Why Investors Should Fear The Permanent Portfolio

[moda0306]

Bongleur,

Those higher-rate 20's are now a more valuable asset than they were because rates have dropped while you've held them.  Considering their high current value, trading them in for the same value of 30's will be better inflation protection, even if you look at it as being at a lower rate.... the effective rate of your 20's based on their values are exactly what 20's are going for today fresh on the market.

[Bongleur]

The bull market in bonds is probably over...

Why do you say that?

IMO long term rates will not continue to decline towards zero for another 30 years.  They might get down to near zero in the near future, but over the long term they will trend up, barring some systemic upheaval that makes it all moot.

[MediumTex]

The bull market in bonds is probably over...

Why do you say that?

IMO long term rates will not continue to decline towards zero for another 30 years.  They might get down to near zero in the near future, but over the long term they will trend up, barring some systemic upheaval that makes it all moot.

Why should U.S. investors believe that the U.S. bond market will not follow the same path as Japan?

I would argue that the systemic upheaval has already occured in the form of the 2008 financial panic.  What we are seeing now are just the continuing effects of a broad and powerful secular deleveraging trend that can push down bond yields for decades, which is what has happened in Japan.

[stone]

Bongleur, don't you think it is possible that LTT but also gold and stocks will be stuck in a trading range for decades to come? LTT yields may oscillate between 6% and 2%, gold may oscillate between twice the cost of digging it out of the ground (its current price?) and 30% of the cost of digging it out of the ground (as in the late 1990s) and stocks may oscillate between the Schiller cyclically adjusted  price to earnings ratio of 24 (current price?) and CAPE of 7 or whatever it was in 1982. In such a scenario the only  PP investment gains (or loss avoidance) available might be re-balancing  gains. LTT, gold and stocks all move down in unison less often than stocks and gold do. That's why I find LTT attractive within the PP, not because I have some blind faith that LTT yields will certainly follow a Japanese course of dropping to l%.

[AdamA]

Bongleur, don't you think it is possible that LTT but also gold and stocks will be stuck in a trading range for decades to come? LTT yields may oscillate between 6% and 2%, gold may oscillate between twice the cost of digging it out of the ground (its current price?) and 30% of the cost of digging it out of the ground (as in the late 1990s) and stocks may oscillate between the Schiller cyclically adjusted  price to earnings ratio of 24 (current price?) and CAPE of 7 or whatever it was in 1982. In such a scenario the only  PP investment gains (or loss avoidance) available might be re-balancing  gains.

I think that's a very good perspective to have.  Many people are waiting for the drama of 2008 to repeat itself in some form.  The more boring scenario that you are suggesting is, IMO, more likely.

[Bongleur]

Why should U.S. investors believe that the U.S. bond market will not follow the same path as Japan?

I would argue that the systemic upheaval has already occured in the form of the 2008 financial panic.  What we are seeing now are just the continuing effects of a broad and powerful secular deleveraging trend that can push down bond yields for decades, which is what has happened in Japan.

OK, bond yields stable.  Same result; no gains from roll yield.  So when doing historical backtesting you still need to somehow subtract out the roll yield gains to guess at forwards total return.  But better than taking a loss with every roll.

[Bongleur]

>Bongleur, don't you think it is possible that LTT but also gold and stocks will be stuck in a trading range for decades to come?
>

Crystal ball hazy... I'm waiting for the next Presidential election, I guess.  If both parties stand pat, then the Treasury will have to pay the debt out of current tax receipts, and delay paying Govt salaries & entitlements.  I understand they can keep that up until after the next election; in which case those elected will have a very clear mandate about whether to raise revenues or cut the budget.

[MediumTex]

I understand they can keep that up until after the next election; in which case those elected will have a very clear mandate about whether to raise revenues or cut the budget.

A clear mandate?

You mean like Obama had a clear mandate for "change" in 2008?

...and nothing changed. 

[Bongleur]

Either the "I'll raise taxes" guy will get elected, or the "I'll cut the budget" guy.

[WildAboutHarry]

0% p.a. if 20 year yield (in ten years time) is 8%
5% p.a. if the yield curve remains much the same as they are now.
7.3% p.a. if 20 year yield (in ten years time) is 2%.

Clive,

Thanks for this.  I've been thinking about the workings of the LTT component, especially the fund versus individual bond aspect.  My preference is for holding individual bonds.

The only permanent portfolio asset you must trade is the long-term bond component, assuming you are holding individual Treasuries and replace at 20 years.  I'm wondering if the conveniences of TLT (no need to do any bond trading, easy reinvestment of interest, etc.) argue against holding individual bonds.  I assume the results of TLT in the scenarios you describe above would approximate the results of individual bonds.

[stone]

In the UK, bonds are listed on the LSE alongside stocks and ETFs so it seems just as convenient to buy a UK 50 year gilt as to buy an ETF. It's weird if US bonds are sold in an awkward to access manner. If so, why?

[WildAboutHarry]

In the UK, bonds are listed on the LSE alongside stocks and ETFs so it seems just as convenient to buy a UK 50 year gilt as to buy an ETF. It's weird if US bonds are sold in an awkward to access manner. If so, why?

