Bond valuations have improved dramatically too. The yield on the Agg as of the end of May 2021 was 1.50%. On June 8, it was 3.53%. This is the fastest one-year improvement in yields since 1995. That likewise represents an improved annual expected return of roughly 2 percentage points over the next 10 years. There are factors that can make the actual outcome differ from the expectation here as well, but the difference is less variable than for stocks simply because you know the price you’ll get for a bond at maturity.
5. Dislocations create opportunities for strategic investors. We’ve been focusing here on the S&P 500 Index, perhaps the most well-known and widely used stock index in the world. But it’s not the only area of the market where stock valuations have improved, and some may offer even better value. Despite its improvement, the S&P 500’s P/E is still in the 82nd percentile of all values going back 20 years, according to FactSet data, with higher percentiles representing less attractive valuation. But there are areas of the market that are in the 10th percentile or lower of all values over the same timeframe and sitting near levels only seen during the Great Financial Crisis and in March of 2020. Prospects for long-term returns for small caps have improved, for example, as valuations have dipped well below long-term averages.
Similarly, there are pockets of the bond market seeing unusually high yield levels relative to the past decade. For both stocks and bonds, attractive valuations tend to be accompanied by very challenging economic conditions, but the most opportune moments often are. Where we see the best strategic opportunities is a piece for another day, but pockets of even more attractive, even extreme, valuations do suggest that for long-term investors there may be ways to further diversify a traditional 60/40.
Conclusion
Recent changes in valuations have improved the outlook for a traditional 60/40 portfolio considerably, in our view, on both the stock side and the bond side. We do think of the traditional 60/40 portfolio only as a starting point for an appropriate investor. And even if the traditional 60/40 portfolio is very much alive, as we believe, there may still be opportunities to improve the risk profile of a portfolio, whether through greater diversification within stock or bond holdings, active management, or investment opportunities outside of traditional stocks and bonds.
It’s been a tough year for many investors, and we don’t think we’re in a position yet to call a tactical bottom for either stocks or bonds despite last week’s losses. But looking out strategically, based on better valuations and still mostly favorable fundamentals, we think the long-term outlook has brightened quite a bit.
Barry Gilbert, PhD, CFA, is an asset allocation strategist at LPL Financial.