Photo Credit: Carl Wycoff || It is a long way to the end of retirement.  People are getting ready for it.  Are you?

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Assuming that you could throw stones on the financial internet, it would be hard to toss a stone and miss articles talking about how high the stock market is.  One good article from last week was Why Do U.S. Stocks Keep Hitting Records? Here Are Five Theories from the Wall Street Journal.  Here were the five theories:

  1. Stocks Reflect the Resurgent Health of American Corporations
  2. The Global Outlook Is Looking Brighter
  3. The U.S. Economy Is in a ‘Goldilocks’ Situation
  4. Passive Funds Are Propping Up Prices
  5. There Is No Alternative

Of this list, I think answers 1, 3 and 5 are correct, and 2 and 4 are wrong.  I have a few other answers that I think are right:

  1. Demographics are leading people to buy assets that will provide long-term cash flows. Monetary policy has led to asset price inflation, not goods price inflation.
  2. People are overestimating the resiliency of the political and social constructs that make all of this possible.
  3. The “Dumb Money” hasn’t arrived yet, but the sale of volatility by retail contradict that.

I disagree with point 2 from the WSJ article because a stronger global economy not only means that profits will rise, but also the cost of capital.  Depending on which factor is stronger, a stronger global economy can make stocks go up, down, or be neutral.

On point 4, I’ve written about that in Overvaluation is NOT Due to Passive Investing.  What matters more than the active/passive mix is the total shift in portfolio holdings into stocks versus everything else.  When people hold a lot of their portfolio in stocks, stock prices tend to be high.

The active/passive mix does have effect on the relative prices of securities in the indexes versus outside the indexes. The clearest place to see the impacts of ETFs and indexing is in bonds, where bonds that are in the indexes trade at lower yields and higher prices than similar non-index bonds.

With stocks, it is probably the same, but harder to prove; I wrote about this here.  In the short run, the companies in the popular indexes are getting a tailwind. That will turn into a headwind at some point, because the voting machine always eventually becomes a weighing machine.

Why are stocks high?

Profit margins are high because of productivity increases from the application of information technology.  Also, there is a lot of lower paid labor to employ globally which further depresses wage rates in developed countries.

Points 3 and 5 of the WSJ article are almost saying the same thing.  Interest rates are low.  They are low because inflation is low,, and general economic activity is not that robust.  As such, the cost of capital is low, people are willing to pay high prices for stocks and bonds relative to their cash flows.

Part of this stems from demographics, which was my first additional point.  For those that are retired or want to retire, there aren’t a lot of ways to transfer money earned in the present so that you can get the equivalent purchasing power or better far into the future.  There are a few commodities that you can store, like gold, but most can’t be stored.  Thus you can buy bonds if you don’t think inflation will be bad, or inflation-protected bonds if you can live with low real returns.  Money market funds will keep your principal stable, but also provide little return.  You can buy stocks if you are willing to get some inflation protection, and run the risk of a rising cost of capital at some point in the future.  Same for real estate, but substitute in rising mortgage rates.

A shift can happen when the marginal dollar produced by monetary policy shifts from being saved to being spent.  For now, monetary policy inflates asset prices, not goods prices (much).

My second point says that people are willing to spend more on stocks when they think that the system will remain stable for a long time.  That seems to be true today, but as I have pointed out before, it discounts the probability of trade wars, real wars, resurgent socialism, and bad future demographics.  Nations with shrinking populations tend to have poor asset returns.  Also, nations with unproductive cultures don’t tend to make economic progress.

My third point is equivocal.  I don’t see a lot of people yelling “buy stock!”  There’s a lot of disbelief in the market; this is what Jason Zweig was talking about in his most recent WSJ column.  That said, when I see lots of activity from people shorting volatility through exchange traded products in order to earn returns, it makes me wonder.  As I have said before, “Nothing brings out the financial worst in people like the lure of seemingly free money.”  Eventually those trades sting those that stay at the party too long.

