This Forum & Dissenting Opinions of the HBPP

[MachineGhost]

I wonder if you can help me understand something.  It seems that when stocks and bonds (especially ltg bonds) both do badly the culprit is "stagflation", which I take to mean a combination of a poor economy with high inflation.

What I don't get is how that can persist for very long - inflation is generally understood as a rise in the costs of goods and services (pace to our Austrian brethren).  So if the economy isn't doing well, people can't afford higher prices and I'd expect one of two things (or both) to happen.  People will not buy stuff at those prices, which should bring them down (supply and demand) and/or as that happens, businesses will struggle, lay people off, etc. and we'll move into a recessionary trend.

Then ltg bonds should do well, right?

So either inflation will drop or the economy will spiral downwards - what am I missing?

The 1970's were complex because there were multiple factors all conspiring to promote high inflation.  It wasn't a black and white situation like proponents would have you believe that inflation all is (Friedman's outdated NeoState monetary policy dreck).

Inflation can manifest from four possible causes, but in the 1970's wages were linked to inflation in employment contracts, so it was a demand push source of inflation each and every year.  Throw in supply shock inflation from OPEC which was in response to the 1973 Israeli War and chronic devaluation of the USD under fixed exchange rates from Guns N' Butter spending (Korea, Vietnam, War on [Black] Poverty, Medicare, Great Society), stupid price controls by Republicans, overregulation, nationalization and socialism in the private economy that promoted secular growth stagnation (especially in the UK), and it was just a huge cornucopia of a clusterfuck of what NOT to do.

You have to understand inflation is as much a psychological phenomenom as it is any actual supply exceeding demand or demand exceeding supply.  It was "baked into the cake" under the fixed exchange system pre-1971, so it had to have its pressure relief valve, kicked off when the fixed exchange rate system collapsed.  Systematically, inflation can take on a self-fulfilling prophecy which did indeed occur in the late closing years of the 1970's when the mainstream Boobuses became utterly convinced the USD was going to go completely worthless.  If people are convinced that inflation won't be brought under control someway, somehow, somewhere and they see the snowballing effect of capital flows into tax shelters and real assets, the trend will feed upon itself endlessly up until that point there is a "straw the breaks the back".  It's an envious bubble dynamic like any other.

Stocks and bonds can also do badly under "Tight Money" which is not the same as "stagflation".  All it takes is a lack of confidence in any asset other than cash.  If the PP had cash that could be leveraged up to match the risk of the other assets, it would be a lot more visible when capital flows choose it.

[MachineGhost]

But, government policy wouldn't be aimed at producing/extending stagflation, since it sucks.  Fed policy has the dual mandate of unemployment/inflation - it wants to create conditions for higher employment and also control inflation.

Stagflation would sort of be the opposite of that, with lower employment and higher inflation.

The Fed no longer has any tools to do either, so it's all a Wizard of Oz show now.

[MachineGhost]

The "stagflation" of the 1970's is the single best example of why holding gold is useful.  All portfolios with < 20% gold had negative real returns during that period.  It's all there in Tyler's charts.

Are you 100% sure about that?  Because the Browne Minimum Risk portfolio wouldn't have succeeded if that was the case.

[jafs]

Right, that's why I'm asking, sophie.

I'm trying to figure what sort of risk is involved from this point on with a stock/bond portfolio, in a general sort of way.

Not sure that government policies created stagflation, but I do think that they (especially the Fed) aren't particularly effective at dealing with it, which makes sense, given that their basic tools are to raise/lower interest rates.  Usually, when the economy's crummy, they'll lower rates to stimulate it, and when inflation is high and the economy's doing very well ("overheated"?), they'll raise them.  The combination of a crummy economy and high inflation is very hard for the Fed to resolve.

As far as rationality goes, those in government probably aren't any more or less rational than the rest of us, I would think    And, markets are as rational as the collective rationality of participants, right?  There's plenty of irrational stuff going on in the private sector all the time, isn't there?

The corrective mechanism for government would be elections, I would think.  And, the outcome of those would be linked to the general understanding/rationality of those who vote (a sobering thought).

