PP: can I skip the stocks?

[melveyr]

I was thinking about your situation while I was doing laundry.

I think I would have a PP for my personal account (total stock market and all). With your business though, any cash that it still part of the business entity could be a mix of money market, GLD/IAU, and TLT.

I think this is a nice clean way of separating the VP from the PP.

I commend you for trying to hedge your business equity! It's definitely something that would be foolish to ignore when setting up your portfolios.

[MediumTex]

I develop and sell entertainment software. My income is highly dependent on discretionary spending. If the economy does badly, my income will do badly. If the economy does well, my income will do well.

It seems to me that you are in the same boat as 50% or more of Americans.

Being dependent upon discretionary spending seems like something that virtually all Americans (including state and local governments) are grappling with.

[Sleeping at the Wheel]

An inflationary scenario suggests that prices would be rising.  Wouldn't rising prices be a good thing for your business?

Not if the dollar is worth less and nobody is buying. The US had both inflation and a recession in the 1970s. I think there's a pretty good chance we'll see it again.

Not likely.  In the 1970s there was upward wage pressure to accompany rising prices.  That's what facilitated the rising prices.  If wages hadn't also been growing (in nominal, not real terms, of course), price increases would have quickly triggered waves of demand destruction as people simply ran out of money to buy the higher priced goods.

This time around, we find an American work force that hasn't seen significant wage gains (in nominal OR real terms) in many years.  Going forward, any upward pressure on U.S. wages is likely to lead to more offshoring of jobs, as opposed to durable domestic wage gains.  Does that look like an environment in which sustained inflation would get any traction?  Where are consumers going to get the money to pay the higher prices?  Answer: they won't.  They will pay higher prices for gas and food, and they will make corresponding cuts in other areas, which on balance will translate into a weak macroeconomic demand picture, even though there will be pockets of inflation.

Remember, too, that we are in the midst of a generational deleveraging event right now, which also tends to place strong downward pressure on prices simply because of structural weakness in demand (households are paying off debt and not taking on more, which means less money for discretionary spending).

I agree with this. If the Fed did nothing and let the market set interest rates, the US would probably go through a deflationary spiral. Interest rates would go up, causing asset prices to drop, causing more borrowers to go underwater, causing more desperate deleveraging and distressed selling, causing yet more asset price drops as well as a further contraction of the money supply, and so on.

The 1930s are a much better analog than the 1970s, if you are looking for something in history as a guide to where we are right now.

The US could certainly go down this path.

Another possibility is following Japan, where a big government response kept the contraction down (but arguably also hindered an eventual recovery).

A third possibility is that the Fed and the government get really aggressive, keeping interest rates at a minimum, pumping money into the system via all sorts of Fed purchases, and running massive deficits. This could easily lead to inflation or worse, but without necessarily fixing the underlying recession.

There are also some more pleasant possibilities. Maybe the government can stimulate the economy just enough to kick-start a gradual recovery, and then sets about cleaning up the deficits and the money supply.

I think it's nearly impossible to know what is going to happen next. It's complicated, and it also depends on what people will do. This is what attracts me to the PP - rather than trying to guess what will happen, it's probably best to just prepare for everything.

[MediumTex]

I think it's nearly impossible to know what is going to happen next. It's complicated, and it also depends on what people will do. This is what attracts me to the PP - rather than trying to guess what will happen, it's probably best to just prepare for everything.

When thinking about an effective hedging strategy for your business, however, it doesn't seem like inflation is something that is a serious risk, since inflation suggests that companies have at least some pricing power, which would be good for you as a business owner.

Deflation, however, is something that you would want to protect yourself against, since deflation implies falling prices, weak demand, tight credit, etc., all of which could be very harmful to a small business.

Of course, if you perceive inflation and deflation to be equally dangerous to your business, then I would say a VP consisting of long term treasuries and gold should do the trick.

BTW, welcome to the site.  Always nice to see new people and perspectives.

[Sleeping at the Wheel]

I was thinking about your situation while I was doing laundry.

I think I would have a PP for my personal account (total stock market and all). With your business though, any cash that it still part of the business entity could be a mix of money market, GLD/IAU, and TLT.

