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THE MOST IMPORTANT CHALLENGE FACING INVESTORS
Why the 'tourist thinks that the decline of the 60/40 portfolio and the flipping of stock/bond correlation should be at the forefront of all investors' minds
While everyone is transfixed on whether the US economy will tip into the most anticipated recession on record, I thought I would instead take some time to write about a topic that I believe will challenge investors for many years to come. In some ways, I believe this to be the most important issue anyone managing money will have to grapple with for the next decade.
I am hesitant to use words tossed around casually in the media because I don’t think it is a “death” by any means, but the 60/40 portfolio faces difficulties not experienced in many years, and the inability of this bedrock strategy to post reliable real returns could well shake modern portfolio management.
In the past, I highlighted what I thought was one of the most crowded market beliefs — you know, the type Mark Twain warned us about. Prior to 2022, there was an almost unanimous conviction that marrying risky assets (like stocks) with bonds (such as treasuries) was the closest thing to a free lunch. And it’s easy to understand why. Over the past 40 years, interest rates declined from 20% to 0%. Whenever the economy or market got into trouble, the Federal Reserve cut rates. But the most important part was that returns from stocks and bonds were negatively correlated. This meant that when the stock market portion of the portfolio struggled, bonds could likely be counted on to provide a cushioning counter balance. Investors embraced this “insurance” as bonds provided handsome returns in their own right, but more importantly, reduced the volatility of their portfolio of risky assets. The negative correlation between stocks and bonds was almost universally accepted as just the way things were, and few considered that it might change.
Although I was early (what else is new?), in October 2020, I wrote a piece titled, “BLUES AND SPOOZ - TIME’S UP?”. From that article:
Another reason why “spooz and blues” has reached its expiration date is that the negative correlation between stocks and bonds is something that has worked over the past forty years, but that’s largely occurred in a dis-inflationary environment. If we have moved to a period of inflation, then the ballast of a fixed-income position in a portfolio of risky assets might turn out to be more of an anchor.
I was worried about a hiccup for the 60/40 portfolio, but I had no idea the worst year in almost a century was in store. Much to almost everyone’s surprise, stocks and bonds both suffered large losses in 2022. It was unusual as it happened together.
After 2022’s terrible performance of the 60/40 portfolio, it is tempting to forecast that the worst is behind us, but I have been reflecting about that bond/stock correlation and what it might mean for markets going forward, and I have decided the answer is not as simple as the previous call.
When rates were rock bottom and stocks gripped in a speculative fever, it was easier to forecast the 60/40 portfolio would underperform. However, rates are now considerably higher and even offer a positive real yield, while sentiment towards stocks has soured considerably. And if I am correct about stock/bond correlation remaining positive, does that mean an economic slowdown that allows the Fed to take their foot off the brake will be accompanied by a stock market rally?
I’m not sure, but I do know that stocks and bonds will trade completely differently in a positively correlated world. There are many implications from this new environment. And with those changes, will come a new series of challenges for investors.
This change is being underappreciated. Many folks are swimming along expecting a return to the 2009-2020 period. We’re not going back. Therefore, it’s vital we spend time understanding how the 60/40 portfolio and the bond/correlation behaved under different regimes in the past to better help us forecast how it might behave in the future.
Today, I am starting with a review of the performance of the 60/40 portfolio through history1, and then the next post will be a discussion of the latest research about the stock/bond correlation. Even if you are a trader trying to determine the direction of the next squiggle, these concepts are important as the very nature of the market is changing.
For portfolio managers and long-term investors, the challenge from a positively correlated stock/bond environment is one of the most difficult problems you will be asked to solve (or at least help ameliorate) in the coming years.
After the post about bond/correlation, I have a suggestion for a new asset class that I believe will improve portfolio returns and reduce volatility in this environment, but before we get to that stuff, we need to go back in history.
The 60/40 portfolio performance throughout the years
Let’s talk about the 60/40 portfolio. According to AFR:
Born out of Modern Portfolio Theory (MPT), the 60/40 portfolio has its origins from Harry Markowitz’s seminal work in 1952. Back then, based on historical long-term results, a near 60/40 split between shares (growth assets) and bonds (defensive assets) was considered the optimal portfolio.
Taking a cursory glance at the returns of the 60/40 portfolio reveals a growth chart that, at first blush, seems awfully attractive2:
Although there were some obvious drawdowns (like around 1932 and 1975), on the whole, the declines were minor compared to the gains.
However, these are returns before inflation. What does the 60/40 portfolio look like when expressed in real terms?
