Not dead yet

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   By Guest Blogger Ryan Lewenza

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In response to a New York reporter who was inquiring about the rumours of Mark Twain’s death, Mr. Twain famously quipped “the reports of my death are greatly exaggerated”. A humorous retort for sure, and I was reminded of this quote as I’ve read numerous articles and heard pundits declaring the death of the 60/40 balanced portfolio. Today I’ll address and pushback against this simplistic narrative and why we believe the death of the 60/40 portfolio has been greatly exaggerated.

Last year was a rough year for the markets and the 60/40 balanced portfolio, to say the least. For example, the S&P 500 and global equities were down around 20% while the TSX was down a gentler 8%. US and Canadian bonds were down 13% and 12%, respectively, in large part due to the aggressive rate hikes by the Fed and Bank of Canada.

This of course weighed on balanced portfolios, which experienced the worst decline since 2008. I ran the return numbers of a US 60/40 portfolio using just the S&P 500 and the Bloomberg US Aggregate Bond Index and last year it declined 16%, which was the worst year since 2008 when it declined 20%. The next worst year was in 2002 when it fell 9%.

The reason for the poor performance last year was that BOTH bonds and equities declined last year. So now I’m talking about the correlation between stocks and bonds.

Annual Performance of a US Balanced Portfolio

Source: Bloomberg, Turner Investments

Over the long-run the correlation between stocks and bonds is negative, meaning, when stocks go up in good economic times, bonds tend to fall and during tough economic times, bond prices tend to rise when stocks fall.

Below I ran the correlation between US government bonds and the S&P 500 and you’ll note that correlations change over time, ranging from -0.90 (strongly negatively correlated) to 0 correlation (no correlation). Last year was a complete anomaly as we saw the correlation actually go positive, which means both stocks and bonds declined together. This is why some are declaring that the 60/40 is dead or no longer works. But this is nonsense, in my view.

Long-term Correlations between Stocks and Bonds

Source: Stockcharts.com, Turner Investments

First, the reason why the correlation went positive is because inflation hit a 40-year high last year, which caused the Fed and other central banks to hike rates at the most aggressive pace in 40 years (4% in 10 months!). But now inflation is peaking and the central banks are nearing the end of their tightening cycles, in my view.

While I see inflation in the coming years averaging more than the 2% seen over the last decade, I still see inflation coming down sharply over the next year. This should help to restore the long-term negative correlation between these two asset classes.

Second, with the big backup in interest rates we’re finally getting some good yields from lower risk bonds. Below is a chart of the current yield for the Bloomberg U.S. Aggregate Bond Index and it’s currently yielding around 4.3%, which is the highest level since 2008.

We’ve all been bemoaning the very low interest rates and now we’re finally seeing some good yields so in my view the 60/40 portfolio makes even more sense today.

Yield of Bloomberg U.S. Aggregate Bond Index

Source: Bloomberg, Turner Investments

Third, up to now I’ve been largely focused on returns, but unlike some other portfolio managers and investors, we at Turner Investments focus a lot on portfolio volatility and downside risk.

We’re not trying to get clients the highest return. We’re trying to get clients the highest return for the risk taken, so we spend a lot time analyzing things like standard deviation, which measures the volatility of different assets and portfolios, and a measure called downside risk, which measures the risk of losses. As Garth likes to say, “Our goal is to first not lose money and second to get client’s a reasonable rate of return”.

The simple facts are: 1) bonds are less volatile than stocks as seen in the chart below; and 2) due to the long-term negative correlation between stocks and bonds, when you combine stocks and bonds you greatly lower overall portfolio volatility, which is a key aspect of what we do at Turner Investments.

Standard Deviations: Stocks, Bonds & 60/40 Portfolio

Source: Bloomberg, Turner Investments

Finally, if the 60/40 is dead as some claim then what do these pundits and analysts propose in replace of a 60/40 balanced portfolio? If we go to say 80/20 then that means a lot more volatility and risk, exactly what our clients are looking to avoid.

In conclusion, last year was an anomaly for balanced portfolios largely due to the 40-year high inflation. But as inflation abates, the long-term negative correlation should re-establish itself and why we stand steadfast in our belief that the 60/40 balanced approach is the right portfolio for most investors.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

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About the picture: This is the stunning tomb of science fiction author Jules Verne (1828-1905), located in the Cimetière de la Madeleine in Amiens, France. Sculptor Albert Roze used Verne’s death mask to make the sculpture, which depicts the famed writer breaking free of his tomb and reaching for the sky. Not dead yet, or ever.