Telemus Weekly Market Review June 27th - June 1st, 2022
This week we hit the halfway point for the year. It’s no surprise the first half of 2022 has not been kind to portfolios with the S&P 500 down -20% and the Bloomberg Barclays U.S. Aggregate bond index down -10%. This past week there was a headline that the stereotypical 60/40 portfolio (that being 60% stocks and 40% bonds) had its worst start since 1988. A portfolio that is 60% stocks and 40% bonds is viewed to have a reasonable level of diversification to provide a steady return pattern over time. What’s transpired in 2022 is that both stocks and bonds have fallen, and the level of diversification has not been what investors hoped for.
The reason why diversification has not performed as expected has been inflation. As prices have shot higher, so have interest rates in anticipation of aggressive moves by the Federal Reserve. In recent years, interest rates have been abnormally low. This has pushed many investors into riskier assets with some using the acronym TINA, for There Is No Alternative, as a guideline for their investment decisions. Given low yields investors embracing TINA have migrated more of their portfolios into stocks in search for higher returns. In fact, the level of equity ownership among investors has been at its highest level since the technology bubble in the late 1990’s. This year, as interest rates have risen and one could now earn a higher return on their bonds, there became a more attractive alternative resulting in stocks appearing less attractive. This has pressured stock prices. Falling in tandem were bonds as the price of a bond moves inverse to interest rates. Thus, higher interest rates resulted in lower bond prices.
So, what is one to think about diversification going forward? First, diversification is a concept and principle that works over a long-term horizon. There are episodes, such as the first half of 2022, where stocks and bonds are more correlated, or move more in tandem than what is typical over longer time periods. Thus, one must over a full market cycle (and ideally longer) when assessing the value of diversification.
Second diversification extends beyond just stocks and bonds. While both asset classes have fallen in 2022, commodity-oriented assets have not. They have been additive to returns year-to-date. While these assets have helped portfolios, they themselves are risky and hard to forecast and thus should only be included in portfolios in small doses.
Finally, looking forward the conditions that we entered 2022 have evolved. Valuations on stocks now sit on top of historical averages. This marks a much more reasonable level than the start of the year when they were at the highest levels since the late 1990’s. In addition, bond yields offer much more attractive returns going forward. Yields on the bond market are near 4%, much better than the sub-2% level that existed going into the year. While stocks and bonds could continue to stay correlated (and less diversified), and they may for as long as inflation concerns drive the market, over time conditions exist where they should once again begin diversifying one another…over the long-term.
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