We have obviously seen a decline in interest rates worldwide that few could have possibly imagined as recently as a few years ago. Almost everyone in this industry with a really long history was “raised” in the 1970s and 80s when interest rates were 10% or more for much of the time, while even those who came along in the early 00s (myself) were taught to believe that a long bond should pay 4% or more under normal circumstances. Let’s look at a chart and then comment:

We are now at the tail-end of a decade in which the 10-year yield has averaged 2.3%. I can recall early in my career and amid the 2000-2003 bear market in stocks when the 10-year yield closed in on 3% (it bottomed at 3.13% on June 13, 2003). When the bear market ended, yields quickly bounced (they were above 4% by mid-summer 2003) and many assumed that we had seen the generational lows in yields.

 

Of course, 5-years later, the Financial Crisis began and not only was the 3.13 level breached (the 10-year has made 24 new closing lows in the last 11-years after making 24 in the prior 46-years), but we have also reached the point in which the average yield over the past decade is more than 80-basis points below the lowest levels we had ever seen prior to 2008.

 

The idea of a 60/40 equity/debt portfolio or something approximating this was born in the 1970s. It made sense at the time because bond yields were approaching 10%. There was really no science or study behind it, but high bond yields and struggling equity prices made it an easy sell for the industry.

 

I like to draw an analogy here to the low fat/high carb diet. This diet was born in the 1950s when studies seemed to show that high fat diets were correlated to obesity and heart disease and thus a diet low in fat and high in carbohydrates could be expected to have the opposite result (i.e. weight loss and lower incidents of heart disease).

 

By 1980 (around the same time that 60/40 became the norm), not only had science embraced the low fat/high carb diet, but also so had the U.S. government and the food industry, which saw a financial boon disguised in low fat products that promised to make one healthier. This has proven to be disastrous for American health as not only have average weights exploded (the average American male is more than 35 pounds heavier than they were in the 1960s) over the past 40-years, but also so have the incidents of heart disease and Type 2 diabetes.

 

Seguing back to stocks, historically, stocks have returned an average of ~8% per annum and if one couples an 8% expected return on stocks with a weighting of 60% with the expected return on bonds - the best predictor for the return on a 10-year bond is its yield to maturity - weighted at 40%, one can generate the following expected return chart of a 60/40 portfolio:

Okay, so even at a 60/40 split and a low yield, we would still generate an expected return of close to 6%, which is not bad. However, this assumes that the expected return on stocks is always 8%, which, of course, ignores valuation. We can get a bit more color when we layer in expected annual 10-year compounded returns from different starting price-to-earnings levels. With that in mind, let’s look at another chart:

We are currently sitting at a PE somewhere in the high teens. In other words, are 8% expected return is likely going to prove hard to achieve. So, with that in mind, let’s adjust expected returns to 5.7%, which is essentially the average return from a starting point above a 15x PE.

Okay, so from where we are now, a 60/40 mix would yield an expected annual total return over the next 10-years of 4.4%. This is likely not sufficient for some, perhaps most investors.

 

The obvious question may then be - what would we have to do to the 60/40 mix if we assumed that the expected return on stocks over the next decade was indeed 5.7% and the expected return on bonds was indeed 2.3% in order lift our expected return to 5% (one could argue that 2.3% expected return for bonds is even too high as the 10-year U.S. treasury yield is currently ~1.7%, but let’s assume we have some mix of corporate bonds/high yield debt/preferred shares that can lift the blended yield)?

So, if history is any guide, one would have to go to 80% equity with a traditional equity/debt portfolio in order to get to an expected return over the next decade of 5%. Now, one could do untraditional things and we have indeed seen an explosion in the liquid alts space, which is really in my view a proxy for adjusting the traditional 60/40 split so it looks more like 70/30 or 80/20. I am not saying it’s the wrong thing to do, but I think it is important to call it for what it is.

 

Now, on the dividend front, the other way to go about the transition from 60/40 (which again, was not born in science, but in the opportunity that the 1970s presented) would be to allow traditional bond proxies in the equity market – Utilities, Real Estate, Pipelines, Telcos – do some of the bond heavy lifting in your portfolio. With that in mind, let’s look at an interesting chart:

We have used Utilities largely because it is the cleanest data set we have. That is – other sectors highly correlated to bonds can have some noise around idiosyncratic issues (government regulations for Telcos, for example), whereas Utilities tend to be immune from economic cycles, competition and government interference. The chart below captures what this looks like in aggregate:

If we use Utilities as the proxy for bond proxies, we can start to think about our 60/40 mix and what it might look like if we went to 70/30 or even 80/20. Now, it would appear from the chart above that this transition is already underway. That is – dividend proxies on both sides of the border have seen their PE multiples rise ~4 turns since the start of 2019. But, if they are going to pay us an average dividend yield of ~4% and grow that dividend at ~4% per annum (good rough estimates), even from a relatively high historic starting point for valuations, we would only need the stocks to compound at ~1.5% per annum to meet our 5.7% total return objective for the stock component of our portfolio.

 

Put another way, at a 70/30 split, we would need our 60% equity component to do an average price return of ~3.5% per annum plus a dividend of ~2%, and our 10% “bond proxy” component to do a price return of ~1.5% per annum plus a dividend of ~4%.

 

Is this more or less reasonable than going down the liquid alts route or piling into rate reset preferred shares or covered call writing or something else? I do not profess to have the answer. But I would suggest that adhering to the traditional 60/40 mix and not facing the reality that in order to achieve an expected return of say 5% or 6% in a world in which bond yields are widely sub-2%, stocks (or something else) are going to need to do a significant amount of heavy lifting.