So, where does that leave me?  The market is high, as my models indicate.  It may remain high for a while, and may get higher still.  That said, it would be historically unprecedented to remain in the top decile of valuations for more than three years.  It would be healthy to have the following:

  • A garden-variety recession
  • A garden-variety bear market
  • More varied sector/industry performance

Will we get any of those?  I don’t know.  I can tell you this, though.  For now, my asset allocation risk is on the low side for me, with stocks at around 70% (that is high for most people, but that is how I have lived my life).  If we get over the 95th percentile of valuations, I will hedge what I can.  For now, I reluctantly soldier on.

Picture Credit: Denise Krebs || What RFK said is not applicable to investing.  Safety First!  Don’t lose money!

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Investment entities, both people and institutions, often say one thing and mean another with respect to risk.  They can keep a straight face with respect to minor market gyrations.  But major market changes leading to the possible or actual questioning of whether they will have enough money to meet stated goals is what really matters to them.

There are six factors that go into any true risk analysis (I will handle them in order):

  1. Net Wealth Relative to Liabilities
  2. Time
  3. Liquidity
  4. Flexibility
  5. Investment-specific Factors
  6. Character of the Entity’s Decision-makers and their Incentives

Net Wealth Relative to Liabilities

The larger the surplus of assets over liabilities, the more relaxed and long-term focused an entity can be.  For the individual, that attempts to measure the amount needed to meet future obligations where future investment earnings are calculated at a conservative level — my initial rule of thumb is no more than 1% above the 10-year Treasury yield.

That said, for entities with well defined liabilities, like a defined benefit pension plan, a bank, or an insurance company, using 1% above the yield curve should be a maximum for investment earnings, even for existing fixed income assets.  Risk premiums will get taken into net wealth as they are earned.  They should not be planned as if they are guaranteed to occur.

Time

The longer it is before payments need to be made, the more aggressive the investment posture can be.  Now, that can swing two ways — with a larger surplus, or more time before payments need to be made, there is more freedom to tactically overweight or underweight risky assets versus your normal investment posture.

That means that someone like Buffett is almost unconstrained, aside from paying off insurance claims and indebtedness.  Not so for most investment entities, which often learn that their estimates of when they need the money are overestimates, and in a crisis, may need liquidity sooner than they ever thought.

Liquidity

High quality assets that can easily be turned into spendable cash helps make net wealth more secure.  Unexpected cash outflows happen, and how do you meet those needs, particularly in a crisis?  If you’ve got more than enough cash-like assets, the rest of the portfolio can be more aggressive.  Remember, Buffett view cash as an option, because of what he can buy with it during a crisis.  The question is whether the low returns from holding cash will get more than compensated for by capital gains and income on the rest of the portfolio across a full market cycle.  Do the opportunistic purchases get made when the crisis comes?  Do they pay off?

Also, if net new assets are coming in, aggressiveness can increase somewhat, but it matters whether the assets have promises attached to them, or are additional surplus.  The former money must be invested coservatively, while surplus can be invested aggressively.

Flexibility

Some liabilities, or spending needs, can be deferred, at some level of cost or discomfort.  As an example, if retirement assets are not sufficient, then maybe discretionary expenses can be reduced.  Dreams often have to give way to reality.

Even in corporate situations, some payments can be stretched out with some increase in the cost of financing.  One has to be careful here, because the time you are forced to conserve liquidity is often the same time that everyone else must do it as well, which means the cost of doing so could be high.  That said, projects can be put on hold, realizing that growth will suffer; this can be a “choose your poison” type of situation, because it might cause the stock price to fall, with unpredictable second order effects.

Investment-specific Factors

Making good long term investments will enable a higher return over time, but concentration of ideas can in the short-run lead to underperformance.  So long as you don’t need cash soon, or you have a large surplus of net assets, such a posture can be maintained over the long haul.

