The Faulty Logic Behind the '60/40' Portfolio

The 'Great Moderation' could be over... The problem with conventional wisdom is it stops working... The faulty logic behind the '60/40' portfolio... A turning point for bonds... The threat of inflation... Watch Doc's retirement 'wake-up call' now...

Is the 'Great Moderation' over?

In the opening line of an academic research paper they co-authored in 2002, renowned economists James Stock of Harvard and Mark Watson of Princeton wrote...

The U.S. economy has entered a period of moderated volatility, or quiescence.

If you've never heard of the word quiescence, you're not alone. I (Doc Eifrig) will admit that I had to look up the definition when I first read this paper.

Quiescence simply means a period of inactivity or dormancy.

In other words, these two academics noticed that economic growth, starting in the mid-1980s, had gotten boring compared with the previous three decades.

Rather than seeing the big swings in U.S. gross domestic product ("GDP") that we had experienced in the past, things had calmed down in the 1990s as we reached the turn of the century...

Booms weren't quite as big, they said. Recessions weren't quite as bad.

Stock and Watson – whose textbook Introduction to Econometrics is the standard for new students of the field (econometrics is the application of statistics to economic data) – called this trend the "Great Moderation."

It seemed the business cycle had been tamed... The variation in "real" GDP – which accounts for inflation – had clearly narrowed by 2002 when their paper came out, compared with what it was for much of the previous half-century...

You don't need advanced econometrics knowledge to see this one on a chart, which I first shared with my Income Intelligence subscribers in the July 2019 issue...

Of course, the 2008 financial crisis appeared to blow the Great Moderation theory to pieces – at least for a stretch.

But while that era certainly saw a spike in volatility, the resulting recession was fairly shallow. Considering the threat that came from the financial system, it wasn't very severe, relatively speaking.

Then, of course, the COVID-19 pandemic reminded us that economics can still surprise us...

Still, while we saw the huge stock market crash in the early days of the pandemic, both asset prices and economic activity bounced back with incredible resiliency.

In the second quarter of 2020, U.S. real GDP declined about 30%, then grew by about the same number one quarter later as the recovery began...

By the end of 2020, U.S. real GDP decreased only 3.5%. And Wall Street firms are projecting around 7% growth for 2021. Both of those numbers are pretty close to the bottom and upper levels of the Great Moderation range.

So, some experts might still argue that recent numbers show that we don't have to worry about market crashes or recessions anymore. They might argue that the government or central banks will always save the day...

As I'll explain today, though, I'm not buying it. In short, I think we're closer to the end of the Great Moderation than the start of it... and that means you might need to change the way you think about investing your money today.

The markets represent human nature...

One potential explanation for the Great Moderation is that policymakers have gotten better at jiggering interest rates and bond buying, and that lets them smooth out the business cycle.

You often hear about the Federal Reserve's latest policy decisions here in the Digest and what they might mean for the markets in the months ahead. I won't rehash that information today...

But if you look through history, you'll of course see that it is riddled with crashes... depressions... recessions... and periods of high inflation... all with varying circumstances, Fed chairs, and other government leadership.

These things don't stem from a particular style of policy or legislation. They come from the fact that humans are impulsive animals.

Said another way, markets rise when earnings grow... but they soar when exuberance takes hold.

They decline in the face of slower growth... but they crash when panic runs wild.

And consider inflation, which many of you have told me is your No. 1 concern about your retirement today. (Thanks to all who wrote in with your questions and concerns about retirement a few weeks ago, too.)

Inflation does depend a lot on "money supply" and interest rates dictated by the Fed, but it's also important to realize inflation is a social phenomenon...

Expectations for inflation drive inflation. ("Buy now before prices go up!") As I wrote in yesterday's Digest, we're seeing it everywhere today.

And this trait of human nature is not going away so long as we're around.

Now, I'll give central banks and economists some credit...

