Is The Traditional Asset Allocation Model Broken?

by: Jim Sloan


Recent bond returns depended upon capital gains from falling interest rates, but capital gains are speculative in nature and are not the reason you hold bonds in your asset allocation.

A bond allocation is designed to produce steady income and fewer and less violent negative years; many statistical studies demonstrate that it does so but a close examination raises questions.

A thoughtful examination of the time series for bond rates and stock prices suggests that the smoothing effect of stock/bond diversification comes from one of four market patterns.

Stocks and bonds were highly correlated in positive return from 1982 to 2000 and negative return 1966 to 1982. Bonds helped mainly during the Great Depression and recently.

The current period looks a lot like 1940s/50s/60s in which bonds were a modest drag on balanced portfolios, but there is currently a valuation/risk premium problem with stocks too.

"History is bunk." -Henry Ford

It used to be so easy. You just subtracted your age from 100 and that was your equity allocation. Or possibly you used 110, if healthy, taking into account the increase in lifespan over the past quarter century or so. The rest was in fixed income, probably a diversified bond fund. Maybe 5% of that fixed allocation was cash, or possibly you took an emergency cash fund out of your investable funds before calculating the percentages.

If you have accumulated enough to hit certain hurdles for total assets in your Vanguard accounts, Vanguard will do it all for you. They will use low cost index funds for both stocks and bonds. The ratio will be determined from your age and risk tolerance. They will ramp up the bond portion as you approach retirement. They will even rebalance for you, regularly: no muss, no fuss, no worries. You can relax and enjoy the journey. Easy, isn't it?

Wasn't it?

This approach is what I suggested to my clients when I decided that managing other people's money was too stressful. Vanguard, for those unfamiliar, is an honest, low-cost outfit, which unlike many money management firms, has investors' interests at heart. In fact, the investors are effectively the owners. Even so, there was one little footnote to my suggestion as early as a decade ago - a concern about the fixed income side of the allocation. I have never been a fan of bond funds. For one thing, their annual/annualized return data is misleading. It is a composite of coupon income and capital gains/losses.

The capital gain/loss portion is fine when it goes in your favor, but it is not what your bond allocation is designed to provide. I tried to explain to clients why it is misleading. A capital gain in a bond differs from a capital gain in a stock. A stock may go up in price because of improving prospects. Stock prices improve with the prospect of better future earnings and dividends. Not so with bonds. The cash return of bonds is permanent. The primary reason for price changes in bonds is change in the prevailing interest rate.

Unless it defaults or you sell it, a bond provides a single immutable return - its series of coupon payments. If it goes up in price, the capital gain reported by your bond fund represents future cash flow pulled into the present. The increase in bond price will be given back when the bond is retired. The performance of a Vanguard bond fund in the quarter just ended provides a case in point:

The Vanguard Intermediate Term Treasury Fund (MUTF:VFITX) had a reported return for the first quarter of this year (ending March 31) of 3.42%. Its yield to maturity, however, was reported as an annual 1.4%; the quarterly portion of that would be .35%. What gives? The reality is that 90% of that reported return derived from an increase in the prices of the bonds in the portfolio - a gain not realized in cash unless you sold the fund.

What happened to cause this outsized gain in intermediate term Treasuries? It's simple: interest rates went down, bond prices went up. Interest rates and bond prices are like the two sides of a seesaw. Bond prices went up sharply in the first quarter as if someone had dropped a boulder on the other side of the seesaw. That person was the Federal Reserve. That's great, right? Well, not so fast.

To think that a capital gain in bonds will be repeated is a naive but common mistake. The coupon return doesn't change. What changes is the price of the bond, and the amount of its future return pulled back into the present. The rate of expected future return goes down. That's not a prediction, that's arithmetic. You could sell your bonds or bond fund shares, of course. If you have held them for a year and a day, you would pay taxes at the capital gains rate. The bad news is that if you want a bond allocation, you will just have to go right back out and buy approximately the same thing, paying up to get the same 1.4% rate. It's a wash.

To be excited by that 3.42% gain, you have to tell yourself that you are actually a speculator in bonds, looking for capital gains.

