What Happened to 60-40 Portfolio Returns in 2022?

Amidst the smoke of the turbulent stock market we’ve experienced lately, many investors noticed something unusual that happened last year. For the first time in a long while, stocks and bonds overall both went down in the year. In addition to being a rare occurrence, this also had deleterious implications for the often recommended “60-40” portfolio, where investors split their investments between 60% common stocks and 40% bonds. How can we explain the disappointing 60-40 portfolio returns in 2022, and does this mean the 60-40 portfolio should be abandoned for the foreseeable future?

How Do Investors Use Portfolio Allocation?

Portfolio allocation is the first task for investors. Each investor must decide what their risk tolerance is and allocate a significant portion of their long-term retirement savings to stocks and the remainder to bonds and bills. The idea is that investors must take risk (no pain-no gain) and at the same time they must feel comfortable with the level of risk they are facing even if the stock market declines substantially. After all, in any given year, there is historically between a one-fourth and a one-third probability of a stock market decline. This means you should expect a down year once every three or four years. Thus, investors should not panic and liquidate their portfolio because of a market decline. This is the cardinal sin of investment. If investors do this even once in their lifetime, their nest egg would be destroyed and it will be extremely difficult to recover. Without this understanding of risk in the stock market, the best advice for investors is to simply avoid investing in common stock altogether.

Furthermore, as investors approach retirement age, they become more risk averse, and they are typically advised to reduce the common stock portion from near 90% to lower levels in order to reduce the risk of their portfolios. For some risk-averse investors, a typical recommendation is to put 60% in common stocks and 40% in bonds.

How are Bond and Stock Returns Related?

Typically, in normal times, we think that the Treasury Bond (T-Bond) returns and common stock returns (S&P 500) are negatively correlated. In this scenario, having Treasury-bonds in your portfolio in addition to an index of common stocks such as the S&P 500 helps reduce your overall risk. When stock returns are negative, T-Bond returns are positive. When stock returns are positive, T-Bond returns are negative. This negative correlation underlies a typical recommendation by investment advisors that a portfolio that is 60% invested in stocks and 40% invested in T-Bonds or T-Notes helps control excess volatility and should be preferred by risk-averse investors, as opposed to having 100% invested in common stocks.

This traditional negative relation in terms of stock and bond returns translates into a positive correlation between stock returns and changes in T-Bond yields. This is because an increase in bond yield means a lower bond price and a negative bond return. A decrease in bond yield means a higher bond price and a positive bond return. Thus, a negative relation in terms of stock and bond returns means a positive correlation in terms of stock returns and changes in bond yields.

The figure below examines the recent correlations of the stock and bond prices. It plots the moving average of correlations for the last 22 days (one calendar month) of returns to the S&P 500 and changes in ten-year T-Note yields. The figure starts out with positive correlations, turns negative, and mostly stays negative except for short periods during late 2022 and early 2023.

How Has the Correlation Between Bond Yields and Stock Returns Changed Over Time?

Based on the figure, before the Fed started raising rates, the correlations between stock returns and changes in bond yields were positive. This means that the correlations in terms of returns were negative. Thus, a decline in stock prices would be offset by an increase in bond prices, and a given investor holding say a 60-40 portfolio would face lower risks by holding both stock and bonds in her portfolio. In this environment, such as in early 2022, historical portfolio allocation recommendations were certainly valid. This was considered normal, when stock returns were driven by demand considerations.

As the Fed started raising the Fed Funds rate in March of 2022 to squash inflation, first gently in 25 basis point increments, and then later as 50 and 75 basis point increments, the historical positive relation between stock returns and changes in bond yields was quickly upended. By April 2022, as you can see in the figure, the correlations between S&P 500 returns and changes in bond yields turned negative, implying that the prices of both stock and bonds started going in the same direction, on average. Thus, returns in 2022 were mostly characterized by supply considerations, with the Federal Reserve’s monetary policy driving both stock and bond returns.

Recent Performance of the 60-40 Portfolio

In fact, as many portfolio managers and investment advisors have noted, 2022 was a terrible year for the 60-40 recommendation for bond and stock allocations, as the declines in the stock market were exacerbated by declines in the bond market as well. Both stocks and bonds lost money in 2022 and there was nowhere to hide from the carnage.

While this was certainly true in 2022, many analysts are now saying that in 2023, it is time to get back into a 60-40 portfolio and that bonds will once again offset the volatility of common stocks. Is it really safe to get back to a 60-40 portfolio? Let us take a look at our figure again.

Unfortunately, our figure below shows that it is premature for such a pronunciation. In January and February 2023, the correlations between common stock returns and changes in bond yields mostly remained negative, similar to much of 2022. So far, there is no fundamental shift in the relationship between stock returns and bond yields based on the correlation. Except for brief periods in 2023, stock and bond prices in 2023 are again going in the same direction.

What about periods when the correlation between common stock returns and changes in bond yields turns positive? Does that help investors? Unfortunately, the answer is once again no.

Our figure again shows us why. If you look at both lines, you will see that they move up and down together. Hence, it also shows a strong positive relationship between the levels of S&P 500 and the stock-bond correlations. This means in good times, when stock prices have gone up substantially, correlations turn positive and bond prices have come down. The reverse however is not true. In bad times, when stock prices have declined substantially, correlations turn negative and bond prices follow stock prices down. Hence, when times are bad and you most need bond prices to offset your losses in the stock market, unfortunately, bonds do not provide this protection.

When investors think that the inflation problem is behind us and things are beginning to normalize (the stock market is back up and times are looking good again), bond prices do provide some diversification. However, when investors are still worried about inflation and increases in the Fed Funds rate (stock market is down and times are bad), stocks and bonds decline together.

What is our takeaway? While risk-averse investors may prefer having some or a lot of exposure to the Ten-Year T-Note (or even longer-dated T-Bonds) because of their inflation outlook and where they think the Fed Funds rate will go, the risk reduction or diversification argument is not yet validated in 2023. Thus, we suggest that investors in stock and bond markets consider the fact that stock returns and bond yields are still negatively correlated in 2022 and going into 2023 when they are considering their portfolio allocations between stocks and bonds. Thus, you should not expect your stock market losses to be stabilized and offset by gains in the bond market, at least not yet. Based on our graph, you can only breathe easy when the Federal Reserve is done and it stops whipsawing both stock and bonds together. Though the most recent data shows the correlation returning close to zero, it is too early to tell if this represents a reversal to positive, or if the correlation will rebound off zero and head back negative.

When the 60-40 portfolio Fails to Provide Protection, Where Can Investors Turn to?

With the 60-40 portfolio currently out of commission, investors will need to consider other ways of analyzing the market to advise on current risk levels. At InsiderSentiment.com, we provide one such other method, and that is by examining insider sentiment based on the aggregated trading activity of corporate insiders. As insiders are highly informed about their own firms and industries, they can anticipate how coming trends and macroeconomic developments will affect their firm, and they trade on this information accordingly. This results in a forward-looking macroeconomic indicator in the aggregate.

At this time, InsiderSentiment.com is reporting that, while insiders are sending a risk-off signal overall, they have not totally abandoned ship. This is seen by increased buying in February relative to January in certain slices of the economy, such as small-cap Value stocks and stocks with a negative 1 month trend. The full details, including exactly which narrative insiders are favoring at this time, is updated weekly for subscribers at InsiderSentiment.com. When the 60-40 portfolio split becomes risky due to the above mentioned correlations, investors can use insider sentiment to help fill in the gaps.