Thanks for the analysis, MG.  You may be completely right about the causes of high inflation back then.  But, given the combination of that and a sluggish economy, why didn't the situation shift somewhat in the ways I imagine it should?

[glennds]

Stocks and bonds can also do badly under "Tight Money" which is not the same as "stagflation".  All it takes is a lack of confidence in any asset other than cash.  If the PP had cash that could be leveraged up to match the risk of the other assets, it would be a lot more visible when capital flows choose it.

Do you think the market conditions we have seen this year would indicate "Tight Money" conditions?

If not, maybe something between "Tight Money" and Deflation?

[MachineGhost]

Right, that's why I'm asking, sophie.

I'm trying to figure what sort of risk is involved from this point on with a stock/bond portfolio, in a general sort of way.

Not sure that government policies created stagflation, but I do think that they (especially the Fed) aren't particularly effective at dealing with it, which makes sense, given that their basic tools are to raise/lower interest rates.  Usually, when the economy's crummy, they'll lower rates to stimulate it, and when inflation is high and the economy's doing very well ("overheated"?), they'll raise them.  The combination of a crummy economy and high inflation is very hard for the Fed to resolve.

As far as rationality goes, those in government probably aren't any more or less rational than the rest of us, I would think    And, markets are as rational as the collective rationality of participants, right?  There's plenty of irrational stuff going on in the private sector all the time, isn't there?

The corrective mechanism for government would be elections, I would think.  And, the outcome of those would be linked to the general understanding/rationality of those who vote (a sobering thought).

Thanks for the analysis, MG.  You may be completely right about the causes of high inflation back then.  But, given the combination of that and a sluggish economy, why didn't the situation shift somewhat in the ways I imagine it should?

Because while a poor economy lowers aggregate demand, but if there is a constriction in supply (price controls, oil embargo) vs higher demand, increase in demand (wage inflation contracts, women entering the workforce, real assets) relative to lesser supply, or excess supply relative to lesser demand (fiscal policy, monetary policy)... In other words, inflation overwhelmed deflation.  It's that simple.

Also, don't fall under the Wizard of Oz illusion that the Fed knows what it is consistently doing throughout time.  Whatever academic economic theory that is in vogue at the time is what will be represented and implemented at the Board of Governors (and they're always fighting the last war...).  They go through fads and are as clueless as anyone else since they are a product of their college training, incestuous collegiate feedback and cliquish tenure reinforcement.  I believe Bernanke was the first Governor to have no real world experience at all, just academic and it shows in his ineffective New Keynesian approach that Yellen inherited.**  Now in the 1970's, the Fed wasn't as constrained as it is today since bank reserves were required for a lot more accounts than just checking, but it had long lost the ability to affect employment in the private sector back in the 1920's.  Serious question: do we actually WANT the Fed to be able to directly affect employment?  Sometimes its better that everyone believe in a fairy tale than wake up and find out what they're missing!

Elections do follow the economic cycle.  "It's the economy, stupid!" as Slick Willie used to say.  We'll have to see how effective the electoral college really is in practical terms if Trump gets the nomination and wins.  I don't think we've quite had someone so real world experienced since Hoover, but back then economic thought was not really a serious and developed discipline in the way it is today.  Keynes changed all that.

** In other words, they operate the Fed according to a parallel fantasy dimension that does not exist anywhere in the real world but only in their own minds instead of according to operational reality.  Nice six-figure paying job if you can get it!!!  You're not held responsible for your Bullshit to anything or anyone other than a blustering, clueless Congress.  It's all a sideshow.  These six-figure earning LEECHES are ENDEMIC on the American body politic.  This has got to change.

[Reub]

jafs, you have to watch yourself in here.
There are a lot of people giving out advice like candy who try to pretend that they're experts when they're not.

[jafs]

I'm still not quite understanding it.

Maybe it's just too complex for me to wrap my head around.

[MachineGhost]

Do you think the market conditions we have seen this year would indicate "Tight Money" conditions?

