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Death of the 60/40 Portfolio ‘Exaggerated’: LPL Strategists

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What You Need to Know

  • Traditional 60/40 portfolio total returns were down 15% this year as of Friday's close.
  • Recent market declines improved valuations and the outlook for the 60/40 portfolio.
  • There may be room for more diversification, given even better valuations elsewhere.

After decades of healthy performance, the traditional 60% stocks/40% bonds investment allocation has lost some support among portfolio managers and strategists over the past year, with some recommending investors add alternatives to the mix to achieve better returns.

In new market commentary, LPL Financial Asset Allocation Strategist Barry Gilbert and Equity Strategist Jeffrey Buchbinder make the case that there’s life yet in the 60/40 portfolio, given dramatically improved valuations following recent market losses. At the same time, they suggest that further diversification could prove advantageous for long-term investors.

“It may have been wounded this year, and took another blow on Friday after the hotter-than-expected inflation data, but we believe the losses in stocks and bonds this year increase the chances of positive outcomes going forward,” they wrote. “Long-term investors take note.”

The 60/40 portfolio certainly has had a tough year so far, Gilbert and Buchbinder explain. Based on the S&P 500 and the Bloomberg U.S. Aggregate Bond indexes, “the traditional 60/40 was down 15% as of market close on June 10 on a total return basis. If the year ended now, that loss would trail only 2008 as the worst year on record,” they said.

While equity market volatility often means gains for bonds, that’s not always the case, Gilbert and Buchbinder note. Low bond yields in 2020 and 2021 and this year’s bond losses, sparked by rising interest rates, have led many to speculate that the 60/40 portfolio is finished, they add.

This year’s steep declines, however, come with a silver lining, according to the strategists.

60/40 Valuations Better Now

“Recent stock and bond losses have improved valuations for the 60/40 portfolio considerably, based on a combination of the price-to-earnings ratio for the S&P 500 and the yield for the Agg. Valuations aren’t an effective market timing mechanism, but they are an important consideration for longer-term return expectations, and that picture has improved quite a bit,” they wrote.

“The time to talk about the death of the 60/40 portfolio was six months to a year ago, and even then it was probably exaggerated,” the two strategists continued. “The 60/40 portfolio may not get back to the level of returns we’ve seen over the last several decades, but over the last year the 10-year outlook for the 60/40 has improved by about 2 percentage points annualized in our view, about as big a one-year improvement as we’ve seen at any time in the last 20 years.”

The S&P 500 forward price-to-earnings ratio reached 21.2 at the end of May 2021, Gilbert and Buchbinder say, citing FactSet data. A combination of higher earnings and lower stock prices resulted in a 17.4 P/E ratio as of Wednesday, an 18% improvement — closer to 20% by Friday — they add.

“That decline translates into almost a 2 percentage point improvement in the annual return expectation of the S&P 500 over the next 10 years, although many factors can strongly influence the actual outcome,” the two wrote. “Outside of earlier this year, that’s the fastest one-year improvement in the forward P/E since 2009. Even with the dramatic decline in P/E, S&P 500 valuations are still slightly above their historical average, but the improvement is meaningful.”

The strategists also note the improvement in bond valuations, stating that the yield on the Agg at the end of May 2021 was 1.50%, compared with 3.53% on Wednesday. “This is the fastest one-year improvement in yields since 1995,” they wrote. “That likewise represents an improved annual expected return of roughly 2 percentage points over the next 10 years. There are factors that can make the actual outcome differ from the expectation here as well, but the difference is less variable than for stocks simply because you know the price you’ll get for a bond at maturity.”

S&P Valuations, While Improved, Remain High

Gilbert and Buchbinder acknowledge that stock valuations beyond the S&P 500 have improved as well, “and some may offer even better value.” Even with the recent valuation improvement, the S&P 500 P/E sits in the 82nd percentile of all values for the past 20 years, based on FactSet data, with higher percentiles representing less attractive valuations.

Some market areas, in contrast, are in the 10th percentile or lower of all values over the same timeframe “and sitting near levels only seen during the Great Financial Crisis and in March of 2020. Prospects for long-term returns for small caps have improved, for example, as valuations have dipped well below long-term averages,” they wrote.

Some bond market pockets also are sitting at “unusually high yield levels relative to the past decade,” the two said. “For both stocks and bonds, attractive valuations tend to be accompanied by very challenging economic conditions, but the most opportune moments often are. Where we see the best strategic opportunities is a piece for another day, but pockets of even more attractive, even extreme, valuations do suggest that for long-term investors there may be ways to further diversify a traditional 60/40.”

“While valuation changes have improved the outlook for the 60/40 portfolio on both the stock and bond sides, the firm sees that allocation “only as a starting point for an appropriate investor. And even if the traditional 60/40 portfolio is very much alive, as we believe, there may still be opportunities to improve the risk profile of a portfolio, whether through greater diversification within stock or bond holdings, active management, or investment opportunities outside of traditional stocks and bonds,” according to the LPL strategists.

Despite last week’s losses, LPL doesn’t believe it’s in a position yet to call a tactical bottom for stocks or bonds, they write, but based on better valuations and mostly favorable fundamentals, “we think the long-term outlook has brightened quite a bit.”

(Image: Bloomberg)