The End of 60/40?

DECEMBER 31, 2022

2022 was an unusual year because the long treasury bond return was actually lower than that of most stock averages. This meant that a traditional 60/40 portfolio constructed with long bonds produced particularly poor results.

There are numerous passive portfolio strategies other than the traditional 60/40. For example, the “permanent portfolio” recommends a quarter of the portfolio in each of stocks, gold or commodities, bonds, and cash. None of these passive strategies did better than minus 10% for the year.

In our last report we noted the manic depression of global stock markets through September. This pattern continued for the year as a whole. The S&P 500 had four drawdowns greater than 13% with four accompanying rallies greater than 10%.

Manic depression is not unknown in all kinds of markets but is especially characteristic of a certain kind of bear market, one which may be described as a “sawtooth” in contrast to a “waterfall.” A “sawtooth” bear market can go on a long time and may or may not end with a “waterfall.”

CPI Inflation

The market retreat was triggered by unanticipated inflation striking at the highest valuations in history. In 2021, we wrote that the reported Consumer Price Index (CPI) would likely surge, which it did. We wrote at the end of last quarter that we expected it to subside, which it has.

As always, we believe that the CPI is constructed to understate inflation, primarily because that saves the government billions in Social Security and other payments.

Reported CPI inflation could conceivably dip back to where the Fed wants it, at 2%, but even if it did, we do not think it will stay there. In today’s massively overindebted economy, the Fed wants low inflation in order to devalue debt, especially government debt, gradually, but is unlikely to get what it wants. Both inflation and deflation hedges are currently needed. And as we have previously explained, the return on one does not offset the return on the other.

The problem facing US policy makers is obvious. The US government owes a record $24.4 trillion and much more off-balance sheet. At the end of the last fiscal year, it was paying interest at 1.5%. If this rose to 4%, consistent with current rates, the cost would nearly triple to almost a trillion a year. This would not happen at once since the average maturity of US debt is 74 months with a bit less than half maturing in three years. The Fed wants enough inflation to erode the real value of the debt but not enough to require higher interest rates.

Interest Rates and Recession Risk

The rise of inflation has brought the fastest interest rate rise in US history. The 4.25% increase in Fed rates that followed the dot.com bubble of the 1990’s came over two years.

The economy reflects the decisions of billions of individuals. It is not reasonable to expect to be able to forecast their collective actions.

Interest Rates and Systemic Fragility

The rapid rise in rates also exacerbates the fragility of the global dollar and Eurodollar market. As we have noted, a global trading and investment system needs dollars for settlement, hedging, and regulatory compliance reasons and pressures can build quickly. So far there has been no collapse of a European bank or any serious tremor in emerging markets.

The pressure of rising rates on low quality or “zombie” companies abated at least temporarily during the fourth quarter. Triple C rates began at 7.2% at the start of the year, reached 16.84% by September 30, but then fell back to 15.75% by year end. By January of 2023, Rule 144A will require all speculative grade bond issues to include financials, and we will learn more.

Market Math

For the first half of the year, only cash, inflation hedges including most notably energy, and some value stocks, especially in Europe, did well.

During the third quarter, only Brazil, Indonesia, corn, and dollar futures rose, and we participated with the exception of dollar futures. Among major asset classes, nothing rose, cash was king.

Gold finished flat for the year, seeming to shrug off each and every headwind, namely the strong US dollar and increasing government bond rates. Gold and commodities are supposed to wither in the face of either of these, but it was more complicated this past year. Gold miners as a group rose 19% in the fourth quarter and 46% from their third quarter lows. A declining dollar made this easier.

As you know, we have avoided China (as we did Russia) and continue to do so. China and Taiwan represent half of the market value of emerging market index funds. Taiwan is of course not really an emerging market and is directly threatened by China. We are active in emerging markets through our Gibson Mountain vehicle.

Another 2022 theme was small and medium sized companies on average doing better than giant companies. This was evident from equal weighted market indexes outperforming capitalization weighted indexes whose construction favors the giants….

Looking Ahead

Doom and gloom there is, which paradoxically supports a rising market, because it suggests that the sellers have already sold. On the other hand, investor action is not really consistent with the dark mood. This unusual bear market could have a long way to go to the bottom, however many ups and downs occur in the meantime. At the bottom of a major bear market, the speculative juices should be fully exhausted, and we do not see this yet….

Looking to [immediate future], back-to-back negative years in the stock market are rare. This has happened only three times since 1957. The average return in the year following a down year over this period is up 15%....

Market Follies

During 2021, more new money flowed into the stock market than in the prior 20 years. The amount fell in 2022, but still far exceeded prior years. This is an example of investors saying one thing but doing another.…

Investors still clamber to get into illiquid vehicles. In part, this seems to reflect a desire not to know about changes in market value, even if it means being locked in forever. Blackstone[’s largest real estate] vehicle says clearly that investors need never be paid back.

Meanwhile sophisticated institutional investors continue to accept valuations from venture and private equity managers which are clearly overstated. It is as if both manager and investor do not want to know the facts, since both parties would suffer financially from doing so. This is clearly not a sustainable situation and could ultimately just enrich the lawyers….

Private investments are not the only illiquid funds. Liquidity can be dicey even for traded vehicles. For example, there are serious and never discussed questions about Exchange Traded Fund (ETF) liquidity. [Vanguard’s] Jack Bogle mentioned this before his death, but was ignored even while being lionized and then eulogized as an inventor (with the forgotten Bill Fouse) of the index fund.