It’s been a tough year so far for a traditional “60/40” portfolio, a portfolio of 60% stocks and 40% bonds. Using the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index (“Agg”) to represent stocks and bonds, the traditional 60/40 is down 14.0% as of market close on May 11 on a total return basis, which would trail only 2008 as the worst year on record if that’s where we ended the year, which is not our base case.
Historically, bonds have typically seen gains during periods of equity volatility, although not always. But low bond yields in 2020 and 2021 and steep bond losses due to rising rates in 2022 have led many to speculate that the 60/40 portfolio is dead. But there’s something of a silver lining in the declines. Recent stock and bond losses have actually helped valuations to improve for the 60/40 considerably, based on a combination of the price-to-earnings ratio for the S&P 500 and the yield for the Agg. Valuations aren’t a market timing mechanism, but they are an important consideration for longer-term return expectations and that picture has improved quite a bit.
“The time to talk about the death of the 60/40 was six months to a year ago and even then it was exaggerated,” said LPL Financial Asset Allocation Strategist. “We still probably won’t get back to the level of returns we’ve seen over the last several decades, but over the last year the 10-year outlook for the 60/40 has improved by about 2 percentage points annualized in our view, about as big a one-year improvement as we’ve seen at any time in the last 20 years.”
For the many investors whose experience this year has them questioning the value of the traditional 60/40, here are five things that provide perspective.
- What we’ve seen in 2022 so far is unusual. Since the inception of the Agg in 1976, the S&P 500 has been down over a calendar year eight times. The Agg was higher every single time (although only by 0.01% in 2018). Those are also the worst eight year for 60/40 performance. From the bond perspective, the Agg has been negative four times in its history. It’s a small sample, but the S&P 500 was higher every time with the average gain over 20%. Of course, neither case is holding this year so far.
The picture is a little more complicated when looking at quarterly data. Since 1976, the S&P 500 has had 50 negative quarters. The Agg has been lower in 16 of them. The worst quarter for the 60/40 was the fourth quarter of 2008, driven by stock losses. The Agg was actually higher that quarter. The worst quarter for the 60/40 in which the Agg was negative was the third quarter of 1981, with the 60/40 down 7.8%. As of May 11, the current quarter would be the worst for the 60/40 when the Agg had a negative quarter, but only the fourth worst overall due to prior quarters that saw heavy stock declines.
- Bonds can go down too, even when stocks do. Using quarterly data, the historical correlation between the S&P 500 and the Agg is close to 0. Stocks and bonds tend to each go their own way relative to average performance rather than moving in decidedly opposite direction. It’s also important to remember that bonds, just like stocks, are perfectly capable of losses. The S&P 500 has been lower 27% of all quarters over the lifetime of the Agg; the Agg, by comparison has been lower 23% of all quarters, a relatively small difference. The Agg is down more often than average when the S&P 500 is down for a quarter (32% of the time), which of course also means that when the S&P 500 was down the Agg has been higher 68% of the time.
- Stock valuations have improved dramatically. The forward price-to-earnings ratio (P/E) for the S&P 500 as of the end of April 2021 was 21.7 according to FactSet data. Yesterday it was around 16.6. As shown in the LPL Chart of the Day, that’s an improvement of 23%. (P/Es improve as they fall, since stocks are “cheaper.”) That decline translates into roughly a 2 percentage point improvement in the annual return expectation of the S&P 500 over the next 10 years, although many factors can strongly influence the actual outcome. That’s the fastest one-year improvement in the forward P/E since 2009. Even with the dramatic decline in P/E, S&P 500 valuations are still slightly above their historical average, but the improvement is meaningful.
- Bond valuations have improved dramatically too. The yield-to-worst for the Agg as of the end of April 2021 was 1.51%. Yesterday it reached 3.47%. This is the fastest one-year improvement in yields since 1995. That likewise represents an improved annual expected return of roughly 2 percentage points over the next 10 years. There are factors that can make the actual outcome differ from the expectation here as well, but the difference is less variable than for stocks simply because you know the price you’ll get for a bond at maturity.
- Dislocations create opportunities for strategic investors. This blog’s focus has been on the S&P 500 Index, perhaps the most well-known and widely used stock index in the world. But it’s not the only area of the market where stock valuations have improved, and some may offer even better value. Despite its improvement the S&P 500’s P/E is still in the 73rd percentile of all values going back 20 years, according to FactSet data, with higher percentiles representing less attractive valuation. But there are areas of the market that are in the 10th percentile or lower of all values over the same timeframe and sitting near levels only seen during the Great Financial Crisis and in March of 2020.
Similarly, there are pockets of the bond market seeing yield levels that have been relatively unusual in the last decade. For both stocks and bonds, times when valuations were most attractive were hard moments to have an optimistic investment outlook, but the most opportune moments often are. Where we see the best strategic opportunities is a blog for another day, but pockets of even more attractive, even extreme, valuations do suggest that for long-term investors there may be ways to further diversify a traditional 60/40.
Recent changes in valuations have improved the outlook for a traditional 60/40 portfolio considerably, in our view, both on the stock side and the bond side. We do think of the traditional 60/40 only as a starting point for an appropriate investor. And even if the traditional 60/40 is very much alive, as we believe, there may still be opportunities to improve the risk profile of a portfolio, whether through greater diversification within stock or bond holdings, active management, or investment opportunities outside of traditional stocks and bonds. It’s been a tough year for many investors and we don’t think we’re in a position yet to call a tactical bottom for either stocks or bonds. But looking out strategically, based on better valuations and still solid fundamentals, we think the long-term outlook has brightened quite a bit.
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