“Be careful what you wish for because it might come true” – someone wise
In this article, I lead by laying out the irony in today’s Federal Reserve behavior and the financial markets. Acknowledging a tough year for the 60/40 portfolio, I look at the worst of historical drawdowns in down market cycles. I benchmark my own expectations for the 60/40 in the current cycle and invite readers to do their own work. Finally, I discuss the psychological fallacies and toughness required to ride out portfolio volatility.
Tears instead of Cheers
For years market participants have been dissatisfied with the Federal Reserve’s mollycoddling of the financial markets.
They are destroying the saver’s retirement income by pegging interest rates to zero! They are killing the market’s ability for price discovery by selling a put under stocks every time the market goes down! The Fed owns all the bonds and signals from bond yields are meaningless!
For the first time in a while, and for reasons none of us like – high inflation – the Federal Reserve is determined to aggressively raise interest rates and liquidate its balance sheet. What’s more, instead of protecting stocks, Federal Reserve Governors are bullying the stock market lower.
Investors have been granted their wish of long-desired Central Bank virtuous behavior, but instead of cheers, there are only tears.
We might soon be calling out for another wish: God, make the Central Bankers chaste, but just not yet!
Not everything is down. Value stocks are a bright spot this year after a decade of underperformance.
Those of us who have done this long enough know that picking sectors, themes, and timing the market only works once in a while.
For the major parts of our investment capital, we have settled for some kind of a saner solution: a diversified and balanced portfolio. For many investors, this means a mix of 60/40, that is, 60% in stocks and 40% in bonds.
No investor has that exact same portfolio and also no one specifies whether those buckets should be passive funds, active funds, individual stock and bond picks, international funds, or whatever. But the 60/40 has a nice ring to it and what’s more, we can analyze past data from a 60% S&P 500, 40% US Bond portfolio rather easily (using MFO Search engine data). The idea of the 60/40 is that it’s somewhat of a balanced portfolio. When the economy is good, Stocks do well. When the economy is suffering, Bonds generally do well.
The problem: The uniform sell-off across ALL MAJOR ASSET CLASSES in 2022 means that the Balanced Portfolio has not worked. A 60/40 portfolio is down about 10-11% this year in 2022.
How should an investor who feels the pain from seeing the portfolio down 10% (or more) look at the situation and what should one do?
1. Were you prudent coming in? Then you are going to be fine.
First of all, know that if you came into the year diversified across a few asset classes, were not levered, and didn’t bet it all on one sector or one emerging market country, you did everything you were supposed to do. There is nothing you did wrong. Capital markets go down to shake off the weak and the overleveraged hands. If you are invested prudently, your portfolio will recover in time. There is not much you can do at this moment and biding time is important. Embrace the powerlessness.
Hopefully, this means that your portfolio is also within a down-10% zone. If you are down much more than that, it could mean your portfolio setup is wrong. Go to the doctor. If you came into the year owning a portfolio of T-Bills and Berkshire Hathaway, good job! Start writing for MFO.
2. Getting familiar with Down Market Cycles
Once we’ve mentally absorbed the loss, there is much to be learnt. Use the market selloff to educate yourself and get prepared for the next market cycle. It’s time to focus on the uglier side of the investment coin.
Yes, we know what attracts us to Risky assets. A 60/40 Balanced portfolio has earned ~10 % annualized return since 1960. But these assets are called Risky for a reason. After 3 stellar years of the Balanced Portfolio’s returns, 2022 is the give-back “risky” period.
| Annualized Percentage Returns | |||
| 2021 | 2020 | 2019 | |
| US 60/40 (S&P 500/US BOND) | 19 | 10.6 | 22.5 |
The MFO Search engine has pre-defined observation windows termed as Down-Market Cycles. We can take any fund, index, or portfolio and see its return over any of the down cycles. Here are the 6 worst market cycles of the last 60 years and the accompanying returns of the 60/40 portfolio.