The same thing applies to the need for income from investments.  investments can shoot less for income and more for capital gains if the need for spendable cash is low.  Or, less liquid investments can be purchased if they offer a significant return for giving up the liquidity.

Character of the Entity’s Decision-makers and their Incentives

The last issue, which many take first, but I think is last, is how skilled the investors are in dealing with panic/greed situations.  What is your subjective “risk tolerance?”  The reason I put this last, is that if you have done your job right, and properly sized the first five factors above, there will be enough surplus and liquidity that does not easily run away in a crisis.  When portfolios are constructed so that they are prepared for crises and manias, the subjective reactions are minimized because the call on cash during a crisis never gets great enough to force them to move.

A: “Are we adequate?”

B: “More than adequate.  We might even be able to take advantage of the crisis…”

The only “trouble” comes when almost everyone is prepared.  Then no significant crises come.  That theoretical problem is very high quality, but I don’t think the nature of mankind ever changes that much.

Closing

Pay attention to the risk factors of investing relative to your spending needs (or, liabilities).  Then you will be prepared for the inevitable storms that will come.

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Stocks always return more than Treasury Bonds.  So why doesn’t Social Security invest the trust funds in stocks rather than Treasury bonds?

The first reason is simple.  The government wanted Social Security to be free from accusations of favoritism.  Why should public businesses have access to government capital, when private capital doesn’t have that same advantage?  The second reason is also simple: do we want the government to be an owner of a large percentage of the businesses of the country?  Do you want the government to have even more influence on businesses than activist investors do?

The third reason is complex.  Do you want to mess up the stock market?  A large dedicated buyer would drive the market up to levels where future returns would be very low, much lower than at present.  Very marginal businesses would go public to take advantage of the dumb capital.

Far from earning more money for Social Security, the investment would put in the top of the market.  There would be a generational top where the brightest investors would leave the market,,  Future returns would be low.

Not that anyone significant is suggesting it at present, but it is wiser to keep governments out of business management.  Don’t reach for false gains in investment performance if the price is government involvement in the details of business.

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One more note: all of the benefits of Social Security are based off of labor earnings, not capital earnings.  Most taxes are collected from labor income.  That’s why Treasury bonds make sense — it is a neutral asset that is similar to those who receive the benefits.  Treasury bonds are as broad-based as those who receive benefits.

26 paths, and all of them wrong

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I lost this post once already, hopefully it will be better-written this time.  I’ve been playing around with the stock market prediction model in order to give some idea of how the actual results could vary from the forecasts.

Look at the graph above.  it shows potential price returns that vary from -1.51%/year to 4.84%/year, with a most likely value of 2.79%, placing the S&P 500 at 3200 in March 2027.  Add onto this a 2% dividend yield to get the total returns.

The 26 paths above come from the 26 times in the past that the model forecast total returns within 1% of 4.79%.  4.79% is at the 90th percentile of expected returns.  Typically in the past, when expected returns were in the lower two deciles, actual returns were lower still.  For the 26 scenarios, that difference was 0.63%/year, which would imply 10-year future returns in the 4.16%/year area.

The pattern of residuals is unusual.  The model tends to overestimate returns at the extremes, and underestimate when expected returns are “normal.”  I can’t think of a good reason for this.  If you have a good explanation please give it in the comments.

Now if errors followed a normal distribution, a 95% confidence interval on total returns would be plus or minus 3.8%, i.e., from 1.0% to 8.6%.  I find the non-normal confidence interval, from 0.5% to 6.8% to be more plausible, partly because valuations would be a new record in 2027 if we had anything near 8.6%/year for the next ten years.  Even 6.8%/year would be a record.  That”s why I think a downward bias on results makes sense, with high valuations.

At the end of the first quarter, the model forecast total returns of 5.06%/year for the next ten years.  With the recent rally, that figure is now 4.79%/year.  Now, how excited should we be about these returns?  Not very?  I can buy that.

