The tremendous comeback in financial assets that began in March and extended through the second quarter of 2009 has proved a welcome relief to investors of all types, a blessed batch of showers for our drought-ridden portfolios. The classic 60/40 stock (S&P 500 Index) and bond (BarCap Aggregate) mix advanced 10.2%, experiencing its third-best quarter since 1988. As we predicted coming into 2009, in a broadly diversified GTAA context, some of the most dislocated credit categories from last fall—high-yield, emerging market bonds, convertibles and bank loans—were some of the biggest winners in the first six months of 2009, as all four dramatically outperformed mainstream stocks and bonds.

Undoubtedly, most portfolios are still well underwater (60/40 is still down 21% from its October 2007 high) and likely have many years of catch-up. But the respite has allowed investors to assess their portfolios and begin to make asset allocation decisions with an eye toward the future. A thorough exercise of asset class valuations reveals that many once-beleaguered asset classes may have come too far, too fast in this recent rally. Accordingly, now is likely a time to take profits and to resume our cautious vigilance of 2008.

Stage 5 Of Recent Markets—The “ABT” Comeback

In one of our favorite graphics, Figure 1 illustrates the benefits and opportunities of a widely diversified GTAA program. Last year saw three distinct asset allocation stages: (1) the traditional equity bear market (January through August), (2) the take-no-prisoners free fall (September and October), and (3) sorting through the carnage (November and December). The first and last periods witnessed opportunities to add value through active asset allocation, as roughly half the asset classes were positive despite moderate losses in the equity market. There was no such luxury in September and October—every asset class was down!

The first two months of 2009 bore an eerily similar pattern to the second stage of 2008: straight down. With nowhere to hide, the equally weighted portfolio fell 8.3%. Only three asset classes were in the black. The last four months, however, have been a welcome—and polar—opposite, with 15 of 16 asset classes posting gains. Only long Treasuries lagged in the market rebound, confirming our call in Barron’s in late December that 2009 was likely to be an ABT (“Anything But Treasuries”) market.[1]

The figure illustrates an important point about the relative performance of the more diversified 16-asset-class portfolio compared to the normal 60/40 mix. The equally weighted 16-asset-class portfolio outperforms in four of the five stages, trailing only in the September/October panic. We’ve seen this before: Diversification will occasionally disappoint in crisis episodes as investors tend to flee niche markets—TIPS, emerging market bonds, convertibles, etc.—en masse, swapping these for more liquid “safe havens.” But, did diversification “fail” in this take-no-prisoners market crash? Or did diversification help us with a lag?

As we noted in January, whenever diversification “failed” to deliver in the past, it more than made up for the underperformance in the subsequent recovery. This trend appears to be holding once again, with the equally weighted 16-asset-class portfolio delivering 240 bps over the 60/40 mix in the rebound of the last four months, and by a whopping 800+ bps since diversification “failed” last September and October. Since the financial crisis started in July 2007, diversification as measured by the 16-asset-class mix has delivered measurably better results than traditionally structured portfolios, with a cumulative loss of –10.7% versus –18.4% for 60/40, a premium of almost 800 bps.

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