The steady march upwards has been replaced with some “lost decades” where the 60/40 portfolio offers no real return (meaning the portfolio did not beat inflation).
And when we look at the yearly returns expressed in real terms, there are now more (and bigger) red bars:
If we examine the trailing 10-year nominal and real returns of the 60/40 portfolio, we notice that although the nominal 10-year return rarely dipped below 2.5%, the real return had four declines to (or below) zero.
What conclusions can we draw from this? Although over all rolling 10-year periods, the nominal returns were always positive, for many long periods of time, the 60/40 portfolio provided almost no real return. A decade and a half of the 60/40 portfolio merely matching the rate of inflation is not something that would be unusual (and is what I expect for the next decade).
Taking a closer look at recent performance
One of the problems with the 60/40 portfolio is that it’s not a standard index. I’ve used the S&P 500, but it’s completely acceptable to use a broader stock market index like the Russell 3000. As for the bond portion, that’s even trickier. Some folks use the Bloomberg Aggregate Index, which is the broadest fixed-income index, and, to some extent, the standard fixed-income benchmark. However, if the 40% of the portfolio which is bonds is meant to offer “safe” income, there is a case to be made that a Treasury Index is more appropriate.
For this next section, I downloaded the S&P 500 total return data and the Bloomberg Aggregate and Treasury Index total return data from 1988 to present. From there, I rebalanced the returns on a yearly basis to create a 60/40 portfolio. I also did quarterly, but it offered so little difference, I decided to stick with yearly.
The purpose of this exercise is to better understand 2022’s decline by looking at the data in a more granular fashion.
All right, let’s get to the data - here are the nominal yearly returns since 1988:
Notice how the 60/40 portfolio using the Agg Index was down 20.1% in 2009, but the Treasury version was only down 12.8%? That’s because of the credit risk in the Agg Index.
Yet, look at 2022. The Treasury version was down 22.6% and the Agg was only down 16.1%. In that case, the longer duration and previously lower interest rate starting point for treasuries caused the “safer” index to underperform.
Depending on the bond portion of the 60/40 portfolio, 2022 was either the worst year in this series, or the second worst.
But these are nominal returns. What does the real return chart look like?
When adjusted for inflation, 2022 was the worst year in this series for both versions. This was due to the fact that 2008/9 was a deflationary bust, while 2022 was an inflationary explosion.
However, these are yearly returns and represent arbitrary starting and ending points. The true risk is the point of maximum drawdown.
To get a better sense of 2022’s pain, I created the following drawdown charts:
The 60/40 portfolio with the Bloomberg Agg Index drawdown was approximately 21% at its worst in 2022. This was almost the same as the COVID drawdown. But it paled compared to 2009’s decline of 35%. And what’s interesting is that even 2002 saw a decline of 23%.
As for the Treasury version:
It was down 20% in 2022 which was more than the COVID max drawdown of 17%. And it’s a long way from 2009’s 31% drawdown or 2002’s 22%.
Although 2022 felt terrible, it was mostly a quirk of the calendar that made it the worst year in almost a century for the 60/40 portfolio. The decline started in January and ended in December, creating the optimum calendar year loss.
The 60/40 portfolio - what to take away
Even if you think you don’t use the 60/40 portfolio, the idea of marrying risky assets with safer fixed-income pervades throughout all portfolio construction, so the relationships between these assets affects almost all portfolios.
The 60/40 portfolio has been a stalwart for portfolio construction for many years, but its pricing was taken to extremes with miniscule interest rates and a belief that the stock/bond correlation would remain forever negative.
Over longer periods, the 60/40 portfolio generally provides a decent nominal return, but there are decades when in real terms, it treads water. It has been 15 years since the end of the last “lost decade” and investors should prepare themselves for the possibility of the start of the next period of underperformance.
Next post, I’ll examine the stock/bond correlation more closely and explain what that means for markets going forward and then follow up with a post about an asset class that will help in this new environment.
Thanks for reading,
Kevin Muir
the MacroTourist
Please use my data and charts in any way you like. You can download the two files here and here. I view this as part of my value-add, so feel free to take off the logo and use it in your own presentation. I spent too long struggling with my R code to get the returns for the rebalanced 60/40 portfolio, so I will be happy to help others avoid that hassle. I know some of you can’t download from OneDrive, so just send me an email at kevin@themacrotourist.com and I will email you the files.
I have used MacroHistory.Net data as it is difficult to find bond return series that go back that far. Unfortunately, they have only updated to 2020 and when I tried to backwards engineer the data series provided by Barclays, I couldn’t replicate it. So, I have created my own 60/40 portfolio using a couple of different bond indices.
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