The 2022 investment year was an extraordinary one as both stocks and bonds went down hard, an unusual combination for the modern investor. In fact, the traditional ‘balanced’ portfolio of 60 percent stocks and 40 percent bonds saw the worst nominal performance in memory, at least since 1871 according to an FT article. The idea of the 60/40 portfolio is based on the assumption that growth rewards the stocks in the portfolio, while the bond portion performs a kind of income-generating buffer function and diversifier in downturns, due to recent years in which bonds were most often negatively correlated with stocks. The return over the last 40 years for the 60/40 portfolio has been about 7.5 percent per year with a volatility of 8.9 percent (by comparison, the volatility for the MSCI World equity index was 15 percent). But with the disastrous investment year 2022, can we argue that the 60/40 portfolio should be a thing of the past?
Just back in time
The outlook for the 60/40 portfolio was not strong in 2020 and 2021. Interest rates were extremely low globally and stocks were extremely expensive by almost any measure. The expected return on bonds (a mix of corporate and government bonds) was slightly above 1 percent, while the earnings yield in equities was a mere 3.5 percent. As the earnings yield is the inverse of the P/E ratio, an earnings yield of 3.3 percent, for example, requires a P/E ratio of 30.
Many analysts did warn of poor outcomes for equities on interest rate sensitivity at the time, noting that only ever lower interest rates (difficult when trillions in global bonds were trading at negative nominal yields) could support equity valuations, much less drive them higher still. With yields rising in 2022, the ‘valuation reality check’ was on the loose to reverse some of the massive equity market gains of 2020 and 2021. This, rather than any recessionary dynamic, which is the normal driver of bear markets (and bond market strength).
But really, equity markets have been supported and valuations have risen in a secular move for most of the last 40 years by falling interest rates, even if shorter term cycles saw negative bond/equity correlations.