At this point, I think most of us are familiar with the old 60/40 portfolio.
The idea is to have a balance between stocks and bonds, so that when stocks go through a rough patch, the bond allocation makes up for that.
In theory, for younger more aggressive portfolios, the financial advisor puts you in 60% stocks and 40% bonds.
It’s the opposite for more conservative accounts, where bonds would get the higher portfolio weighting.
Good Idea Until It’s Not
I can tell you for a fact that on several occasions throughout my career, I bought Treasury bonds as my vehicle to express a bearish thesis in stocks.
In late 2018, for example, I was super-bearish equities, suggesting stocks would fall aggressively.
But I didn’t even short any stocks. I bought Treasury bonds and options on bond ETFs instead.
It was just easier.
When stocks would fall, bonds would rise.
Stocks falling meant the Fed would come in and likely lower rates, sending bond prices flying.
The 60/40 portfolio wasn’t terrible during that environment.
Then it all changed.
Remember back in 2022, when stocks were getting crushed to start the year?
Not only did bonds not rally, bonds actually sold off even harder than stocks.
The 60/40 portfolio became 100.
Here’s a great chart showing the relationship between stocks and bonds going from a negative correlation to the positive correlation we saw in 2022:
Bonds are no longer a hedge. They’re just increasing your concentration.
This is where math helps.
Inflationary Regime
You’ll rarely hear me talk about economic theory in this daily note, or anywhere else for that matter.
But, today, I think it’s appropriate to at least bring it up, to maybe get you thinking about it a little bit.
When stocks and bonds were trading inversely to one another, like they did for the majority of all of our careers, this was possibly a “deflationary” regime.
During this type of market, stocks and bonds trade inversely, as market forces are mostly concerned with deflation.
During inflationary environments, like we’ve seen recently and like we saw in the 1970s, stocks and bonds trade together.
This is the market suggesting, in theory, that market participants are mostly concerned with inflation.
Hence, rates fall while stock prices are rising, sending bonds up along with them.
Lower bond yields mean rising stocks, not falling ones, like you’d see during deflationary regimes.
I don’t want to overstate my expertise in economic theory. That’s not what this is about.
But I’ve seen the data. Call it inflationary/deflationary. Call it positively correlated or negatively correlated.
Your preferred nomenclature doesn’t actually matter.
What matters is the relationship. What’s important is understanding how they dance with one another and how the dance routine changes depending on the type of music playing.
Right now, the market is playing a more inflationary tune.
Or so that’s what the market participants are dancing to anyway, which is all that matters.
Some people still think a 60/40 portfolio of stocks and bonds is a good idea.
I think they’re all wrong.
Perhaps the new 60/40 portfolio should include stocks and Gold. Or maybe stocks and a basket of commodities.
Bonds make little sense as a portfolio diversifier in this environment. Not that I don’t think bond prices can rise. I do, actually.
It’s just that I wouldn’t want to use bonds as a hedge against a stock portfolio.
Because they’re not.
Stay sharp,
JC Parets, CMT
Founder, TrendLabs