This Asset Manager Offers A Solution For When The 60/40 Portfolio Fails
Over the decades, one bit of financial advice that has stood the test of time has been to allocate 60% of a portfolio to equities and the other 40% to bonds. However, investors who followed that advice in 2022 lost a lot of money.
In fact, Bank of America BAC said in October that investors who allocated to a traditional 60/40 portfolio were down 34% for the year — the worst performance for the traditional portfolio in a century. Typically, stocks and bonds are negatively correlated, but in 2022, everything plunged in tandem.
Why a 60/40 portfolio doesn’t always work
Phillip Toews, CEO of Toews Asset Management, has successfully navigated bear markets in the past. He focuses on building all-weather portfolios capable of withstanding the type of all-encompassing bear market we saw in 2022. In an interview with ValueWalk, Toews notes that history shows other periods when the traditional 60/40 portfolio didn’t work.
“One of the insights we have there that is resonant to anyone who hears about it is that the message ‘you’ll always be OK in a conventional portfolio’ is based on a limited view of history,” he explained. “So if you go back to certain periods of time, like the obvious time during the Great Depression, a 60/40 balanced portfolio’s total return, if you put into place the standard real-world assumptions, cost of ownership in the market, things like that, what you realize is the size of the downturn and the duration would be unnavigable for virtually all investors.”
He added that a balanced 60/40 portfolio would’ve been down 72% during the Great Depression, leaving investors with only 28% of their capital left after the first two-and-a-half years. After that decline, the market recovered in fits and starts for about five years, but then another five-year bear market hit, which would’ve caused many investors to run out of money if they were taking distributions.
“If you understand that and things like Japan’s stock market is still below where it was in 1990, what you realize is that the… ‘stay invested no matter what’ mindset is flawed, especially in periods of high valuations,” Phillip says. “… If we are really honest about understanding history to prepare for it, we have to change the way we think about portfolios.”
Flawed standards
He also believes that the main goal of the industry, which is to outperform benchmarks, is flawed. As a result, the fund manager has aimed to build products and strategies that differ from those offered by other firms and that meet the end user where they want to go. He noted that investors want “a portfolio with a tolerable return path that has a built-in means of addressing a much broader range of historical outcomes.”
“So it sounds almost like a cult because the world is so dominated by perspectives like Gene Fama’s ‘Efficient Markets Hypothesis’ research that it feels like heresy to suggest anything other than benchmark or index investing,” he adds. “But if you change your focus to building investments that are focused on the ultimate needs of investors, you understand the fundamental truth about the markets is contrarian. If the world thinks you should be long all the time, the best thing to do is not to do that.”
Market vulnerability
Phillip describes himself as “passionate about real results for products that work for people,” which he said is at the heart of being contrarian. He is also willing to suggest ideas that aren’t universally believed in or that challenge orthodoxy.
Toews has remained true to his trading strategy over the decades. Thinking back to one thing that changed the way he invested forever took him back to the first month or two after he became licensed to sell securities. The fund manager says October 1987 was a wakeup call for him as he realized just how fragile the marketplace was.
Over time, he has developed a broader understanding of the markets in the sense that they are vulnerable. Phillip believes the markets are not like something that will always come back into balance. He disagrees with the widely held view that stocks always rebound in time for investors to remain solvent, noting that the stock market consists of companies that can go bankrupt, which can happen during an economic downturn that lasts long enough.
The other formative thing for Toews over the years has been understanding that the focus on a stock market decline occurs only when the decline is of a long duration and there is real economic damage. He noted that investors haven’t really seen this type of situation since the financial crisis about 20 years ago.
Recession debate
Toews’ base case is that we are either in or will enter into a recession soon. One thing he finds interesting about the recession narrative is about the recession itself. He notes that many see the next recession as being like Armageddon, possibly because it’s been so long since we had a lengthy, severe downturn. The pandemic did bring a very brief recession, but he said many are talking about the next one as if it could be an “off-the-rails experience for the economy.”
“That’s one of the things you step back and realize is that in a normally functioning economy, recessions are a naturally recurring part of the business cycle, ” Phillip adds. “It doesn’t seem like a productive time, but having a recession in the economy creates a time for things to heal and greater efficiencies to come along. As painful as it might be for different parts of the market, it is not a dire thing to have a recession.”
Unfortunately, he sees a possibility of a deeper recession because the money supply is particularly tight and government and private debt is very high. The last time we had a 100% net-debt-to-GDP in the U.S. was after World War II. However, the overall private and government debt picture was much lower at around 100%. Total government and private debt is closer to 350% of GDP now.
Debt warnings
Looking at the current levels of private, government and corporate debt, Toews sees some things happening that suggest we could be at the end of an 80-year experiment in Keynesian economics.
“To say the idea of taking loans with impunity at the sovereign debt level and never having to worry about it may not work,” he added. “… There’s a lot of evidence in history that with higher levels of debt, it increases the probability of financial crises and the magnitude of them and slows growth in economies.”
As a result, he said the high levels of debt create the potential for disorderly markets and a deep recession. Such a scenario would be a paradigm change for how stocks are valued. Phillip believes that stock valuations could plunge from 18 or 19 times earnings to as low as 10 times earnings.
“That could translate to a great deal of pain and challenges for the investing class,” he added.
Currency crisis?
As interest rates rise, what the U.S. pays on interest may ultimately exceed all other discretionary spending. A severe recession would significantly reduce tax revenues for the government at a time when interest rates are high, a scenario many find onimous.
“If you think about currency crises from a historical perspective, if a smaller government has loans from a bigger government, the way a currency crisis plays out… their currency is worth so much less than everyone else’s,” he explained. “It translates into a hyperinflation currency crisis. What’s not fully understood is what happens when a government is self-funded to a large extent like the U.S., and all currencies are involved from developed countries. Japan, Europe, the U.S. all have high debt levels.”
Phillip notes that countries can’t pay more on their debt during a severe recession because they can’t increase taxes or revenue. He added that there was a brief glimpse of what could happen in the U.K., where the 30-year Gilt momentarily lost 33% of its value because the marketplace perceived that the U.K. couldn’t pay its debt due to decreased taxes. He describes the Gilt crisis as a “real example of a situation where we always thought it never could happen.”
“It’s just a question of confidence,” he adds. “When does confidence go away, and what point do people want to stop funding Treasuries? It’s impossible to think about, like oxygen to the financial system, and what would be the consequences is if that oxygen was pulled away, and all of a sudden, people didn’t want to own Treasuries?”
It’s essentially impossible for a government to default on something where they print their own money. However, what is on the table is the possibility of a currency debacle involving very high inflation in developed countries globally. Phillip notes that the last three episodes when inflation in the U.S. doubled over a period of time. Suddenly, debt was worth half as much as before, so it was easier to rebound.
