Japan PP performance after its stock market crashed

[LNGTERMER]

An interesting observation from Clive's spread sheet posts is that the PP lagged in the aftermath of it's stock market crash. The reason is that when prosperity ended there was no other asset to take its place. That seems to contradict a basic thesis of the PP that assets are not correlated and are in some what inversely related. While gold and bonds did not certainly crash they dropped by about 10% each. Does that mean money went outside the country?
What would happen here in the US in a similar circumstances? Or is that even possible here in the US?

Here are the four basic categories, that supped to be sort of mutually exclusive:
  1. Prosperity
  2. Inflation
  3. Deflation
  4. Recession

[SmallPotatoes]

I prefer a Total World Stock fund to insure against just such a circumstance. As long as money stays in the WORLD I'm covered. I realize PP purists will turn their noses up at my remark, but HB advocated Swiss Francs and overseas bank vaults, so can I really be that backwards to choose TW over Domestic TSM?

[LNGTERMER]

It seems HB is implicitly implying that these 4 periods cannot simultaneously coexist and hence he devised these 4 clever assets. I thought at least in the case of Japan their bonds would have gone up. So, what I am asking is, is the situation HB observed kind a unique to the US since the dollar is a world reserve currency? If not I would agree that perhaps a world index would be appropriate instead of the domestic total stock market index.

[LNGTERMER]

I thought, the reason HB advocated buying the PP within the markets of your home country is that investors may shift funds between assets. At least I thought that is what he was hinting at. Here in the US the economy is quit large with respect to the rest of the world so until now it seems investors did not shift funds outside the country and that long term LT which is backed by the credibility of the US government served as a haven in testing economic times.  If we start using a world index instead then at least in my judgment that would decouple the LT from that index.

Edit:
I see Clive has just posted a reply during my post, I'll see how these questions change.

[LNGTERMER]

Thanks Clive, I still have a few questions that actually go into what HB was thinking. I will formulate them later in the day.
Stay tuned 

[LNGTERMER]

But the underline concept generally holds, some funds in real assets (gold, commodities, property), some in paper investments (stocks, bonds) and some cash is overall likely to have a relatively smooth ride as a collective set, whilst likely pacing inflation with a bit of additional growth on top.

Sure, this seem to be inline with the HBs' PP philosophy, however, I am concerned with the Japan case. Is it an anomaly or an important cautionary tail against the PP itself? It would be nice if you run the same test above for Japan. My tests, in all the available data -Yahoo- seem to work for the US, but I do not know how to interpret the Japan case. It's obvious that PP there did not work for a period of 14 years. That is a long time in ones' lifetime, wouldn't you say!.

So, why all 3 assets went south in tandem, especially when one of them completely melted down?

[Indices]

But the underline concept generally holds, some funds in real assets (gold, commodities, property), some in paper investments (stocks, bonds) and some cash is overall likely to have a relatively smooth ride as a collective set, whilst likely pacing inflation with a bit of additional growth on top.

Sure, this seem to be inline with the HBs' PP philosophy, however, I am concerned with the Japan case. Is it an anomaly or an important cautionary tail against the PP itself? It would be nice if you run the same test above for Japan. My tests, in all the available data -Yahoo- seem to work for the US, but I do not know how to interpret the Japan case. It's obvious that PP there did not work for a period of 14 years. That is a long time in ones' lifetime, wouldn't you say!.

So, why all 3 assets went south in tandem, especially when one of them completely melted down?

Don't compare a Japan PP to a US PP. Compare a Japan PP to what everyone else who was Japanese was investing in. The PP doesn't work relative to the world, it works relative to everyone in the country you choose to invest in.

[LNGTERMER]

Indices, I am not comparing the Japanese PP to any thing. All PPs are constructed of the same 4 asset classes, because of the assumptions underlying HB's philosophy. To date I did not hear of any counter argument to otherwise. If we need to compare it to what the Japanese investors were investing in at the time, then perhaps the PP construction should vary to reflect a more fundamental representation of the investment climate rather than assuming we go through four cycles which necessitate holding these assets to account for them. You are suggesting changing that definition-If I understand you correctly-, which I have nothing against but then that definition should spelled out clearly in a more generic manner.

