This was co-authored by Chris Galipeau, Senior Market Strategist, of Putnam’s Capital Market Strategies team, and Jonathan Schreiber, Senior Investment Director, Global Investment Strategies.
Volatility in both stock and bond markets persisted in Q3 2022, with equity markets making new year-to-date lows and interest rates reaching the highest levels since 2008. As one would expect, 2022 has also presented challenges for the traditional 60% equity/40% fixed income portfolio, which is down 22.1% to start the year.
As students of history and believers in empiricism, whenever asset performance reaches extremes, we turn to history and data as a guide. We seek to understand how extreme today’s data is in a historical context and, with further analysis, we hope to discern what we believe the future may hold for the traditional 60/40 portfolio.
In studying performance of the traditional 60/40 portfolio, we are fortunate to have nearly a century’s worth of data to consider. We craft our 60/40 portfolio using U.S. large-cap stocks and a blend of intermediate-term and long-term Treasury bonds.*
So how extreme is the loss sustained by 60/40 through Q3 2022? Looking at calendar year returns dating back to the mid-1920s, the 22.1% loss ranks second all-time. The losses experienced in the traditional balanced portfolio have been greater this year than in any year since 1931.
Sources: Bloomberg, Putnam.
*U.S. large-cap stocks: IA SBBI Large Stock TR USD before 31 January 1988 and S&P 500 TR thereafter; U.S. intermediate-term treasuries: IA SBBI U.S. IT Govt TR USD before 31 January 1973 and Bloomberg U.S. Treasury Intermediate Index thereafter; U.S. long-term treasuries: IA SBBI US LT Govt TR USD before 31 March 1992 and Bloomberg U.S. Treasury 20+ Index thereafter; 60/40 Portfolio: 60% U.S. large-cap stocks, 20% U.S. intermediate-term treasuries, 20% U.S. long-term treasuries, rebalanced monthly.
With recent performance in context, we then look to understand how the traditional 60/40 portfolio has performed following similar periods. We used our almost 100-year sample and observed performance around long-term moving averages. Moving averages can serve as a useful mean reversion tool – when the level is below its long-term moving average, this can indicate an oversold market. Using a simple 36-month moving average, we found that there have been nine instances where both stocks and bonds were trading below their 36-month moving average. The observation, as of September 30, 2022, marks the tenth. In our analysis, any month-end where both stocks and bonds are below their moving average serves as a signal.
As the chart below indicates, stocks, bonds, and 60/40 each average strong returns in the 12 months following a signal. Importantly, the average return is meaningfully higher than the return realized over the full history.
Sources: Bloomberg, Putnam.
Hit rate and Sharpe ratio
With all three assets demonstrating outperformance following a signal, one could make the case that the higher average return for stocks is a reason to own equities and not 60/40. But averages can be skewed by outliers and, while nominal return is important, a prudent investor also values consistency and considers risk.
We make two additional observations about asset class returns when the signal described above is active. First, the 60/40 portfolio and bonds deliver positive forward one-year returns in all nine cases, but stocks are positive in only seven. So, while stocks delivered a better average return, they still ended negative in 22% of the forward one-year periods. The 60/40 portfolio and bonds were always positive.
Second, in one observation where stocks and bonds were both positive, stocks still underperformed bonds (see Figure 3). As a result, there is still a meaningful diversification benefit to owning 60/40 in these volatile periods. When risk is high, investors want to ensure they are receiving maximum compensation for any risk they are taking. The Sharpe ratio measures how much return an asset delivers relative to its risk. Not only are forward one-year returns significant following a signal, but as Figure 4 below illustrates, forward one-year risk-adjusted returns are also remarkably strong. In fact, the average forward Sharpe ratio of 60/40 is ahead of both stocks and bonds in our nine post-signal observations, demonstrating the power of diversification.
Sources: Bloomberg, Putnam.
The qualitative case
While we believe a strong empirical case exists, we also recognize that informed judgement can add value to the investment decision. Volatility in both stock and bond markets remains high. Through our conversations with market participants of all types, it becomes clear that fear and uncertainty are prevalent. Faced with such uncertainty, it seems logical to us to invest in a portfolio that balances the allocation of assets. The benefit of multi-asset portfolios is they are not dependent on a single outcome to deliver positive results. By combining stocks and bonds, the traditional 60/40 portfolio can offer investors a mix of upside potential while mitigating downside risk.
This year has delivered a challenging investment environment – for owners of stocks, bonds, or a balance of the two. The 60/40 portfolio has experienced losses not seen in over 90 years. But we believe there is reason for optimism. When both stocks and bonds are trading below their 36-month moving average, as they are today, the average forward one-year 60/40 return is 19%. In addition, the forward return has been positive 100% of the time, and the traditional balanced portfolio has delivered an average one-year Sharpe ratio of 1.52. While it is unclear exactly what the future holds, history informs that now could be an attractive time to consider a traditional 60/40 portfolio again.
For informational purposes only. Not an investment recommendation.
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