You Don't Buy Bonds Seeking Capital Gains

Unless you are a hotshot bond trader at Goldman Sachs, capital gains is not what you are seeking in a fixed income portfolio. What you want is stability of both price and income.

The basic premise of the traditional asset allocation model is that the fixed income allocation will provide a smoother return by being relatively stable in price or even leaning in the opposite direction of the equity allocation. It should bolster and smooth your returns by going up or staying flat when stocks go down, an advantage which you pay for as bonds moderate your returns when stocks go up. Portfolio risk, defined as variance, is reduced. The standard asset allocation model is predicated upon that assumption.

The bond part of a stock/bond portfolio is supposed to provide ballast. It should reduce the number of down years and reduce the bite of the down years that you do experience. Statistical backstudies show that the various mixes of stocks and bonds have all performed that function reasonably well in proportion to the level of the bond allocation. See, for example, this compilation of data.

What really makes the standard allocation model a winner is that when you combine the roughly 10% average return of stocks and the roughly 5% return of bonds (averages from 1926 to present), you don't really lose that much for owning, say, 40% bonds. You still trounce inflation and you sleep well at night, two important investment goals.

Does the model still work in current markets? I think the answer comes with careful qualifications. As with so many perfect models of the world, there's a catch.

What if those backstudies, from Vanguard and many others, do not have useful predictive power in this very unusual low rate environment? What if, in this instance, Henry Ford was right? Is it possible that "history is bunk"?

Are Bonds Really Uncorrelated To Stocks?

Let me start by stating my concern backward. Around 1990, I stood in a brokerage office with a friend who had asked for advice about his portfolio and who had no bond allocation at all. His broker insisted on keeping him in stocks, with which he could more easily justify regular churning of my friend's portfolio. Using the standard allocation model, which I did not question at that time, I was suggesting that my friend should include at least some bonds.

"Bonds are garbage," the broker insisted. "Bonds only have an average long-term return of 5%."

This was true as far as it went. The long-term average return of the 10-year Treasury bond is about 5%, but I pointed to the large wall chart behind the broker's desk. It happened to include the current 10-year Treasury yield. That yield at the beginning of 1990 was more than 8%.

"Look at your own chart!" I said. "You can get 8% from Treasuries right now! Risk-free. And if you want to, you can buy Treasury STRIPS or Zeroes (bonds or "stripped" coupons discounted back from the maturity date and making no intervening cash payments). You can lock in the current rate internally compounded for 25 or 30 years!"

That conversation took place in the middle of the longest bond bull market in history. It had gone about halfway in price, a fourth of the way in time. Bonds were then a totally wonderful part of your portfolio, and obviously add a good bit of the statistical evidence that owning bonds doesn't much harm the returns of a mixed stock/bond portfolio. I myself owned them in the form of Treasury Zeroes. Rates continued to fall and I eventually sold my bonds in order to take the return in capital gains rather than paying current taxes on the Original Issue Discount (OID on your tax report) phantom interest income.

I had done great, right? I had received stock-like returns on a totally safe asset. Great! No portfolio drag to speak of. By then, however, something was beginning to occur to me. Those Treasury Strips had not been stable ballast to my portfolio at all. They had produced speculative gains. Bonds had been just another way of playing the long 1982-2000 bull market in all financial assets which had been based on falling interest rates. Falling rates were part of the long, slow grind from inflation (the 1970s and 1980s) to disinflation (the 1990s and 2000s).

To what extent did the stock bull market from 1982 to 2000 depend on declining rates? Here's an interesting fact: Depending on your exact choice of beginning and end dates, the annualized return on a Treasury Strip was almost exactly the same as the annualized return on the S&P! Bonds in general did about as well as stocks, and Strips, which compounded internally without "reinvestment risk," did as well as the major averages. The trade-off was that you had to pay taxes on phantom income as you went along in exchange for the safety of Treasury bonds.

From 1982 to 2000 a mixed stock/bond portfolio did well not because stocks and bonds were uncorrelated, but because they were correlated - closely correlated. There were differences year to year, but the long-term upward curve fits closely.