I think this is a nice clean way of separating the VP from the PP.

Yes, that's a nice way to think about it. This way the business can keep "paying" me.

The question is how the VP should look. TLT makes sense. Gold makes sense. Does cash make sense?

In other words, are there scenarios where discretionary spending is down, bonds are down, and gold is down?

I commend you for trying to hedge your business equity! It's definitely something that would be foolish to ignore when setting up your portfolios.

[Sleeping at the Wheel]

I develop and sell entertainment software. My income is highly dependent on discretionary spending. If the economy does badly, my income will do badly. If the economy does well, my income will do well.

It seems to me that you are in the same boat as 50% or more of Americans.

Being dependent upon discretionary spending seems like something that virtually all Americans (including state and local governments) are grappling with.

Yes, true.

[cabronjames]

@sleeping

You could have an orthodox PP, & a VP without stocks - bond, gold, cash.  The PP should be the majority (definitely > 50%) of the PP + VP total.

Maybe this approach would give you comfort of setting up your investments in a PP-way right now, despite being a stock bear right now.

In the future, if you are more comfortable with stocks, you could merge the VP into your PP, sell the leading non-stock asset, & buy up more stock to rebalance.

Just remember the rule, that you can take VP funds & put them in the PP, but never visa-versa.

[Sleeping at the Wheel]

I think it's nearly impossible to know what is going to happen next. It's complicated, and it also depends on what people will do. This is what attracts me to the PP - rather than trying to guess what will happen, it's probably best to just prepare for everything.

When thinking about an effective hedging strategy for your business, however, it doesn't seem like inflation is something that is a serious risk, since inflation suggests that companies have at least some pricing power, which would be good for you as a business owner.

Inflation itself isn't a risk for a business, but it does destroy long-term fixed rate bonds. So, if you have both inflation and a depression, then business will be bad and the long term bond won't work as a hedge.

Deflation, however, is something that you would want to protect yourself against, since deflation implies falling prices, weak demand, tight credit, etc., all of which could be very harmful to a small business.

Absolutely.

Of course, if you perceive inflation and deflation to be equally dangerous to your business, then I would say a VP consisting of long term treasuries and gold should do the trick.

That leave the question of whether these two together can cover all of the bad cases.

BTW, welcome to the site.  Always nice to see new people and perspectives.

Thanks. This looks like a great forum, I found some really good stuff in the archives.

[Sleeping at the Wheel]

@sleeping

You could have an orthodox PP, & a VP without stocks - bond, gold, cash.  The PP should be the majority (definitely > 50%) of the PP + VP total.

Maybe this approach would give you comfort of setting up your investments in a PP-way right now, despite being a stock bear right now.

In the future, if you are more comfortable with stocks, you could merge the VP into your PP, sell the leading non-stock asset, & buy up more stock to rebalance.

Just remember the rule, that you can take VP funds & put them in the PP, but never visa-versa.

Yes, I like this structure. The one question now is if the VP also needs cash, or if 50% gold, 50% bonds is enough.

[MediumTex]

When thinking about an effective hedging strategy for your business, however, it doesn't seem like inflation is something that is a serious risk, since inflation suggests that companies have at least some pricing power, which would be good for you as a business owner.

Inflation itself isn't a risk for a business, but it does destroy long-term fixed rate bonds. So, if you have both inflation and a depression, then business will be bad and the long term bond won't work as a hedge.

Inflation and a depression.  How would that work in a reserve currency economy like the U.S.?

What is driving the inflation if the economy is in a depression?

Inflation presupposes a certain baseline of economic activity and nominal expansion of the economy, right?

I think you are imagining a 1970s-style economic environment which is, to me, extraordinarily unlikely, primarily because there is simply no mechanism for the nominal wage gains that would be necessary for an inflationary spiral to get any traction in the first place.  There is also not the pent up inflationary pressures today that were released in the 1970s through the twin blows of going off the gold standard and enduring two energy shocks.

Take a look at historical periods following the bursting of credit-fueled asset bubbles.  They are not inflationary.

