An Unknown Economic Climate?

[craigr]

From a recent blog post:

https://web.archive.org/web/20160324133 ... c-climate/

Someone wanted to know: Are we sure there are no more than four economic investing climates that can affect the Permanent Portfolio?

What the question refers to is the core idea in the Permanent Portfolio that we have to only contend with four states in the economy:

1) Prosperity
2) Inflation
3) Deflation
4) Recession

This is a critical concept in the portfolio and why it works so well in protecting and growing money against an unknown future.  Because there are only four economic climates, we need to own just four assets to deal with each:

Stocks are for Prosperity
Gold is for Inflation
Long Term Bonds are for Deflation
Cash is for Recession

So are we really sure that’s all that exists? Is there a fifth case that could blindside the portfolio?

This is an excellent question.

Aside from Harry Browne and Terry Coxon who created the strategy, a lot of other people have put many brain cycles into this. My own review of history agrees with what Browne and Coxon postulated. I’ve only ever seen four economic cycles.

A review of US market history and other market history you can find various events on the timeline and see how the markets reacted. Before we went off the gold standard there were periods of inflation and deflation in the US - During the Civil War (inflation) and Reconstruction (deflation) for instance.

In other economies we can see similar cases of how the stock market, bonds and the money supply expanded and contracted. Recently I had a person in Greece write and they are facing huge problems that could very likely impact their savings due to bad inflation if they leave the Euro. In that country people are responding by buying gold if they are able. So even in that unpredictable situation inflation is the likely predicted outcome and people are responding to it by buying gold just as the Permanent Portfolio idea would suggest.

In 2008 we had a currency crisis in Iceland that caused bad inflation and gold was again the asset to hold for Icelanders.

Yet in that same year 2008 we had a deflationary event kick off in the US and LT bonds were the asset to have. But in 2009 the markets righted themselves and the stock market recovered sharply as deflation threats seemed to fade so stocks responded well.

Are you dizzy yet?

These were different countries with different results but the economic climates were each respectively accounted for with the portfolio.

But here’s the thing: These events were not predicted by the portfolio at all. Yet they all fell into the four economic climates model perfectly fine and the portfolio weathered the storms.

Could another economic climate exist? What history we have across multiple countries shows that some pretty serious events have occurred and the four economic climate model has pretty much accommodated them all as far as I can tell. So from my view I think the four economic climates are all we need to worry about.


=====

What say you? Is there a fifth economic climate or other risk being overlooked?

[Plurimus]

Great Blog post! 

[slk23]

From a recent blog post:

https://web.archive.org/web/20160324133 ... c-climate/

Someone wanted to know: Are we sure there are no more than four economic investing climates that can affect the Permanent Portfolio?

[....]

What say you? Is there a fifth economic climate or other risk being overlooked?

This is timely for me since just last night I was thinking about the HB's four economic environments and the performance of his recommended asset classes. 

I've read numerous blogs saying we're presently in a deflationary environment.  According to HB, during deflation long term bonds should be doing well.  But rather than long term bonds we've seen gold and stocks (in the last year) push the permanent portfolio up.  In this because the markets are anticipating inflation?

 

[craigr]

I've read numerous blogs saying we're presently in a deflationary environment.  According to HB, during deflation long term bonds should be doing well.  But rather than long term bonds we've seen gold and stocks (in the last year) push the permanent portfolio up.  In this because the markets are anticipating inflation?

I think gold has been on a tear the past eight years because that's when the US decided to get involved in two overseas wars and wars have historically always been very expensive and resulted in inflation. There has also been a vast expansion in domestic social programs which puts more pressure on the dollar. In the 1960s Johnson did the whole "Guns and Butter" thing and it caused big problems later with inflation.

To add to this, this year we've also had problems in a major world currency (Euro) and many overseas are buying gold as well pushing the price up. IMO.

In 2008 we did have a very fast deflation situation as housing prices crashed and LT bonds reacted strongly posting 30%+ gains in about two months time. But the govt. came in again and bailed everyone out to fight it and this is probably making the markets think inflation is coming as well eventually.

