The Damocles Sword of Asset Allocation
Enjoying the feast of rising rates and equity multiples
Dionysius had Damocles seated on a throne and surrounded him with all the luxuries and pleasures of kingship. But there was one catch: a sharp sword hung from the ceiling above Damocles' head by a single thread.
Damocles was initially delighted with his new role, but he soon realized that he could not enjoy the feast or the entertainment because he was constantly afraid that the sword would fall and kill him.
Untold trillions are managed based the foundational assumption that stocks and bonds are negatively correlated. The possibility, the mere suggestion, that this correlation might instead be positive impacts everyone from public pensions to college savers, to the clients of financial planners.
The "prudence" of this assumption is practically codified in law; acting as though it is absolute truth is a matter of fiduciary responsibility. But as Unlimited Funds’ Bob Elliott notes, it is an historical aberration that bonds were such good diversifiers.
The past two years have demonstrated an abject failure of "60/40" portfolios to achieve their stated goal. The obvious objection would be that 24 months is not an adequate time-period over which to judge a portfolio strategy, but that does not make any attempt to explain why asset behavior has changed so much. How could yields rise so dramatically with such little impact on equity valuations? Bill Gross writes in his latest commentary,
uses the 30 Year TIPS yields to show the cognitive dissonance investors are experiencing.
S&P 500 forward P/E multiples have for the last 5 years been correlated to real 10 year Treasury yields with the exception of the last 12 months or so. There is a long-term logic for this. A P/E ratio turned upside down to E/P is really an earnings yield. One might commonsensically assume that if bond yields go up by 350 basis points that (everything else being equal) earnings yields (E/P) should follow somewhat. They did until the Fall of 2022 as the chart will show but not since.
Expressed differently, guaranteeing real purchasing power gains over the next 30 years has become substantially cheaper in the last 18 months. And yet oddly, we see little evidence that this has impacted the valuation of equities.
Gross and Green both identify the thin reeds upon which the equity market may be hanging— the potential for inorganic growth from fiscal spending, an AI-fueled productivity boom, or some secret third thing that powers corporate earnings. All possible, but perhaps pollyannish in the face of rising capital costs and other exogenous shocks.
The biggest issue with this explanation though is the high level of agency it assumes on the part of investors. Let's go back to the original premise: A huge number of assets are managed with essentially no discretion. Target Date Funds, Model Portfolios, and fiduciarily mandated asset allocations are all based on the belief that past is prologue in terms of correlations. Green:
If the dominant mechanism of asset allocation shifts from one where bonds and equities are considered to be substitutes (I can own EITHER bonds or equities based on forward expected return and risk) to one where allocations are FIXED based on the use of historical distributions and correlations, the behavior of asset markets changes markedly.
Extending this dynamic on to a market where the supply of Treasuries is increasing due to monetary tightening and deficit finance, but where many investors are indifferent to yield or relative valuation, creates an obvious distortion.
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