I believe they know more about how the economy works than they did in past decades. They've developed new tools and methods and collected much more data. I expect they'll do a better job managing the economy and inflation this time than they have in the past.

But that doesn't mean we'll only see rising markets and growing economies forever...

Most of the financial industry doesn't think the way we do...

Today's financial industry – and in turn, its general portfolio allocation recommendations – is modeled on what has happened over the past 30 years... because in general, we've been in the same economic environment.

For the most part, the past three decades have seen steady growth, low inflation, and low interest rates...

The Great Moderation has powered stocks and bonds higher, making owning both assets an easy decision in the traditional "60/40 stock-bond" portfolio.

The idea being that stocks could give investors capital appreciation while bonds can offer income and hedge against unexpected events.

We've had some bear markets and recessions, but overall, they appear as blips in a constant march upward. Things are pretty straightforward with stocks...

But now, let's look at bonds...

When interest rates decline, bond prices go up. This means they reward investors even more than the interest payments would suggest. By and large, this has happened for the past 30 years.

Most people simply expect bonds to march ahead, pay out interest, and earn a little capital gains as well. But here's what most folks in the mainstream aren't telling you... That's going to be hard to do today.

Today, interest rates are so low, they can't really go lower. So bond prices can't rise, putting a mathematical end to a 40-year bond bull market that started in 1981 when interest rates peaked.

What's more, the Fed's primary weapon to fight inflation is to raise interest rates, again meaning bond prices would go lower... The central bank has already indicated it will do just that as soon as next year.

(In another scenario, the Fed could do nothing and let inflation run wild... Neither is a good outcome for income investors.)

Bonds have been around in some form for a long time, much longer than the U.S. stock market. So we can look back much longer in history at the bond yield of the world's leading economies... And today, you'll see bond yields are at roughly 800-year lows.

We simply can't expect the bond bull market to continue...

You may also notice in the chart above that the bond bull market began in the 1980s, right when things were starting to trend into Great Moderation range.

Is that a coincidence? Perhaps. But it's possible that investors expected the "quiescent" economy to continue and were willing to accept lower rates on bonds they now saw as less risky.

In other words, today, it looks like we're at an important inflection point in the relationship between stocks and bonds.

Still, the conventional wisdom in the financial industry is to own both of these asset classes as has always been recommended...

Many money managers tell people to 'just own a 60/40 portfolio'...

And many people simply expect that the 60/40 portfolio will keep making a "safe" 7% or 8% annual return in the years ahead... But that's based entirely on the faulty premise that the returns of the past 30 years will continue in the future.

And the thing is, we're already seeing the conventional wisdom might be outdated...

As my colleague Mike Barrett wrote in the November 17, 2020 Digest, the 60/40 portfolio failed miserably during the COVID-19 crash of February and March 2020. From Mike's essay...

Morningstar reports that core bond strategies actually lost 3% on average during this span.

Now, that doesn't sound bad compared with 30% losses (or worse) in stocks. But the 3% "average" loss also masked incredible volatility – something you don't expect with bonds. For instance, the Vanguard Total Bond Market Fund (BND) was down an astounding 13.5% at one point in March.

Rick Rieder, chief investment officer of BlackRock's $2.4 trillion global fixed-income group and co-manager of the BlackRock Strategic Income Opportunities Portfolio (BASIX), knows that investors can no longer trust this traditional approach. As he recently told Barron's...

"If you are holding the same portfolio as two years ago and expect it to do the same, it won't. You have to restructure how you think about asset allocation, especially fixed income."

It's only natural to get caught in the conventional-wisdom trap...

Everybody struggles with "recency bias," in which we place too much importance on recent events and expect what has happened recently to continue happening. It's built into our psychology.

It's only fitting that we think that the bull market in stocks and bonds will continue... It's the only thing we've seen since the early 1990s. Any investors using a 60/40 strategy have posted fantastic returns.

A financial adviser studying history would be wise to recommend such a strategy... if they stopped at a certain point 30 years ago.