I think the markets are in this murky area where things could go deflation or inflation and both sides are placing their bets. It has been the case in the past that transitions between economic climates can overlap and often it's not possible to say what was happening until after the fact in hindsight.*


* Then again everything can just kind of work out and stocks continue to post good gains on recovery. Which is why the portfolio holds all four assets all the time and doesn't attempt market timing.

[fred9]

From Clive:
The primary risk of a PP style as I see it is that of relatively under-performance in prosperous times.

If this is "true" ( I see Harry quote about the expected not happening) I'm in for the long term. But how long would that be for a 66 year old? :-)

Yes I'm 66 and plan to retire at 67 1/2. I just put 5% of my investments into PP - today I bought my first bond online via Vanguard - 29 year Treasury. Also bought GTU, VTI and VGSH. I'll have a pension, SS & spousal SS. I plan to gradually move to at least 25% in PP. As of now I can see myself going to 50% PP.  I'm now around 50/50 with preferreds being in the "bond" side which I realize is not accurate.

My point is that I'm not worried about missing a lot of the upside. I want to avoid most of the downside. 

I'm glad I found you. I did so on Random Roger. (I don't invest like Roger but I do enjoy reading his site.)

Thanks

[slk23]

* Then again everything can just kind of work out and stocks continue to post good gains on recovery. Which is why the portfolio holds all four assets all the time and doesn't attempt market timing.

So basically you're saying we're in a confused environment which is why the performance of the four assets doesn't quite match HB's model?  I ask because as I listen to his radio show he makes it clear that gold is meant to bolster the portfolio in times of inflation.  Well, inflation has not appeared but gold has gone up anyway.  So is Harry's model flawed?  Are other surprises, perhaps less pleasant, coming? 

I realize that HB's description of the four economic environments and the corresponding asset classes is simplified for the radio audience.  The real picture is never that clear but the permanent portfolio has trudged along admirably.  I guess I'm looking for reassurance that the permanent portfolio's basic concepts have not been undermined by events and trends of the last five years.

.

[craigr]

* Then again everything can just kind of work out and stocks continue to post good gains on recovery. Which is why the portfolio holds all four assets all the time and doesn't attempt market timing.

So basically you're saying we're in a confused environment which is why the performance of the four assets doesn't quite match HB's model?  I ask because as I listen to his radio show he makes it clear that gold is meant to bolster the portfolio in times of inflation.  Well, inflation has not appeared but gold has gone up anyway.  So is Harry's model flawed?  Are other surprises, perhaps less pleasant, coming?  

No I think we have certainly had inflation the past few years. Oil has gone up a hundred+ percent from eight years ago. Personally, I can say that my health insurance premiums have been going up 25-50% a year over this time for someone has had no health issues ever. Property taxes have increased where I live. Food prices where I go to eat have all gone up each year. We own some livestock and feed prices have all gone up 50%+ in some cases (such as with hay). My overall annual expenses have all gone up.

Yes, home prices have gone down. But since most people tend to be fairly stable where they are this is not a help to them unless they are new buyers moving into a home. If I were to sell my current home for instance I'd find that it has not increased in value over the time I owned it so there has been no net gain there, either.

So overall there is an argument for deflation in some parts of the economy, but from my own perspective at least I don't see it personally and I suspect I'm not alone.

However, what I'm saying is that the future is not predictable and that there are always a myriad of scenarios we can come up with about this or that but in reality these things rarely come true and the real problems tend to be out of left field. The Permanent Portfolio idea is unique in this regard because it is not performing a risk analysis with this typical mindset. For instance it is not saying "Buy this because the Chinese are going to dump treasuries." or "The Euro is going to crash and drive the price of US Bonds up so buy bonds."

What it does instead is remove itself from this endless game of if A then B and just say, basically, "I don't care what is going to happen or what caused it because I already own an asset that can deal with it."

If you read other investing advice you'll see this split in philosophy. The conventional approach is reactive in nature. It is rushing to put out the latest fire or anticipated fire. Sometimes it gets it wrong and the fire department is across town at the wrong house when the problem starts.

The Permanent Portfolio instead takes a proactive and preventative approach. It is constructed to the best of its ability to resist being set on fire. Yet it also has mechanisms to deal with a fire in part of the structure effectively if it should occur with no need for guesswork.

