by David Robertson, CFA
January 2023
Stocks recovered a bit in the fourth quarter to partly salvage what had been a horrific year for 60/40 portfolios. Instead, it was just a really bad year. The big question confronting investors and advisors is, "Was 2022 just a bad year to look past or was it a harbinger of a different and more challenging investment regime?"
The answer implies very different courses of action. In the case of the first, little needs to be done. Markets bounce around and long-term investors should not alter their strategic direction due to a few bumps in the road. On the other hand, if the environment has become hostile to stocks and bonds, the mainstay of most investment portfolios, a serious re-evaluation is in order. So, which is it?
Batten down the hatches
One sensible and relatively straightforward way to address the question is by directly comparing the relative attractiveness of the three major asset classes of stocks, bonds, and bills (i.e., cash). This is the approach outlined by John Hussman in a white paper on strategic allocation and serves as the basis for a model I have adapted.
Bond and bill returns can be projected based on current rates and basic assumptions about the longer-term drivers of those rates. Stock returns can be projected based on the current market price/sales relationship and basic assumptions about longer-term drivers of stock returns.
The output of the model is stunning: Based on current prices, rates, and other economic inputs, the optimal allocation among stocks, bonds, and bills currently is 100% bills. No stocks. No bonds. Cash is king.
The reason is stocks, even after last years' downturn, are still extremely expensive historically - to the point where the baseline expectation over the twelve-year horizon is for slightly negative returns. Bonds don't work since they yield less than bills and have more risk.
One of the key benefits of this approach is its objectivity. For investors with longer investment horizons, this objective comparison of asset classes indicates we are in an unusually hostile environment for stocks and bonds.
What should investors make of shorter-term considerations? While a number of factors can influence stocks over shorter periods of time, one of the most important is that of liquidity. Benign liquidity conditions were a strong influence on stock returns between the GFC and the pandemic and kicked into high gear during the pandemic. Things changed, however, last year when inflation reared its ugly head and forced the Fed to take a tougher stance.
Opinions differ on the more likely course of future Fed actions and therefore on the outlook for liquidity. Some believe the Fed will be forced to give up its fight and renew liquidity provision measures in the not-too-distant future. Others, myself included, believe the Fed has the will and the way to continue draining excess liquidity from the system.
Feeling lucky
The best case for investors who remain bullish on stocks, then, is to win the bet the Fed will deviate from its stated position and do so in a way powerful enough to incentivize investors to increase risk, despite the terrible longer-term expected returns for stocks.
While this wager may make sense for traders and investors with a proclivity for speculation and a capacity to absorb losses, it is an unappealing proposition for people who are retired or near retirement. Not only are the odds unfavorable, but there would be limited opportunities to regain losses.
Nor is it a very appealing proposition for younger investors who have a lot more time to make up potential investment losses. Experiencing significant losses is never fun and doing so early on can inhibit one from taking exposure to risk assets even when tradeoffs are more favorable later.
Yet, despite the currently unfavorable risk/reward tradeoffs for stocks and bonds, those are exactly the assets many investment portfolios are anchored on. Whether it be 60/40 portfolios, balanced funds, target date funds, or some other iteration, most asset allocations do basically the same thing: They focus on stocks and bonds.
Cash, the would-be king
Investors who take heed of the argument for cash may think their work is done - just liquidate stock and bond holdings and sit on cash until better opportunities arise. Alas, it is not quite so straightforward in practice.
If that cash is in a bank account, it is earning next to nothing. Banks have ample reserves and therefore do not need to offer competitive rates for savings (though that may be starting to change). If you want to get competitive rates, you have to go out and get them yourself. Fortunately, that is fairly easy to do by buying Treasury bills through TreasuryDirect, but you do have to do it.
If the cash is in a brokerage account, there is a good chance it gets swept into a money market fund. Money market funds are designed for the very purpose of providing competitive interest rates by investing in safe, interest-bearing securities like Treasury bills. They still do that, but often with management fees that exceed 1% for funds with low investment minimums.