With all that said, this time may be different, and the PP positions you well for whatever may come along.  If I were you I would probably just put most of my money into a traditional PP and focus on running my business as well as I could.

[cabronjames]

@sleeping

You could have an orthodox PP, & a VP without stocks - bond, gold, cash.  The PP should be the majority (definitely > 50%) of the PP + VP total.

Maybe this approach would give you comfort of setting up your investments in a PP-way right now, despite being a stock bear right now.

In the future, if you are more comfortable with stocks, you could merge the VP into your PP, sell the leading non-stock asset, & buy up more stock to rebalance.

Just remember the rule, that you can take VP funds & put them in the PP, but never visa-versa.

Yes, I like this structure. The one question now is if the VP also needs cash, or if 50% gold, 50% bonds is enough.

The VP by definition can be whatever you wish.  It would be OK for your VP to be 50% each gold, bonds.

cash can be referred to as the non-volatile asset, it will not go up or down much in a year in real CPI adjusted terms.  OTOH, stock, gold, & bonds are each volatile, can easily be +-30% real in a year.

[Sleeping at the Wheel]

When thinking about an effective hedging strategy for your business, however, it doesn't seem like inflation is something that is a serious risk, since inflation suggests that companies have at least some pricing power, which would be good for you as a business owner.

Inflation itself isn't a risk for a business, but it does destroy long-term fixed rate bonds. So, if you have both inflation and a depression, then business will be bad and the long term bond won't work as a hedge.

Inflation and a depression.  How would that work in a reserve currency economy like the U.S.?

What is driving the inflation if the economy is in a depression?

Inflation presupposes a certain baseline of economic activity and nominal expansion of the economy, right?

Inflation could just come from a huge expansion of the money supply.

I understand that the Fed doesn't directly control the money supply. Borrowing is needed to grow the money supply, and borrowing does depend on some baseline of economic activity.

It seems to me, though, that if the Federal reserve is aggressive enough, we could have inflation and a recession at the same time. And it also seems to me that they are going to be quite aggressive.

I think you are imagining a 1970s-style economic environment which is, to me, extraordinarily unlikely, primarily because there is simply no mechanism for the nominal wage gains that would be necessary for an inflationary spiral to get any traction in the first place.  There is also not the pent up inflationary pressures today that were released in the 1970s through the twin blows of going off the gold standard and enduring two energy shocks.

It's true that the current situation is different than in the 1970s. I just brought that up as an example to show that inflation and recession are not automatically exclusive.

Take a look at historical periods following the bursting of credit-fueled asset bubbles.  They are not inflationary.

True. However, in the past governments were quite passive in the face of private sector deleveraging. The guys in control now seem determined to avoid that path.

With all that said, this time may be different, and the PP positions you well for whatever may come along.  If I were you I would probably just put most of my money into a traditional PP and focus on running my business as well as I could.

Yes, I totally agree with this. I just want to set up my passive investments and not have to think about it every time a new QE or debt ceiling discussion rolls around.

[MediumTex]

With all that said, this time may be different, and the PP positions you well for whatever may come along.  If I were you I would probably just put most of my money into a traditional PP and focus on running my business as well as I could.

Yes, I totally agree with this. I just want to set up my passive investments and not have to think about it every time a new QE or debt ceiling discussion rolls around.

The PP would be perfect for what you are looking for.

[Sleeping at the Wheel]

@sleeping

You could have an orthodox PP, & a VP without stocks - bond, gold, cash.  The PP should be the majority (definitely > 50%) of the PP + VP total.

Maybe this approach would give you comfort of setting up your investments in a PP-way right now, despite being a stock bear right now.

In the future, if you are more comfortable with stocks, you could merge the VP into your PP, sell the leading non-stock asset, & buy up more stock to rebalance.

Just remember the rule, that you can take VP funds & put them in the PP, but never visa-versa.

Yes, I like this structure. The one question now is if the VP also needs cash, or if 50% gold, 50% bonds is enough.

The VP by definition can be whatever you wish.  It would be OK for your VP to be 50% each gold, bonds.

cash can be referred to as the non-volatile asset, it will not go up or down much in a year in real CPI adjusted terms.  OTOH, stock, gold, & bonds are each volatile, can easily be +-30% real in a year.

