The outlook remains challenging for 60/40 portfolios.
That was the message from Goldman’s Christian Mueller-Glissmann, Cecilia Mariotti and Andrea Ferrario who, in note published Tuesday, cautioned that equity valuations “remain elevated” which, when “coupled with little cyclical upside and continued policy tightening, results in a continued poor risk/reward for 60/40 portfolios with less potential for a strong recovery and still above-average drawdown risk.”
What a bummer, right? An entire generation of investors was raised to believe the 60/40 split was a guaranteed path to reliably positive, diversified returns with relatively low volatility. That was true right up until it wasn’t. It was based on the assumption that the negative stock-bond return correlation which persisted for two decades (give or take) would persist in perpetuity. The risk was always inflation: A bout of unstable prices had the potential to end the four-decade bond bull and central banks’ efforts to slay the inflation dragon could reset equity valuations, resulting in a simultaneous selloff — a positive stock-bond return correlation.
Do note: The correlation assumption was a product of recency bias. The same recency bias that said The Great Moderation was the new normal and that the age of great power struggles and ideological clashes was over. We were lulled to sleep.
Towards the end of 2021, Goldman cautioned that 60/40 portfolios might not perform as well going forward. “The key reasons for this were elevated valuations for both bonds and equities post the COVID-19 recovery but also high and rising inflation,” Mueller-Glissmann wrote Tuesday, recapping. “Increased inflation volatility is likely to drive more rates volatility and can result in more growth volatility, increas[ing] the risk of a ‘lost decade’ or very low real returns for 60/40 portfolios.”
Inclusive of losses incurred over the past two months, when the bear-steepener in the US curve undercut 2023’s equity rally, the 60/40 drawdown for US-focused portfolios is still in excess of 20% in real terms, Goldman noted, adding that in locales where stocks didn’t benefit from a euphoric tech surge, “real drawdowns have been even larger.”
The good news is that the selloff has resulted in a more attractive starting valuation for a 60/40 portfolio thanks in no small part to cheaper bonds, which are “likely to support 60/40 returns in the coming years and could eventually provide a buffer for equities in the event of large growth shocks,” as Mueller-Glissmann put it.
The bad news (from the perspective of anyone looking for a cheap entry point in a 60/40 portfolio) is that 2023’s equity re-rating on the back of A.I. optimism means stocks are still expensive.
“Equity valuations are not a good short-term market timing indicator and the elevated levels might in part reflect structural shifts in the index to more profitable, higher growth Tech stocks with stronger balance sheets,” Goldman conceded, but nevertheless cautioned that long-term investors should “consider” the possibility that stocks will eventually succumb to “valuation mean-reversion.”
The bottom line: Bonds might be approaching cheap territory, which in theory means they can cushion an equity drawdown. But as Mueller-Glissmann emphasized, the reset in equity valuations over the past two months is “limited,” and as such “may not provide enough support for a large and sustained rebound in 60/40 portfolios in the near-term.”
Shiller P/Es, Goldman noted, are higher than levels seen in and around post-War 60/40 drawdown troughs.
It’s not hard to imagine a lost decade given how many tailwinds equities and bonds had over the last several decades that are now not so favorable or neutral – the internet, rates and taxes consistently trending down, the Fed Put being all but confirmed, favorable demographics with the baby boomer generation, relative international stability, the rise of cheap labor in China.
If you read personal finance subreddits, it’s taken as gospel that an index fund will always be your best bet over the long-term, but to your point, that strikes me as recency bias and was a function of the aforementioned highly favorable tailwinds. If we’ve exhausted those, there might not be much gas in the tank to keep driving assets higher.
That being said, I’m obviously bullish on AI and I still think we are generally trending toward the zero bound in the medium-to-long term. Also, what are the alternatives other than throwing darts to pick stocks?
Ten years of forecast damage to bonds from changes in rates has been more than paid for by the 40 year bond bull, during which time there were 34 years of dead money in the stock market. We also seem to forget that inflation doesn’t only damage bond returns. It lowers the purchasing power of all investment returns to the same degree. The data shows that the idea of stocks as an inflation hedge is more myth than reality in several decades.