Why Morgan Stanley Says the 60/40 Portfolio Is Doomed

As U.S. stocks set new record highs, Morgan Stanley warns that returns on a traditional balanced portfolio with 60% stocks and 40% bonds could approach 100-year lows and drop by half versus the last 20 years. "The return outlook over the next decade is sobering--investors face a lower and flatter frontier compared to prior decades," Morgan Stanley wrote in a note to clients, as quoted by Business Insider.

"Investors will need to accept much higher volatility to eke out small incremental units of return," the note added. Morgan Stanley forecasts a 2.8% average annual return over the next 10 years for a 60/40 portfolio. The average has been nearly 8.0% since 1881 and about 6% over the last 20 years, after double digit annual returns reaching as high as 16% from the early 1980s to the early 2000s.

Significance for Investors

"U.S. equities expected returns are dragged down by a combination of lower income return, low inflation expectations and penalties on both higher-than-average valuations and above-trend growth that cannot be sustained for the next decade," the note said. Additionally, in the 10 years since the financial crisis, "risk-asset prices were sustained by extraordinary monetary policies that are in the process of being unwound," per a passage quoted by Bloomberg.

Morgan Stanley assumes that, over the next 10 years, the S&P 500 Index will produce an average yearly return of 4.9%, while the 10-Year U.S. Treasury Note will offer an average yield of 2.1%. At first bush, that implies an annual return of 3.8% for the 60/40 portfolio.

However, the 10-Year T-Note currently yields slightly under 1.9%. To yield 2.1%, its price must drop by almost 10%, thus reducing the average annual total return of the portfolio by one percentage point per year over 10 years, cutting it from 3.8% to 2.8%.

"2019 equity gains have been about [valuation] multiple expansion on the heels of lower costs of capital," as Lisa Shalett, chief investment officer (CIO) of Morgan Stanley Wealth Management states in the current edition of The GIC Weekly from their Global Investment Committee. A different group in Morgan Stanley issued the note cited above.

"Without the tailwind of lower rates as the Fed pauses, future gains will depend on positive earnings improvements, which in turn are reliant on economic growth," Shalett adds. Calling profit growth "lackluster," she is unimpressed by current economic data, and expects the markets to be "directionless for months."

Looking Ahead

Many leading market watchers already have been anticipating a reversion to the mean in investment returns going forward. They expect that an extended future period of subpar returns by historic standards is likely, balancing out the above-trend gains posted during the current decade-long bull market.

Earlier this year, Jermey Grantham, Scott Minerd of Guggenheim Investments, Jim Paulsen of The Leuthold Group, and economist Robert Shiller of Yale University, also predicted sharply lower returns ahead, per a previous report. Meanwhile, the S&P 500 Index has a valuation in the top 10% of its historical range, as investors fail to price in the risk of a recession that could cut stock prices by 30%, a recent study by The Leuthold Group argues.