Markets: 60/40 trade has 'come off life support and is back to life,' expert explains

VettaFi Vice Chairman Tom Lydon breaks down how investors should be thinking amid markets preparation for a potential Fed pause.

Video Transcript

AKIKO FUJITA: Well, the next Fed meeting is still a month away but markets are pricing in a pause. The likely shift in policy has investors looking for new opportunities. And our next guest says stocks will be the place to go, as history shows equities do well in the period between the last rate hike and the following rate hike.

Vice Chair Tom Lydon joins us for this week's ETF Report brought to you by Invesco. Tom, good to talk to you today. We had a guest on earlier who was saying, look, we're already looking ahead at least in the medium term, potential rate cutting cycle. But as you look across the sector right now, how do you think investors should be positioning themselves?

TOM LYDON: Well, we're surveying advisors all the time. And just yesterday, we had over 600 advisors tell us how they felt about the next year. It's funny, two years ago, their biggest fear was inflation. 2/3 said that that was keeping them up at night. Now, it's only 16%.

Their biggest fear is a recession. But most feel that the recession is going to be kind of a soft landing. And with that in mind, kind of what you pointed out, the period of time between the last rate hike and the first rate cut usually is a good period of time for the markets.

But so far this year, we've seen most of the movement in tech stocks and the S&P, like SPY, has had a pretty good run since the beginning of the year. However, small caps have basically put up a big goose egg.

But the big thing to remember here when you look at SPY, which is the S&P 500, and IWM, which is the Russell 2000 ETF, their PE ratios are quite different-- 21 for the S&P 500 and half that, 11, for the Russell 2000. So when you see days like we've seen today where the Russell 2000 has done twice what the S&P has done, that might be an indication that it might be smaller and mid-cap stocks' days coming ahead.

SEANA SMITH: Tom, what about the bond market, the opportunities within fixed income? What are you hearing from advisors in that space?

TOM LYDON: Yeah, Seana, the 60/40 for a lot of advisors and investors was dead, but it's kind of come off of life support and it's back to life. And as you're getting paid for short duration, that's really nice. But if we're going to have lower interest rates a year from now, advisors are pushing out towards longer duration in the form of intermediate term bonds where you can get a higher yield, but a higher yield for longer.

And on top of that, if you pick something like a Vanguard intermediate term corporate ETF VCIT, not only can you get higher yield, but also you might have an appreciation as rates go down over the next year. I mean, it's amazing for us to even talk about it, as people have lost so much money in the bond market. The pendulum may have swung. And over the next year, things look a lot more rosy for fixed income.

AKIKO FUJITA: So what's the breakdown, you think, that investors should be looking at? We talked about 60/40. Is that still the number? Or how should they be allocating-- if you're looking at fixed income as a potential opportunity, but still keeping your foot in the equity space?

TOM LYDON: Sure. I think the biggest concern for most investors is after going through a year like we did last year, a bad market for stocks, a bad market for bonds, the worst time that that's happened in 40 years, a lot of people put money on the sidelines. What you don't want to do is wait until you feel good about the market again, get back to that 60/40 allocation.

Diversify. Don't just put it all into the S&P 500. Make sure you have some mid-cap, small cap, and overseas. Overseas stocks are also a great value today. And then as far as fixed income, we're now finally getting paid.

And there may be a period of time where bonds actually pay something that's decent for the coming years. So again, I think the water feels better than it did last year. Get back to a long term allocation. If you got scared last year, don't wait til your stomach tells you that it's OK to go back in.

SEANA SMITH: Tom, how are advisors, how are investors viewing the stress that we're seeing within the banking sector? Because, yes, regionals-- a number of regionals moving to the upside today. But every couple of days, we certainly see that uncertainty creep back in. How much is that clouding investors' judgment at this point?

TOM LYDON: Well, it's one of the things they are concerned about, Seana. But we're also concerned about global tension, higher taxes, those types of things. I think for the average investor, over the fact of what happened with those banks that had to be bought out or went under, I think they feel that the government, the Fed, and the big banks are working together.

There's also good opportunities where many of these regional banks are in pretty good shape, but they got painted with the same brush. And their valuations are pretty cheap. So you're going to see more buyouts in those areas. I think the worst is behind us.

That's a sector that's always going to be there and probably always going to do well. And most importantly, if we see rates lower a year from now, for those bonds that they've got on their balance sheets, they're going to be priced at better levels.

AKIKO FUJITA: So is the way to invest in that space through ETFs? I mean, we are seeing it bounce back today, the regional banking ETF. But when we saw some of the concerns around First Republic as well as PacWest, it was hit pretty significantly.

TOM LYDON: It was. So KRE is the regional bank ETF. Boy, I tell you, if you've got a cast iron stomach and a little bit of money on the sidelines, look, there may be a little bit more movement to the downside. But that's come down pretty low.

Go in, lift up the hood. Look at the banks in there. There's some really solid banks, and they all shouldn't have the baby thrown out with the bathwater as far as regional banks. I think this is something in the coming months we're not going to talk about as much.

AKIKO FUJITA: We'll see. We'll have to have you back on, Tom. Tom Lydon, Vetify Vice Chairman, appreciate your time today.

TOM LYDON: Thank you, folks.