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Smart people are being punished by the market this year.
Prudence in standard investment wisdom means diversifying across asset classes, keeping exposure constant and rebalancing along the way to properly spread risk.
It’s really interesting.
Holding a fixed proportion of stocks and bonds has become more of a confusing trap than a useful tool these days. of iShares Core U.S. Aggregate Bond ETF (AGG) Stocks are down 4.8% this year, and even after interest income, the total return is -2.2%, dragging down the S&P 500’s 14% year-to-date total return in a diversified portfolio.
At the end of the last quarter, S&P500 If AGG were up 15% and AGG was roughly flat, a disciplined investor would have sold stocks and bought bonds to get the allocation back on target. The trade has been weak this quarter, with the S&P 500’s nearly 3% return almost exactly offset by further losses in bonds as benchmark yields climbed relentlessly toward 19-year highs.
This set the stage for a shift to quarterly rebalancing in favor of bonds, which now provide enough yield cushion to prevent further rises in interest rates. There was little indication that these trends were growing towards the end of the quarter.
Investor attitudes toward bonds are a mix of fear and loathing, even as wealth managers’ adherence to pre-arranged plans has boosted the flow of retail money into bond funds.
We find that typical investors view bond declines as scary in a different way than they view stock declines, which are often viewed as a buying opportunity.
Few people would refuse to buy a battered marquee stock because its price might fall a few more percentage points, but someone who refuses to buy a five-year Treasury bond, for example, with a guaranteed 5% yield to maturity, would refuse to buy it because the yield could continue to rise to 5.25%.
To be fair, the negative reinforcement for investors who have clung to bonds as portfolio stabilizers and insurance against economic downturns has been going on for a long time.
As this chart clearly shows, the 10-year annualized total return of the S&P 500 minus the return from the Treasury portfolio is about the same as its all-time high. This spread currently favors stocks by 15 percentage points over the past 10 years.
This is primarily due to the incredible rise in large-cap stocks driven by the era’s technology leaders. But the absolute underperformance of bonds over the past decade hasn’t helped.
Recall that 10 years ago, the Federal Reserve was just beginning to gradually lower short-term interest rates from the zero lower bound, and inflation was chronically below its 2% target. Almost everything has changed since then. Not only are there now richer nominal yields on offer, including the initial conditions for new capital to enter the bond market, but real yields (which far exceed the inflation implied by the market in the coming years) are also nearing 20-year highs.
Savita Subramanian, equity and quantitative strategist at Bank of America Securities, explains the case: “We’ve been bond bears since the ZIRP days, but we’re seeing a better picture today. Why? Based on yield, dividend yield, and short-term CD yields, it’s more attractive relative to the S&P 500 than at any time in over 20 years, easily beating short-term CD yields. Valuations are bad for market timing, but they are a strong predictor of long-term rates.” The S&P return suggests an index return of -3% (annualized) over the next 10 years. ”
The current dividend yield on the S&P 500 index is less than 1.4%, the lowest in modern times, and with high-quality corporate bonds yielding 6% and low default risk, this could constrain the index’s future returns.
This does not mean that the 60/40 mix of stocks and bonds contains any special formula to optimize long-term results. It’s also a bit of a straw man. The industry has long since moved away from these specific ratios. I own a portion of the Vanguard Targeted Retirement 2035 fund, which has less than nine years left and is 67% stocks and 32% bonds.
But broadly speaking, balancing equity risk with low-volatility income (or substitutes, products) has not yet been proven obsolete over longer time horizons.
I think people should have an open mind that with rising nominal economic growth and gigawatts of supply-side productivity miracles being built, an unprecedented golden age of equity enrichment is unfolding. This can make a large bond allocation appear to have severe opportunity costs over time.
I always remember the late, famous Wall Street strategist Byron Wien talking about getting into the investment business in the late 1950s, around the same time that stock market dividend yields first fell below U.S. Treasury yields. Veteran investment experts thought of it like the sun rising in the west or a bird flying backwards. For them, riskier assets that offer lower income protection do not make sense.