But what if you were a financial planner and thought this argument to be plausible?  Maybe you can get 3.5%/year out of bonds over the next ten years.  With 4.79% on stocks, and a 60/40 mix of stocks/bonds, that means returns of 4.27%.  Not many financial planning models are considering levels like that.

But now think of pension plans and endowments.  How many of them have assumptions in the low 4% region?  Some endowments are there as far as a spending rule goes, but they still assume some capital gains to preserve the purchasing power of the endowment.  Pension plans are nowhere near that, and if they think alternative investments will bail them out, they don’t know what they are doing.  Alternatives are common enough now that the face the same allocative behavior from institutional investors, which then correlates their returns with regular investments in the future, even if they weren’t so in the past.

I don’t have much more to say, so I will close with this: if you want to study this model more, you need to read the articles in this series, and the articles referenced at the Economic Philosopher blog.  Move your return expectations down, and diversify away from the US; there are better returns abroad — but remember, there are good reasons for home bias, so choose your foreign investments with care.

 

What could be more a propos to investing than a bubble spinner?

What could be more à propos to investing than a bubble spinner?

 

A letter from a “reader” that looked like he sent it to a lot of people:

Hello my name is XXX,
After looking through your website I have really been enjoying your content.
I am also involved in the investing space and wanted to ask a quick question.
I was curious as to what you think the biggest problems are for investors today?
For example do they not have enough investment choices? Do they just not have enough knowledge? Really anything that you have noticed.
I would love to hear your perspective on this. I really appreciate the help. If you have any questions feel free to ask. Thanks.

This was entitled “Love what your doing, my question will only take 2 minutes.”  I wrote back:

This is not a 2 minute question.

That said, it’s a decent question.  Here are my thoughts:

  • The biggest problem for investors is low future returns.  Bonds have low rates of returns, and equities have high valuations.  You’ll see more about equity valuations in my next post.
  • The second largest problem is investment monoculture — there is a handful of large cap growth stocks that dominate the major indexes, and there is a self-reinforcing cycle of cash flow going on now that is forcing their prices well above what can be justified in the long run.
  • Third is inadequate ability to diversify.  This is largely a function of the two problems listed before, and benchmarking and indexing, which has been correlating the markets more and more.  I’m not talking about short-term correlations — diversification applies of the time horizon of the assets, which is long.
  • Fourth is bad government and central bank policy.  The growth in government debt is the growth in unproductive capital, which drives the first problem.
  • Fifth, too many people are relying on investments to fund their future spending — that also exacerbates the first problem.

That’s all — if you can think of more, leave your suggestion in the comments.

PS — my apology to those I tweeted to on Friday about a post on equity valuations.  That will appear Saturday night.  Thanks.

Markets always find a new way to make a fool out of you.  Sometimes that is when the market has done exceptionally well, and you have been too cautious.   That tends to be my error as well.  I’m too cautious in bull markets, but on the good side, I don’t panic in bear markets, even the most severe of them.

The bull market keeps hitting new highs.  It’s the second longest bull market in the last eighty years, and the third largest in terms of cumulative price gain.  Let me show you a graph that simultaneously shows how amazing it is, and how boring it is as well.

The amazing thing is how long the rally has been.  We are now past 3000 days.  What is kind of boring is this — once a rally gets past two years time, price return results fall into a range of around 1.1-2.0%/month for the rally as a whole, averaging around 1.4%/month, or 18.5% annualized.  (The figure for market falling more than 200 days is -3.3%/month, which is slightly more than double the rate at which it rises.  Once you throw in the shorter time frames, the ratio gets closer to double — presently around 2.18x.  Note that the market rises are 3.2x as long as the falls.  This is roughly similar to the time spans on the credit cycle.)

That price return rate of 1.4%/month isn’t boring, of course, and is close to where the stock market prediction model would have predicted back in March 2009, where it forecast total returns of around 16%/year for 10 years.  That would have implied a level a little north of 2500, which is only 3% away, with 21 months to go.

