Monday, April 10, 2023
There deservedly was a lot of hand-wringing about the death of the 60/40 portfolio in 2022, a portfolio of 60% stocks and 40% bonds. As we stated back in June, the call for the demise of the 60/40 had likely come too late. Even at that time, we believed the challenges the markets were facing were likely already contributing to the prospect of better times ahead.
What was most surprising for the 60/40 in 2022, or course, was how spectacularly bonds failed to play their traditional role as a portfolio diversifier in a down market for equities. Equity volatility is unnerving, but many investors understand the path to potential longer-term stock gains is rarely smooth. But we are less accustomed to bond volatility and we had plenty of it (although still less than stocks). In fact, the first three quarters of 2022 were all among the 5 worst quarters for the Bloomberg U.S. Aggregate Bond Index since its inception in 1976.
But the tide does seem to be turning. While the fourth quarter of 2022 and the first quarter of 2023 weren’t spectacular for the 60/40, using the total return for the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index as our proxy for stocks and bonds, the 60/40 has been on solid footing the last two quarters, as seen in the chart below. Both stocks and bonds were up both quarters with the 60/40 for each quarter in the top 30% of historical values.
But that’s looking backward. What about looking forward? LPL Research’s Asset Allocation Committee sees reason to be bullish on the 60/40 over both a tactical and a strategic time frame.
Looking at bonds from a tactical perspective, with higher starting yields, a Federal Reserve (Fed) likely near the end of its rate hiking campaign, and inflation coming back down, not only do return prospects look brighter for bonds, we believe they have become more likely to return to their historical role of a portfolio diversifier in the event of an economic downturn.
On the equity side, there is still economic uncertainty ahead to work through, but we think some of the same factors that may support bonds (lower inflation, a steadier rate environment) may also provide a lift for stocks. The economy is still on shaky ground as Fed policy tends to act with a lag and we have not yet felt the full impact of higher rates. However, we believe the kind of economic excesses that have contributed to steeper downturns in the past are not currently a threat and markets may look past a modest economic downturn relatively quickly.
Turning to the strategic perspective, we base our outlook on our long-term capital market assumptions, which look ahead 10 years and are based on the long-term drivers of returns. For stocks, that’s largely the outlook for earnings growth together with some expectation that valuations will move toward historical norms. For bonds, the main driver is yields, which are generally solid predictors of returns 5–10 years out. (Stock forecasts, by contrast, are subject to greater variability even over a 10-year time horizon.)
As seen in the table below, our long-term forecasts for stocks and bonds, again using the S&P 500 Index and the Bloomberg Aggregate as proxies, improved substantially from 2022 to 2023. While stock valuations remain somewhat elevated relative to history, giving us a below-historical return expectation, they did see some improvement during the downturn, with prices coming down more quickly than forward earnings expectations. The jump in bond returns is even more meaningful as the downside from higher yields (falling bond prices) turns into upside looking forward. Between the two, our forecast for a 60/40 portfolio improved 2.3 percentage points, which over the course of a 10-year investing cycle would make a profound difference to returns.
While our outlook for the 60/40 portfolio has improved and we believe many investors remain overly cautious—on fixed income markets in particular—we shouldn’t forget the lessons learned in 2022. Bonds are risky assets, even if core bonds are generally not as risky as stocks, and are vulnerable to downturns. And while high quality bonds have historically acted as an effective portfolio diversifier much of the time, they will not necessarily all the time. There were also some effective hedges against losses in 2022 that investors can sometimes forget when the 60/40 is on a roll, especially in alternative investments. We do believe that there are ways in which a portfolio can be better diversified beyond the traditional 60/40, but we think the 60/40 remains a sound foundation for a diversified portfolio, both tactically and strategically, something that is easy to forget after the challenges of 2022.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
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For a list of descriptions of the indexes and economic terms referenced in this publication, please visit our website at lplresearch.com/definitions.
All index and market data from FactSet and MarketWatch.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Bond yields are subject to change.
Certain call or special redemption features may exist which could impact yield.
Alternative investments may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.
This Research material was prepared by LPL Financial, LLC.
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