US Treasury Bonds are easy to buy, especially at auction.  Many brokerages offer free or low-cost access to Treasury auctions, and of course Treasury Direct doesn't charge to participate in auctions.

Selling is easy, too, but costs for small lots can be relatively high (commissions, bid/ask spreads, etc.).

In holding individual bonds you also have to deal with disposition of coupon payments, etc.  ETFs or bond funds do simplify most aspects of bond ownership.

And what Clive said

[Bongleur]

0% p.a. if 20 year yield (in ten years time) is 8%
5% p.a. if the yield curve remains much the same as they are now.
7.3% p.a. if 20 year yield (in ten years time) is 2%

type risk/reward NOMINAL amounts. Assuming equal chance of each, then the average is just over 4% (i.e. much the same as the 30 year recent yield value).

That's the sort of calculation one must do & then stay the course for the decision.  Of course, Swedroe would say to buy the short term bond for the least variable result and "take your risk on the equity side."

>according to Simba's backtest spreadsheet...

I have no confidence in that history because of the fundamental change in the roll yield vs all those past years.

[stone]

Carl "On the LTT plus side, LTT's move (more) counter direction to stocks which helps smooth the volatility, but that's typically a relatively short lived characteristic and affects paper values only (excepting perhaps if the move is large enough to trigger a add-low/reduce-high type rebalance gain/benefit)."

I've wondered whether it makes more of a difference over time if the PP user is someone who adds to the PP say every couple of months for thirty years, then incrementally draws down the PP every couple of months for thirty years. For such a person getting the portfolio in balance by just adding to the lagging asset would be a constant process and so short term volatility could be fully harvested.

I agree that someone who was purely conveying a PP through time and never paying in or taking out might never benefit from much of that short term volatility. But, even for such a person, those occasions  where a stock crash/boom triggered a re-balance could prove deceptively important. A 50% loss needs a 2x gain to get even and a 75% loss needs a 4x gain to get even. A central bank decision to hike interest rates could, as you say, make the LTT add to the problem  but then again, in a more traditional stock market crash, the LTT really help. 

LTT are the lowest risk investment for someone with an investment horizon extending to the duration of the LTT.  If you wanted to know how much savings you would have in 20years time, then a LTT  would give you a more certain answer than short term bonds. From that perspective having short term bonds only could be interpreted as gambling that interest rates will rise. To my mind, the steepness of the yield curve says that there is a lot of presumption that interest rates will rise already priced in. So not holding LTT becomes a gamble that interest rates will rise more than the market thinks they will.

[pershing83]

Since I hold a lot of PRPFX and read all this every day (it's sometimes a bit to difficult for my taste) thought you all would enjoy this column by Mark Hulbert, I have always liked him:

http://www.marketwatch.com/story/invest ... 2011-02-11

[doodle]

Clive, I have really gone back and forth regarding the five year ladder vs. barbell strategy. I wish I could come to a conclusion but I am sort of paralyzed halfway between the two.

There are some issues in my mind that come to the table that prevent a rise in interest rates. Mostly, the issue is that I don't believe that the United States economy is capable of sustaining a rise in rates without truly calling into question the stability of the whole system. A sustained rise in rates to 12 percent with a slow trickle down would likely bury our country under such a mountain of debt as to call into question the continued viability of our country as we know it.

Under the scenario of a protracted rise in rates I think the question wouldn't matter between 5 year ladder and barbell. I think at that point you would be looking to get out of the dollar entirely because it would be a doomed currency. Higher rates would destroy any economic recovery, gut the housing market further, balloon our debt to unmanageble proportions etc. etc. It would really be a nightmare scenario for the US and greater world economy.

I think that rates have to be locked into the low end because there really is no alternative short of economic chaos.

[stone]

Carl what you are saying does make me more comfortable with the situation that my household has where my better half likes cash so we have 82% cash: 6%LTT: 6%gold: 6%stocks. I have to live with the 82% cash allocation. I could increase it but not decrease it. Your anxieties about LTT make sense but as you say could also apply to gold and stocks. I initially did dither about whether to swap some of the LTT allocation to being "emerging market local currency debt" but in the end instead swapped some of the stock allocation to being emerging market so as to quell my fears about having gold as the main link to the global rather than local economy. For me the generally negatively correlating short term volatility of the LTT really does seem attractive. I'm generally pessimistic about LTT but equally pessimistic about cash, gold and stocks!

[stone]

Doodle, could high taxes targetted at the rich enable high interest rates to coincide with reducing debt? Perhaps the economy just needs taxes to be shifted from the less well off to the more wealthy in order to get enough consumption for things to boom. Taxing the very rich might not impair economic growth but potentially could provide lots of tax $ (just have levels of tax for the richest 1% as they were in the 1960s)?

I'm not saying that there is the faintest possibility of the above scenario coming into place. My crystal ball looks much as you describe.

