Are Traditional Portfolios Broken?

Are Traditional Portfolios Broken?

over 3 years ago2 mins

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A traditional “60/40 portfolio” is 60% invested in stocks and 40% in government bonds. It’s a well-known asset allocation strategy used by many investors. But the combined outlook for equities and bonds has never been this poor...

What does this mean?

To state the obvious when investing, the lower the price you pay, the higher your potential future return. Metrics such as the more technical price-to-earnings ratio known as the Shiller cyclically-adjusted price-to-earnings ratio (a.k.a. the “Shiller CAPE”) has been shown to be a good indicator of valuation and therefore a good predictor of future stock market returns.

The Shiller CAPE takes the average of the last ten years of earnings, adjusts them for inflation, and divides the current S&P 500 price level by those adjusted earnings. One benefit of this approach is that the ratio smoothes out fluctuations in corporate profits due to the business cycle.

To evaluate bonds, investors look at their yields compared to history. If bond yields are much lower than recent historical averages, that could imply they’re set to rise in the future, meaning bond prices would simultaneously fall.

Why should I care?

The graphs below show the current level of the Shiller CAPE at almost 30x, and the future average annual return (labeled as “CAGR”) of equities given different levels of the Shiller CAPE historically. The picture it paints is not pretty: a ratio between 25x and 30x has historically implied negative equity returns over the next five years, while a ratio of more than 30x has implied a negative return across all timeframes.

US Shiller CAPE and implied future returns (Source: Robert Shiller, Bloomberg, Man Solutions)
US Shiller CAPE and implied future returns (Source: Robert Shiller, Bloomberg, Man Solutions)

The picture is even uglier for bonds: the graphs below show the yield on 10-year US Treasuries at 0.60%, and the future average annual return of these bonds given different yield levels historically. A 10-year yield below 2.5% implies a negative future return across all timeframes.

10-year US Treasury Yields and implied future returns (Source: Robert Shiller, Bloomberg, Man Group)
10-year US Treasury Yields and implied future returns (Source: Robert Shiller, Bloomberg, Man Group)

Taken together, the traditional 60/40 portfolio has a tough road ahead as this is the only time in the dataset where the outlook for both equities and bonds was simultaneously so poor (and the dataset includes the Great Depression). What should investors do in this scenario? One option might be to consider adding other asset classes to their portfolios using ETFs such as gold (GLD), investment-grade corporate bonds (LQD), emerging market debt (EMB), real estate (VNQ), and commodities (DBC).

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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