The Investors' Dilemma when both Stocks and Bonds are Cheap

Asset allocators must continuously evaluate how to divide investments between bonds and stocks. Bonds, as fixed income instruments, add stability to portfolios. Equities, conversely, offer long-term growth potential but introduce volatility—portfolios may remain depressed for extended periods. Investors typically allocate a portion to bonds for protection during equity market downturns. Historically, equities and bonds have shown low correlation, enabling meaningful diversification. However, this strategy doesn't guarantee protection during market crashes, as there are scenarios where both stocks and bonds may simultaneously decline or rise.

For example, in the U.S. inflation reached multi-decade highs in 2022. To fight the inflation the FED embarked on aggressive tightening cycles. This led to one of the worst years for the traditional 60/40 portfolio, with both stocks and bonds posting double-digit losses. The Bloomberg US Aggregate Bond Index fell over 13% while the S&P 500 declined by approximately 19%. Similar situation took place during the stagflation era of 1970s. Stocks declined by approximately 40% while bonds also performed poorly as rising inflation eroded fixed income returns. The oil crisis exacerbated economic conditions, leading to a rare scenario where traditional diversification failed to protect investors.

The opposite side of the spectrum is when both the stock market is depressed and valuation is cheap due to high interest rate and high inflation scenario. Bonds are also cheap due to high yield offered by the market due to monetary tightening to fight the inflation. But once the tightening is over, both the stocks and bonds can rally together. For example, following Paul Volcker's aggressive interest rate hikes to combat inflation, both stocks and bonds became extraordinarily cheap by 1982. The 10-year Treasury yield peaked above 15%, making bonds attractively priced, while stocks traded at single-digit P/E ratios with the Dow below 800. As inflation was tamed and economic growth resumed, both assets experienced spectacular bull markets. Stocks more than doubled within five years, while bonds delivered double-digit annual returns as interest rates declined substantially from their peaks.

Bangladesh has entered a similar situation where the default risk-free rate hovers between 11-12%, and the stock market has been in continuous downturn for the last four years. The country has been grappling with rising inflation since 2022, particularly after the Russia-Ukraine War began. Energy and commodity prices surged, the Balance of Payment situation worsened, the currency devalued by more than 35%, and inflation remained elevated. The banking sector's asset quality deteriorated significantly, leading to many banks and NBFIs being unable to honor customer deposits.

The prolonged economic mismanagement by the autocratic government, along with discriminatory economic and political policies, created immense public outrage that ultimately forced the regime's collapse. A new interim government took over to reform the damaged economy. Following the July 2024 revolution, an interim government under Dr. Muhammad Yunus's leadership is working to revive the economy.

The appointment of the new central bank governor last year marked a major step forward. The pragmatic governor, Mr. Ahsan H. Mansur, appropriately tightened monetary policy and allowed interest and FX rates to settle based on market demand and supply, with careful central bank supervision. We're beginning to see benefits from these policies. The June inflation (YoY) showed a meaningful decline to 8.48%. The BoP situation has improved, forex reserves have increased, and the currency has stabilized.

The central bank is gradually easing money supply, and government bond rates have started to fall. Recently, the central bank began purchasing USD from the market, which injects liquidity as money is supplied to buy dollars. Though we're still in the early stages and macro risks remain, markets are beginning to reprice for better-than-expected results.

The equity market index still hovers around 5000, reflecting deep distrust and lack of confidence. Many investors remain skeptical that conditions can improve soon, with the prolonged economic downturn affecting market psychology. Consequently, any optimism is counteracted by persistent bears who sell during short rallies. Many believe the market won't recover significantly due to ongoing economic challenges, especially the banking sector's non-performing loan situation.

My take is that the stock market can rally even in a poor economic scenario because so much bad news is already priced in. The market will adjust as actual revenue and earnings prove less dire than expected. The stock market is traditionally considered a leading indicator, and market rallies often precede economic recovery. The next few months are crucial because as inflation continues to ease and currency stability becomes widely accepted, the central bank will likely adopt a more dovish stance, causing interest rates to fall more rapidly than expected. This will drive long-duration bonds higher alongside an equity market rally.

I had been extremely bearish over the last three years and recommended aggressive bond allocation to investors. For asset owners with low liquidity needs, I advocated for long-duration bonds. However, the time has come to advise clients to gradually increase their equity allocation to avoid missing potential stock market rallies. Currently, both stocks and bonds are cheap, and investors should maximize savings and investments, allocating to high-duration fixed-rate bonds and quality equities trading at attractive valuations. Both asset classes should generate good investment outcomes. The appropriate allocation depends on each investor's age, liquidity needs, risk tolerance, and personal financial situation. This represents a rare market opportunity that doesn't come often in a lifetime, and investors should position themselves to benefit from it.

[Disclaimer: This article is solely based on writer's own opinion and done for educational purpose. It does not reflect any official advise to buy or sell. Investors should carefully consider their own investment objectives, risk tolerance, and financial situation before making any investment decisions. Past performance is not indicative of future results. Please consult with a qualified financial advisor before implementing any investment strategy discussed in this article.]