How many times have you heard that the 60/40 equity/bond mix is dead? Every time bond interest rates hit new lows; the argument is used. Every time equities decline; the 60/40 death argument is raised as a reason to change diversification strategies. Every time the stock/bond correlation increases into positive territory; the argument for moving away from 60/40 is employed. Nonetheless, here we are at the end of the summer with a simple 60/40 SPY/AGG at 8.35 percent for the year (9.68% for SPY and 6.37% for AGG).
Going back to basics, why is the 60/40 doing so well?
The bond bull continues - Bond markets have been in a bull market since early 1980's. While there have been some notable rate increases, annual positive bond total returns have been the norm. No alternatives have better bond returns especially after accounting for diversification benefits. The AGG bond return for 2020 has surpassed most equity diversification strategies such as small cap or international stocks. It has done better than low volatility and dividend benchmarks.
The SPX benchmark allocation has worked - Large cap growth has supported holding the equity benchmark over any other equity allocation. The declining real rates over the bond rally period have supported equity exposures in the US.
The value of negative correlation - The zero to negative correlation between stocks and bonds has supported the 60/40 allocation over alternatives that have had positive correlation.
The same questions as in the past have to again be addressed. Can US valuations continue? Can a bond rally continue?
The bond rally - With interest rates again reaching lows and no indication that US rates will follow the rest of the advanced world and go negative, the bond rally could be considered over and bond allocations will be a drag on performance. This argument is based on the premise that the zero bound will not be breached. This premise may be wrong. Additionally, while Fed inflation averaging should scare investors, there is no Phillips Curve trade-off that makes inflation likely.
US equities - The high CAPE value and heavy tilt to technology makes it hard to hold the equity benchmark. Stock performance may be low over the next few years but it is less clear that value, small cap or international equities will provide an alternative.
Equity/Bond negative correlation - The negative equity bond correlation is based on the low inflation environment. If there is no inflation, it is less likely that a positive correlation will arise. This correlation threat again takes us back to the flat Phillips Curve. Fed policy of reaching for full employment may not create conditions for higher inflation.
You may not like simplicity, but simple has still worked and will likely continue. Any change should be benchmarked against the 60/40 base. Change should only focus on close bond substitutes or alternatives forms of risky assets. Perhaps changes can be applied along the margin, but the core allocation of risky equity and safe bonds still makes sense.
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