In every week from April 4 to May 20, the S&P500 ETF (SPY) lost ground The total loss came to just over 13%.
Did it help to diversify with treasuries? Not at all. The most liquid U.S. Treasury ETF (TLT) lost just over 11% during that period.
Without question, the typical 60-40 portfolio of stocks and bonds, which had performed well for so long up to this year, is under a lot of pressure. Many investors have not encountered a market in which both stocks and bonds go down at the same time.
The reasons for this are everywhere in the news—inflation and higher interest rates. Inflation is a bond-killer when bond yields are low because it becomes a self-defeating exercise to lock up your funds for years at 2% interest while inflation is multiples higher. Inflation and higher rates hurt stocks as well, but it hurts some stocks more than others.
They really hurt growth stocks because their valuations and prices fluctuate greatly depending on interest rates. Growth stocks are correctly perceived as “longer-dated” instruments because investors are wiling to tie up their capital in them based on the expectation that the stocks’ growth rates are so high that higher valuations and stock prices are justified. When interest rates are low, growth stocks can soar as they did since the Great Financial Crisis because the stock’s future earnings are worth more today than when interest rates are high. This is why the Nasdaq 100 ETF (QQQ), which is heavy with growth stocks, has suffered so much lately. During this seven-week period, QQQ lost more than 20%.
A similar principle holds true the longer dated the bond instrument is. When inflation is high and interest rates are rising, longer-term bonds suffer more than shorter-term bonds do. By contrast, stocks with lower valuations and ones that pay dividends suffer less because, in effect, these are shorter-dated instruments. Investors can receive the benefits of their investments sooner. For example, the First Trust Dividend Leaders ETF (FDL) was nearly flat during this 7-week period.
But passively buying and holding stocks and bonds is not the only way to go. Investors who diversify by style can avoid or minimize the slings and arrows of a buy-and-hold portfolio when inflation is high and interest rates are rising. Utilizing a momentum approach on assets, in addition to stocks and bonds, can help keep a portfolio strong in conditions like these because momentum does an excellent job of minimizing losses and portfolio drawdowns.
In that respect, the portfolios that Stillpoint manages performed much like the FDL ETF during this period—flat or nearly so after fees. Some of our strategies and portfolios actually gained during this time. Positions in commodities, gold, high dividend paying stocks, and short-dated fixed income made the difference.
This is important because minimizing portfolio drawdowns in times of market stress plays a crucial role in compounding gains over time. The bigger the portfolio drawdown, the harder it is to compound gains, and the harder it is for investors to reach their long-term goals. Of course, maintaining an investor’s peace of mind is crucial, too.
In 2018, I wrote this blogpost about how buy-and-hold investors could achieve better risk-adjusted returns by diversifying with momentum. I closed the blogpost with this sentence: “No one knows how passive investors will fare in the next decade, but incorporating a simple momentum strategy is one straightforward way they can manage the risk that the next decade will not be as kind as the current one.”
Since then, the case for diversifying with momentum has only grown stronger.