Asset allocation works...until it doesn't

About 18 months ago, I wrote a newsletter titled After a balanced portfolio fails, what happens next? When I published it in May of 2022, I wrote:

"(1981) was the last time that a balanced portfolio of both stocks and bonds would simultaneously have market losses for a 12-month holding period. If May continues as it started, this could be another 12-month loss for a balanced portfolio."

Guess how 2022 ended for a 60/40 portfolio (defined here as a mix of 60% U.S. equities and 40% U.S. Treasury bonds)? Down 17.5% in 2022.

Then I continued to write the following:

Rare occurrences like this are ripe for strong returns. A 60/40 allocation gave investors a positive return 81% of the time following the 12-month loss. (That number jumps to 100% positive returns in post-Great Depression periods.) Investment returns were not only double digits, but in the periods when there was a loss, it was at worst, just 5%. (Past performance is NOT indicative of future returns; but you knew that).

Drumroll please on how 2023 faired for the 60/40 allocation that nobody wanted to own ever again: UP 17.2%!

The backdrop actually tells the entire story

If you look at the economy in both 1981 and 2022, it was eerily similar: high inflation and consequently, high interest rates, as well as aggressive fed tightening. In 2022, central banks raised interest rates to tame the highest inflation rate in 40 years amid the tightest labor market in 50 years. This was the most aggressive rate-hiking cycle since, you guessed it, the early 1980s. These are textbook negative situations for most investments, especially for anything tied to growth or interest rates.

As you continue to dig deeper, it makes sense why a balanced portfolio gave you positive returns after a year of losses. Generally, the losses occurred either during a high inflationary period, a recessionary period, or both. Consequently, when the Fed cut rates to get the economy out of each slowdown, falling rates fueled returns of both stocks and bonds.

What happens next?

Over the last year, a 60/40 portfolio has rallied for the fourth consecutive quarter (+5.6%) to a new record high as both stocks and bonds contributed to positive returns. It's been eight years since BOTH stocks and bonds have both rallied for five consecutive months, and almost 30 years since we saw a seven month streak of consecutive gains. Which, by the way, was the last time the Fed achieved a so-called "soft landing."

With continued good economic news being printed, low unemployment, and easing inflation, this is a rare instance where rate cutting is not happening during poor conditions. On the contrary, the Fed is attempting to keep the economy steady and normalized for the consumer, without rocking the boat. This moderate scenario is setting up well for both quality stocks (with flush balance sheets), as well as fixed income...especially as rates trend down.

Why asset allocation still matters

60/40 portfolio performance aside, we feel that proper asset allocation has a place in EVERY portfolio, regardless of your risk tolerance and time horizon. Limiting investment losses not only helps with a clients' mental stress, but it's also important on a clients' portfolio stress. Remember that your return to break even becomes easier when your downside is protected and you have a better chance of achieving positive returns the longer you stay invested.

-Jason

Any opinions are those of Jason Macaluso and not necessarily those of Raymond James.

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation.

The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.? Past performance may not be indicative of future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.? Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation.