8 BARRON’S August 3, 2020
downgrade is a crisis is for a later date.
T
he classics never go out of style,
it’s often said, but the days of one
classic investment strategy might
be waning. That is the 60/
portfolio, consisting of those respective per-
centages of stocks and bonds, which could
be a victim of its own success.
The idea behind it is simple: Stocks do
better during good times, while bonds act as
shock absorbers during bad interludes. This
negative correlation—a fancy way of saying
that when one zigs, the other zags—reduces
risk with relatively little sacrifice in returns.
In a sense, the concept has worked too
well. While stocks and bonds have been
negatively correlated over short periods,
over the longer span they’ve been positively
correlated, with both benefiting from the
steady decline in longer-term interest rates,
explained Marko Kolanovic, J.P. Morgan’s
global head of quantitative and derivatives
strategy, in a client call this past week.
Indeed, many equities trade in tandem
with bonds, he continued, including the
monster megacap technology stocks that
dominate the market. These have benefited
from lower interest rates, thereby boosting
the value of their long-duration, but reli-
able, cash flows. Actual bond proxies, such
as utilities, real estate investment trusts,
and consumer-staples stocks, have simi-
larly benefited, while their low volatilities
make them popular with multi-asset port-
folio managers. And environmental, social,
and corporate governance, or ESG, stocks
tend to overlap with those factors, he
added, aiding them indirectly.
But with yields on bonds approaching
0%—the benchmark 10-year Treasury note
fell to 0.54% on Thursday—they offer little
scope for income or price appreciation,
Kolanovic continued. That raises the possi-
bility that 60/40 won’t work as it has in the
past and needs to be tweaked. Assuming
bond yields don’t go to zero, or below, as in
much of Europe and Japan, there is the
chance they will move higher. That, in turn,
would hurt bond proxies, as well as the
megacap growth stocks heavily represented
in the S&P 500 and other major indexes.
The question, then, the strategist contin-
ues, is how to hedge portfolios. Buying
protection, such as through put options, is
relatively expensive now. (A put gives the
purchaser the right to sell a security at a
stated price for a period; its value increases
as the underlying security’s price decreases.)
The key is to find stocks that are highly
negatively correlated with most equity
portfolios. And the strategist found some,
including value shares, financials, industri-
als, small-caps, and materials stocks. These,
he says, are positively correlated with the
10-year yield (which moves inversely to the
bond’s price). And not coincidentally, they
have been laggards in the market’s advance,
which has been led by the megacaps and
low-volatility bond proxies.
This situation is relatively recent, hav-
ing emerged over the past five to seven
years, Kolanovic observes, and possibly
enhanced by the rise of passive invest-
ments, such as S&P 500 index funds, as
well as by momentum-chasing and ESG.
The problem is that traditional fixed-
income investments are neither fixed nor
provide much income—a key observation
of the J.P. Morgan strategist’s presentation.
A relatively small uptick in yields would
result in price declines that would more
than wipe out the meager annual income
offered by bonds today.
As this column contended late last year,
the chance of a rise in yields make bonds
a less effective hedge for equity portfolios.
What couldn’t be foreseen then, with the
economy cruising along at full employ-
ment, was the catastrophe wrought by the
coronavirus, which has sent bond yields
crashing to record lows.
The lessened effectiveness of 60/40-
type portfolios can’t be offset by just add-
ing stocks correlated with bonds, such as
the megacaps, Kolanovic argues. Rotating
into currently out-of-favor assets, such as
value stocks, he says, would provide the
sort of ballast that bonds traditionally had.
This approach could attract more big
multi-asset managers, such as pension
funds, which could lead to a rerating of
these groups, he maintains.
To be sure, the 10-year Treasury note’s
yield could drop another 50 basis points
(one-half percentage point), to near-zero.
The 30-year Treasury, recently at a record-
low 1.18%, could see a similar decline in
yield, which would produce a double-digit
total return from a price gain. Such a yield
collapse would probably be associated
with an economy in even more dire straits
than revealed in the record 32.9% annual-
ized plunge in second-quarter GDP
reported this past week.
Investors looking ahead to a recovery
should consider J.P. Morgan’s advice to
hedge portfolios away from the megacap
tech champions and other stocks heavily
correlated with bonds, to those that should
benefit from a rising-rate environment, such
as unloved value and financial shares.B
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