But it has remained that way for almost 70 years, with brief hiatuses around the global financial crisis, and this is a real structural shift.
Still, the reason to rebalance and diversify is not to have the best reaction to changes in government bond yields, or to have a strong and specific idea of how the macro and policy path will affect market prices. The reason why we do this is precisely because we don’t understand.
Diversification is humility in the informed but unguaranteed hope that the market gods will be generous.
market thermometer
This index from John Kolovos of Macro Risk Advisors uses several data points to reflect both what investors say and what they do.
“Amid tightening financial conditions characterized by widening spreads and a sustained upward trend in oil prices and real interest rates, bullish sentiment has not yet reset despite only 25% of stocks trading above their 50-day moving averages,” Kolobos said of the latest statistics.
around the street
-Financial news outlets have done an admirable job of unraveling the constellation of causes of the brutal global bond market crash without pretending to get to the individual causes. This is a recent New York Times Dealbook effort that hits all the important points.
Robust global growth, persistent inflation, voracious demand for debt by the private sector and government, central banks unwilling to assess the rise in oil prices, and vague but clear fiscal instability. Like in “Murder on the Orient Express,” perhaps all the suspects did the act or attempted to do it.
– Wall Street is deftly trying to quantify how much future revenue growth it will cost to justify its reckless investments in hyperscalers’ new computing power, totaling about $2 trillion this year and next. The numbers are so large and the range of assumptions so wide that it is not an exact science. But FT Alphaville usefully explores some of the conclusions here.
market is closed
Most accounts of the current market environment describe the S&P 500 index as relatively stable near all-time highs “despite sharp increases” in oil prices and bond yields.
However, I recommend replacing “despite” with “because of.”
It certainly sounds strange. But in reality, oil and interest rates and constant pressure from a hawkish Federal Reserve are hurting large swaths of the stock market, forcing it to chase money away from these macro-sensitive areas and into the less economically powerful, defensive AI-driven tech giants that ultimately drive the S&P 500.
True, the S&P 500 is only 2% off its all-time high, and the Nasdaq 100 is even closer to that record, while the equally weighted S&P 500 is down 6%. russell 2000 8% off, KBW Bank Index There was a 12% adjustment, with the equally weighted consumer discretionary sector down 13%.
The market is thus making a mockery of diversification principles within stocks as well as asset classes as a whole.
In a way, this is a vindication of passive index investing. The S&P 500 has so far protected its owners by having 40% of its value heavily concentrated in the top 10 tech stocks.
The key debate at the moment is whether the current market breadth is so weak and the non-tech oversold conditions are setting us up for a huge de-escalation rally with guaranteed relief from Iran and bonds, or whether the resilient giant stocks will have to break first.
This behind-the-scenes weakness is also a reminder that financial conditions are tight, even more so when you exclude the benchmark S&P 500 and its subdued volatility measures from the calculation. That’s what this breakdown of Goldman Sachs shows — its financials, excluding stocks, are about as bad as they were after the tariff panic in early 2025.
Does this mean the Fed doesn’t need to tighten significantly from here?
The familiar complaint is that raising interest rates will only squeeze consumers and small businesses because the Fed can’t “print more oil” or directly slow AI capital spending. But the Fed always uses only blunt instruments.
In July 2022, Sen. Elizabeth Warren wrote an op-ed in the Wall Street Journal deriding the Fed’s tightening policies, saying, “Raising interest rates will not end the high energy prices caused by President Vladimir Putin’s war with Ukraine. They will not repair supply chains still reeling from the pandemic.”
But central bankers’ mandates often tend to move in a direction that roughly matches current data, hoping that things will work out in their favor.
In this case, the mismatch between the drivers of inflation and the areas affected by the Fed’s policy rates may not mean a forced hike in rates this cycle.
“The ‘divergence conundrum’ facing central banks around the world is one reason why we see this as a realignment around higher neutral rates rather than the start of a significant rate hike cycle,” said Lauren Goodwin, chief investment strategist for global wealth at KKR.
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