Month: January 2012

Permanent Asset Allocation

Permanent Asset Allocation

Short run Intermediate Long Run
Nominal Real Nominal Real Nominal Real
Stocks + + small – big + 0
Bonds 0 0 0 + 0
Cash + + +
Gold 0 + small +
Short run Intermediate Long Run
Inflation Real Inflation Real Inflation Real
Stocks + 0 – small – big + +
Bonds 0 0 + +
Cash + 0 + 0 + 0
Gold 0 + small – small + 0

(Note: Nominal = Real + Inflation)

This article is meant to tie up some loose ends, and suggest the outline of what might be a clever way to do asset allocation.? Who knows?? At the end, there might be a surprise.

I’ve done two articles recently on the effects of inflation expectations and real interest rates on two asset classes in the short run — gold and stocks.? Tonight, I want to extend that two directions, to bonds and cash, and whether the effects aren’t different in the long run.

First, bonds in the short run.? Interest rates rise, bond prices fall.? Interest rates fall, bond prices rise.? Doesn’t matter whether that comes from real rates rising, or inflation.? That’s pretty simple, because most bonds are mostly interest-rate driven.

Second, cash in the short run.? Leaving aside financial repression, for the most part cash assets return in line with inflation.? Cash is simple… so what happens in the short run is also what happens in the long run.

Okay, now let’s lengthen the time horizon.? In the long run, gold keeps pace with inflation, nothing more, nothing less.? Bond returns rise if interest rates rise over the long term because of higher reinvestment rates for cash flow, and again, it doesn’t matter whether that comes from inflation or real rates.? Opposite if interest rates fall.

Think of 1979-82: by the time bond yields were nearing their peak levels, bond managers were making money in nominal terms with rates rising because the income from the coupons was so high, and it set up the tremendous rally in bonds that would last for ~30 years or so.

In that same era, stock multiples collapsed.? But eventually stock prices stopped going down even with competition from bond yields, because the earnings yields were so large that book values roared ahead, supporting prices.? That also set up the tremendous rally in stocks that would last for 18 years, until it finally overshot, giving us the present lost decade-plus.

But high rates, whether from inflation or real rates, presage high future bond and equity returns.

One nonlinearity here: in the intermediate-term, rises in real rates kill stocks, but rises in inflation nick stocks.? Why?? Inflation may improve nominal revenues at the same time that it raises the cost of capital, but rises in real rates indicate capital scarcity, raising the cost of capital with no increase in revenues.

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Harry Browne proposed a “permanent portfolio” back in 1981, composed of equal portions of cash, bonds, gold, and stocks.? Reading about the idea in Barron’s in the late 1980s, I did not think much of the idea.? I think differently now.? After my last few articles on related issues, mentioned above, I realize that each of the four asset classes react differently to macroeconomic stimuli in the short run, with a lot of overshooting.? A mean-reverting strategy has a lot of power in this context, and it is double-barreled, in that it lowers volatility and raises returns.

My clients will receive the full details on this as an asset allocation strategy, but my readers have enough from this that if you want to do a little work you can figure this all out yourselves.

All that said, I am surprised at how well the strategy works.? Too easy, and easy strategies rarely work.

Stock Prices versus Implied Inflation

Stock Prices versus Implied Inflation

Eddy Elfenbein wrote a good post recently on the stock market versus inflation expectations.? When I read it, I said to myself, “Wait, is the relationship between nominal and real rates really 1:1, or is it more complex?”? Though it is not certain, the regressions that I ran indicated that 1:1 was not falsified by the data.? The regression:

Inflation expectations determined the much of the value of the S&P 500 for the last nine years.

And you can see the relationship here as well:

The short answer is “yes, inflation expectations have driven stock valuations for the last nine years.”

I’ve been spending time on issues like this for a variety of reasons, and I’ll try to explain them in the near term, but that’s all for now.

Searching for the Not-Romney

Searching for the Not-Romney

Over the last six months, I have described the Republican nomination to be the search for the not-Romney.? The average Republican does not want Romney, but they don’t know who they do want, among the midgets that are running.? Thus we see candidates spike in their approval ratings — everyone except for Huntsman, as Republicans search for an alternative to Romney.

Tonight, Santorum may be the not-Romney.? Ron Paul can never be the not-Romney because he is Ron Paul; he is something in himself, and not the competitor in relative terms.

My guess is that the not-Romney, whoever he might be, will win the nomination, and maybe the election.? My best hope is for a deadlock at the Republican convention, and they choose someone other than the midgets that are currently running.

On Insurance Stock Indexes

On Insurance Stock Indexes

I’m still toying with the idea of starting an insurance-only hedge fund.? I own a lot of insurers, and I think that I get the better of that market.

Where I have a harder time is with what to short. Shorting is tactical not structural, and I am less good at the tactical vs structural.? Having a tradable benchmark to short against would be useful, but what exists there?

There is one ETF focused on insurance that has any significant volume — KIE.? In the past, it was capitalization-weighted, but now it is equal-weighted.? That stems from a change in the index that the ETF follows, from one set by KBW to one set by S&P.

Personally, I don’t get the change, but here are my statistics on the change:

The “Old KBW” column comes from segmentation done by KBW.? The other columns are done by me.? There are some matters for judgment:

Do you include Berkshire Hathaway?? I think you should.? Do you include foreign life insurers traded on US exchanges?? I think you should.

I am also more willing to place a company in the “Conglomerate” category because of companies that are in multiple lines of insurance, without a dominant area of insurance that they are in, or, they have significant non-insurance ventures.

Anyway, the new KIE overstates the insurers in Bermuda and the Brokers.? It understates life insurers and conglomerates.

Aside from that, the new S&P index, being equal-weighted, is more mid-cap than a whole market index would be.? Also, if I put more effort into this, I would segment companies into their proportions, and there we be no conglomerates.

These may be trivial concerns to some, but if you are thinking of running a portfolio that might be shorting KIE against other insurance longs, it makes a considerable difference.

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