These Strange Times Call For A New Kind Of Portfolio

These Strange Times Call For A New Kind Of Portfolio
Andrew Rummer

over 2 years ago4 mins

  • After two decades in which a balanced 60/40 portfolio has provided consistent strong returns above the rate of inflation, we might be heading into a trickier time for investors.

  • There’s a risk that stocks and bonds flip into dreaded positive correlation, and investment banks are lining up to recommend alternatives to bonds should that happen.

  • If you believe inflation is here to stay, small allocations to gold, bitcoin, or cash could help your portfolio’s overall risk-adjusted returns. Or you could tilt your stock holdings towards cheaper value stocks.

After two decades in which a balanced 60/40 portfolio has provided consistent strong returns above the rate of inflation, we might be heading into a trickier time for investors.

There’s a risk that stocks and bonds flip into dreaded positive correlation, and investment banks are lining up to recommend alternatives to bonds should that happen.

If you believe inflation is here to stay, small allocations to gold, bitcoin, or cash could help your portfolio’s overall risk-adjusted returns. Or you could tilt your stock holdings towards cheaper value stocks.

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After 20 years of a mostly benign investing environment, inflation and weak economic growth are now threatening to make the next decade very difficult indeed for investors. But if you make just a few tweaks to the long-revered 60/40 portfolio, you’ll be in a better position than most to boost your risk-adjusted returns.

Why are the next few years looking choppy?

Stock and bond prices have shown a negative correlation for the past two decades, with one rising whenever the other fell. This handy trend has been investors’ best friend, helping increase risk-adjusted returns for portfolios that contained both. 

However, a look back further into history shows that this state has hardly been typical. In fact, stocks and bonds have been positively correlated for the vast majority of the past 150 years, rising and falling at the same time.

10-year correlation between stocks and bonds
10-year correlation between stocks and bonds

And after September saw a nasty return to that longer-term trend of positive correlation – with both stocks and bonds firmly in the red – investment banks from Goldman Sachs to Bank of America to JPMorgan have been sounding the alarm for traditional 60/40 portfolios, consisting of 60% stocks and 40% bonds.

US stocks and bonds fell together in September
US stocks and bonds fell together in September

What’s driving this positive correlation?

For start, we can blame accelerating inflation – and particularly a potential shift in the type of inflation we’re seeing. 

When inflation is “pro-cyclical”, it rises as economic growth accelerates. This means a pickup in inflation – which erodes bond prices – also gives stocks a boost as the economy grows. This is the situation that has existed in most rich countries since the early 2000s.

But when inflation turns “counter-cyclical”, inflation picks up even as the economy slows, often due to supply constraints. This combination of stagnating growth and rising inflation – known as “stagflation” – undermines the prices of stocks and bonds simultaneously and creates a toxic environment for investors.

As Goldman Sachs put it in a report this week, “negative equity/bond correlation has been a function of anchored inflation expectations and tended to turn positive as inflation exceeded 2%.” And with US inflation exceeding 5% at the moment, you start to see where the problem might be.

Stock/bond correlations tend to turn positive with high inflation
Stock/bond correlations tend to turn positive with high inflation

You can also blame the growing dominance of tech in modern stock markets. As the stock market has become heavily weighted to fast-growing tech names – particularly in the US – it’s become more vulnerable to inflation. That’s because tech stocks’ valuations are reliant on how much their earnings will grow in future, compared to the returns available from safer investments like bonds.

Growth stocks are particularly highly correlated with bond markets
Growth stocks are particularly highly correlated with bond markets

How can you adjust your portfolio?

There’s plenty of consensus that 60/40 portfolios will struggle in the current market environment. JPMorgan, for example, forecasts they’ll return less than 4% a year over the next decade, roughly half what they achieved over the past 20 years. 

There’s no guarantee that consensus will prove correct, of course, But in case you agree that inflation – and even stagflation – are growing risks, we’ve compiled a few options for replacing a part of your portfolio’s allocation to bonds.

1. Gold

If you’re worried that bonds are becoming too correlated with stocks, gold could be a good option. After all, it’s shown a pleasingly low correlation with the global stock market over the past decade. 

360-day correlation between global stocks and gold
360-day correlation between global stocks and gold

And the research firm TS Lombard pointed out this month out that gold is one of few investments that climbed during the past two major bouts of stagflation, from 1965-1975 and from 1975-1985.

Gold performance in prior periods of stagflation

They don’t, however, recommend holding huge quantities of the shiny stuff, which suffers from the major drawback of paying no income. Rather than a traditional 60/40 portfolio, then, TS Lombard recommends holding 4% of the precious metal, and then 70% stocks and 26% bonds.

2. Bitcoin

Bitcoin – which is often dubbed digital gold – could play a similar role in your portfolio to the yellow metal. Just keep in mind that its correlation with stocks hasn’t been quite as low as gold’s over the past decade: it even became quite highly correlated with stocks during 2020’s market excitement. 

360-day correlation between global stocks and bitcoin
360-day correlation between global stocks and bitcoin

3. Cash

Another option is to switch out some bonds for cash – particularly the US dollar, which JPMorgan has highlighted for its strong negative correlation with stocks. Trouble is, interest rates on cash savings are all well below the rate of inflation at the moment, so you’d be settling for a negative real-terms return. 

360-day correlation between global stocks and the US dollar
360-day correlation between global stocks and the US dollar

4. Value stocks

Alternatively, you could leave your bonds alone and switch some of your “growth” stocks – those of fast-growing companies like tech – for cheaper “value” shares. 

As Goldman Sachs points out, value stocks – those with the cheapest valuations relative to profits or assets – are showing less correlation with bonds at the moment. And TS Lombard has highlighted that value stocks “comfortably” beat their growth counterparts the last time we experienced major stagflation in the 1970s. 

5. Puts/options

For those comfortable trading options, Goldman Sachs currently recommends buying puts on the iShares 20+ Year Treasury Bond exchange traded fund (ticker: TLT) to protect against a bond selloff. And if you’re comfortable adding more risk, you could fund the trade by selling calls on the SPDR S&P 500 ETF (ticker: SPY). But be warned that this call trade could lead to big losses if the S&P 500 rallies strongly. 

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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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