I guess I'm looking for reassurance that the permanent portfolio's basic concepts have not been undermined by events and trends of the last five years.

Nobody can give a reassurance because there could always be some unknown threat that could throw a curve ball. You just have to do your research and make your best call on what is best for your own situation.

But with that said I have faith in it and eat my own dog food with my own money on the line in the strategy. The assets in the portfolio represent a very wide and deep diversification strategy that is very sophisticated although it appears very simple. The last five years have not been great, but they have hardly been the worst in US history. I'd argue that the inflation of the 1970s which produced zero real returns in stocks and bonds from about 1966-1982 was probably worse. People don't like the low interest they are getting now, but I suspect they would like getting 10% on a CD when inflation was 12% even less as has happened before. The 1930s were definitely worse as well.

I've looked at many other approaches and found that they all had risks that were not accounted for and some of them showed up in 2008, some showed up in tech crash 2000-2002, some showed up from the "lost decade" 1999-2009, some showed up during the stock boom 1980-2000, some showed up in the inflation 1970s and other risks showed up in market problems in other countries elsewhere.

I can can also say that the Permanent Portfolio may face some threat going forward that we don't know. However, I know for a fact that the alternative approaches have all shown to have their own problems already! So, I have to stick with what has been working and been shown to work through a variety of good and bad markets. So far, it's been Browne's strategy. Until I come across something that can definitively show it can meet the portfolio in terms of returns, risks and dealing with the unexpected I'm going to have to stick to the plan.  

[KevinW]

So basically you're saying we're in a confused environment which is why the performance of the four assets doesn't quite match HB's model?  I ask because as I listen to his radio show he makes it clear that gold is meant to bolster the portfolio in times of inflation.  Well, inflation has not appeared but gold has gone up anyway.  So is Harry's model flawed?  Are other surprises, perhaps less pleasant, coming? 

I don't think Browne's idea was that the four assets would move in lockstep with their economic drivers.  Rather, I would state the Permanent Portfolio theory as "for any economic climate, at least one asset should perform well enough to carry the portfolio."

For example, under deflation long term bonds should rally.  Nothing in particular is said about what the other three assets will do during deflation.  They might go up and might go down.  The other three may well cancel each other out.  For the portfolio as a whole to work, we just need that, no matter what, at least one asset is increasing enough to overcome any aggregate losses that might exist in the rest of the portfolio.

More explicitly, the claim is that
IF prosperity is dominant, THEN stocks rally (enough to carry the portfolio)
IF inflation is dominant, THEN gold rallies (enough to carry the portfolio)
IF deflation is dominant, THEN bonds rally (enough to carry the portfolio)
IF recession is dominant, THEN cash becomes more valuable (enough to carry the portfolio)

This is a significantly weaker claim than
stock prices fluctuate up and down in proportion to prosperity forces
gold prices fluctuate up and down in proportion to inflation forces
...etc

The second kind of claim does not follow logically from the first kind; that would be an example of "affirming the consequent."  Likewise, a gold and stock rally during deflation would not contradict the IF/THEN claims.

Also, we never really know which climate we're in until several years in the future when we can look at things in hindsight.  Likewise, we can't know whether today's price movements are blips of random noise, or part of a major shift, until we can look at them in a historical context.

[slk23]

I don't think Browne's idea was that the four assets would move in lockstep with their economic drivers.  Rather, I would state the Permanent Portfolio theory as "for any economic climate, at least one asset should perform well enough to carry the portfolio."

For example, under deflation long term bonds should rally.  Nothing in particular is said about what the other three assets will do during deflation.  They might go up and might go down.  The other three may well cancel each other out.  For the portfolio as a whole to work, we just need that, no matter what, at least one asset is increasing enough to overcome any aggregate losses that might exist in the rest of the portfolio.