Have you missed the boat?

If you haven’t been invested during this rally, you’ve most like missed more than 80% of the gains of this rally.  So yes, you have missed it.

“The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.”

Omar Khayyám from The Rubaiyat

In other words, “If ya missed the last bus, ya missed the last bus.  Yer stuck.”

We can only manage assets for the future, and only our decrepit view of the future is of any use.  We might say, “I have no idea.” and maintain a relatively constant asset allocation policy.  That’s mostly what I do.  I limit my asset allocation changes because it is genuinely difficult to time the market.

If you are tempted to add more money now, I would tell you to wait for better levels.  If you can’t wait, then do half of what you want to do.

A wise person knows that the past is gone, and can’t be changed.  So aim for the best in the future, which at present means having at least your normal percentage of safe assets in your asset allocation.

(the closing graph shows the frequency and size of market gains since 1928)

Photo Credit: Daniel Broche || To the victor goes the spoils, or, does a victory get spoiled?

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I was at a CFA Baltimore board meeting, and we were talking before the meeting.  Most of us work for value investors, or, growth-at-a-reasonable-price investors.  One fellow who has a business model somewhat like mine, commented that all the money was flowing into ETFs which were buying things like Facebook, Amazon and Google, which was distorting the market.  I made a comment that something like that was true during the dot-com bubble, though it was direct then, not due to ETFs, and went to a different group of stocks.

Let’s unpack this, starting with ETFs.  ETFs are becoming a greater proportion of the holders of stocks, and other assets also.  When do new shares of ETFs get created?  When it is profitable to do so.  The shares of the ETF must be worth more than the assets going into the ETF, or new shares will not get created.

It is the opposite for ETFs if their shares get liquidated. That only happens when it is profitable to do so.  The shares of the ETF must be worth less than the assets going out of the ETF, or shares will not get liquidated.

Is it likely that the growth in ETFs is driving up the price of shares? Not much; all that implies is that people are willing to pay somewhat more for a convenient package of stocks than what they are worth separately.  Fewer people want to own individual assets, and more like to hold bunches of assets that represent broad ideas.  Invest in the stock market of a country, a sector, an industry, a factor or a group of them.

The creators and liquidators of ETF shares typically work on a hedged basis.  They are long whatever is cheaper, and short whatever is more expensive — but on net flat.  When they have enough size to create or liquidate, they go to the ETF and do that.  Thus, the actions of the creators/liquidators should not affect prices much.  Their trading operations have to be top-notch to do this.

(An aside — long-term holders of ETFs get nipped by the creation and liquidation processes, because both diminish the value of the ETF to long-term holders.  Tax advantages make up some or more than all of the difference, though.)

Does the growth in ETFs change the nature of the stickiness of the holding of the underlying stocks?  Does it make the stickiness more like a life insurer holding onto a rare “museum piece” bond that they could never replace, or like a day trader trying to clip nickels?  I think it leans toward less stickiness; my own view of ETF holders is that they fall mostly into two buckets — traders and investors.  The investors hold a long time; the traders are very short term.

As such, more ETFs owning stocks probably makes the ownership base more short-term.  ETFs are simple looking investments that mask the underlying complexity of the individual assets.  There is no necessary connection between a bull market and and growth in ETFs, or vice-versa.  In any given market cycle there might be a connection, but it doesn’t have to be that way.

ETFs don’t create or retire shares of underlying stocks or bonds.  And, the ETFs don’t necessarily create more net demand for the underlying assets.  Open end mutual fund holders and direct holders shrink and ETFs grow, at least for now.  That may make a holder base a little more short-term, but it shouldn’t have a big impact on the prices of the underlying assets.

My friend made a common error, confusing primary and secondary markets.  No money is flowing into the corporations that he mentioned.  Relative prices are affected by greater willingness to pay a still greater amount for the stock of growthy, highly popular, large companies relative to that of average companies or worse yet, value stocks.

