Key point: no need for diversification — the 10-year total return gap between stocks and bonds is close to its highest level in history. Bank of America believes bonds are offering one of their best buying opportunities relative to stocks in more than 20 years. With the S&P 500 once again approaching record highs, could that itself be a result of high rates?

Market memo

This year, cautious investors have been the ones hurt by market setbacks. In classic investing thinking, prudence means diversifying across major asset classes and rebalancing continuously to control exposure and spread risk.

Today, that approach sounds somewhat outdated. Lately, a fixed-ratio stock-bond portfolio has not been an effective investment tool; it has looked more like a confusing trap. The Bloomberg U.S. Aggregate Bond Index (AGG) has fallen 4.8% in price this year; even including coupon income, total return is still -2.2%. In a diversified portfolio, bonds have dragged down the S&P 500's 14% total return year to date. At the end of last quarter, the S&P 500 was up 15%, while AGG was roughly flat. Disciplined investors should have sold stocks, bought fixed-income assets, and rebalanced allocations back to target ranges. But this quarter that rebalancing trade failed: the S&P 500 returned nearly 3%, while benchmark yields kept climbing toward a 19-year high, bonds fell again, and gains were almost completely offset. That sets the stage for the next quarterly rebalance — money will again tilt toward bonds. Bonds now offer a sufficient yield buffer to withstand further increases in yields. But in the final trading days of this quarter, there was no sign of large-scale inflows into bonds. Investor sentiment toward bonds is a mix of fear and loathing. Although financial advisers are rebalancing according to plan, driving modest retail inflows into fixed-income funds. I have found that ordinary investors view bond declines very differently from stock market pullbacks: bond declines are frightening, while stock pullbacks are often seen as buying opportunities. Even if a leading large-cap stock has another 2% downside, few people would refuse to buy the dip; yet many investors are unwilling to buy a 5-year Treasury yielding 5%, simply because yields might rise further to 5.25%. Fairly speaking, investors who have long treated bonds as a portfolio ballast to hedge against economic downturn risk have continued to receive negative feedback. As the chart shows, the gap between the S&P 500's rolling 10-year annualized total return and the return on a Treasury portfolio is almost at a historical peak. Over the past decade, stocks' return advantage over bonds has reached 15 percentage points. The first reason is that tech leaders drove large-cap stocks sharply higher; the second is that bonds themselves delivered dismal returns over the past decade. Remember, a decade ago the Fed had only just begun nudging short-term rates up from near zero, and inflation had long been below the 2% target. Now the situation has completely changed — the starting environment for new money entering the bond market is very different: not only are nominal yields significantly higher, but real yields (after subtracting market-implied inflation) are also at nearly 20-year highs. Bank of America Securities equity and quantitative strategist Savita Subramanian laid out the logic: "We were bearish on bonds throughout the zero-rate era, but the current environment has improved. Why? Comparing earnings yield and dividend yield, bonds' attractiveness relative to the S&P 500 is at its highest level in more than 20 years, and easily exceeds short-term CD yields. Valuation is not a precise timing indicator, but it is strongly predictive of long-term S&P returns; the model suggests the index's annualized return over the next decade could be -3%." Currently, the S&P 500 dividend yield is below 1.4%, a low in modern history, which may also limit future index returns; meanwhile, high-grade corporate bonds can yield 6%, with very low default risk. Of course, this does not mean the classic 60/40 stock-bond model is a universal formula for optimizing long-term returns; the model itself is a bit like a "straw man argument." The investment industry long ago stopped being bound by this fixed allocation. I personally hold the Vanguard Target Retirement 2035 Fund, less than 9 years from its target retirement date, and the fund is currently 67% stocks and 32% bonds. But over the long term, the idea of balancing stock risk with low-volatility income assets (or alternatives and commodities) has not been proven ineffective. We can also keep an open mind: perhaps an unprecedented golden age of stock market wealth is beginning, with higher nominal economic growth and a sustained miracle in supply-side productivity. Over time, allocating heavily to fixed-income assets would create high opportunity costs. I always think of the late well-known Wall Street strategist Byron Wien. He entered the industry in the late 1950s, almost exactly when stock dividend yields fell below Treasury yields for the first time in history. Older investment professionals found it baffling: a riskier asset offering a lower income return made no sense. But that state persisted for nearly 70 years, reversing only briefly during the global financial crisis, a truly structural shift. However, the purpose of rebalancing and diversification is not to precisely predict the peak in Treasury yields, nor because we can be certain how macro and policy will affect market prices. On the contrary, we do it because we cannot predict the future. Diversification is about remaining humble before the market, holding prudent but unguaranteed expectations, and waiting for what the market gives.

