Market Memo

The prudent have been punished by markets this year.

Prudence, in standard investing wisdom, means diversification across asset classes while rebalancing along the way to keep exposures in line and risks well-distributed.

Holding fixed proportions of equities and bonds has been more a confounding trap than a useful tool lately. The iShares Core U.S. Aggregate Bond ETF (AGG) is down 4.8% in price terms this year and has suffered a negative 2.2% total return even after interest income, dragging on the S&P 500's 14% year-to-date total return in a diversified portfolio.

At the end of last quarter, when the S&P 500 was up 15% and the AGG about flat, a disciplined investor would have sold equities and bought fixed-income to get allocations back to target. In the current quarter, this trade has fizzled, with a near-3% S&P 500 return almost exactly offset by further losses in bonds as benchmark yields climbed relentlessly toward 19-year highs.

This sets the stage for another quarterly rebalancing shift in favor of bonds, which now offer enough of a yield cushion to protect against further upside in rates. There have been few signs that such flows have been material in the closing days of the quarter.

Investor attitudes toward bonds are a mixture of fear and disgust, even though retail flows into fixed-income funds have perked up thanks to wealth managers adhering to prebaked plans.

I find the typical investor regards selloffs in bonds as scary in a way that differs from their take on weakness in equities, which is more often seen as a dip-buying chance.

Few would refuse to buy a beaten-up bellwether stock because its price might have a couple of percent more downside, but plenty of folks refuse to buy, say, a five-year Treasury with a guaranteed 5% yield to maturity because the yield might continue higher to 5.25%.

In fairness, the negative reinforcement administered to investors who've stuck with fixed-income as portfolio ballast and insurance against economic weakness has been going on a long time.

The rolling 10-year annualized total returns of the S&P 500 minus the return from a Treasury portfolio are almost as high as they've been in history, as this chart makes clear. This spread is now at a 15-percentage-point advantage in favor of equities over the past decade.

This is due, first, to the fabulous gains in large-cap stocks propelled by this era's technology leaders. But the poor absolute performance of bonds over the past decade hasn't helped.

A decade ago, keep in mind, the Federal Reserve had barely begun inching short-term rates off the zero floor, and inflation was chronically below its 2% target. Almost everything has changed since then – including the initial conditions that would greet new money entering the debt market now, with not only richer nominal yields on offer, but real yields (over and above market-implied inflation in the years ahead) also near two-decade highs.

Bank of America Securities equity and quant strategist Savita Subramanian lays out the case: "We have been bond bears since the ZIRP days but see a better set up today. Why? Bonds today are more attractive relative to the S&P 500 index than at any point in the past 20+ years based on earnings yield and dividend yield, and easily clear short duration CD yields. Valuation is a bad market timing signal but has been a strong predictor of long-term S&P returns and implies -3% [annualized] index returns for the next decade."

The present S&P 500 dividend yield of under 1.4%, a modern-era low, is also a potential restraint on forward-going returns for the index from here, at a time when high-grade corporate debt yields 6% with low default risk.

None of this means the 60/40 stock/bond mix contains any special formula for optimizing long-term results. It's also a bit of a straw man. The industry has long ago moved away from those specific proportions. I hold some of the Vanguard Target Retirement 2035 fund, and with less than nine years of investing horizon left, it's 67% stocks and 32% bonds.

But broadly speaking, balancing equity risk with lower-volatility income (or alternatives, or commodities) has not yet been proven obsolete over longer spans.

I suppose one must be open-minded that an unprecedented golden age of equity enrichment is unfolding, with a higher nominal economic growth rate and a supply-side productivity miracle under construction gigawatt by gigawatt. This could make a sizable fixed-income allocation seem like it carries a stiff opportunity cost over time.

I always remember the celebrated and now-deceased Wall Street strategist Byron Wien talking about having entered the investment business in the late 1950s, at almost the exact time that the stock-market dividend yield fell below the Treasury yield for the first time. Veteran investment pros saw this as the sun rising in the west or birds flying backward: The higher-risk asset offering lower income compensation made no sense to them.