[craigr]

It seems HB is implicitly implying that these 4 periods cannot simultaneously coexist and hence he devised these 4 clever assets. I thought at least in the case of Japan their bonds would have gone up. So, what I am asking is, is the situation HB observed kind a unique to the US since the dollar is a world reserve currency? If not I would agree that perhaps a world index would be appropriate instead of the domestic total stock market index.

You can have bonds, stocks and gold all go down at once during a "tight money" recession. This is usually the result of the central bank deliberately restricting new money in an attempt to influence the economy. However once the economy adjusts to the new reality, one economic condition generally starts to dominate. It's not a light switch effect, more like the rudder on a big ship changing direction.

In Fall 2008 there was a period where the drawdown on the portfolio exceeded 10% and was getting close to 15% if I recall. But once the rudder moved the ship then LT bonds took off very quickly, a matter of days/weeks really, and the losses in the portfolio quickly vanished.

This really just gets back to a principle I follow with my investments: Move slowly.

I never rush any investment decision. Sometimes I may look and decide that "Gee I need to rebalance" but still take a few weeks to really even do it. I'm never in a rush and by not being in a rush I find I avoid getting carried away by the news.

Re: Japan. Realize they have been in a deflation situation for a couple decades now, but life goes on. I'd much rather face deflation than inflation. Bad deflation is a problem, but you won't wake up one day to find that your life savings is becoming worthless due to decrease in purchasing power like bad inflation can do. Also realize that the first 130 years of the existence of the US we had a small amount of deflation the entire time. In fact the dollar in 1913 was worth more than a dollar when the country was founded. Yet, the country was very prosperous.

As I've said in the past I think that the central bankers are doing things ass backwards. They are constantly looking to create inflation and feel that deflation is the most evil of things. But I'd argue that a citizen of Japan is far better off under their deflation than an Argentine citizen has been under that country's very bad inflation.

[LNGTERMER]

caigr, thanks for the reply.

You can have bonds, stocks and gold all go down at once during a "tight money" recession. This is usually the result of the central bank deliberately restricting new money in an attempt to influence the economy. However once the economy adjusts to the new reality, one economic condition generally starts to dominate. It's not a light switch effect, more like the rudder on a big ship changing direction.

It is obvious from the cells copied from Clives' spread sheet that indeed bonds did curry the day in span of years. My puzzlement stems from the fact that in the one year when the stocks fell almost 40% no other asset including the bonds carried the day, granted here we are looking at the yearly data. So, the possibility does exist that the data capture a snap shot of the actual moment of the crash were the rise in bonds was still away but not far. Some one needs to verify the monthly data if available. However, if this phenomenon is not due to some unlucky snap shot of data alignment then perhaps it does show some black swan event in the PP. 40% drop in stocks with additional 10% in each of gold and bonds would be a painful draw dawn to live through. What makes this even more interesting is that we did go through the same thing here in 08 but our bonds did indeed carry the day and the divergence between the bonds going up in gear and the stocks tumbling was almost symmetrical. So the question is why this did not happen in Japan? What was at play there? Was the flight to safety external to the country i.e to the US? Not sure you can answer these but we need to make sure that indeed HB was not smoking something. All the data available to me does show a wisdom in his thesis at least in the US.

Japan
Year Stocks Bond MM Gold CPI
1984 27       -21.1 6.2 -14.5 2.6
1985 14.6       7.3 6.7 -13.3 1.9
1986 59       19.1 5.3 -4.9 -0.3
1987 8.8       7.4 4.3 -1.5 0.8
1988 39.7       9.1 4.6 -18.3 1
1989 17.1       0.2 5.5 13.6 2.6
1990 -39.5       -9.8 8 -10.3 3.8
1991 0.3       13.3 7.7 -12.5 2.7
1992 -21.4       17.2 4.6 -8.9 1.2
1993 12.4       18.5 3.1 4.1 1
1994 8.7       -7.7 2.3 -10.7 0.7
1995 4.3       25.7 1.2 2.9 -0.3
1996 -4.8       4.2 0.6 6.7 0.6
1997 -14.4       9.3 0.6 -10.9 1.8
1998 -8.7       17.5 0.7 -10.2 0.6
1999 46.8       -10.3 0.2 -11.5 -1.1
2000 -19.7       2.4 0.2 2.6 -0.2
2001 -18.8       6.3 0.1 15.2 -1.2
2002 -18.6       6.2 0.1 18.7 -0.3