If not, maybe something between "Tight Money" and Deflation?

I suspect so.  But hey, I'm no expert!

[Pointedstick]

I'm still not quite understanding it.

Maybe it's just too complex for me to wrap my head around.

If you think the people in government are no better or worse than people like us, that means it's too complicated for them to wrap their heads around, too.

[MachineGhost]

I'm still not quite understanding it.

Maybe it's just too complex for me to wrap my head around.

Put yourself in the 1970's.  The economy is stagnant but prices are rising everywhere.  What do you do?  Do you argue with theoretical models of wouldas, couldas, shouldas in your mind or do you believe your very own eyes?  What does everyone else believe?

[jafs]

Well, that's where I started.

Individually, people will generally have less income to spend (and be worried about the economy and their job), and so they won't be able to afford higher prices (or just tighten up spending due to fear).  Then businesses will either lower their prices, reducing inflation, or they'll go out of business.  If businesses go out of business, that gets us into a recessionary trend, and then ltg bonds will do well, right?

[MachineGhost]

Individually, people will generally have less income to spend, and so they won't be able to afford higher prices.  Then businesses will either lower their prices, reducing inflation, or they'll go out of business.  If businesses go out of business, that gets us into a recessionary trend, and then ltg bonds will do well, right?

Yes, that's correct.  But that's not what happened in the 1970's.  You have to look at context.  It's not a simple black or white issue when it comes to inflation that A = B.  There are many potential sources of inflation manifesting in the economy and there are several causes of inflation as I've tried to outline.  You need to debrainwash yourself of the neostate monetary policy theory.

[jafs]

Right, that's what I'm trying to understand - why that didn't happen, when it seems like the most likely/common sense outcome.

And I wasn't arguing that the government should be able to fix the problem, in fact given the limited tools the Fed uses, it seems like a hard problem for them to deal with to me.

But, given that their approach is likely to be trying to move things in the opposite direction, it's hard to understand how a combination of that plus the stagflation results in ongoing/exacerbated stagflation.

Regardless of the possible causes of inflation, if the economy sucks, that means people don't have a lot of money to spend, which would mean that they can't afford to keep spending more money on things, doesn't it?  Linking wages to inflation doesn't "cause" inflation, it just means that when inflation happens, wages rise with it.  That would mean that people have more money, and can spend it.

But if the economy sucks, there's no way that employers can just keep paying employees more money - they'll undoubtedly wind up laying people off instead.

[MachineGhost]

But, given that their approach is likely to be trying to move things in the opposite direction, it's hard to understand how a combination of that plus the stagflation results in ongoing/exacerbated stagflation.

The Fed was clueless in the 1970's.  You're still operating under some assumption that they knew what they were doing.  Arthur Burns royally screwed up through neglect, then the disastrous Monetarism experiment poured gasoline onto the flames of "baked in the cake" inflation and then Volcker via Regean finally came in and set everyone's head straight by jacking up the FFR to nearly 20% and reeling in fiscal policy.

Read this so you get the full overview of the different explanations for stagflation from different schools of economic thought (not all are correct but most are): https://en.wikipedia.org/wiki/Stagflation#Causes

But if the economy sucks, there's no way that employers can just keep paying employees more money - they'll undoubtedly wind up laying people off instead.

Human behavior is wired in such a way in terms of envy that rising prices induces people to spend and hoard, other people notice this activity and spend and hoard also, repeat, and all this spending and hoarding makes people think All Is Well from the dopamine boost.  This is how New Keynesianism views "stimulating the economy".  It's a drug fix.  Throw in guaranteed wage increases each year and its very easy to mask a stagnant economy if you personally feel like you're not the one losing out.  People are also slow to react to higher inflation because they don't think in real terms, only nominal.  Frog in boiling water syndrome.  If you still don't understand, I pass the torch to someone else.

[jafs]

Ok, so it looks like it started with high oil prices.  But, again, when prices go up, if people don't have a lot of money, they'll adjust their spending habits (although lots of stuff uses/needs energy).  So maybe people bought a lot less, and that pushed the economy downwards,

And, then, because we were heading towards a recession, the government did what it would normally do and lowered rates to stimulate the economy.