Yet it's stayed that way for almost 70 years, with a brief interruption around the global financial crisis, a true structural shift.

Still, the reason to rebalance and diversify is not to top-tick the move in Treasury yields or because we have a strong and specific idea of how the macro and policy paths will inform market prices. The reason for doing it is precisely because we don't know.

Diversification is an offering of humility before the market gods, in the informed but unguaranteed hope that they will be generous.

Market Temperature Gauge

This indicator from John Kolovos of Macro Risk Advisors uses several data points to reflect both what investors are saying and what they are doing.

"Despite only 25% of stocks trading above their 50-day moving average amid tightening financial conditions — marked by widening spreads and a persistent uptrend in oil prices and real rates — bullish sentiment has yet to reset," said Kolovos of the latest reading.

Around the Street

-The financial press is doing an admirable job of puzzling through the confluence of causes of the brutal global bond-market rout, without pretending to arrive at a discrete cause. Here's a recent New York Times Dealbook effort that hits all the key points.

Resilient global growth, sticky inflation, voracious private and government demand for debt, central banks unwilling to look through high oil prices, vague but palpable fiscal worries. As in "Murder on the Orient Express," perhaps all the suspects did the deed, or tried to.

-Wall Street is gamely trying to quantify what it will take in terms of future incremental revenue to justify the hyperscalers' headlong investments in new computing capacity, which this year and next will total some $2 trillion. The numbers are so huge and the range of assumptions so wide, it's hardly a hard science. But FT Alphaville helpfully surveys some of the conclusions here.

Market on Close

Most accounts of the current market setup describe the S&P 500 holding relatively steady near record highs "despite" the surge in oil prices and bond yields.

But I'd suggest we could replace "despite" with "because of" there.

Sounds odd, for sure. But the fact is, the steady pressure from oil and rates and a hawkish Fed is taking a toll on a majority of the stock market, which is chasing money from these macro-sensitive areas to the more economically impervious and defensive AI-driven tech giants which ultimately drive the S&P 500.

Sure, the S&P 500 is merely 2% off its peak, the Nasdaq 100 even closer to its record, but the equal-weighted S&P 500 is in a 6% pullback, the Russell 2000 off 8%, the KBW Bank Index in a 12% correction and the equal-weighted consumer-discretionary sector down 13%.

In this way, the market is likewise mocking the diversification principles within equities as it is across asset classes.

In one way this is a vindication of passive index investing. The S&P 500 - through the very extreme concentration of 40% of its value in the top ten tech stocks – is protecting its owners, for now.

The crucial debate at the moment is whether the current brutally weak market breadth and pockets of oversold conditions in non-tech areas prime the tape for a huge tension-release rally on any solid relief from Iran and bonds, or whether the resilient mega-caps must buckle first.

This weakness below the surface is also a reminder that financial conditions are tightening, and more so if one excludes the benchmark S&P 500 and its muted volatility readings from the calculation. That's what this breakdown from Goldman Sachs shows - ex-equities, financial conditions are almost as tight as they were following the tariff panic of early 2025.

Does this mean the Fed won't have to tighten much from here?

We're hearing a familiar line of complaint that the Fed can't "print more oil" or directly slow AI capex, so rate hikes merely pinch consumers and small businesses. But the Fed always only wields blunt instruments.

In July 2022, Sen. Elizabeth Warren wrote an op-ed in the Wall Street Journal deriding the Powell Fed for tightening policy, saying, "Higher interest rates won't end skyrocketing energy prices caused by Vladimir Putin's war on Ukraine. They won't fix supply chains still reeling from the pandemic."

But central bankers' remit is often to tack in a direction roughly consistent with current data while hoping that conditions move in their favor on their own.

In this case, it might not mean a forceful jacking of rates this cycle, due to the mismatch between the drivers of inflation and the areas exposed to Fed policy rates.

Lauren Goodwin, chief investment strategist for global wealth at KKR, puts it this way: "That 'Divergence Conundrum' facing central banks globally is one reason we see this less as the beginning of a pronounced hiking cycle and more as a recalibration around a higher neutral rate."

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