[LNGTERMER]

Clive,

The choice of the 4 assets for the PP is sound LngTermer.  Individually they do as HB outlined in the particular economic cases.  The problem with the PP IMO is however that it doesn't address volatility balancing.

If you've one asset that goes up as another goes down, but the scaling of those moves are mis-aligned, then you end up with an overall bias/over-run in one direction or the other.

Your strategy of volatility weighing is interesting, I will run it through a back tester and see how it works. However, my concerns are precisely after the thesis itself, it actually shows a gigantic move that was not countered at all, I mean we are not talking about 10, 15 20 percent moves here. So, one of the following must be true:
1- The yearly data captures a snap shot that corrected itself quickly in the monthly data.
2- Japan was experiencing a unique situation that rendered the PP in effective, if that is the case what prevents the US/UK from experiencing the same in 
    the future.
3- The PP and hence HBs' thesis works uniquely for the US.

[Indices]

Clive,

The choice of the 4 assets for the PP is sound LngTermer.  Individually they do as HB outlined in the particular economic cases.  The problem with the PP IMO is however that it doesn't address volatility balancing.

If you've one asset that goes up as another goes down, but the scaling of those moves are mis-aligned, then you end up with an overall bias/over-run in one direction or the other.

Your strategy of volatility weighing is interesting, I will run it through a back tester and see how it works. However, my concerns are precisely after the thesis itself, it actually shows a gigantic move that was not countered at all, I mean we are not talking about 10, 15 20 percent moves here. So, one of the following must be true:
1- The yearly data captures a snap shot that corrected itself quickly in the monthly data.
2- Japan was experiencing a unique situation that rendered the PP in effective, if that is the case what prevents the US/UK from experiencing the same in 
    the future.
3- The PP and hence HBs' thesis works uniquely for the US.

Your final point is incorrect. The point of the PP is that it works no matter what happens in the future. You are predicting that we will have a Japanese deflationary scenario in the future. NO ONE KNOWS. If you prepare yourself for a Japan scenario and then there's a bull market or inflation, you are going to look silly. The PP is not the best portfolio, if you can predict the future. Unfortunately no one can predict the future, so the PP is the best to go with.

[LNGTERMER]

Your final point is incorrect. ... You are predicting that we will have a Japanese deflationary scenario in the future. NO ONE KNOWS.

Indices, I am not making predictions, but noting possible explanations. I have listed these, so that they can be refuted or supported with facts by any one who is reading and interested.

The point of the PP is that it works no matter what happens in the future.

I am fully in this camp for now, so, I am trying to see its performance when bad things have taken place not only in the US but in all other countries were we can get data. The PP did very well in the US judging from available data, however I find Japan an anomaly and I am trying to stir a debate so that we can all make informed decisions rather than just a belief. The strength of any hypothesis is measured by how it performs when it is put to the test, so I am noting an exception to the rule as far as I can tell and listing possible explanations. (How is that for repeating myself  ;D)

[LNGTERMER]

Clive, thanks for sharing this idea of taking into account the volatility of the asset mix. It's definitely worth some time for me to research it further. However, getting back to the PP, I do like the fact it draws its strength form designing an asset mix that is aligned with the economic phases. All my testing have shown that it performs well without any tweaks, even in the case of Japan the bonds did eventually carry the portfolio the next a few years. I guess my confusion stems from the assumption that LT bonds are inversely correlated to stocks in the short term. So, when stocks tumble sharply then I was expecting a short term counter spike in the bonds, which did not happen-or maybe it did but we can't see from the yearly data-. I am thinking the answer is one of the four explanation I put fourth in my previous posting.