While it is somewhat understandable fund managers want to recoup some of the fees lost while rates were set at or near zero, current fees seem excessive in many cases. At a time when broad-based US equity funds can normally be had for 0.2 - 0.4% in fees, and when the Vanguard S&P 500 index funds charges just 0.04%, fees of 1% or more for essentially a cash product are a lot. Investors can also buy Treasuries in their investment accounts, but those purchases often involve relatively high transaction costs as well and are harder to diversify.
The bottom line is while Treasury bill rates are increasingly attractive, and especially so relative to expected returns from stocks and bonds, it is not a trivial exercise to achieve those yields without a significant haircut due to fees and transaction charges. As a result, while cash is still investment royalty, its stature is somewhat belittled by implementation frictions. Perhaps it is most appropriate to say, "Cash is king-ish".
A good story
In light of this discussion, the unresolved question is why so many investors continue to cling onto 60/40 and similar investment strategies? Certainly, inertia is one possible explanation. Balanced funds have worked in the past and investors are disinclined to change things without a clear impetus.
This hints at another possible explanation. Brent Donnelly, author of The Alpha Trader, highlights the need for traders to be objective. Further, he highlights the only way to really be objective is to be "flat", i.e., to not have a position in a given trade idea. As he puts it, “It is easier to honestly evaluate competing hypotheses when you are flat, open-minded, and flexible”. This insight from trading also informs longer-term investing.
Since longer-term investors, namely those saving for retirement, are pretty much always invested, they are never "flat". As a result, they are also never wholly objective. The very act of owning stocks and bonds makes it hard to honestly evaluate the possibility of holding only cash for some periods.
This suggests yet another possible explanation for the stubborn adherence to 60/40 strategies. As Rusty Guinn at Epsilon Theory points out, "There are a lot of ways to steer a story." In other words, there a lot of ways to develop a narrative in such a way as to nudge listeners, i.e., to steer them toward a preferred interpretation of available facts. For example:
January 2023
Stocks recovered a bit in the fourth quarter to partly salvage what had been a horrific year for 60/40 portfolios. Instead, it was just a really bad year. The big question confronting investors and advisors is, "Was 2022 just a bad year to look past or was it a harbinger of a different and more challenging investment regime?"
The answer implies very different courses of action. In the case of the first, little needs to be done. Markets bounce around and long-term investors should not alter their strategic direction due to a few bumps in the road. On the other hand, if the environment has become hostile to stocks and bonds, the mainstay of most investment portfolios, a serious re-evaluation is in order. So, which is it?
Batten down the hatches
One sensible and relatively straightforward way to address the question is by directly comparing the relative attractiveness of the three major asset classes of stocks, bonds, and bills (i.e., cash). This is the approach outlined by John Hussman in a white paper on strategic allocation and serves as the basis for a model I have adapted.
Bond and bill returns can be projected based on current rates and basic assumptions about the longer-term drivers of those rates. Stock returns can be projected based on the current market price/sales relationship and basic assumptions about longer-term drivers of stock returns.
The output of the model is stunning: Based on current prices, rates, and other economic inputs, the optimal allocation among stocks, bonds, and bills currently is 100% bills. No stocks. No bonds. Cash is king.
The reason is stocks, even after last years' downturn, are still extremely expensive historically - to the point where the baseline expectation over the twelve-year horizon is for slightly negative returns. Bonds don't work since they yield less than bills and have more risk.
One of the key benefits of this approach is its objectivity. For investors with longer investment horizons, this objective comparison of asset classes indicates we are in an unusually hostile environment for stocks and bonds.
What should investors make of shorter-term considerations? While a number of factors can influence stocks over shorter periods of time, one of the most important is that of liquidity. Benign liquidity conditions were a strong influence on stock returns between the GFC and the pandemic and kicked into high gear during the pandemic. Things changed, however, last year when inflation reared its ugly head and forced the Fed to take a tougher stance.
