“If you intend to go any further, I would entreat you to stay here a little. If you are, like many in this pretending age, a sign or a title gazer, and you come into challenges like Cato into the theater, only to go out again, then you have had your entertainment; farewell! But if you are someone resolved to take a serious view of the following discourse…then I desire a few words in the doorway.”
Thus begins John Owen’s classic treatise, The Death of Death in the Death of Christ. The reference to Cato is meant to discourage attention that is purely entertainment-driven. Owen wanted to stress the seriousness of his subject. We too live in a “pretending age”, where in-depth evaluations of important subjects are rare. Often, shallow analysis is passed off as game-changing discoveries instead of the fodder they are for title gazers. Such is the case with the recent obituaries published for the 60/40 portfolio. When it comes to investing, there is perhaps no issue more important than asset allocation. It is, in fact, the greatest determinant for portfolio returns over time. So with that in mind, let’s discuss the death of depth in the death of the 60/40 portfolio.
What is the 60/40 portfolio, you ask? It’s the Walmart of big-box stores. It is the Amazon of e-commerce. It’s the iPhone of mobile devices. It refers to the asset allocation of nearly all balanced investment portfolios for the last few decades. Target Date funds, default investment options within retirement plans – not to mention most investment professionals – utilize a variation of the 60/40 portfolio allocation.
60% of the portfolio is invested in equities, and 40% in bonds – almost all within the U.S. market. This is considered a “diversified” portfolio because the assets tend to have negative correlations to one another. Stocks protect against inflation while bonds provide a hedge in recessions. When stocks go down, bonds typically go up as buyers seek safety. In short, this portfolio allocation limits an investor’s downside risk while also allowing them to participate in asset growth and keep up with inflation. Steady income and appreciation – the best of both worlds!
Not so fast…
This has been the narrative for quite some time, which is why most investors utilize this allocation strategy (or a variation of it). And as long as the correlation between stocks and bonds remains negative, this narrative is likely to remain convincing. But recently, Bank of America published research arguing for the end of the 60/40 portfolio, and others have chimed in to agree. The big risk, according to Bank of America, is that “the correlation could flip, and now the longest period of negative correlation in history is coming to an end”.
If the current trend (as indicated by the red arrow) continues, we may once again have a sustained period of a positive correlation between the bond and equity markets. If this were to occur, a 60/40 portfolio would provide no diversification benefit. A balanced (60/40) portfolio would be susceptible to larger price fluctuations as stock and bond prices begin to move in tandem. The major benefit of the 60/40 portfolio would disappear, and a different approach to asset allocation would be needed.
Buy more stocks?
The advice given by Bank of America and virtually all other critics of the 60/40 portfolio is to buy – unsurprisingly – more stocks. It seems the answer is always more stocks. In an era of incredibly low-interest rates, bonds are producing sparse income. Right now, the dividend of the S&P 500 index is about 1.75% while the “risk-free” return of a 10-year government bond is about 1.60%. Loan the government your money for 30 years, and you’ll get around 2% per year. Woohoo!
This data point alone would suggest stocks are a better investment. If both stocks and bonds are going to move in the same direction, why not invest in the one that will obtain higher rates of growth and income? It’s a no-brainer!
The death of depth
If we assume Bank of America’s trend line continues, does that mean we should abandon the 60/40 portfolio? Is that the right take-away from this chart? In short, no. First, the chart gives no explanation for why the correlation between stocks and bonds will turn positive. In fact, recently the correlation between the two has been negative when it mattered. When stocks dropped by 20% in the 4th quarter of 2018, the 10-year note rallied over 10%. That relationship exists because fear in the equity market drives investors to the treasury market. That relationship is unlikely to change any time soon.
Secondly, the chart does not explain why the correlation went from positive to negative 20 years ago. The economy is comprised of innumerable complex relationships. Prudence would suggest cautious conclusions until these sorts of relationships are explored and understood. What caused the correlation between stocks and bonds to change in the mid-’90s? Why was it mostly positive in the ’70s and ’80s? Why was it negative in the late ’50s and ’60s? These questions aren’t asked or answered.
