Rethinking 60-40

By David Nelson, CFA CMT

We came into 2022 with a set of market challenges investors knew would prove difficult.
The Fed was already gearing up for an intense interest rate hiking cycle, the first since 2018.
Add a frightening war in the Ukraine, a sociopath in Russia hell bent on turning the clock back 30 years and an inflation cycle we haven’t seen in 40 years its amazing stocks have held up at all.

Data by FactSet

We’re in the process of retesting the February 24th low as we enter the second week of earnings season. The first wasn’t anything to write home about. Morgan Stanley (MS) and Goldman (GS) both saw substantial declines in investment banking. Jamie Dimon maybe the most trusted CEO in the banking community has come right out and said he sees significant challenges ahead.

This should be the golden age for banks given the rising rate setup. But it only works if the economy doesn’t slip into recession. With job growth robust that doesn’t seem likely soon but increasingly economists are starting to tilt that way for 2023.

The added albatross: increasingly banks may be losing market share to fintech. In fact, Jamie Dimon has said repeatedly he views it as one of their biggest risks.

2018 Playbook

Data by FactSet

Investors will have to navigate the mine field above but without question the biggest risk to equity pricing is a rising risk-free rate. Year to date stocks are giving a repeat performance of what we saw in the 4th quarter of 2018. Then like today, as 10-year yields approach 3% institutions start to de-risk.

Insurance companies, endowments and pension plans use the higher yields to match assets and future liabilities with something other than stocks. In the end it means less buyers for equity even as prices decline.

Rethinking 60-40

Equity investors have been here before and know that to succeed long term you have to sometimes take the pain. But Bond investors are in shock with their fixed income holdings in many cases down more than stocks. The Bloomberg Aggregate Bond Index is down -7.9% vs the S&P 500 off -7.45%

Asset Correlation Matrix 6 Years (Correlation of 1 means assets move together)

Data by Morningstar

The whole idea of the 60-40 stock bond blend is to have bonds offset your equity risk. Over the long term the correlation between stocks and bonds is close to zero even negative. Just what you want when you’re building a balanced portfolio able to do well during the good times and survive during the down turns.

Asset Correlation Matrix 1 Year

Data by Morningstar

Over the last year those correlations have moved closer to 1. Bonds are going down just as fast as stocks. Today, conservative investors are feeling the same pain as stock jockeys who are ALL-IN.

What can we do about it?

The good news is you have a couple of choices.

Buy the actual bonds on the short end of the curve. A 2-year treasury investor can capture 87% of the yield of a 10-year bond. You could put an effective bond ladder together staggering your purchases starting at 6 months up to 3 years.

U.S. Yield Curve 

Data by FactSet

Your only goal in fixed income this year is to not lose money.

Diversify with other asset classes. Think like an endowment. Most investors understand real estate even if they don’t own it in the equity market. Many may own a home.

Asset Correlations 1 year with Commodities, Managed Futures and Merger Arb

Data by Morningstar

With inflation likely to be with us a while, turn to commodities and managed futures funds. Look, I’m not expecting to run out and buy pork bellies and I know about as much about cattle as you do but I do know that now more than ever we need asset classes to offset our equity risk. I doubt bonds are going to be that asset class for some time.

Unless you’re a professional trader turn to diversified ETFs and Mutual Funds to manage your natural resources, commodities and managed futures. There are many out there. AQR Funds right here in Greenwich is a great place to start. They have several including ARCIX and AQMIX.

Yes, I know they are up a lot. That’s what bull trends look like. Start small maybe 5%.

Free Cash Flow

I could talk about what isn’t working but let’s focus on what is. Stocks generating lots of free cash flow. Even at these levels energy stocks are cheap relative to the market. Pioneer Natural Resources (PXD) even at these levels generates over 12% free cash flow yields. They are right in the heart of the Permian Basin. Probably has another 50 points of upside. Oil could certainly go lower especially as demand destruction starts to kick in but unless it starts living below 80, should still do well.

You can even find ETFs that specialize in free cash flow. PACER U.S. Cash Cows (COWZ) is up close to 7% year to date in a down market. They focus on the 100 highest free cash flow yielding stocks in the Russell 1000. Free Cash Flow yield is the holy grail for value investors.

*At the time of this article some funds managed by David were long AAPL, AMZN, MSFT, FB, SPY, KLAC and COWZ