[doodle]

Stone,

I think that prolonged high interest rates would be unsustainable from the standpoint of our budget. If you look at the breakdown of the debt:
http://www.treasurydirect.gov/govt/repo ... 062011.pdf

You can see that the majority is held in bills and notes (and I think I have heard that it is at the shorter end of the notes). Less than ten percent is held as bonds. Overall, I think the figure I hear being tossed around is that financing our debt costs about 250 billion dollars a year at present interest rates.

Now if interest rates were to rise on average from their present levels to around 6 percent this would balloon our debt payments to something approximating the size of our military budget. If this happens for a sustained period I think it is game over. There is no way the US can come through something like that without a restructuring event of some kind.

I don't think it matters where taxes are hitting at that point.

[doodle]

I really like Jim Rogers approach to this.

He is heavily long commodities, short emerging markets (as a hedge) and long various currencies.

I would imagine it would be some breakdown like:

40% commodities

20% short Emg Mkts

40% currencies


His viewpoint is that if things get better commodities will go up with increased demand. If things get worse commodities will go up because central banks will continue to print more money.

The short Emg. Mkts. are a hedge that function inversely to commodity prices but are more volatile.

If you look at EUM vs. DBC you can see the inverse correlation.

Anyways, if things get terrible and no more money printing happens I think you can look at the collapse in commodities in 2009 for guidance and you will see that they declined about 30% from present values. Of course if the world economy goes back into a tailspin you will see that emerging markets will also tank driving up the value of his shorts.

One nice thing about commodities is that unlike treasuries or paper currency they will never go to zero.

Interesting portfolio.

[doodle]

The one worry with commodities is that higher prices create more supply. Jim Rogers is convinced that supply wont arrive more many more years....prolonging the bull market. I need to do the research to feel comfortable.

Does anyone here have experience with researching commodity supplies?

I have read that more and more people in poorer nations around the world are gold prospecting. My father is actually working on a huge mining product in South America right now that will come online in a few more years. I wonder how much supply is getting ready to come on market due to these higher prices....

[doodle]

Looks like we need the impossible to happen shortly: http://www.cnbc.com/id/43765730

[stone]

Doodle, the problem with those commodity index funds is that they suffer very badly from front running because they roll the futures over at specified times. My hope is that holding gold would provide much of the protection that people hope will come from holding commodities. I do take your point that gold price is probably more extended above its extraction cost that many other commodities perhaps giving it a long term headwind unless gold mines get exhausted.

Personally, I would never save in agricultural commodities because it seems to have caused mispricings that have starved people eg:
http://www.independent.co.uk/opinion/co ... 16088.html

[doodle]

Stone,

I have the same issue with commodity futures as well about the negative roll issue....(which I think some of the funds have addressed through contango mitigation strategies).

In addition I share your sentiment that if food prices were to skyrocket we would see great political pressure placed on commodity traders who were not interested in physical delivery regardless of whether they were the cause of the price increases or not. I think this is why most of the smart money bought Agricultural land many years back because it avoids this conflict....they make their profit being part of the solution rather than part of the problem.

I posted the attached below that indicates that what we are going through is nothing new...and we have muddled through before. My main concern however is whether the world gets to a point where the debt becomes so overbearing that things just start to break down. Eventually there is a point where it is more difficult to hold things together than to just destroy and move forward in a new way. Brazil was a recent example of this where the Real replaced the Cruzeiro which had become a currency which no one trusted and was undergoing heavy deflation.

What ever happened to this??
http://en.wikipedia.org/wiki/Gramm–Rudm ... Budget_Act

It seems like we have been here before....

It is 1985, and the president has just been re-elected. The deficit has been rising through his first term, despite his annual promises to cut it. Rising also are the trade deficit and dependence on foreign capital. Congress is alarmed but undisciplined. As for the president, the deficit is his second priority. His first priority is everything else—especially avoiding tax increases, increasing security spending, and protecting entitlements.

His method of squaring the circle is to propose reductions in one narrow portion of the budget, domestic discretionary spending. Most of these cuts are too politically sensitive to pass Congress, especially when other parts of the budget and taxes are fenced off; and in truth, the president does not seem particularly interested in getting them passed. He and members of Congress all protect their agendas, and the deficit takes the hindmost.

In September of 1985, three senators—Phil Gramm, R-Texas; Warren Rudman, R-N.H.; and Ernest Hollings, D-S.C.—unexpectedly offer the ugliest, stupidest bill anyone has ever seen. It proposes to set declining annual deficit targets and impose primitive across-the-board cuts ("sequestration"), as needed, to reach the goals. Rudman calls the measure "a bad idea whose time has come."

[stone]

doodle, I get shifty whenever any economic outcome gets touted as a sure fire certainty. I agree that low interest rates are possibly here to stay but that is very different from saying that they are certainly here to stay. Establishing that high interest rates would make the debt unaffordable is actually not entirely straightforward with a fiat currency. If money is not spent then it is just electronic numbers. I agree that high interest rates might mean that debt ceilings would have to be raised. Also I'm not sure what the potential is for a tax on wealthy Americans to reduce the debt. What are the rough numbers for outstanding holdings of equities, commercial bonds, treasuries and real estate of US citizens? I'd imagine taxing 5% of that value per year would take a sizable chunk out of the government debt (would that 5% amount to a couple of trillion USD per year?).