Opinions differ on the more likely course of future Fed actions and therefore on the outlook for liquidity. Some believe the Fed will be forced to give up its fight and renew liquidity provision measures in the not-too-distant future. Others, myself included, believe the Fed has the will and the way to continue draining excess liquidity from the system.
Feeling lucky
The best case for investors who remain bullish on stocks, then, is to win the bet the Fed will deviate from its stated position and do so in a way powerful enough to incentivize investors to increase risk, despite the terrible longer-term expected returns for stocks.
While this wager may make sense for traders and investors with a proclivity for speculation and a capacity to absorb losses, it is an unappealing proposition for people who are retired or near retirement. Not only are the odds unfavorable, but there would be limited opportunities to regain losses.
Nor is it a very appealing proposition for younger investors who have a lot more time to make up potential investment losses. Experiencing significant losses is never fun and doing so early on can inhibit one from taking exposure to risk assets even when tradeoffs are more favorable later.
Yet, despite the currently unfavorable risk/reward tradeoffs for stocks and bonds, those are exactly the assets many investment portfolios are anchored on. Whether it be 60/40 portfolios, balanced funds, target date funds, or some other iteration, most asset allocations do basically the same thing: They focus on stocks and bonds.
Cash, the would-be king
Investors who take heed of the argument for cash may think their work is done - just liquidate stock and bond holdings and sit on cash until better opportunities arise. Alas, it is not quite so straightforward in practice.
If that cash is in a bank account, it is earning next to nothing. Banks have ample reserves and therefore do not need to offer competitive rates for savings (though that may be starting to change). If you want to get competitive rates, you have to go out and get them yourself. Fortunately, that is fairly easy to do by buying Treasury bills through TreasuryDirect, but you do have to do it.
If the cash is in a brokerage account, there is a good chance it gets swept into a money market fund. Money market funds are designed for the very purpose of providing competitive interest rates by investing in safe, interest-bearing securities like Treasury bills. They still do that, but often with management fees that exceed 1% for funds with low investment minimums.
While it is somewhat understandable fund managers want to recoup some of the fees lost while rates were set at or near zero, current fees seem excessive in many cases. At a time when broad-based US equity funds can normally be had for 0.2 - 0.4% in fees, and when the Vanguard S&P 500 index funds charges just 0.04%, fees of 1% or more for essentially a cash product are a lot. Investors can also buy Treasuries in their investment accounts, but those purchases often involve relatively high transaction costs as well and are harder to diversify.
The bottom line is while Treasury bill rates are increasingly attractive, and especially so relative to expected returns from stocks and bonds, it is not a trivial exercise to achieve those yields without a significant haircut due to fees and transaction charges. As a result, while cash is still investment royalty, its stature is somewhat belittled by implementation frictions. Perhaps it is most appropriate to say, "Cash is king-ish".
A good story
In light of this discussion, the unresolved question is why so many investors continue to cling onto 60/40 and similar investment strategies? Certainly, inertia is one possible explanation. Balanced funds have worked in the past and investors are disinclined to change things without a clear impetus.
This hints at another possible explanation. Brent Donnelly, author of The Alpha Trader, highlights the need for traders to be objective. Further, he highlights the only way to really be objective is to be "flat", i.e., to not have a position in a given trade idea. As he puts it, “It is easier to honestly evaluate competing hypotheses when you are flat, open-minded, and flexible”. This insight from trading also informs longer-term investing.
Since longer-term investors, namely those saving for retirement, are pretty much always invested, they are never "flat". As a result, they are also never wholly objective. The very act of owning stocks and bonds makes it hard to honestly evaluate the possibility of holding only cash for some periods.
This suggests yet another possible explanation for the stubborn adherence to 60/40 strategies. As Rusty Guinn at Epsilon Theory points out, "There are a lot of ways to steer a story." In other words, there a lot of ways to develop a narrative in such a way as to nudge listeners, i.e., to steer them toward a preferred interpretation of available facts. For example:
If you are a central banker who wants to influence how investors process current and future monetary policy into risk-taking decisions, you embrace communications policy as your primary policy tool.