But what if things turned around and rates began a long and steady rise? One day that will happen. Will bonds help smooth and temper portfolio variance? It is an important question to think about, because we are probably close to such a reversal moment, give or take a year or two. Fortunately, there are a couple of number series which may provide a more detailed and useful historical precedent.

Making Numbers Talk: Two Time Series And A Chart

So let's get back to that catch about bonds. The broker was right about one thing. The long-term average return of high quality bonds is in the area of 5%. If there is such a thing as normal times, a 5% rate on the 10-year Treasury is it.

If you acquire quality bonds when the rate is at or above 5%, you will do decently most of the time and look brilliant some of the time. One of those times I have always kept in the back of my mind was the Great Depression era, beginning in 1929 and lasting until 1942. The other time - in case you haven't noticed - is the present, beginning in the year 2000.

There are very good reasons for this to be the case. Bond returns are driven by one thing: The direction of movement in interest rates. The direction of interest rates is driven in turn by the direction in the rate of inflation. Just that one thing drives the long-term direction of bond prices.

Stocks, on the other hand, are driven by two things: earnings growth and valuation. Earnings growth is highly correlated to GDP growth, which is the most important force driving it. Valuation is greatly influenced by interest rates. This is true because the return available in fixed income provides investment competition for stocks and also because the risk-free rate provides the basis for thinking about the equity risk premium.

Falling rates, good earnings growth, and a low starting valuation supercharge stocks. Rates falling from a high beginning level supercharge bonds. Those were the conditions from 1982 to 2000. Stocks were great, bonds were also great. But this is just Condition #1 of four major market environments.

Condition #2 occurs when rates and inflation are at an above-average level and rising steeply, with decent nominal earnings and GDP growth but much lower real growth. Stock PEs fall, often sharply. Bonds are terrible, stocks are terrible. Think 1966 to 1982.

(As an aside for those new to this sort of analysis: the term real, used for such things as earnings, investment returns, or GDP growth means that you have subtracted the prevailing inflation rate from the top line, or nominal, number. The very long-term inflation rate in the U.S. is about 3%, but the annual rate has varied wildly.)

Condition #3 occurs when interest rates and inflation are falling - perhaps approaching deflation - while stock earnings and GDP growth are poor. In the Great Depression, stock PEs fell from the high point reached in 1929, then kept falling and remained low for a full 20 years because of punk business conditions. This has usually been the case under poor business conditions. I say usually because the current case appears to be different. For the usual case, however, bonds are good, stocks are down or up-and-down, and sometimes down a lot. The bond portion of a stock/bond mixture is very helpful. This is their golden moment.

Condition #4 occurs when rates and inflation are slowly increasing, but nominal GDP growth and stock earnings are also steadily increasing, with stock prices also helped by PEs rising from a low starting point. In this case bonds are mildly bad, except for brief moments when there is a passing recession. Stocks are persistently good. Think 1949 to 1966. Bonds in your portfolio don't kill your returns, but they become an increasing drag. Overall, you would have done better to own nothing but stocks.

Most statistical studies advocating the traditional asset allocation model treat the year-by-year returns of stocks and bonds as if they are random. A deeper look suggests that this is not really the case. While stock/bond non-correlation includes elements of randomness within longer trends, they are very much not random over the duration of the market conditions described above.

If you are willing and able to look at nothing but a column of numbers and think long and hard about what they want to tell you, I suggest looking at these two number series here and here. You could also just glance at them and see if any patterns strike you.

There is no accepted theory as to why persistent market conditions recur in these four clusters. I have an open mind on the subject. For now, though, let me just provide a chart which demonstrates visually the behavior of rates, bonds and stocks with particular focus on the 20th century. It is provided by an advocate of the Kondratiev Long Wave theory, which I may review in a future article. You should look closely at the S&P 500 price line and the price line for the Treasury Long Bond, noting distinct periods of correlation and non-correlation. Scroll down for the chart and click to make it larger and clearer.

Where Are We Right Now?

