- The 60/40 portfolio invests 60% of assets in stocks and 40% in bonds.
- Stocks and bonds have declined sharply this year, making the performance of a 60/40 portfolio among the worst in history.
- If inflation falls and the economy worsens, a Fed pivot toward dovish policy could result in stocks and bonds rallying.
This year has been one of the worst for investors who have embraced the 60/40 stocks-to-bonds allocation model. The 60/40 portfolio was supposed to insulate investors against big losses because bonds should perform better when stocks fall. Unfortunately, this year’s been a “sell everything” market, and Treasuries have offered investors little comfort.
In mid-October, Bank of America put the carnage into perspective. Annualizing the double-digit declines for both stocks and U.S. Treasury bonds revealed that 2022 was on pace to be the worst year for the 60/40 model in nearly a century. You’d have to go back to the Great Depression to find a period where returns were as bad as this year!
The sharp decline in stocks and bonds is testing investors' resolve. However, better performance may be on the horizon.
Why stocks could be a buy
On Thursday, Real Money Pro’s Doug Kass discussed the potential for stocks and bonds in his daily trading diary. Specifically, he explained why he’s become more optimistic about stocks, particularly beaten-up technology stocks, and that he’s been buying Treasuries.
As for stocks, he writes:
“With each passing month, I believe we are closer to the road of emerging long opportunities. As I have noted, inflation is peaking, supply chain dislocations are being arrested, and revenues/earnings benefit from inflation and insulate corporate profits from large drawdowns…after months of being cautious, I am warming up to expanded opportunities which will allow investors to buy great companies at good or even great prices…I expect inflation and interest rates to fall -- and a clearer pathway to the end of tightening of monetary policy might be at hand shortly.”
Kass’ expectation that inflation will retreat gained traction yesterday after the Consumer Price Index data for October was released. The report showed that while inflation remains high at 7.7% year-over-year growth, the increase was less than the prior month and below economists’ expectations. The data added support to thinking that the Federal Reserve may slow the pace of future rate increases, potentially setting the stage for the central bank to shift to the sidelines next year.
If so, it could take the pressure off stocks, particularly technology stocks. The technology sector has been most negatively affected by higher Treasury rates because of their use as the risk-free-rate comparison in models used to determine the value of future earnings.
A strong Dollar caused by a hawkish Fed has also taken a toll on the sector because international markets account for nearly 60% of technology revenue. As a result, converting foreign sales into U.S. Dollars has been a substantial headwind this year. For instance, Meta Platforms and Amazon’s revenue growth would have been about 6% and 4% higher, absent the strong dollar headwind last quarter.
Back to Kass:
“One new area I have begun to embrace is large-cap technology…The decline in big tech has accelerated in recent weeks, and with every downtick, I am buying incrementally…The daily drubbing in FAANG + M makes it hard for many to understand my buying - especially those that are guided by price and price momentum…There are numerous reasons for my renewed optimism in this much-hated space…Alphabet (GOOGL) , Amazon (AMZN) , Meta (META) , and Microsoft (MSFT) (the objects of my recent affection) are now much hated, and their share prices have plummeted. Nonetheless, their moats are deepening as their financially disadvantaged competitors have been weakened…Though technology revenues have been pulled forward from Covid, something I warned about at the beginning of this year, and e-commerce sales have weakened - the shares of these four market-dominant technology companies will likely recover well before the cycle turns.”
A contrarian at heart, Kass views big-cap technology stocks as too unloved and likely to rebound. His thinking is bolstered by the fact that share prices have fallen faster than corporate revenue, allowing a key valuation measure – the price-to-sales ratio – to retreat to about 4. That’s a level similar to what investors paid from 2014 to 2016, long before COVID-era easy money caused the price-to-sales ratio to eclipse 8.
Why bonds could be a buy
It’s not only stocks that have Kass interested in buying, though. He’s also started buying Treasuries because they’ve also tumbled significantly this year, lifting yields to their most attractive levels in recent memory. So, for example, you’d have to go all the way back to 2006 to find a higher yield on the 2-year U.S. Treasury note.
Back to Kass:
“On Wednesday, we saw a flight to quality despite a poor auction, which buoyed bond prices and depressed yields. I continue to hold an outsized position in short-dated Treasuries up to two years. And I recently extended duration by initiating a position in TLT, twenty-one-year maturity…The 30-year bond auction was excellent [Thursday] and in stark contrast to yesterday's poor 10-year.”
The potential for bond yields to attract buyers could allow Treasuries to produce solid returns in the coming year if the Federal Reserve becomes friendlier. Historically, down years for Treasury bonds are followed by positive years.
The preceding table may undersell the opportunity for bonds from intra-year lows to intra-multi-year highs, though.
For perspective, similar to this year, the central bank was raising rates and quantitatively tightening (not replacing maturing bonds on its balance sheet) in 2018. That caused a sharp decline in stocks and bonds in the fourth quarter of 2018.
After that, however, stocks and bonds rallied substantially once the Fed signaled a dovish tilt. For example, the 20-year Treasury ETF (TLT) rallied to $179.70 in March 2020 from $112 in November 2018 – a very un-bond-like 60% return. The technology-heavy NASDAQ 100 (QQQ) ? It rallied about 65% from its December 2018 low to its February ‘20 high!
The Smart Play
There are reasons investors may argue Kass’ contrarian bet is risky. Despite an encouraging CPI report, inflation remains higher than wage growth, and negative real wages aren’t bullish for corporate revenue and profits. Inflation is also pressuring corporate operating margins, causing earnings growth to fall. As a result, analysts have reduced fourth-quarter S&P 500 earnings growth estimates to -1% from 9.1% in June. That’s a big drop in less than six months, suggesting recessionary layoffs are coming.
Nevertheless, investors should remember stocks are a leading indicator. Individual stocks bottom before the stock market, and the stock market bottoms before the economy.
Conversely, unemployment, a lagging indicator, usually peaks in the back half of a bear market after stocks have put in their lows and the economy is mired in recession.
It’s also important to remember that Kass isn’t going all-in with his portfolio. He’s tilting exposure net long and opportunistically trading within his expected 3,700-4,100 range for the S&P 500. This means that while he’s inclined to buy dips to the low end of his range, he’s also inclined to lighten up near the top of the range until the market proves itself more.
Regardless, if you want to follow in Kass’ footsteps, consider starter positions on down days in the same names he’s been buying, including Amazon, Meta Platforms, Alphabet, and Microsoft. If you don’t want individual stock risk, consider the NASDAQ 100 ETF QQQ, which he owns. As for bonds, you could pick up some TLT and shorter-term Treasuries.