(Bloomberg Opinion) — The traditional 60/40 portfolio of U.S. stocks and bonds isn’t dead, but it has fallen on hard times. U.S. interest rates are hovering around zero and, even after a coronavirus-induced sell-off, the U.S. stock market isn’t cheap. For adherents of 60/40, it’s a good time to revisit some old assumptions.
When in doubt, tradition has it, investors should put 60% of their portfolios in U.S. stocks and 40% in bonds. Why 60/40? There’s no satisfying answer. A common explanation is that stocks can be expected to outpace bonds over time, so tilting the portfolio in favor of stocks is an easy way to reach for extra return without excessive risk. And why the U.S.? Well, there’s no place like home.
That tradition has paid off. A 60/40 combination of the S&P 500 Index and long-term U.S. government bonds has returned 8.9% a year from 1926 to 2019, including dividends, or 6% a year after inflation. The results were even better during the last decade. The 60/40 portfolio returned 12.6% a year from 2010 to 2019, or 10.5% a year after inflation.
Past isn’t prologue, however, and that admonition has never been more fitting for 60/40 portfolios. A widely cited barometer of real expected returns from stocks is the cyclically adjusted earnings yield, which uses an average of inflation-adjusted earnings over the previous 10 years. That yield for the S&P 500 Index is 4.8%, according to Bloomberg data. Meanwhile, the yield on inflation-protected Treasuries is a negative 0.2%. A 60/40 combination of the two produces an expected return of 2.8% a year after inflation.
Investors don’t appear to have grasped that reality. In its most recent annual investor survey, French lender Natixis SA reported that U.S. investors expect their portfolios to generate returns of 10.9% a year after inflation. To put that delusion in perspective, the 60/40 U.S. portfolio managed to equal or surpass that mark just 9% of the time since 1926 over rolling 10-year periods, counted monthly. And those periods were all clustered around the 1990s, a decade with an enchanted combination of bond yields that fell from record highs and stock valuations that climbed to records. Suffice it so say, no one expects those tailwinds to return soon.
Those who want a preview of what the next decade might look like should consider the recent experience of investors in other developed countries. Home bias, or the propensity to invest in one’s home country, is common to all investors. A recent paper by FTSE Russell examined euro zone home bias in equity allocations from 2008 to September 2019. It found, for example, that French pension funds invested 88% of their equity portfolios in French companies, which is 29 times France’s weight in the FTSE All-World Index. In Spain, the equity allocation of pension funds to local companies was 67 times the country’s weight in the FTSE index.
Staying home paid off for a time. The MSCI French Index outpaced the MSCI All Country World Index, or ACWI, by 2.6 percentage points a year in euros from 1999 to 2007, including dividends, the earliest year for which numbers are available. And the MSCI Spain Index outpaced ACWI by 5.2 percentage points a year over the same period.
But the cost of higher stock prices is lower earnings yields. By the end of 2007, the cyclically adjusted earnings yield was 4.2% in France and 3.7% in Spain. Since 2008, French stocks have returned 4% a year through February, lagging ACWI by 3.2 percentage points a year, and Spanish stocks have been flat, trailing ACWI by 7.3 percentage points a year.
France and Spain are hardly alone. While the U.S. stock market has soared since the 2008 financial crisis, the rest of the world has floundered. The cyclically adjusted earnings yield of the MSCI World ex USA Index, a basket of companies in developed countries outside the U.S., has swelled to 6.5% from 4% at the end of 2007. Similarly, the yield for the MSCI Emerging Markets Index has jumped to 7.2% from 3.8% over the same time.
Value-minded investors can find even higher yields. The MSCI World ex USA Value Index offers an earnings yield of 9.5%, while the MSCI Emerging Markets Value Index packs a yield of 11%. If there’s ever a time for Americans to start leaving home, this is it.
It won’t be easy. Given 60/40’s stellar past performance, investors are more likely to look back than forward. Also, overseas stocks have been laggards for years and have only tumbled further over time — and nothing repels investors like falling stock prices. The timing isn’t great, either. Everyone wants the comforts of home during a crisis.
Unfortunately, there’s not much investors can do about the 40 because the U.S. still boasts some of the highest bond yields in the developed world. But when it comes to the 60, the value is overseas. So let’s tip our hat to the old 60/40 — and then give it an upgrade.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.
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