All that makes sense to me.

What still doesn't make sense is how the combination of a slow economy and high inflation can possibly persist over time.

Ah, you're saying that people act in exactly the opposite way that common sense would indicate, that when prices rise, they adjust their spending accordingly downwards.  That's possible - the myth of a rational consumer is just that, a myth, clearly.  But all of that spending does in fact stimulate an economy, so the economy should be getting better, not stagnating.

Unless the wages tied to inflation are the real problem - but that's hard for me to accept, given that I think people should get paid enough to live on, and I don't like the "squeeze" that inflation causes if wages don't rise.

Thanks for your efforts.

Interestingly, if you're right, then the idea that the markets will self-correct is off as well, given the lack of rationality of consumers/market participants.

So maybe the answer is that people don't act rationally, and in addition the government has limited tools to employ.  Clearly, by lowering rates they were more concerned about employment than inflation, and in the end the other approach worked better (but at the cost of a bunch of jobs).

Rather than blaming the government for that, I'd probably conclude it would be better for people to act more reasonably in the first place 

[sophie]

Note that even the retrospectoscope doesn't help us figure out exactly why stagflation occurred.

Given that, what do you think the chances are of accurately predicting what's going to happen in the next 5-10 years?  (Accurate = better than random chance.)  Probably zero, is my guess.

There's nothing wrong with a stock/bond portfolio, as long as you realize that it is quite possible for it to experience negative real returns over as much as a 10 year period.  And none of us can know if the next negative-return 10 year period will start tomorrow.

[MachineGhost]

I had a new thought.  Stagflation is the larval form of hyperinflation.  It's where the productive capacity of the capitalist economy is impeded but not outright destroyed as is the case of the latter.  Historically, only war, economic sanctions, Preatorian corruption and Communist takeovers can cause hyperinflation.

Since oil is "Black Gold" and the "lifeblood of capitalism", restricting its supply is Very, Very, Very Bad.  I suppose it could be done to the point of absolute nullification of the West, but Nixon came up with the secret Petrodollar Hegemony Pact with Saudia Arabia to soothe them.

Also, compared to the 1970's, oil is a much smaller percentage of costs today.  To even approach the previous oil peaks, oil would have to first cross $187 a barrel in today's money then go up enough additionally to take the percent bite out of revenues that it did in the 1970's.

[MachineGhost]

The "stagflation" of the 1970's is the single best example of why holding gold is useful.  All portfolios with < 20% gold had negative real returns during that period.  It's all there in Tyler's charts.

Are you 100% sure about that?  Because the Browne Minimum Risk portfolio wouldn't have succeeded if that was the case.

Following up on this, I think I see a flaw in Tyler's pixels charts.



The vertical years do not match the horizontal, i.e. 1972 year 2 does not match 1973 and so on.  Or am I misreading it wrong and the intention is to show sequence of returns risk?  If the latter, sophie is right after all.  Crikey!!!  Isn't that what did budd in???  I'm ready to kill myself now.

I do get different results depending on how the inflation is calculated.  Simba uses CPI yoy December end of period, but you could use the month when rebalancing occurs (March) or use an average for the year in question or an average of the trailing 12 months.  No easy answer, but unfortunately, I think any real return portfolio now needs to be robust to at least four different ways of calculating inflation.

[rickb]

The vertical years do not match the horizontal, i.e. 1972 year 2 does not match 1973 and so on.  Or am I misreading it wrong and the intention is to show sequence of returns risk?  If the latter, sophie may be right after all.  Crikey!!!

I'm fairly sure each row of the chart is showing the CAGR of an investment started in the year indicated and held for the indicated number of years.  So 1972 year 2 is showing the (annualized) CAGR of an investment made in 1972 and held for two years - as opposed to 1973 year 1 which shows the CAGR of an investment started in 1973 and held for 1 year.  The basic point of these kinds of charts is that they show how long you need to hold an investment until your CAGR approaches "normal". 