If you are a CEO who wants to train investors to value your stock on a multiple of a number you periodically pull out of your ass, you go on CNBC to tell the story every time you announce earnings.
If you are a journalist who wants to make sure that readers come away from an article with the Correct Interpretation, you look for ways to present your opinions as facts.
Not surprisingly, narratives are also widely employed in the investment world. Why is owning stocks and bonds so common? At least partly because that's what investors have been told to do. The thing everybody knows that everybody knows is stocks and bonds outperform cash over the long-term. They know this because almost every advisor, manager, marketer, and university professor says so. It’s a strong belief system … and it’s mostly right.
Mostly, but not completely. The glitch is there can be fairly long periods during which returns from stocks and bonds fail to outperform cash. Those periods can wreak havoc on investment portfolios. The risk of those periods can also be identified fairly objectively … and there is a very good chance we’re in one of those periods now. You don't hear that story quite so often.
So, why don’t more providers try to steer their clients towards safety when the evidence points in that direction? Partly, because it is less profitable to do so and partly because it is hard. So instead, they “steer the story”. If investors want to avoid the risk of being overexposed to overvalued assets, they need to be proactive and make the move themselves, or they need to find a provider who prioritizes objective analysis over stories.
Sure, it means doing something different. No, it's not market timing. It is simply recognizing that things change. When both stocks and bonds become unappealing, the worst thing to do is to anchor an investment portfolio on those two asset classes. When stocks and bonds become more appealing, there will be a time to productively redeploy cash.
Conclusion
The new year is an opportune time to take a fresh look at one’s allocation. Currently, an objective analysis of the relative attractiveness of stocks, bonds, and bills points to an allocation comprised entirely of Treasury bills. The bad news is this implies a lot of investors will need to make changes in order to avoid the downside risks.
The good news is Treasury bills not only provide a safe harbor for investors, but also provide a decent return, albeit not yet ahead of annualized inflation. Further good news is the rally to start the new year provides a fortuitous opportunity to move to cash while the getting is still pretty good.
Of course, some investors will take the wrong message from the rally that started last year and has continued into the early days of 2023. These investors will take the positive short-term performance as evidence of the utility of the 60/40 strategy and ignore the warnings from strategic allocation. While this reaction is understandable, it is also a shame. When those bets go awry, surely some story will emerge as to why it wasn’t anybody’s fault.
Mostly, but not completely. The glitch is there can be fairly long periods during which returns from stocks and bonds fail to outperform cash. Those periods can wreak havoc on investment portfolios. The risk of those periods can also be identified fairly objectively … and there is a very good chance we’re in one of those periods now. You don't hear that story quite so often.
So, why don’t more providers try to steer their clients towards safety when the evidence points in that direction? Partly, because it is less profitable to do so and partly because it is hard. So instead, they “steer the story”. If investors want to avoid the risk of being overexposed to overvalued assets, they need to be proactive and make the move themselves, or they need to find a provider who prioritizes objective analysis over stories.
Sure, it means doing something different. No, it's not market timing. It is simply recognizing that things change. When both stocks and bonds become unappealing, the worst thing to do is to anchor an investment portfolio on those two asset classes. When stocks and bonds become more appealing, there will be a time to productively redeploy cash.
Conclusion
The new year is an opportune time to take a fresh look at one’s allocation. Currently, an objective analysis of the relative attractiveness of stocks, bonds, and bills points to an allocation comprised entirely of Treasury bills. The bad news is this implies a lot of investors will need to make changes in order to avoid the downside risks.
The good news is Treasury bills not only provide a safe harbor for investors, but also provide a decent return, albeit not yet ahead of annualized inflation. Further good news is the rally to start the new year provides a fortuitous opportunity to move to cash while the getting is still pretty good.
Of course, some investors will take the wrong message from the rally that started last year and has continued into the early days of 2023. These investors will take the positive short-term performance as evidence of the utility of the 60/40 strategy and ignore the warnings from strategic allocation. While this reaction is understandable, it is also a shame. When those bets go awry, surely some story will emerge as to why it wasn’t anybody’s fault.
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