The market’s sentiment at the beginning of 2023 is decidedly bearish. The path of least resistance of the stock and bond market is in the hands of...
Rethinking the 60-40 Stock Bond Ratio: The Pros and the Cons
The conventional wisdom has been a diversification of both growth and income, but many market participants are abandoning this rule of thumb.
Many financial advisors have their clients invested in 60-40 portfolios, with 60% of their capital in stocks and 40% in bonds or fixed-income investments. The conventional wisdom over decades has been that diversification of both growth and income has provided a safe and low-stress path for investors to grow their savings that limits risk.
In March 2022, the U.S. Fed Funds Rate stood at zero to 25 basis points, and in March 2023, it soared to 4.50% to 4.75%. The latest inflation data and comments from Fed Chairman Powell before the House and Senate financial committees on Capitol Hill reiterated the central bank’s commitment to push inflation down to its 2% target rate. Meanwhile, inflation remains at the highest level in decades and multiples of the target. While interest rate hikes tend to have a lagged impact on the economy and inflation, many issues causing soaring prices are supply-side economic factors beyond the Fed’s monetary policy reach. Aside from short-term hikes, the quantitative tightening program is reducing the Fed’s balance sheet by $95 billion monthly, putting upward pressure on rates further out on the yield curve. After a recent U.S. banking crisis and European Credit Suisse liquidity concerns, the ECB still increased short-term rates by 50 basis points on March 16.
Investors now face a shaky stock market and a falling bond market, with rising interest rates making fixed-income yields a lot more attractive. The 60-40 stock-bond allocation formula caused losses in 2022 and threatens the same in 2023. Many market participants are abandoning the old rule of thumb, and that trend looks set to continue.
Rates will continue to rise despite the recession risks
- Chairman Powell left no doubt that the Fed will continue increasing interest rates in 2023.
- The data-dependent Fed uses backward-looking statistical evidence to conduct monetary policy, not considering the lag between increase rates and the economic impact.
- The Fed waited too long to address inflation in 2021 and 2022 and could be doing the same to address the rising recessionary pressures in 2023.
- The Fed takes a reactive, not a proactive, approach to monetary policy.
Geopolitics poses systemic risks
- The war in Ukraine impacts food and energy prices, which are economic essentials. Supply-side inflationary factors are beyond the Fed’s monetary policy reach.
- The bifurcation of the world’s nuclear powers impacts trade and economic issues creating raw material surpluses in some regions and deficits in others.
- The U.S. dollar’s role in the global financial system is declining as China, Russia, and other countries are using non-dollar assets for cross-border transactions and trade.
- The geopolitical landscape creates significant challenges for U.S. consumers and multinational companies, negatively impacting earnings.
The case for following the 60-40 path
- Buying stocks on corrections has been the optimal approach for decades.
- Gridlock in Washington, DC, with a slim Republican majority in the House of Representatives, has historically been bullish for the stock market.
- In the pre-pandemic era, the 60-40 balance between stocks and bonds has delivered growth for investors.
- History tends to repeat.
The case for changing the allocation
- Fixed-income yields have risen to the highest level in years, making the guarantee of U.S. government bond yields more attractive.
- The market perceives government bonds held to maturity are risk-free assets.
- The dramatic shift in the geopolitical landscape makes the current environment an atypical time in history. A significant change in investment approach is necessary to keep pace with inflationary pressures.
- Past performance is no guarantee of future performance.
- The ETFs with the most significant redemptions in 2023 have been SPY, IWF, QQQ, and IWD. Money has flowed into TLT and other bond-related products.
- The 60-40 allocation model may not be appropriate as historical trends are only a guide until they bend.
Markets hate uncertainty- Volatility will be the norm, not the exception
- Uncertainty is the market’s worst enemy. Central bank policies and geopolitical turmoil support increased price variance in markets across all asset classes.
- Alternative assets that keep pace with inflation will likely attract more capital in the current environment.
- Market participants are realizing that substantial changes in the economic and political landscapes translate to a different investment approach.
- Limiting capital risk while enhancing growth is a challenge in March 2023.
Thanks for reading, and stay tuned for the next edition of the Tradier Rundown!