Much has been written recently about the death of the ‘balanced’ portfolio, which is a portfolio that blends both stocks and bonds. However, we believe that the Mark Twain quote “the rumors of my demise have been greatly exaggerated” more accurately describes the state of the balanced portfolio market. In our view, the balanced portfolio is far from dead… we believe it has been recently resurrected.
Critics are Looking Through the Rearview Mirror, In Our View
We believe the argument against the balanced portfolio can be summed up in two ways. First, in early 2022, critics, including us (see table, next page) argued that low interest rates and expensive stock valuations negatively impacted the long-term return expectations for balanced portfolios. Second and more recently, critics have complained that balanced portfolios have performed poorly in 2022 and have failed to display the protective characteristics that investors have become accustomed to. While the second point is factual, we believe the new levels of both stock valuations and bond yields mean both points are now 'rearview mirror thinking' and we prefer to make investment decisions based on the view ahead.
We Believe that the View Through the Windshield has Improved Significantly
Stock and bond valuations are much improved from the beginning of 2022. Looking forward, we see a view that is very different than what lies in the rear-view mirror. For one thing, yields in the fixed income markets have risen significantly across all maturities. Fed Fund target ranges, for example, have risen from around 0.00-0.25% to 3.75 – 4.00% in the space of ten months and the 10-year Treasury Note now yields 3.75%, up from 1.5% at the beginning of the year (See Chart, right). Valuations on stocks have also come down significantly from where they started this year. On January 1, 2022, the S&P 500 was valued at a 21.7x forward Price-to Earnings (P/E) ratio, which was equal to 4.6% earnings yield, or earnings/price. As of Friday (November 25, 2022), forward P/E's on the S&P 500 have contracted to roughly 17.4x and a 5.7% earnings yield. We believe higher yields on bonds and lower P/E’s on stocks set the stage for better returns in the future for balanced portfolios.
Back in March 2022, low bond yields and high stock valuations led to relatively low long-term capital market assumptions (LTCMAs). As can be seen in the accompanying table (below), our 2022 base case LTCMAs were just 4.9% for US large-cap stocks and 1.5% for US bonds. In early 2023 we will try to assign a value as to 'how much better' we expect returns to be when we release our annual capital market assumptions (CMAs). Assuming stocks and bonds are at similar levels to where they are today, we anticipate the increase in our CMAs to be meaningful.
Bonds: Higher Yields = Greater Future Protection, In Our View
We expect that many investors with balanced portfolios are suffering from 'statement shock' in 2022. Balanced investors are not used to their portfolios declining as much as the stock market during periods of weakness. Investors have become accustomed to better returns from their balanced portfolios during market routs as in the Financial Crisis of '08-'09 or the pandemic sell-off of 2020. During those periods, yields declined, and bond prices increased because the issue was recession and the Fed was cutting interest rates, which helped offset falling stock prices. This year the Fed has raised rates significantly.
As a result, asset class returns in 2022 have been very different with bonds and stocks down roughly the same 13% to 14%. Therefore, no matter the mix (30/70, 50/50, 60/40 or 80/20), returns have been similar to a 100% stock portfolio thus far in 2022. A combination of very low starting yields and an inflation shock led to negative returns that were highly unusual. In fact, according to The Daily Shot/Bank of America, this is only the fourth year in over 300 where the global bond market has experienced such negative returns as a percent of GDP (the others being 1721, 1865 and 1920). Given the rarity of its occurrence (about every 100 years), it would be difficult, if not foolhardy to construct portfolios anticipating a similar environment in the future since historically one would be wrong far more often than one would be right. Going forward, bond yields are now high enough, in our view, that they have room to decline if the economy goes into recession and equities encounter additional difficulties. In a recession, we think the Fed is more likely to cut rates allowing bond prices to rise, which can help offset some stock market losses.
Conclusion: The Case for Balanced Portfolios is Now Compelling, In Our View
If you are going on a road-trip, as many did over the Thanksgiving holiday, the length of the journey is dependent upon the starting point, the destination, and the average travelling speed. For example, a destination that is 100 miles away and can be made by interstate will be much quicker than one that is only reachable by back roads, or one that is longer. Similar rules can be applied to investing. Each of us is traveling toward an investment destination, like retirement, college funding or endowing a favorite cause. Our arrival time is also dependent on the length of the journey and the travelling speed. When yields are low and stock valuations are high, which they were last year, one can expect the length of the journey to be long since the speed of travel will be slow. As yields rise and stock valuations fall, long-term portfolio returns have historically accelerated, shortening the length of the journey. Therefore, due to our improved long-term outlook for balanced portfolios, we think investors for balanced accounts can expect attractive returns again.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.