[MachineGhost]

The vertical years do not match the horizontal, i.e. 1972 year 2 does not match 1973 and so on.  Or am I misreading it wrong and the intention is to show sequence of returns risk?  If the latter, sophie may be right after all.  Crikey!!!

I'm fairly sure each row of the chart is showing the CAGR of an investment started in the year indicated and held for the indicated number of years.  So 1972 year 2 is showing the (annualized) CAGR of an investment made in 1972 and held for two years - as opposed to 1973 year 1 which shows the CAGR of an investment started in 1973 and held for 1 year.  The basic point of these kinds of charts is that they show how long you need to hold an investment until your CAGR approaches "normal".

Yes, that makes sense.  I spent too much time at this, but I found the margins below which the sea of red appears.  They are:

Stocks 13%
TBonds 11%
Gold 17%
ST Treasuries 59%

The above has the least risk in terms of red squares and beating inflation.  Two maximum red in a row and was in 1977.  I really doubt Browne new about this risk variable back in 1987 but what an awesome work of art.  I'm blown away.  Why would anyone invest in any other portfolio once you look their sea of red?!!  Only Swedroe comes close to duplicating the PP and that's just after the fact curve fitting anyway.

[buddtholomew]

Looks like it's LTT's now. Sure makes the PP look obsolete doesn't it?

So much for it being a rising dollar issue. Dollar is down 1.5% and gold is up pennies.

[rickb]

I really doubt Browne new about this risk variable back in 1987 but what an awesome work of art.  I'm blown away.  Why would anyone invest in any other portfolio once you look their sea of red?!!  Only Swedroe comes close to duplicating the PP and that's just after the fact curve fitting anyway.

Because other portfolios have a higher "expected" CAGR and people investing in these portfolios either (in decreasing order of probability)

a) have never seen this kind of chart or don't understand what they say

b) don't understand that the higher expected CAGR may well not materialize for them for 15 or 20 years

c) do understand, but think a 80-90% chance of achieving a higher CAGR (in, say, 5 years) is worth the downside risk (i.e. believe that they won't be the unlucky ones who will be on the short end of the stick for 15-20 years)

d) do understand, and are investing money they won't need for 15-20 years

[sophie]

Yes, that makes sense.  I spent too much time at this, but I found the margins below which the sea of red appears.  They are:

Stocks 13%
TBonds 11%
Gold 17%
ST Treasuries 59%

The above has the least risk in terms of red squares and beating inflation.  Two maximum red in a row and was in 1977.  I really doubt Browne new about this risk variable back in 1987 but what an awesome work of art.  I'm blown away.  Why would anyone invest in any other portfolio once you look their sea of red?!!  Only Swedroe comes close to duplicating the PP and that's just after the fact curve fitting anyway.

Time well spent MG!!  Thanks for doing this.  17% gold sounds about right, based on what I'd seen reading Tyler's charts.  I expect none of this would surprise Harry Browne, may he RIP.  He ran simulations also- I think not just backtesting but actual model scenarios.  He probably ended up with the 25x4 for simplicity and figured it wasn't too far off.

Because other portfolios have a higher "expected" CAGR and people investing in these portfolios either (in decreasing order of probability)

a) have never seen this kind of chart or don't understand what they say

b) don't understand that the higher expected CAGR may well not materialize for them for 15 or 20 years

c) do understand, but think a 80-90% chance of achieving a higher CAGR (in, say, 5 years) is worth the downside risk (i.e. believe that they won't be the unlucky ones who will be on the short end of the stick for 15-20 years)

d) do understand, and are investing money they won't need for 15-20 years

The way I see it, if your time horizon is truly 15-20 years, why mess around with any asset allocation portfolio?  Just put everything in stocks.  I've been figuring that once I've saved enough in the PP to cover basic living expenses, I might happily plow the rest into stocks - either bought directly or via index funds.

[jafs]

It seems extremely counter-intuitive that a very cash heavy portfolio would be the best way to beat inflation.