Edit- In brief, here is what I am really asking:
Is the theory behind the PP universal? or specific to US? If so, why?
Do you think the Japan case worked as expected or is an anomaly and why?

[Bonafede]

Just to clarify I'm not condemning the PP as its much better than many other alternative investments.  Just that I lack faith to rely 100% on the PP alone.

There's a risk that the PP might provide insufficient rewards albeit with low risk for an investors needs.  If drawdowns are the greatest fear then a PP and bond barbell blend seems to work well (but will generally reward less).  If growth is more desired then using PP as a form of cash and blending that with more speculative investments might serve better (but expect more up's and down's in total fund value over the years).  If you opt for the PP alone then its worthwhile being aware of some of the risks before they occur rather than after the event.

Clive, if you don't mind me asking, what is your portfolio allocation with regard to the PP? Seems like you leverage the PP and the variable idea.

I agree with you on the insufficient rewards with the PP, but that it can be used as a base. I'm just not sure how best to fit this into my overall portfolio and how much I should dedicated towards the base/variable...of course taking personal risk tolerance into account.

Thanks in advance!

[Bonafede]

Thanks Clive.

I've gotta ask, do you find that having the PP as part of your 'entire portfolio' has played to your advantage? I ask because it seems to me the PP could be viewed / used as a bond portion of one's overall portfolio, and I'm trying to figure out how best to construct my PP with my VP if this thought is indeed the case.

For example, one thought I have is using the typical 60/40 mix...with the 60 being VP and the 40 being the PP. The 60% was considering using an aggressive model based on Bogle or Ultimate Buy and Hold, etc. Then of course the 40% close to the PP. However in doing this it seems that perhaps mixing such investment styles may actually cannibalize each other...if that makes sense...:-)

Confused? Me too....at the end of the day it seems to me that if you are to have a VP/PP combination....these two can't be viewed in isolation of one another, but rather viewed as one's entire portfolio. It is here I'm trying to understand the impact.

Thanks Clive and crew!

-b

[LNGTERMER]

...together with maybe Mebane Faber's Quantitative being the PP 'cash ...

Mebane uses a single monthly MA for entry and exits. I would be very careful with such approach. MAs has two inherent weaknesses which work against you:
1- You always enter at the high.
2- You always exit at the low.

These by themselves might not be bad if the position is making profits, however if not you are donating money.
In addition many false entries/exits when combined with the above make it even less attractive.
MAs look excellent when looking back and combined with your own biases and greed may push towards overlooking dangers.
If one must uses them they must be part of many supporting componenets and not standing alone.

My suggestion is to stick with the PP or whatever works for you, and not follow any one till you fully understand their methodology. It seems Clive has been studying these for a while so he is probably with the exception.

[melveyr]

I am really interested in your work clive because 25 in each asset seems too simple to be the best available option. However, the goal of the PP is to return a constant rate of return after inflation, not nominally. When long term treasuries are doing well you are getting the nominal return from the bond, but also prices of other goods are falling adding an extra kicker to your returns. Similarly when gold is rising, the nominal return looks better than real returns you are getting in the inflationary environment. These economic environments warrant more allocation to gold and less to long term treasuries than nominal numbers would have you suggest. Perhaps the portfolio could still use tweaking and maybe you could use numbers that account for inflation when measuring volatility.

[LNGTERMER]

Both the BDVQT and the SL7 approaches you outlined seem to be sensible. Once, I have some time to spare, I will run a few tests on them and see how they perform under various conditions. Thanks for explaining and sharing.

People are mislead with the classic slice and dice approaches, they are blind sided with this long running bull in the stocks and assume things will be as they were. Wrong. I like the PP's all weather neutral approach. It's safe with reasonable returns, not that we should not question it and try to understand it more, as I am trying with the Japan's case. However, and if one had to tweak it he/she better be armed with data and reliable and unbiased tests or strong historical and theoretical understanding.