Now the CEOs of companies with overvalued shares may indeed find ways to take advantage of the situation, and issue stock slowly and quietly.  The same might apply to value stocks, but they would buy back their stock, building value for shareholders that don’t sell out.  In this example, the secondary markets give pricing signals to companies, and they use it to build value where appropriate — secondary markets leads primary markets here.  The home run would be that the companies with overvalued shares would buy the companies with undervalued shares, if the companies were related, and it seemed that management could integrate the firms.

What we are seeing today is a shift in relative prices.  Growth is in, and value is out.  What we aren’t seeing is the massive capital destruction that took place when seemingly high growth companies were going public during the dot-com bubble, where cash flowed into companies only to get eaten by operational losses.  There will come a time when the relative price of growth vs value will shift back, and performance will reflect that then.  It just won’t be as big of a shift as happened in the early 2000s.

There’s a lot of bits and bytes spilled in the war between Elliott Associates (and those that favor their position) and the current board of Arconic.  I want to point out a few things, having held Alcoa since prior to the breakup, and added to my positions in both new Alcoa and Arconic post-breakup.

  • Profitability will likely improve more if Elliott’s nominees are elected to the board, and Larry Lawson is CEO.
  • The existing management team does not deserve credit for the recent rise in the stock price for two reasons: a decent amount of the rise in Arconic’s stock price anticipates a rising probability that the board and management team will be replaced.  Second, a decent amount of the increase in the stock price of Alcoa has been due to a rise in the price of aluminum, for which no single entity can take credit.  Current Arconic benefited from that, at least until it sold its whole stake in Alcoa.
  • To their discredit, the existing management team and board resisted the breakup of the company into upstream and downstream for years.  (See point 2 of this Elliott letter, Was Dr. Kleinfeld the Driving Force Behind the Separation?)
  • Existing management was not a good capital allocator.
  • Prior to the agitation by Elliott, Alcoa and Arconic sold at low valuations, because earnings prospects were poor.  Now new Alcoa is in better hands, and that might be true for Arconic in the future, which may further improve valuation.
  • The existing board has low ownership in Arconic.  Many of the existing board members have been around too long.
  • The current board are late to the party of improving corporate governance.  Though their proposals are good, it looks like they were dragged there by the activists, and therefore, can’t be trusted to maintain these improvements.

That’s my short summary; it is not meant to be detailed, as Elliott’s arguments are.  In general, I agree with the arguments over at New Arconic, and will be voting the blue proxy card.  If you disagree, then you should vote the white proxy card sent out by the existing board.

I’m not telling you what to do.  Vote the proxy that reflects your view of what will improve Arconic the most.

Full disclosure: long AA & ARNC for my clients and me (Note: Aleph Investments, LLC, is dust on the scales in this fight, representing less than 0.01% of outstanding shares.)

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This will be a short post, though I want to toss this question out to readers: what investment strategies do you know of that are simple, and work on average over the long-term?

Here are four (together with posts of mine on the topic):

1) Indexing

Index Investing is not Inherently Socialistic

Why Indexes are Capitalization-Weighted

Why do Value Investors Like to Index?

On Bond Investing, ETFs, Indexes, and the Current Market Environment

2) Buy-and-Hold

Buy-and-Hold Can’t Die

Buy-and-Hold Can’t Die, Redux

Buy and Hold Will Return — 2/15/2009 (what a time to write this)

Patience and a Little Courage

Risk vs Return — The Dirty Secret

3) The Permanent Portfolio

The Permanent Portfolio

Can the “Permanent Portfolio” Work Today?

Permanent Asset Allocation

4) Bond Ladders

On Bond Ladders

I chose these because they are simple.  Average people without a lot of training could do them.  There are other things that work, but aren’t necessarily simple, like value investing, momentum investing, low volatility investing, and a few other things that I will think of after I hit the “Publish” button.

