Now that should be a big bank slogan! But we all know the banks will never say it, so we’ll be the one to warn you that your traditional 60/40 stock-and-bond portfolio may be dead. It has been the poster child portfolio allocation for a generation of investors, and has performed exceptionally well, especially since The Great Recession almost 10 years ago. That being said, the stock and bond market bulls are getting tired. It’s impossible to know when the bulls will go into hibernation and the bears will come out to play, but the following are good indicators that it may be sooner rather than later.
"For 50 years, WWF has been protecting the future of nature. The world's leading conservation organization, WWF works in 100 countries and is supported by 1.2 million members in the United States and close to 5 million globally."
Howard Marks, Co-Chairman of Oaktree Capital, legendary investor and prolific writer
As we know interest rates typically have an inverse relationship to bond prices - as rates go up, bond prices go down and vice versa. If we look at history from a 10,000 foot view we would notice that the first bond bull market started after World War I and lasted until after World War II – a period of just under 30 years. Increased government spending to support the war efforts resulted in an inflationary environment which would typically lead to higher interest rates; however, the government kept rates artificially low during these times. It wasn’t until the government lifted these restrictions in 1951 that the bond bull market came to an end. Interest rates began to properly reflect this new inflationary environment, rising from sub-2% to nearly 15% by 1981.
Then, during the 1980s, Federal Reserve Chairman Paul Volcker and then Alan Greenspan worked hard to reduce the annual inflation rate, leading to lower interest rates. Combine that with the globalization of the world’s markets, bond market innovations, and significantly higher demand from retail investors, and investors got to enjoy the next great bond bull market as bond prices rose to levels not seen in over 60 years.
The chart below is where we are today. The magic number seems to be 30 with bond market cycles. But if you recall the inverse relationship between interest rates and bond prices, investors today have little to look forward to as there is only one direction interest rates will realistically go (taking a page from Howard Mark’s book, trees don’t grow to the sky and few things go to zero). Combine that with inflation expectations and the potential capital requirements to implement many of President Trump’s policies (unless he can get Mexico to pay for everything), and we have a very grim outlook for bonds.
Does anyone remember the subprime mortgage crisis, toxic derivatives that plagued the banks’ balance sheets, TARP bailouts, Bear Stearns, and Fed Chairman Henry Paulson asking his wife to pray for him just before Lehman Brothers collapsed? The Great Recession may be a distant memory of the past for many investors as the equity bull market just celebrated its eighth birthday! The S&P 500 bottomed on March 9, 2009 and has more than tripled since then.
Investors need to be cognizant of the role timing plays on investment results. How difficult or easy it will be to produce satisfactory returns will be foreshadowed by where the market is in the overall cycle. By looking at the table below from two distinct periods in time, we should be able to understand why investors from the 80s enjoyed such healthy returns and why investors from today should proceed with extreme caution. We can use the PE Ratio of the S&P 500 and the 10-Year Treasury yield as proxies for the health of the stock and bond markets. Simply, in 1980, stocks and bonds were well below their historical averages and therefore priced to deliver strong robust future returns. Today, assets are trading above their historical averages and therefore priced to deliver below-average future returns.
| Year | S&P 500 PE Ratio | 10-Year Treasury | Earnings Yield (1/PE ratio) | Expected Portfolio Return (60/40 split) |
|---|---|---|---|---|
| March 1, 1980 | 7.39 | 10.80% | 13.50% | ~12% |
| March 1, 2017 | 26.31 | 2.50% | 3.80% | ~3% |
| Historical Average (since 1871) | 15.65 | 4.58% | 6.39% | ~6% |
Unfortunately, when it comes to bull markets, there’s no listed expiry date. Deceivingly, the bull is at peak strength just before it goes into hibernation. If you, like most investors, have significant exposure to stock and bonds, then what options do you have to increase expected future returns while simultaneously reducing portfolio risk? Well, if stocks and bonds are the problem, then you need to look elsewhere, and alternative investments may be your best bet.