The Great Bond Rally that started in 1982 has continued until the present moment. Starting in 2000, owning bonds did exactly what the traditional allocation model suggested it would do: It added stability by means of a reliable coupon and capital gains provided by rates which continued to fall from the mid-single digits to less than 2%.

If your portfolio contained a significant bond allocation, you did well. You greatly moderated the effects of the two 50% bear markets in stocks. You had predictable income. You had less anxiety than stocks-only investors and you probably let your allocation formula keep you in the market despite temptations to sell.

This is all probably about to run its course. For one thing, the returns on bonds are unrepeatable. I repeat: the recent bond returns are unrepeatable. Why? The yield of the 10-year Treasury is under 2%. You have less than 2 points to go. You might get that 2% in several forms, with immediate cap gains if rates fall to 1%, but 2% is it. It's what you will get to maturity. Again, this isn't opinion. It's arithmetic.

Bonds are probably about done helping your portfolio by providing capital gain returns. From this point they would likely only help by being stable while stocks have a major bear market. This by no means impossible.

You should consider that link to the time series on Treasury bond rates. The interest rate on 10-year Treasuries has been below 2% on January 1 of just four years, three of them among the past five years. The other time was 1941. If the current rate is sustained until next January 1, by the way, it will add a fourth occasion in recent times. If the 10-year Treasury rates decline further, we will truly be in uncharted waters.

The chances would appear fairly good that if we are not at a generational low in interest rates, we are pretty close to one. From that 1941 low, interest rates climbed at a glacially slow pace for 25 years before crossing the 5% level with inflation ticking up and starting to worry people. If precedent is any guide (that history problem again!) it would seem that serious inflation is a long way off.

My approach for whatever fixed income assets I owned would be to construct a ladder going out something like 10 or 12 years. The ladder should maintain the same interval and the same amount for each maturity. Bonds may produce a lower return than the other side of your portfolio, but a ladder of bonds with set maturities won't actually lose money and will naturally turn over gradually at higher rates if the prevailing rate does indeed begin to climb.

That's what I would do for the more distant parts of the ladder, but I would consider holding the amount which would have gone into the first five years or so of the ladder in cash. The current yield is so low, that the cost of holding cash is low. A moment of better opportunity might appear.

I would also consider buying I Bonds, which currently have the inflation rate plus .10% as their return. This has obviously been a wretched return, but it has beaten all other available short term returns for several years. I Bonds have several unusual qualities, including the fact that they have a duration of your choice as you can redeem after one year or hold them for as long as 30 years. Because of the way they reset, they also offer both inflation and deflation protection. The only downside is that you can currently buy only $10K per family member per year. I wrote about them in more detail here.

But why have any fixed allocation at all? Bonds, after all, are giving you basically nothing. The slow rise in rates from 1941 to 1966 didn't bother stocks a bit. The year 1942 would have been a pretty good time to buy stocks and hold them for the rest of your life, with 1949 maybe a smidge better. Bonds didn't actually lose money over that period -- a bond ladder would have produced gradually increasing returns - but bonds did much less well than stocks. Enough better that you would have wished in 1966 that you had owned nothing but stocks.

Owning bonds at this point is not just a matter of smoothing returns. It's insurance against the possibility that history doesn't repeat: You may always be wrong. The thing you are least likely to be wrong about is the return on quality bonds, especially Treasuries.

But that's not the only consideration. Stocks have their own problem at the moment. There's something haywire in their valuation and risk premium. This time really is different.

The Stock Problem: Valuation And The Risk Premium

Why not just go wild and own nothing but stocks? If you want to make anything resembling a reasonable return, you have to go out there in the jungle and try to get it from stocks, don't you? I mean, hey, all you have to do is beat 1.8%, right? Even the dividends on the S&P will do that! Good dividend growth stocks will do better. Many Seeking Alpha articles argue that all we should care about is dividends anyway, maybe some dividend growth. The heck with stock prices!

There's just this one thing you have to remember. The last time 10-year rates were under 2% - 1941 - the PE of the S&P 500 was just north of 7. In 1949, when the great 1950s/60s bull market really kicked into gear, it was about 6.6. Right now the S&P PE is above 22. The current earnings season is likely to make it higher.