But go back further, and there are huge periods of time in which a 60/40 strategy just didn't work...

According to an extensive historical study from Artemis Capital, different broad epochs – the Great Depression or post-World War II years, for instance – brought very different returns for 60/40 investors...

Still, the entire retirement planning and investment industry is based on the past 30 years of stocks and bonds doing the same thing they've always done...

I'm here to tell you it can pay to think differently. Here's another example...

I think we all sense that market crashes can blow up your investments...

And this is true. I can't tell you exactly when the next market crash will come, but I can tell you there will be one...

In the meantime, though, inflation – which is mysterious to many and insidious to all – can wreak havoc on those trying to build wealth or generate income from it... in other words, those who are retired and are living on a fixed income or want to be retired soon.

By definition, inflation means your nest egg can do less to pay your bills.

If a dollar is worth less tomorrow than it is today, those holding or investing dollars today will be punished, while those borrowing dollars today and paying back debts in the future benefit...

And if you're holding assets, not only do they lose value to inflation, but it can be very hard to earn returns during periods of rising inflation.

For example, the stock market peaked in 1968 and declined from there... and inflation was rampant at the time. It took until 1993 – 25 years later – for stocks to regain their previous values, when adjusted for inflation.

Again, that was right about when the Great Moderation started.

And of course, fixed-income investments like bonds are just that – fixed. The number of dollars they pay you doesn't go up, but the value of those dollars goes down.

Inflation is a nightmare for fixed income, especially if bonds make up 40% of your portfolio – like conventional wisdom would tell you.

In short, a market crash plus inflation can really sour your retirement plans.

Making correct predictions is difficult, but preparing is not...

We're seeing inflation in prices today. Where it goes from here is a difficult thing to predict, and a lot depends on the Federal Reserve's willingness to choke it off.

But economic growth will slow – at some point. It always does.

In the end, stocks and bonds are in a position in which they just can't keep up the kinds of returns they've seen over the past 30 years during the Great Moderation...

So, the question to ask yourself today is, "If the next 10 or 20 years are your last chance to save for retirement – or if you're already living off your nest egg – are you ready if a 30-year trend breaks?"

My bet is most people aren't, which is why I've come up with just the solution...

Earlier today, I detailed my advice in my retirement 'wake-up call'...

If you missed the broadcast, don't worry. You can watch the full replay right here.

I was joined by my right-hand man, senior analyst Matt Weinschenk. We dove into this topic in even greater depth and shared exactly how you can prepare your portfolio for this big change I've talked about today.

In short, I'm simply fed up with the traditional advice I see most people getting today... And I want to urge anyone who takes their investments seriously to hear what we have to say about what to do with your portfolio instead.

Nobody else is doing the type of work we do for everyday folks in or close to retirement...

During the event, among other things, Matt and I revealed the ticker symbol of an investment that is designed to specifically protect your wealth against the effects of inflation.

You'll also hear what you should really be doing with your portfolio today, especially if you're in or close to retirement... and how to access my best research and a series of special new bonuses that I've created exactly for this moment in time.

I'm doing all of this because I want you to have the chance to tilt your portfolio allocations in your favor. So, please, if you haven't yet, watch my retirement wake-up call right now.

New 52-week highs (as of 6/22/21): CBOE Global Markets (CBOE), Costco Wholesale (COST), Cintas (CTAS), DocuSign (DOCU), Expeditors International of Washington (EXPD), Facebook (FB), Microsoft (MSFT), Motorola Solutions (MSI), Cloudflare (NET), ResMed (RMD), ProShares Ultra Technology Fund (ROM), S&P Global (SPGI), and Smith & Wesson Brands (SWBI).

In the mailbag today, we received several messages from folks who weren't able to watch my presentation when it went live this morning, but still want to hear it.

If you're one of these folks, good news... You can watch a replay of my retirement wake-up call here at your convenience.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig
June 23, 2021