23 Oct COTW: Worst Year for U.S. Core 60/40 in a Decade
The chart below can be downloaded here.
With U.S. core bond benchmark yields at record lows and U.S. equity valuations on the higher side (highish on a forward price-to-earnings basis but near record high on a Shiller or price-to-sales basis), the prospect of lower expected returns is a theme we have been forced to incorporate into our asset allocation views this year. For instance, for the 10 years ending September 2018, a U.S. core 60/40 portfolio (60% S&P 500 and 40% BarCap Agg Bond) has delivered a return of 8.7% p.a. Using current yields and starting valuations and assuming modest mean reversion to long-term profit margins and valuation levels, returns will likely be less than half of that for the next 10 years: we estimate somewhere in the 3-4% range before inflation.
So what are investors to do? Our strategy has been twofold: (1) raise incremental amounts of liquidity through allocations to cash and high-quality short duration bonds and (2) allocate to niche or opportunistic managers that may be able to generate alpha relative to core allocations during episodes of volatility. Picture a barbell with one ends representing safe, boring and liquid assets and the other more esoteric and niche opportunities in less trafficked corners of the market.
While the year is not over and anything can happen in the short-term, the performance of U.S. core markets for the year-to-date should not come as a surprise given the starting conditions of low yields and high valuations. Perhaps ironically, the very recent pick up in yields and global stock market weakness is a tremendously positive development for long-term investors with “dry-powder” to put to work.
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