That said, most people don’t need to work on investing.  They need to work on cash management, and I have written a small fleet of articles there.  Managing cash is simple, but it takes self-control, and that is what most people lack in their financial lives.

But for those that have gotten their cash under control, with a full buffer fund, the above strategies will help, and they aren’t hard.

Final note: I realize valuations are high now, so buy-and-hold is not as attractive as at other times.  I realize that interest rates are low, so bond ladders aren’t so great, seemingly.  Indexing may be overused.  Most of the elements of the Permanent Portfolio look unappealing.

But what’s the alternative, and simple enough for average people to do?  My answer is simple.  If they can buy and hold, these strategies will pay off over time, and far better than those that panic when things get bad.  There are few regularities in the markets more reliable than this.

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I will admit, when I first read about the Permanent Portfolio in the late-80s, I was somewhat skeptical, but not totally dismissive.  Here is the classic Permanent Portfolio, equal proportions of:

  • S&P 500 stocks
  • The longest Treasury Bonds
  • Spot Gold
  • Money market funds

Think about Inflation, how do these assets do?

  • S&P 500 stocks – mediocre to pretty good
  • The longest Treasury Bonds – craters
  • Spot Gold – soars
  • Money market funds – keeps value, earns income

Think about Deflation, how do these assets do?

  • S&P 500 stocks – pretty poor to pretty good
  • The longest Treasury Bonds – soars
  • Spot Gold – craters
  • Money market funds – makes a modest amount, loses nothing

Long bonds and gold are volatile, but they are definitely negatively correlated in the long run.  The Permanent Portfolio concept attempts to balance the effects of inflation and deflation, and capture returns from the overshooting that these four asset classes do.

What did I do?

I got the returns data from 12/31/69 to 9/30/2011 on gold, T-bonds, T-bills, and stocks.  I created a hypothetical portfolio that started with 25% in each, rebalancing to 25% in each whenever an asset got to be more than 27.5% or less than 22.5% of the portfolio.  This was the only rebalancing strategy that I tested.  I did not do multiple tests and pick the best one, because that would induce more hindsight bias, where I torture the data to make it confess what I want.

I used a 10% band around 25% ( 22.5%-27.5%) figuring that it would rebalance the portfolio with moderate frequency.  Over the 566 months of the study, it rebalanced 102 times.  At the top of this article is a graphical summary of the results.

The smooth-ish gold line in the middle is the Permanent Portfolio.  Frankly, I was surprised at how well it did.  It did so well, that I decided to ask, what if we drop out the T-bills in order to leverage the idea.  It improves the returns by 1%, but kicks up the 12-month drawdown by 7%.  Probably not a good tradeoff, but pretty amazing that it beats stocks with lower than bond drawdowns.  That’s the light brown line.

ResultsS&P TRBond TRT-bill TRGold TRPP TRPP TR levered
Annualized Return10.40%8.38%4.77%7.82%8.80%9.93%
Max 12-mo drawdown-43.32%-22.66%0.02%-35.07%-7.65%-14.75%

 

Now the above calculations assume no fees.  If you decide to implement it using SPY, TLT, SHY and GLD, (or something similar) there will be some modest level of fees, and commission costs.

 

 What Could Go Wrong

Now, what could go wrong with an analysis like this?  The first point is that the history could be unusual, and not be indicative of the future.  What was unusual about the period 1970-2017?

  • Went off the gold standard; individual holding of gold legalized.
  • High level of gold appreciation was historically abnormal.
  • Deregulation of money markets allowed greater volatility in short-term rates.
  • ZIRP crushed money market rates.
  • Federal Reserve micro-management of short-term rates led to undue certainty in the markets over the efficacy of monetary policy – “The Great Moderation.”
  • Volcker era interest rates were abnormal, but necessary to squeeze out inflation.
  • Low long Treasury rates today are abnormal, partially due to fear, and abnormal Fed policy.
  • Thus it would be unusual to see a lot more performance out of long Treasuries. The stellar returns of the past can’t be repeated.
  • Three hard falls in the stock market 1973-4, 2000-2, 2007-9, each with a comeback.
  • By the end of the period, profit margins for stocks were abnormally high, and overvaluations are significant.