And thirdly, the claim of a positive correlation for the 65 years prior to the late ’90s conveniently ignores a 15-year period of mostly negative correlation from 1955-1970. That period, coincidently, began with low rates and low inflation and saw both rise to incredible heights by the late ’70s. At the same time, stocks lost value in real terms (adjusted for inflation) from 1955 until the mid-1980s. We presently find ourselves in a low-rate, low-inflation environment similar to the starting point of the mid-’50s. Is that not relevant? Suffice to say, the analysis by Bank of America is rather shallow. It has no depth. It’s fodder for title gazers and pretenders.
The foregoing analysis may lead to you think that the 60/40 portfolio is alive and well. It is not. It is very much dead – or at least “on ice” – but for very different reasons. And if this is at all confusing, it’s because even blind squirrels sometimes find nuts. The problem, of course, is that they may not know what it is, or where to store it, or that they can eat it. They found the food they need, but they are still blind.
Similarly, analysts occasionally come to the right conclusion for the wrong reason. But that isn’t isn’t the same thing as coming to the right conclusion for the right reason. The idea that the 60/40 portfolio is dead (for now) is absolutely right, but it doesn’t have anything to do with the positive or negative correlations between stocks and bonds.
The 60/40 is on ice
The 60/40 portfolio is on ice because both bonds and stocks are at their most expensive levels in history. Below is a chart of the most accurate valuation metrics utilized in the industry today. The historical percentile refers to the current value compared to historical values. The higher the current value, the more expensive stocks are compared to their historical norms. The lower the current value, the cheaper stocks are.
At current prices, stocks have never been more expensive relative to most of their fundamentals. The stock market would need to drop 60-65% from current levels to acheive a “fair-value” price. That is why the current 12-year projected return on the S&P 500 is approximately 0%.
Similarly, bonds are also expensive as indicated by the historically low-interest rates on virtually all fixed income securities. This is specifically concerning in the high yield corporate bond market, which is much more susceptible to sell-offs during a recession. As discussed in a previous blog, bond fundamentals are also flashing yellow. The corporate debt market is a powder keg as well.
At current prices for bonds and stocks, then, the 60/40 portfolio is poised to return next to nothing over the next decade. According to one analyst, the expected returns for a passive 60/40 portfolio are lower today than in 1929, right before the Great Depression. From this, we can reasonably surmise: the 60/40 portfolio (and all its derivative portfolios) allocation is currently dead. And if you implement it at this point, so too will be your investment objectives.
What to do about it
As mentioned above, a nut in the hands of a blind squirrel isn’t much help. The squirrel still has to store it for winter, or else he dies. Bank of America, along with several other news outlets, all are arguing that the 60/40 portfolio is dead. In this, they are right. But they are all saying so for the wrong reason. Subsequently, many of them advocate selling some bonds and adding more stocks. But that’s like leading the blind squirrel to store his nut in the serpent’s den. As the above fundamentals suggest, adding more stocks at this point will only make future return expectations worse.
The solution, then, is not to add over-priced U.S. stocks, but rather to look to asset classes outside the traditional U.S. stock and bond markets. The global economy offers lots of opportunities to invest in under-valued (“on sale!”) assets that have great return expectations over the next 5-10 years. Unfortunately for many, these investments – if present at all – are a small part of standard 60/40 portfolio allocations.
Here at Plan Financial, our disciplined process and investment philosophy enables us to identify and allocate to those asset classes that will weather (and profit from!) the coming economic storms. Our asset allocations are unique precisely because we believe the investment landscape is fundamentally changing. If you find yourself questioning your current allocation and wondering what comes next, consider Plan Financial a resource to help you accomplish your objectives. In the meantime, don’t settle for a 60/40 portfolio – the survival of your goals depend upon it.