So what is the reason for having cash in the PP?

[Sleeping at the Wheel]

With all that said, this time may be different, and the PP positions you well for whatever may come along.  If I were you I would probably just put most of my money into a traditional PP and focus on running my business as well as I could.

Yes, I totally agree with this. I just want to set up my passive investments and not have to think about it every time a new QE or debt ceiling discussion rolls around.

The PP would be perfect for what you are looking for.

Except that it includes stocks.

At the moment I quite like the idea of PP plus VP with 50% gold, 50% bonds.

[MediumTex]

So what is the reason for having cash in the PP?

Dry powder for rebalancing and protection in the event that all three volatile assets decline, as they did in the early 1980s during the so-called "tight money" recession.

You can do a three asset 33%x3 PP, but it is a bit more volatile and there is no method for the eventual orderly drawdown of the portfolio when you get ready to spend it.

[AdamA]

At the moment I quite like the idea of PP plus VP with 50% gold, 50% bonds.

Would you have liked it in the 1990's?

[Sleeping at the Wheel]

So what is the reason for having cash in the PP?

Dry powder for rebalancing and protection in the event that all three volatile assets decline, as they did in the early 1980s during the so-called "tight money" recession.

You can do a three asset 33%x3 PP, but it is a bit more volatile and there is no method for the eventual orderly drawdown of the portfolio when you get ready to spend it.

Ok, thanks.

[Sleeping at the Wheel]

At the moment I quite like the idea of PP plus VP with 50% gold, 50% bonds.

Would you have liked it in the 1990's?

Absolutely - business would have been great.

[melveyr]

If the Fed ever goes Volcker on us, you are going to want cash. The Fed is free to manipulate as they see fit, and sometimes they manipulate short term rates so far up, that everything else tanks.

With everything else held constant, monetary tightening makes gold, bonds, and stocks less attractive. However, the tightening makes cash more enticing.

Cash definitely plays an important role in the portfolio at key junctures.

[cabronjames]

If the Fed ever goes Volcker on us, you are going to want cash. The Fed is free to manipulate as they see fit, and sometimes they manipulate short term rates so far up, that everything else tanks.

With everything else held constant, monetary tightening makes gold, bonds, and stocks less attractive. However, the tightening makes cash more enticing.

Cash definitely plays an important role in the portfolio at key junctures.

An analysis of 4X25 v 3X33 would make for a great separate thread.  Would love to see Clive analyze this!

Good description melveyr, of the benefits of using the 4X25 HBPP, YES cash

The benefits AFAICT of 3X3, NO cash:
1. slightly higher real return.  I did some calculations on top of Clive's USA, JPN, UK spreadsheet he shared.
Real return for a US PP 1980-2009, 4.89% in 4X25, 5.05% in 3X33

2. Possibly better for holding assets in taxable accounts, using craigr's bond, cash, stock, gold as the priority of which assets to hold in tax-sheltered accounts.  This concern may be eliminated for some individuals via maxing out the yearly limit of I Bond US Saving Bonds.

3. smaller downside in case of currency devaluation wrt other major currencies - say if the US experiences a milder case of Iceland, Argentina, etc, by having only 33% of your allocation in sovereign US debt (bond), vs 50% of your allocation in sovereign US debt (25% bond + 25% cash - even the $1 bill Federal Reserve Note in your wallet is also a sovereign US debt).  I feel that even if the USD remains the primary reserve currency, it may lose "market share" to other currencies.  Many countries in Asia, are making bilateral deals for their bilateral trade (including oil) in which they are no longer using USDs.

[fnord123]

Another reason to not remove stocks from the PP is psychological - let's assume you go ahead and invest in a gold/treasuries/cash non-PP, and over the next two years, both gold and treasuries crash.  Will you wake up one morning and look at your brokerage statement and say, "gosh, my non-PP has lost 25% of its value over the last two years - this is a loser, I'm getting out!"  Of course, gold and treasuries might go on and have a big bull market the day after you get out of them...

