Weekly Wisdom – October 26, 2022

By Hightower Great Lakes on October 26, 2022

Diversified Investing

Diversification continues to be a cornerstone of a long-term portfolio allocation. Investments are designed to serve a purpose within the context of the total portfolio – whether that represents a security within a fund or a fund within a household’s broader allocation.

Asset class diversification traditionally refers to allocating toward a particular range of stocks and bonds. Investors can also allocate a portion of their illiquid wealth toward private markets or alternatives, such as real estate or artwork.

Diversification contributes to long-term returns by optimizing an individual’s portfolio to a certain level of overall risk and return. This is often referred to as the “efficient frontier.”

Volatile stock markets traditionally lead investors toward safe haven bond assets, and economic growth traditionally leads investors to invest in the earnings potential of businesses via equity.

Throughout most of the 21^st century, as interest rates and inflation remained low, stocks and bonds remained negatively correlated.

This year, that negative correlation turned positive as high inflation and rising interest rates creates headwinds for both stocks and bonds.

Positive correlation also occurred pre-21^st century during periods of rising rates and inflation.

Chart 1: Rolling Stock/Bond Correlation Has Remained Near Zero¹

Chart 2: This Year’s Positive Stock/Bond Correlation²

Five-year rolling correlation between stocks and bonds, nonetheless, remains near zero. This supports diversification across stocks and bonds for a long-term investor.

In addition to returns, lower risk is also a major component to diversification.

The aggregate bond index has consistently been the least volatile asset class when compared to stocks, commodities and other styles within those asset classes.

Bonds within a portfolio have historically reduced volatility during stressed markets – often outperforming equities during recessions.

We’re in a Historic Bond Market Drawdown and Recoveries Can Happen Fast

Both stock and bond markets are discounting mechanisms – seeking to predict future factors. Outperformance is generated by investing in mispriced assets that then realize certain opportunities or non-consensus predictions.

In the long-run, liquid asset classes tend to be efficient, and hence, we go back to the overarching benefits of long-term diversification.

For much of the past decade, high quality bonds have provided very little interest yield opportunities.

They protected the portfolio from volatility, offer liquidity and steady income, but performance for the U.S. aggregate bond index (AGG) has been just +2.8% annualized over the past decade leading up to 2022 (compared to +16.5% for the S&P 500).

Including this year, annualized performance since 2012 for the AGG is <1%. Given this set-up, why have more than $100 billion flowed into U.S.

Treasury ETFs this year, including $21.5 billion in September alone?³ It’s because investors are finally being compensated with interest yield on their fixed income investments.

Chart 3: Record Treasury ETF Flows⁴

Despite these inflows, the AGG has experienced a 16% drawdown and has gone a record 26-consecutive months without a new all-time high.⁴

According to Northern Trust, historically, the past six major U.S. Treasury drawdowns have recovered in an average 6-months post-max drawdown, whereas equities have averaged 50 months to recovery (30 months if we exclude the Great Depression).

During these bond drawdown periods, in 5/6 instances, stocks have been positively correlated, like today.

During past major equity drawdown periods, bond correlation has been consistently negative, indicating that a bond market recovery and an economic recession might coincide.⁵

The conclusion remains that bonds offer downside protection for portfolios, outperforming during periods of equity volatility, and when a drawdown period reaches its low, bonds historically recover much faster than equities.

This seems likely to occur again, given the volume of inflows and investor appetite for U.S. fixed income.

Looking Past the Macro, Thinking Logically and Acting

We think that investors are starting to look past the Fed tightening, and markets have significantly discounted for what might happen in 2023.

The Fed remains behind the curve and will continue tightening, but there will come a point where they pause and watch their actions flow through the economy.

Valuations are attractive, and opportunities exist. We believe long-term investors should do something to capture the opportunities that markets are giving – whether that’s equity valuations or bond yields.

It’s the start of the MLB World Series, so I had to use the baseball reference in the title. The metaphor is that you can’t participate in the recovery opportunity without putting yourself in the game.

It’s impossible to time the bottom, and anyone who predicts where earnings will go in 2023 is guessing. News articles mentioning “market bottom” skyrocketed in the past week.

We’re mitigating risk by investing in historically cheap valuations with yields. We believe it’s prudent to not simply sit on the sidelines, and investors should remain diversified.

Click here to read last week’s Weekly Wisdom (10/19).

Disclosures

Investment Solutions is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors.

All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Investment Solutions and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Investment Solutions and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.

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¹ Source: Strategas ETF Research (October 26, 2022).

² Source: Northern Trust Wealth Management Portfolio Research (October 26, 2022).

³ Source: Strategas ETF Research (chart) (October 26, 2022).

⁴ Source: Strategas ETF Research (October 26, 2022).

⁵ Source: FactSet (chart) (October 26, 2022).

⁶ Source: Morningstar (chart) (October 26, 2022).