Late-cycle investing how to put excess cash to work

U.S. stock indexes are near all-time highs, yet investors are rushing into money market mutual funds at the fastest clip since the global financial crisis. While we believe a quality-conscious, late-cycle investing approach makes sense in today’s market, over-allocating to cash can unnecessarily put a major drag on portfolios. For investors looking for a better way to put large cash balances on the sidelines to work, a simple yet elegant solution may be a 60/40 balanced portfolio.

The S&P 500 Index is up more than 20% so far this year through mid-November, but investors remain concerned about the economy, high U.S. equity valuations, and the length of the bull market. Also, the 2020 U.S. presidential election is a huge source of uncertainty. This caution is apparent in the nearly $400 billion that has flowed into U.S. money market funds so far in 2019 just through October.¹ Total assets in U.S. money market funds have risen to about $3.5 trillion, the highest level in about a decade.²

Money market funds have seen hefty inflows despite falling yields due to U.S. Federal Reserve (Fed) rate cuts. Average money fund yields have been trimmed to about 1.8% from as high as 2.5% in early 2019.³

Although cash feels good to anxious investors, low money fund yields mean it’s an inefficient asset class at the portfolio level. First, investors who own money funds may be subject to reinvestment risk if yields move lower (our base case if economic growth slows further).  Second, money funds lack the duration that is needed when spreads widen in risk-off environments.

For investors with large cash balances that may become a drag on portfolios, we believe moving to a traditional balanced portfolio of 60% stocks and 40% bonds may be a worthwhile solution. And for investors worried about election uncertainty, dollar cost averaging or investing smaller amounts over a period of time may be an attractive way to invest in a balanced portfolio.

Although traditional 60/40 portfolios have faced some questions lately, we think the approach could be an attractive way for nervous investors to put cash into the markets for several reasons.

First, correlations between investment-grade bonds and U.S. stocks have been falling over the past year.⁴ This means bonds are doing a good job of fulfilling one of their main roles: diversifying stock portfolios. After being positively correlated to the S&P 500 Index earlier this year, the Bloomberg Barclays US Aggregate Bond Index has seen its correlation fall to negative 0.45.

The diversification value of bonds means a 60/40 balanced portfolio can offer a prudent way to reposition oversized cash balances for 2020 regardless of the election outcome.

Of course, the negative correlation of bonds and equities means that fixed-income portfolios are losing value as equities break out to all-time highs. Still, that means bonds are acting as they should. Also, our view is that bonds continue to offer more attractive yields than money markets, where yields have declined in the wake of the Fed’s three 25 basis point cuts in short-term interest rates.

So, putting it all together, we prefer high-quality bonds to cash, and an equity allocation to counterbalance the fixed-income exposure. 

Balanced portfolios that split between stocks and bonds are fairly simple strategies, but we think they may work quite well for investors looking to move out of cash over time, especially as core holdings. Historically, balanced portfolios provide some upside participation when stocks are moving higher, while the bond allocation may provide some protection when equity markets sell off. And some balanced funds have the flexibility to move away from a static 60/40 allocation.

Over the past 20 years, a theoretical portfolio of 60% in the S&P 500 Index and 40% in the Bloomberg Barclays US Aggregate Bond Index had an annualized return of 6.19% and an annualized standard deviation of 8.63%. Over the same period, the S&P 500 Index had an annualized return of 6.12% and an annualized standard deviation of 14.50%. Therefore, a 60/40 balanced portfolio slightly outperformed the S&P 500 Index, but with much less volatility.⁵

Investors can take additional steps to shore up portfolios for late-cycle market investing. One approach would be to move up in quality in bond portfolios. For example, investment-grade bonds could be favored over high-yield bonds because investment-grade bonds have held up much better in periods of market stress and slowing economic growth and traditionally have provided important ballast that can help offset volatility in equities.⁶

Other late-cycle investing strategies that we favor now include extending durations in bond portfolios, and also moving up in quality in equity allocations to focus on highly profitable companies that can better withstand slower economic growth.

1 Simfund Mutual Fund Database, as of 10/31/19. 2 Money Fund Report, as of 11/12/19. 3 Bloomberg, as of 11/19/19. 4 Correlation is a statistical measure that describes how investments move in relation to each other, which ranges from -1.0 to 1.0. The closer the number is to 1.0 or -1.0, the more closely the two investments are related. 5 FactSet, as of 10/31/19. 6 FactSet, as of 12/31/18.