WisdomTree Minds on the Markets
WisdomTree
Minds on the Markets
WisdomTree
Minds on the Markets
ARCHIVE: January 22, 2024
The 60/40 Portfolio’s Diversification Benefit Has Been Slapped Around
Maybe “The Great Moderation” was an understatement. The period of declining inflation, falling interest rates and central banks hell-bent on supporting stock and property markets existed for most of our careers; some say it didn’t really end until the COVID-19 lockdowns ushered in the supply chain muck-up. For large chunks of that time, policy rates in the U.S. and elsewhere converged to zero; in countries such as Switzerland and Japan, entire yield curves went negative.
For many, it was reassuring to own a 60%/40% stock/bond portfolio because there was a high degree of confidence that any stock market troubles would usually be met by a rally in fixed income. In fact, for most of the decade since the end of the Global Financial Crisis, the rolling three-year correlation between stocks and bonds was negative.
Stocks zigging with bonds zagging was taken for granted. The diversification benefit of the zig-zag worked the other way too: for some investors, the fear wasn’t so much stock market risk but instead that bonds were priced for perfection. Well, the refrain went that if bonds were selling off, it was probably because the economy was running hot. If so, then that must mean S&P 500 earnings growth was probably robust. It all made plenty of sense, until 2022.
“The 40” in the 60/40 didn’t protect stocks, and vice versa. The S&P 500 declined 18% that year, while the Bloomberg U.S. Aggregate Bond Index laid an egg itself, posting a -13% total return.
Then 2023 rolled around and the story was the same, though the trend was generally in the opposite direction: up. Last year started off gangbusters, with the S&P 500 up 9% by the first week of February while bonds were up 4% themselves. Then, as winter was turning into spring, the stock market endured a six-week sell-off that sent the S&P down 8%, accompanied by a bond market loss of 2%.
Much of the rest of last year went on like this, with stocks and bonds rising and falling together. The reader may recall that the S&P 500’s late summer selloff window was from July 31 to October 27; the total loss was 10%. For bonds, the loss-making timeframe was almost the same, from July 18 to October 19, with a 6% loss.
Ever since carving out lows around Halloween, both asset classes are back off to the races. Stocks have returned over 15% since the S&P 500’s low, while aggregate bonds are up nearly 7%. Disconcertingly for those seeking diversification, the ebbs and flows on a week-by-week basis look locked at the hip, like identical twins.
No surprise then that the latest tally on the rolling three-year correlation between stocks and bonds clocked in at 0.69, akin to the correlation we may expect to see between maybe the French and German stock markets, or even Coke and Pepsi.
With classic diversification now offering little in the way of portfolio protection amid downdrafts, logic points us directionally toward a focus on so-called “down capture” rising in importance in hearts and minds.
In other words, low volatility stocks should now appear that much more attractive relative to high beta stocks, owing to the dearth of diversification opportunities between stocks and bonds. From a sector perspective, this may be a bullish portent for stodgier groups such as consumer staples and utilities at the expense of cyclical groups such as industrials and information technology.
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