Copyright The Street
For years, the 60/40 portfolio had been the gold standard for diversified investing. A lengthy bull rally coupled with two decades of falling interest rates produced one of the best periods in history for total risk-adjusted returns. That all ended when the financial crisis hit. The Fed dropped interest rates to 0%, and bonds hit a ceiling—there was no more share price upside from falling yields and virtually no income to speak of. Investors began pushing into riskier asset classes, such as junk bonds and dividend stocks, to find any yield at all. Conditions hit their low point in 2022 when the Fed aggressively raised interest rates to combat soaring inflation. The result was the first year in history when both stocks and bonds declined by 20% at the same time. Diversification and safe-haven trades completely stopped working. That time, however, may be coming to an end. The Fed has already cut rates once recently and may be getting prepared to do it several more times in 2025 and 2026. With interest rates falling, the U.S. economy still growing and the Fed signaling an end to quantitative tightening, a rally for both stocks and bonds seems likely and it could set the stage for what may be the 60/40 portfolio’s next great comeback. Why the 60/40 portfolio struggled in recent years For decades, conservative, old-school wealth building meant that a 60/40 portfolio, a mix of 60% stocks and 40% bonds, was the benchmark for long-term investing success. Equities drove long-term capital growth while bonds provided income and stability. Plus, the two often moved in opposite directions, which means that risk-reducing diversification benefits were high. In recent years, that relationship has become severely broken. Thanks to an enormous amount of liquidity flowing in the system post-COVID and the advent of the AI boom, stocks have soared, but bonds have failed to provide a balance. Yields have bounced up and down, but the introduction of high-yield, derivative income products has made bond performance inconsistent at best. The yield spike in 2022 saw investors take steep losses at a time when many were counting on bonds to provide safety. Since then, conditions haven’t significantly improved. Gains in the S&P 500 and Nasdaq 100 have been concentrated around a handful of mega-cap tech stocks dubbed the magnificent 7 (Microsoft, Apple, NVIDIA, Tesla, Amazon, Alphabet and Meta Platforms). Stubborn inflation has prevented bonds from achieving much, if any, upside. For years, the 60/40 portfolio looked stale and outdated. Many declared it dead. But the financial markets evolve. With inflation largely under control and the Fed looking to loosen conditions again, the environment that hurt the 60/40 portfolio before is beginning to reverse. The 60/40 may soon experience a revival. Why falling interest rates could revive both stocks and bonds The key driver behind a 60/40 comeback would be falling interest rates. This would not only serve to make bonds more valuable but could also give stocks a boost as long as the economy doesn’t slip into recession. How lower rates help bonds When interest rates fall, bond prices rise. We saw the opposite of that occur in perhaps the sharpest way possible back in 2022. Now that interest rates are at multi-decade highs and the Fed is signaling that it’s prepared to cut, it could trigger a bond rally for the first time in years. The upside, however, would be nuanced. Short-term bond yields tend to be heavily influenced by the Fed. Those bonds often see quick reactions to rate cuts or hikes, but share price appreciation is usually modest because the bonds are short-term. Long-term bond yields are more influenced by the economy than the Fed. If the economy is doing well, yields rise as investors pivot away from bonds and into stocks. If the economy falters, yields often fall as investors seek safety. As the Fed begins what could be a lengthier rate-cutting cycle and the U.S. economy starts to slow, it could create the ideal set of conditions for bonds to rally across the board. Why equities benefit from lower rates too Lower rates benefit stocks for several reasons. First, lower rates can reduce borrowing costs for corporations, improve balance sheet health and stimulate consumer spending. Historically, the stock market tends to perform well in the early stages of a Fed rate cutting cycle for these reasons. Second, lower rates could lead income investors back to dividend stocks instead of bonds. For people interested in yield from their investments, lower rates on bonds make dividend stock yields look comparatively more attractive. The result is a scenario where stocks and bonds can rise together at the same time. The end of quantitative tightening may add fuel Recently, Jerome Powell indicated that the Fed is close to stopping reducing its bond holdings. More ETFs Forget VOO, SPY, VTI: Best stock investing pick is this Fidelity fund Best Bitcoin ETFs 2025: Fidelity and Grayscale Challenge IBIT Why the Schwab Dividend ETF (SCHD) Is losing its edge to Vanguard This is important because the Fed’s reduction of its bond holdings takes money out of the system, leading to tighter conditions that can increase bond yields and negatively impact stocks. If the Fed stops reducing its bond holdings, it would provide a relative improvement in liquidity conditions. This is also likely to provide a tailwind for stocks, although its impact on bonds is unclear. What a 60/40 comeback could look like Looking at the last six Fed rate-cutting cycles, history shows that returns for both stocks and bonds could be quite positive over the next 12-24 months. According to JP Morgan Asset Management research, in each situation, long-term Treasuries produced gains in the two years following the first cut. The median return was about 18%. Stock results were mixed, although the two big corrections were during the tech bubble and the financial crisis, two of the worst economic situations of all time. The other four cases produced strong gains for stocks. If history is any guide, we could be looking at an ideal setup for stocks and bonds over the next couple years as long as the economy doesn’t slip into a deeper recession. Key takeaways The Fed recently cut interest rates and may do so several more times in 2025 and 2026. History shows that stocks and bonds tend to perform well following the first Fed rate cut. Many investors believe that the 60/40 portfolio is dead. Falling interest rates could be the catalyst that ignites a revival in the 60/40 portfolio. Bottom line: Don’t count the 60/40 portfolio out yet While many investors still believe the 60/40 portfolio is dead, the early stages of a Fed rate-cutting cycle have historically been ideal for stocks and bonds. It’s not a guarantee, though. A sudden increase in credit defaults or another rise in inflation could quickly derail the narrative and send stocks lower. However, the classic mix of stocks and bonds may be setting up for a nice rebound. Focusing on balanced ETFs, portfolio diversification, and tactical tilts could produce favorable results over the coming 24 months.