Sentiment indicator

This indicator was compiled by John Kolovos, integrating multiple data points to reflect both investor rhetoric and actual capital behavior. In his latest interpretation, Kolovos said: "Financial conditions continue to tighten — spreads are widening, oil prices and real yields keep rising, and only 25% of stocks are trading above their 50-day moving averages, yet bullish sentiment has not repaired."

Wall Street CN financial media is working to sort out the multiple causes of this global bond market selloff, rather than simply attributing it to a single factor. A New York Times article covered the core logic comprehensively: global economic resilience, sticky inflation, huge government and private-sector borrowing needs, central banks' unwillingness to ignore high oil prices, and clearly perceptible fiscal concerns. Like Murder on the Orient Express, perhaps all factors are working together. Wall Street is trying to calculate how much additional revenue tech giants will need in the future to support their massive expansion of computing power (about $2 trillion in combined capital spending this year and next). The number is huge, the assumption range is extremely wide, and it is not rigorous science; but FT Alphaville provided a useful breakdown.

Closing observation

Most market interpretations believe that despite soaring oil prices and bond yields, the S&P 500 can still hold near record highs. But I think the "despite" here should perhaps be replaced with "because." It sounds counterintuitive, but the fact is: oil prices and rates remain under pressure, the Fed is hawkish, and most individual stocks are being dragged down. Capital is flowing out of macro-sensitive sectors and into defensive tech giants driven by AI that are less affected by the economic cycle, and these giants are the weighted pillars of the S&P 500. Admittedly, the S&P 500 is only 2% below its high, and the Nasdaq 100 is even closer to its record; but the equal-weighted S&P 500 is down 6%, the Russell 2000 small-cap index has fallen 8%, the bank index has pulled back 12%, and the equal-weighted consumer discretionary sector has dropped 13%. It is clear that the market is challenging the idea of diversification not only across asset classes, but also within stocks. To some extent, this confirms the effectiveness of passive index investing. The top ten tech stocks in the S&P 500 are highly concentrated, together accounting for 40% of the index, temporarily protecting index holders. The core debate now: with weakening market breadth outside tech and some sectors oversold, once the Iran geopolitical conflict eases and bond market pressure is released, will that trigger a strong recovery rally; or will mega-cap tech leaders come under pressure first? This weakness beneath the surface also reminds us that financial conditions are tightening; if we exclude the S&P 500 and its low-volatility readings, the tightening would be even more obvious. Goldman Sachs' breakdown shows that excluding the stock market, current financial conditions are nearly as tight as during the tariff panic in early 2025. Does that mean the Fed does not need to raise rates much further later? We hear the familiar complaint: the Fed cannot "produce oil out of thin air," nor can it directly restrain AI capital spending; raising rates would only squeeze consumers and small businesses. But the Fed's policy tools have always been blunt. In July 2022, Senator Elizabeth Warren criticized the Fed under Powell for tightening policy: "Rate hikes cannot end the energy prices driven higher by the Russia-Ukraine war, nor repair the supply chains devastated by the pandemic." But central banks' routine practice is to adjust policy direction based on current data, hoping the economic environment will improve on its own. In this cycle, the drivers of inflation and the areas affected by rate policy do not match, so this is likely not the start of an aggressive hiking cycle, but rather a policy reassessment around a higher neutral rate. KKR global wealth chief investment strategist Lauren Goodwin summarized it this way: "Global central banks face this 'divergence dilemma.' That is why we do not see this as the beginning of a sharp hiking cycle, but more like policy calibration around a higher neutral rate."