Stocks are like bonds in that a rise in price, and PE, pulls future returns into the present. Stocks don't have a maturity date, but their discounted cash flows serve as a measure. When stocks go up, you pay more for the future. A PE of 22 is paying a lot for the future. It's more than three and a half times the amount you had to pay for future earnings and dividends when stocks exited the last Great Depression and took off in 1949. The future had better be pretty good and pretty certain.

And I'll add one thing: The PE on the S&P 500 didn't reach the 20s until 1966. It's that column of PEs again. The current PE of 22 when earnings are more or less normal resembles PEs at market peaks, not market bottoms. So what's up?

The problem with stock valuations and the risk premium has to do with those two sisters - Janet and TINA. Janet is Janet Yellen, who drops those boulders on the rate side of the bond seesaw. Stock PEs are on a similar seesaw, and the stock earnings yields get bombed just like rates. I don't know whether this is good policy or bad policy. I do know that we emerged from the Great Depression pretty well without such determined monetary policy, but we can't know the counterfactual. What worked best then was World War II. If he hadn't been assassinated, Huey Long might have challenged FDR for the presidency. Does he remind you of anyone? So let's leave Janet alone.

The other sister, TINA, is a construction of the marketplace. It means There Is No Alternative. If you can't get any return out of bonds, you have to make certain categories of stocks into bonds. That's why the Coca-Colas (NYSE:KO), Procter & Gambles (NYSE:PG), utilities, and telecoms sell at historically high multiples for their slow but steady growth and dividends. If you want income, There Is No Alternative.

So that accounts for stock valuations higher than usual for a low growth period. Probably. Maybe there is something invisible lying ahead - a new technological revolution, profitable trade with space aliens, whatever.

The same thing that drives high valuation causes the equity risk premium to be haywire. What standard for risk-free return should the equity risk premium be measured against? Is it the current 10-year Treasury yield, which is less than 2%. Against that number, an earnings yield of about 4.5% (22 P/E) might make some sense.

But if you think the proper duration in valuing the earnings and dividend stream of stocks is at least 30 years, you would probably want to consider the historical average 10-year Treasury yield of, remember, 5%. A 3% risk premium would require an 8% earnings yield on stocks. An 8% earnings yield implies (by inverting) a PE of 12 1/2. That means an instant haircut of more than 40% would be necessary to get stocks to fair value.

Are we really living in a TINA world, or is there an alternative? One alternative is to keep some cash reserves and wait. That's why I'm 50% in cash. See this piece on holding a large cash reserve.

So What's The Verdict On The Standard Allocation Model?

The answer remains complicated. It worked brilliantly during two periods with very similar financial conditions: the Great Depression and the current era, which began in 2000 and is probably approaching its end. It did not provide much in the inflationary era of the 1970s. It produced great returns between 1982 and 2000 because stocks and bonds were very strongly correlated.

The biggest complication is the era which most resembles the present and likely future - 1941 to 1966. If you knew that the future would closely resemble that period, you would do better to own only stocks.

But you don't know. The demographics are much less helpful (maybe another force behind TINA investing), and there is some question whether current technological innovation is as friendly to growth with mild inflation as it was then. Valuation, no matter how you explain it, looks like a major headwind. The PE of the S&P 500 just isn't going to triple the way it did between 1941 and 1966.

Diversification into fixed income at this point seems to me less a matter of trying to smooth return streams than an acknowledgment of what you just don't know. Maybe stocks cruise slowly up from here, maybe they correct violently. In part because rates are so low, I hold a disproportionately large amount of cash. In the current environment, cash is my favorite "fixed income" investment because it is flexible. I feel able to do this mainly because I count my pension as a phantom bond (the way John Bogle looks at Social Security). I don't recommend it for everybody.

As for stocks, I would love to own index funds with a focus on small caps and value. At present, however, I feel constrained to put together my equity allocation with individual stocks - blue chips which I understand thoroughly and which appear more reasonably priced than the market as a whole.

I have laid out the facts as I understand them without providing an answer. You'll need to come to your own judgments. Please share them with me and other readers.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.