| Eval Start | Eval Stop | Cycle description | MAXDD % | Date Max DD | Recvry mo. |
| 197301 | 197409 | Stagflation | -35.4 | 197409 | 21+ |
| 200711 | 200902 | Housing Crisis | -28.1 | 200902 | 16+ |
| 196812 | 197006 | ? | -26.3 | 197006 | 19+ |
| 200009 | 200209 | Dot com bust | -17.4 | 200209 | 25+ |
| 198709 | 198711 | 1987 | -16.9 | 198711 | 3+ |
| 202001 | 202003 | Covid Pandemic | -11.2 | 202003 | 2+ |
Focus on the numbers in the MaxDD % Column for each cycle. The worst cycle was in the mid-70s when a bout of high inflation and a slow Federal Reserve devastated stocks and bonds. The Balanced portfolio would have been down 35%. No joke.
| Cycle description | MAXDD % |
| Stagflation | -35.4 |
| Housing Crisis | -28.1 |
| Late 60s | -26.3 |
| Dot com bust | -17.4 |
| 1987 | -16.9 |
| Covid Pandemic | -11.2 |
However, some of the other cycles – Covid Pandemic -11%, 1987 Crash -17%, Dotcom bust -17%, look better than I thought we would see. It’s possible that the numbers are off based on the observation windows, but they are in the right ballpark.
What is the goal of looking at these negative scenarios?
- We want to see what the range of negative outcomes looks like.
- We want to use our judgment and our own market participation history to determine if the current cycle looks like a milder version of the down cycle or something far more sinister.
- We want to compare where we are today (-10 to -11%) to our mental expectation of a likely worst-case scenario for this
For example:
- I don’t think we are on the cusp of a 2007-2009 type crash because a lot of regulations have been put in place to curb excess banking leverage.
- I don’t think we are in the middle of uncontrolled inflation, even though it feels like that right now. Let’s take a look at Crude Oil in the 1970s. Oil went up TEN-FOLD from $4 to $40. If we think $50-$60 oil was a neutral recent price, do I expect the price of oil to go to $500-600? I don’t.
- I expect the Federal Reserve to aggressively tighten this time. Chair Powell has said that he wants to be remembered as not having lost control of inflation. I believe they mean business.
- Unlike the 1970s, we have Assets like TIPS and Equity REITs, which behave very well during inflationary times. They can protect if inflation lingers and if the Fed is sloppy.
In conclusion, based on my expectation and my own portfolio constructions, I do not see a 60/40 portfolio having a 25-35% crash.
I think it’s possible the portfolio in this cycle could be down around 15%, which means the 60/40 could lose an additional 5% points from here. This is manageable and my worst-case expectation for this cycle.
Knowing the numbers – where we stand, what’s the worst case, how much of the way we are there – is very helpful in learning how to stay sane. Investors should have their own sense and know what they are rooting for over the long-term and should also know what’s at stake in any given bear market cycle.
3. Get tough and prepare for tomorrow
Constantly, I hear people say this time is different and the world feels out of control. I am not sure about the reader, but I can barely control my own mind, let alone control the world. It’s a psychological fallacy to think that today is more complicated than the past. We have had the time to wrap the past in convenient narratives, while today is still naked. Things are always complex in the present moment.
Learning to become psychologically tough is necessary to get the long-term returns offered by capital markets. We know there are no guarantees for the future. Statistics and past data are a way to bring sense into the present and prevent our minds from getting too imaginative or too dark. But there are no guarantees. Get tough.
Finally, there is the chance that things to do tip over, we get a hard landing or bad recession, and we get the big one. Do I want to sell all my long-term holdings and pay taxes today just because there is a possibility of a crash? I’d rather wait and see how the world develops and if the changing facts make me change my worst-case scenario. I am not in a rush.
Conclusion
Over and over, I like to come back to who does this correctly? Is there anyone who gets this right? I keep coming back to Buffett and Munger model for one particular reason.
For all of the madness and all of the volatility, Buffett is not saying, “Hey Charlie, how about I liquidate the $500 billion portfolio today, and I’ll buy it back in six months!”
Federal reserve, politicians, wars, and even recessions will come and go. Owning good assets at good prices is the only thing in our control. We must let go of the need to control the outcome. We must learn to focus on the long-term returns while keeping a watchful eye on the worst-case scenarios.