The PP theory is that by having stocks in there, if gold and treasuries go down, stocks would likely have gone up, hopefully enough to counterbalance or even outweigh the losses in the other two.  So when you woke up that morning, you would say, "gosh, even after all those market swings, I'm still doing ok with the PP" and not get out of gold/treasuries and into stocks just before stocks start going down and gold/treasuries start going up.

Seeing a portfolio decrease in value is very unpleasant and a big reason people quit an investment strategy wrong time. Seeing my PP continue to do well and maintain a strong CAGR day after day, even in crazy times like the last 7 months, is the best (investment) feeling I've ever had.  I strongly urge you to take into account the emotional aspect of not including stocks in your portfolio and whether it will impact your willingness to stick with your strategy.

[Sleeping at the Wheel]

If the Fed ever goes Volcker on us, you are going to want cash. The Fed is free to manipulate as they see fit, and sometimes they manipulate short term rates so far up, that everything else tanks.

With everything else held constant, monetary tightening makes gold, bonds, and stocks less attractive. However, the tightening makes cash more enticing.

Cash definitely plays an important role in the portfolio at key junctures.

Yes, that's a good point.

An analysis of 4X25 v 3X33 would make for a great separate thread.  Would love to see Clive analyze this!

Good description melveyr, of the benefits of using the 4X25 HBPP, YES cash

The benefits AFAICT of 3X3, NO cash:
1. slightly higher real return.  I did some calculations on top of Clive's USA, JPN, UK spreadsheet he shared.
Real return for a US PP 1980-2009, 4.89% in 4X25, 5.05% in 3X33

2. Possibly better for holding assets in taxable accounts, using craigr's bond, cash, stock, gold as the priority of which assets to hold in tax-sheltered accounts.  This concern may be eliminated for some individuals via maxing out the yearly limit of I Bond US Saving Bonds.

3. smaller downside in case of currency devaluation wrt other major currencies - say if the US experiences a milder case of Iceland, Argentina, etc, by having only 33% of your allocation in sovereign US debt (bond), vs 50% of your allocation in sovereign US debt (25% bond + 25% cash - even the $1 bill Federal Reserve Note in your wallet is also a sovereign US debt).  I feel that even if the USD remains the primary reserve currency, it may lose "market share" to other currencies.  Many countries in Asia, are making bilateral deals for their bilateral trade (including oil) in which they are no longer using USDs.

Gold tends to overreact to the dollar. If the dollar weakens, gains in gold could easily more than compensate.

Maybe it also makes some sense to diversify into several currencies.

[Sleeping at the Wheel]

Another reason to not remove stocks from the PP is psychological - let's assume you go ahead and invest in a gold/treasuries/cash non-PP, and over the next two years, both gold and treasuries crash.  Will you wake up one morning and look at your brokerage statement and say, "gosh, my non-PP has lost 25% of its value over the last two years - this is a loser, I'm getting out!"  Of course, gold and treasuries might go on and have a big bull market the day after you get out of them...

In theory I would wake up and say, "Ok, I constructed my portfolio partly as a hedge against bad times. Fortunately they didn't come. The small investment loss is a small price to pay."

The PP theory is that by having stocks in there, if gold and treasuries go down, stocks would likely have gone up, hopefully enough to counterbalance or even outweigh the losses in the other two.  So when you woke up that morning, you would say, "gosh, even after all those market swings, I'm still doing ok with the PP" and not get out of gold/treasuries and into stocks just before stocks start going down and gold/treasuries start going up.

Seeing a portfolio decrease in value is very unpleasant and a big reason people quit an investment strategy wrong time. Seeing my PP continue to do well and maintain a strong CAGR day after day, even in crazy times like the last 7 months, is the best (investment) feeling I've ever had.  I strongly urge you to take into account the emotional aspect of not including stocks in your portfolio and whether it will impact your willingness to stick with your strategy.

Sure, but there is also another psychological aspect. If you're overhedged against bad things, you don't mind as much when they are happening. A few years ago I got a bunch of gold. Not enough that I would cheer for bad news, but enough to make it easier to take.

[AdamA]

Not enough that I would cheer for bad news, but enough to make it easier to take.

That's the feeling that I get from owning the PP as a whole.