adminThe traditional 60/40 investment portfolio, a staple of American retirement planning, has been taking a beating since the start of 2022. Incredibly, even during a bear market, this supposedly moderate-risk approach has underperformed compared to the S&P 500. This unexpected phenomenon can be traced back to peculiar economic conditions over the past two years.
The rapid rise in interest rates has devastated the 40% bond allocation of the 60/40 portfolio. The Vanguard Total Bond Market Index Fund ETF is down more than 15% since January 2022. Simultaneously, the stock market has also experienced losses with the Vanguard Total Stock Market ETF down 13% over the same period.
To have bond losses almost as severe as stock losses has taken investors by surprise. The warning for people with a 60/40 portfolio is that with a possible recession looming, stocks could fall much further with little to no support from bonds as is historically expected.
Yield Curve Warning Signs
The yield curve is undergoing a drastic flattening, with rates on the longer end of the curve skyrocketing, causing havoc for the value of bonds with even moderate duration. The horrible performance of longer bonds amid higher rates has taken a toll on the bond component of the 60/40 portfolio, significantly dampening the stock rally observed in the first two-and-a-half quarters of 2023.
A more alarming development for equity investors is the yield curve between the 2-year and 10-year treasury bonds is close to uninverting. The normalization of the yield curve has historically been the most dependable leading recession indicator.
According to a 2018 report from the Federal Reserve Bank of San Francisco, the yield curve has only had one false positive since 1955. The last four recessions have all commenced shortly after this segment of the curve normalized. Consequently, the equity market could be on the edge of a downturn, potentially leading to significant losses.
Excess Bond Supply
In the past, during protracted bear markets, bonds have typically offset some stock losses. This is because yields tend to fall substantially as equity investors seek the safe haven of bonds, which in turn, forces yields down.
However, this time, the situation could be different. The recent rise in rates is likely driven by an excess supply of bonds, which could remain high and buffer any expected decline in yields. This means the U.S. may be experiencing a supply-driven rate increase – a worrying new market dynamic – resulting in bonds behaving differently than investors would historically anticipate.
Reviving Inflation
Over the last 15 years, investors have grown accustomed to the Federal Reserve stepping in to rescue stocks from significant declines through various market interventions. However, this time, Fed leaders might be out of options.
If they lower rates or add economic stimulus, the economy could be on a path similar to the 1970s, with inflation rapidly reemerging. This poses a higher-than-usual risk to stock market investors as the conditions for a recession emerge, threatening the 60% stock allocation in the already beleaguered 60/40 portfolio.
The past two years have been a perfect storm for the 60/40 portfolio. Unfortunately, we may be merely in the eye of the storm, and the knockout punch may be forthcoming. Despite the S&P 500 being just 8% off the highs of the year-long rally investors have enjoyed, it’s not too late to take risk off the table. Diversifying into other assets, such as gold, and reducing exposure to stocks may be wise at this juncture.
The traditional 60/40 portfolio could continue to underperform due to the unique economic conditions investors are experiencing. Be vigilant and consider unique diversification and pro-active risk management to weather this storm. The next few years could be a trying time for the 60/40 strategy, and investors should remain flexible and open to alternative strategies.
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