shift from equity allocations that are still high to more fixed income securities, Loeys concludes.
Other strategy analysts recommend shifting tactics in portfolios to bonds based on the growing risks that have become painfully apparent lately.
Guggenheim Partners Investment Director Scott Minerd fears the Federal Reserve is making a “serious political mistake” in tightening its policy. The result could be a “sudden collapse of risky assets”, such as stocks and speculative corporate debt. To hedge, the company’s portfolio distribution was reversed to focus on long-term bonds, which are expected to increase if cracks in the financial system worsen.
David A. Levy, who heads the Jerome Levy Forecasting Institute, told customers last week that he would not be “surprised” if Tuesday’s high bond yields signaled the peak of the business cycle. The Treasury Department market already appeared to have discounted the expected Fed rate hikes and had also outsold in erratic trading, it added in a research note. Unusually, risk-free government securities also failed to take advantage of the turmoil in risk markets, which he did not believe would continue.
A more aggressive and faster monetary policy could mean that bond prices will fall (and yields peak) before equities fall, says John Higgins of Capital Economics. Stricter monetary policy can lead to peak yields, but it could also lead to weaker economic growth and, in turn, corporate profits fall short of analysts’ expectations. This scenario would hurt the stocks but would probably strengthen the bonds.
Janet Henderson’s Hetts says the equity side of a 60/40 portfolio should focus on quality, which can have either growth or value factors (like most generals, it does not offer individual names). Despite the risk of recession, he also likes circular companies, but those with cosmopolitan advantages, plus technology, other than those that have no profits and risk losing funding.
On the fixed income side, Hetts focuses on securities backed by mortgages, where yields have risen dramatically. This reduces the usual risk with MBS — prepayments. Homeowners are unlikely to refinance older loans by 3%, while new homeowners’ costs have doubled to 6% this year.
There is a silver lining to decimating bond and equity portfolios, Hetts adds. Redistribution and balancing portfolios provide the opportunity to record tax losses while upgrading holdings.
This may include a review of the respectable 60/40 balanced portfolio.
Write to Randall W. Forsyth at randall.forsyth@barrons.com