But maybe the way to view the abnormalities of the period as being “tests” of the strategy.  If it can survive this many tests, perhaps it can survive the unknown tests of the future.

Other risks, however unlikely, include:

  • Holding gold could be made illegal again.
  • The T-bills and T-bonds have only one creditor, the US Government. Are there scenarios where they might default for political reasons?  I think in most scenarios bondholders get paid, but who can tell?
  • Stock markets can close for protracted periods of time; in principle, public corporations could be made illegal, as they are statutory creations.
  • The US as a society could become less creative & productive, leading to malaise in its markets. Think of how promising Argentina was 100 years ago.

But if risks this severe happen, almost no investment strategy will be any good.  If the US isn’t a desirable place to live, what other area of the world would be?  And how difficult would it be to transfer assets there?

Summary

The Permanent Portfolio strategy is about as promising as any that I have seen for preserving the value of assets through a wide number of macroeconomic scenarios.  The volatility is low enough that almost anyone could maintain it.  Finally, it’s pretty simple.  Makes me want to consider what sort of product could be made out of this.

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Back to the Present

I delayed on posting this for a while — the original work was done five years ago.  In that time, there has been a decent amount of digital ink spilled on the Permanent Portfolio idea of Harry Browne’s.  I have two pieces written: Permanent Asset Allocation, and Can the “Permanent Portfolio” Work Today?

Part of the recent doubt on the concept has come from three sources:

  • Zero Interest rate policy [ZIRP] since late 2008, (6.8%/yr PP return)
  • The fall in Gold since late 2012 (2.7%/yr PP return), and
  • The fall in T-bonds in since mid-2016 (-4.7% annualized PP return).

Out of 46 calendar years, the strategy makes money in 41 of them, and loses money in 5 with the losses being small: 1.0% (2008), 1.9% (1994), 2.2% (2013), 3.6% (2015), and 4.5% (1981).  I don’t know about what other people think, but there might be a market for a strategy that loses ~2.6% 11% of the time, and makes 9%+ 89% of the time.

Here’s the thing, though — just because it succeeded in the past does not mean it will in the future.  There is a decent theory behind the Permanent Portfolio, but can it survive highly priced bonds and stocks?  My guess is yes.

Scenarios: 1) inflation runs, and the Fed falls behind the curve — cash and gold do well, bonds tank, and stocks muddle.  2) Growth stalls, and so does the Fed: bonds rally, cash and stocks muddle, and gold follows the course of inflation. 3) Growth runs, and the Fed swarms with hawks. Cash does well, and the rest muddle.

It’s hard, almost impossible to make them all do badly at the same time.  They react differently to changes in the macro-economy.

Upshot

There are a lot of modified permanent portfolio ideas out there, most of which have done worse than the pure strategy.  This permanent portfolio strategy would be relatively pure.  I’m toying with the idea of a lower minimum ($25,000) separate account that would hold four funds and rebalance as stated above, with fees of 0.2% over the ETF fees.  To minimize taxes, high cost tax lots would be sold first.  My question is would there be interest for something like this?  I would be using a better set of ETFs than the ones that I listed above.

I write this, knowing that I was disappointed when I started out with my equity management.  Many indicated interest; few carried through.  Small accounts and a low fee structure do not add up to a scalable model unless two things happen: 1) enough accounts want it, and 2) all reporting services are provided by Interactive Brokers.

Closing

Besides, anyone could do the rebalancing strategy.  It’s not rocket science.  There are enough decent ETFs to use.  Would anyone truly want to pay 0.2%/yr on assets to have someone select the funds and do the rebalancing for him?  I wouldn’t.