More explicitly, the claim is that
IF prosperity is dominant, THEN stocks rally (enough to carry the portfolio)
IF inflation is dominant, THEN gold rallies (enough to carry the portfolio)
IF deflation is dominant, THEN bonds rally (enough to carry the portfolio)
IF recession is dominant, THEN cash becomes more valuable (enough to carry the portfolio)

This is a significantly weaker claim than
stock prices fluctuate up and down in proportion to prosperity forces
gold prices fluctuate up and down in proportion to inflation forces
...etc

The second kind of claim does not follow logically from the first kind; that would be an example of "affirming the consequent."  Likewise, a gold and stock rally during deflation would not contradict the IF/THEN claims.

Also, we never really know which climate we're in until several years in the future when we can look at things in hindsight.  Likewise, we can't know whether today's price movements are blips of random noise, or part of a major shift, until we can look at them in a historical context.

In case it's not clear, I do have confidence in the permanent portfolio concept.  But as Harry said, don't invest in something you don't understand.  I'm only trying to increase my understanding.  

What you, Clive, and Craig are saying makes sense to me.  But my question remains: have the basic concepts of the permanent portfolio been validated or undermined in the last five years (or whatever period you prefer)?  Harry Browne constructed the portfolio with specific elements which correspond to each of the four economic climates.  We should be able to look back and find some correlation between economic cycles and the performance of the four asset classes.  Harry did that himself in his radio show when explaining how the portfolio works.  Since that was five years ago I thought we could do a review of the portfolio's performance and hopefully find some sense in how the asset classes did WRT the economy.

The permanent portfolio was designed to be a safe, low maintenance way to invest.  Trusting that the elements will balance each other and resisting the desire to tweak its composition are important points. But at the same time it shouldn't be treated as a 'black box'; by analyzing the inner workings we increase our understanding.  But of course we have to be careful to avoid falling into the trap of 'A leads to B which must lead to C', which is something Harry often warned against.

[craigr]

But my question remains: have the basic concepts of the permanent portfolio been validated or undermined in the last five years (or whatever period you prefer)?

Here's something else to consider about the concepts being validated.

Prior to 2008 the portfolio had never been through a condition to test the deflation protection. This is because the last period of serious deflation occurred in the 1930s well before the portfolio was created. Up to that point it was all theoretical how it would perform. This is something I noted in my 2008 year review and confirmed with John Chandler (Browne's former business partner and newsletter publisher) as well afterwards. Yet the economic theory behind the asset allocation worked as expected. It was just too bad Browne wasn't around to witness it.

The four asset classes in the portfolio provide strong diversification because the risk factors that can affect each are so radically different. The market will favor stocks for reasons that would make gold very unattractive (better returns from corporate profits). The market favors gold for reasons that make bonds unattractive (rising interest rates). The markets favor bonds for reasons that make stocks unattractive (a fast contraction in the economy lowering the ability of companies to maintain profitability). These movements are based on rational decisions of the market participants at any particular time that are unlikely to change.

We can even ask ourselves how rational actors behave in each case:

1) If interest rates are falling rapidly what is the best investment? A rational actor would want an asset that locks in a higher interest rate so they can make more money than current market rates are likely to pay going forward. That's LT Bonds.

2) If there is high inflation eroding purchasing power what is the best investment? Tangible assets are what people want because it detaches their wealth from a falling paper currency. A dollar may be worth less, but the hard assets they own are still the same. The asset that is most desired in this case because of the compact form of wealth it represents has been gold for much of Western history. Although we could argue other hard assets like general commodities and real estate could fall into this category. However they are not as liquid and much harder to store in useful quantities compared to gold.

3) If business is booming and the economy is stable what is the best investment? Stocks. They represent an ownership in profitable businesses and gives a share of those profits back to investors to grow their wealth. Assets that are not generating good returns during boom years tend to be shunned because they are seen as a lost opportunity by many.

4) If the markets are not giving up any clear opportunity due to various monetary policy decisions of the Fed and uncertainty is present what is the best asset? Cash. Cash is stable and investors will sell what assets they hold and park money there until they feel more comfortable.

Overall I don't know what would going to change going forward. There are only so many ways each economic condition can play out. While we can debate the merits of whether some particular asset is best for each situation, I think overall we'd probably come back to where we started in the end. Investors will react to each situation for their own self-interest and that self-interest only leaves them with a few choices that are a good decision in each case (stocks, bonds, cash or gold).