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In this issue:
- Global Equity Market Performance
- Diversification
- Correlation
- Balance
- Debate
- March So Far
- Wrapping Up
Global Equity Market Performance
The S&P/TSX 60 shrugged off a poor start in January and led the pack in February, up 6.6%. MSCI Emerging Markets and MSCI EAFE added to impressive gains, up 6.4% and 4.4% respectively. The S&P 500 lost 0.9% and is now down on the year.
As of this writing—the second week of March—our systems are indicating positive momentum in all four equity markets although there are some signs of caution in the shorter-term signals.
If you would like to stay current on our measures of trend and momentum in the markets we follow, please click here.
This letter will revisit the debate surrounding diversification and the 60/40 portfolio.
Diversification
The idea of a diversified portfolio is to allocate across assets that have performance paths that differ from stocks. The definition of a good diversifier is one that has a positive expected return but behaves differently than other assets.
The reason some investors, though not all, value diversification is it attempts to protect capital when things in the stock market are not going well.
The classic balanced portfolio is the 60/40 stocks/bonds mix. The origins of the 60/40 portfolio can be found in Modern Portfolio Theory. This theory was developed by economist Harry Markowitz and outlined in the 1952 paper Portfolio Selection published in the Journal of Finance.
Short version: historical analysis of risk, return and correlation between assets can generate an ‘efficient frontier’ for portfolio construction.
The idea being that investors should be able to use this to create a portfolio that meets their objectives once they have considered their risk tolerance.
But as we know, no diversifier is perfect. 2022 was a recent example of stocks and bonds being highly correlated—and not in a good way. After one of the worst Septembers in stock market history our October 2022 letter noted that long-term bonds had performed even worse.
By the end of September 2022, the long-term bond ETF ZFL was down almost twice as much as the S&P/TSX 60. The U.S. long-term bond ETF TLT was down 5% more than the S&P 500.
What does this relationship look like over a longer period?
Correlation
We’re looking at U.S. markets because there is more data. In 2003 AGG, the iShares Core U.S. Bond ETF, one of the first broad bond market ETFs, was launched. The chart below is the rolling twelve-month correlation between the S&P 500 and AGG.
The average is around 0.05. But it is not a stable relationship. After the 2022 meltdown it was over 0.80. This is one of the problems with constructing portfolios of assets that behave differently. Over a long period of time the statistics might display a low correlation relationship, but sometimes when you need that protection it might not be there.
Even if you could accurately determine your return and risk preferences (a difficult task on its own) what you experience in terms of dollars gained or lost at any one point in time is going to be different than a long-term average. It might seem like the ‘frontier’, but sometimes it ain’t going to feel so ‘efficient’.
That chart only shows how stock and bond returns perform relative to one another. There’s no direction in it. And direction is important if you prefer to protect capital while it grows.
So let’s look at a theoretical balanced portfolio over the same time.
Balance
One of our favourite measures of risk is drawdown. It’s simple and shows what any portfolio or asset can lose, in percentage terms, from its peak to trough. The following chart compares a 60/40 portfolio of the S&P 500 and AGG versus the S&P 500 only.
The red line is the difference in drawdown between the two. When it is above zero, diversification is working. It might not have felt that way in September 2022, but a 60/40 portfolio outperformed the S&P 500 by roughly 9% at that time.
At the market lows of March 2009, the 60/40 portfolio was better by 16%.
Note: the first chart above from 2022 used the long-term bond ETF TLT. This chart uses AGG. The longer duration TLT was down 18% versus AGG by the end of September of that year. That’s a good example of the risks in bonds themselves.
Why is this relevant now?
Debate
The benefits of diversification are often debated. Some investors don’t believe in it.
And bonds haven’t really gone anywhere for years despite the Federal Reserve cutting rates from 5.50% in 2024 to 3.75% now.
Meanwhile the S&P 500 was up 24% in 2023, 23% in 2024 and a more modest 15% last year.
These are some of the reasons pundits and investors have recently been questioning the relevance of the 60/40 portfolio. 2022 was not that long ago. Looking at the correlation chart above, it recently fell below zero. Over the past few months there’s been chatter that correlations will revert higher while both asset classes fall.
That could happen. Or stocks could fall, bonds cushion the blow and the correlation trends negative. Or any combination of events could happen. No one knows.
That’s why, while we invest in medium-term bonds as a core holding, we diversify in other ways using different strategies and other asset classes.
Not all diversifiers are reliable, but your chances improve if you use more than one.
Now for some recent news.
March So Far
It has been an eventful start to the month. Over the first weekend of March, Iran was bombed. Oil rallied that Sunday night from $67 to over $75 and closed Monday just over $71. By Friday, March 6, it was at $90 and after some further events in the Middle East it spiked to just under $120 the following Sunday and closed Monday at $95. As of March 16, it is trading at $93.
Markets are trying to figure out the consequences of such dramatic moves. As of March 16, the S&P 500 is down 2.5% and the S&P/TSX 60 2.9%. Bonds are down a little less.
In related news, on March 11 the International Energy Agency announced that member countries will supply 400 million barrels from their strategic oil reserves and stated: The war in the Middle East is creating the largest supply disruption in the history of the global oil market.
These developments will continue to fuel (apologies) the debate around the effects of energy prices on economic growth and inflation. And the debate about what should be in a diversified portfolio.
Wrapping Up
Asset allocation is one of the primary drivers of investment performance. Regardless of the outlook, over time, we think a well diversified portfolio employing assets other than stocks along with different strategies helps preserve capital.
No asset or strategy will always perform as it has in the past. And no diversification strategy will always work. One of the primary reasons for this is that correlations are not stable. It’s important to know that.
In non-market news, Canada had its best result at the World Baseball Classic ever, making it to the quarterfinals where they faced a stacked U.S. team and lost 5-3.
In case you’re still getting the gears from American friends regarding Canada’s loss in the Olympic Games hockey final, you can always remind them that their baseball team lost a game to Italy. That’s more of a tactic than a strategy.
The Jays have their home opener on March 27.
Let’s Go Blue Jays.
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Challenging the status quo of the Canadian investment industry.
