Can the PP perform well when two of its asset classes are falling

[doodle]

If the economy is just barley inching by and you can't count on stocks to lift you, LTT are in the toilet, and gold probably isn't doing that great -- I think that is going to be a very painful time for the PP.

Potentially, yes. But what actionable rules based strategy is there to avoid this pain? When the world produces little to no real wealth there is no investment that will prosper. At the end of the day we are only as rich as what we produce. The "money" comprising our investments rests on the foundation of real material production.

Robinson Crusoe could have had a million dollars in gold coins and English bonds but still starved to death.

[craigr]

The Variable Portfolio exists to allow modifying the core of the strategy without potential damage. Nothing says you need to put 100% into the Permanent Portfolio if you are comfortable doing some wagering outside the basic framework.

The periods of time being discussed includes a major world war that had price and other commodity controls plus a host of other major historical events going on. The performance of the portfolio needs to consider these things plus how other strategies may have done.

Again, as I've stated a bunch, the PermPort is not a magic elixir. It is however a way to diversify against a wide variety of serious or not-so-serious economic events. As an entrepreneur I like having flexibility at all times to deal with the uncertain and the PermPort does that. I don't however spend a lot of time considering every possible dark scenario that could play out because it likely won't happen that way. I think the best strategy continues to be one in which it makes no assumptions about any particular future, but at the same time gives an investor access to assets to accommodate even extreme situations if they show up.

For instance, let's say the Dow dives by 90% tomorrow. If your portfolio was very heavy into stocks this would be a disaster. But if your portfolio is more PermPort the damage is limited. You would also have access to options to deal with the disaster (such as rebalancing into stocks which is very likely best option). On the opposite end if LTT's tank and yields rise to 10+% tomorrow the gold allocation will be there to allow a rebalancing into what is likely going to be the lucrative options of high yields LTT bonds.

Then again, if you find out in 10 years that the US has gone to pot and a very dangerous government is rising to power you can make a decision to keep the gold separate and not rebalance.

But each situation needs to be addressed when it comes about.

I've never found the dwelling on doomsday scenarios specifically to be very useful because the future rarely ever works out the way we think. Usually it is new and surprising outcomes that nobody expected that are the problem.

[moda0306]

I think it's unreasonable to think in a post-gold-standard world that we'd have rising real interest rates without stocks doing very well, unless it was some move by the fed to enact Austrian monetary policy.

That, or we've somehow gotten into the seemingly impossible situation where we've developed a self-fulfilling default-risk spiral like certain Eurozone countries.

I think in the latter case, gold would do quite well, despite inflation possibly being quite tame and real interest rates being high.

But until Ron Paul is elected to president or fed chairman, or we start seeing some evidence of default risk even being possible, I think the PP is poised to work as advertised.

The PP is simply much less appealing in a pegged currency or gold standard scenario.  Your gold would appear to be somewhat reduntant, but it would still be necessary as your country can always drop the gold standard.  Also, your bonds are going to have a default risk component that is going to mute their protection from recessions.  The muddied waters make it tough to invest in a pegged currency country, IMO.  However, we're lucky enough (IMO) not to have that weight, and the USD being the world's reserve currency helps even more make it a solid gyroscope.

[doodle]

Buying long term bonds at these rates in some sense is similar to shorting stocks after a market collapse. Sure, they can go lower but the risk profile has shifted.

What about the idea of 10% zero coupons and 40% five year ladder?

1. Yield would be about the same as a traditional barbell...

2. If deflation hit and rates collapsed you would participate in gains...

3. If rates rose, you would take a smaller hit to principal...

I know it's not PP, but maybe an acceptable tweak that stays within the framework while taking account of historical times? What is the longest historical bond bull market on record? Were approaching 31 years....is there prior precedence for this?

[doodle]

Another interesting long term question is whether relatively cheap energy over the last 50 years has provided a deflationary bias to our economies...

With waning cheap energy, does the economic bias turn inflationary?

Many questions....few answers

[stone]

doodle, my hunch is still that the bull market in bonds is not something reversible but rather a one off consequence of coming off the gold standard. Stage two of the ecological succession after the 1970s inflation. I don't think we will have Volker style rates again and keep the same currency system we have now. Either we will progress to a very low interest rate perpetual state or the currency will totally die (much less likely IMO). I'm just saying it's my hunch not that that is worth much.

[systemskeptic]

I wouldn't say it is fair to call stagflation a "doomsday scenario."  Really it would be a very slow, almost invisible process which slowly saps the wealth of the US over a long period of time. If you look at the last ten years we have had dropping rates and a flat market in nominal terms, and quite negative in real terms.  The next decade may very well be another one where the stock market returns near or below zero in real terms.  

I certainly wouldn't call the last decade a "doomsday" scenario but the reality is anyone with a large weighting in anything other than gold or bonds lost a great deal of their net worth, upwards of 30-40%.

One modification I am making to the PP given the current rates is to swap out TLT for VBMFX, but then again a big share of my holdings are in a 401k, so I don't have much choice even if I did want to invest in TLT.

Since 2003, the CAGR of VBMFX vs. TLT was 5.5% to 8.8%.  I can swallow a 3.3/4 = 0.825% reduction in overall performance in the PP if it means I don't get a 50% haircut in TLT in only 6 months as happened when rates rose in 2009.

[craigr]

I can swallow a 3.3/4 = 0.825% reduction in overall performance in the PP if it means I don't get a 50% haircut in TLT in only 6 months as happened when rates rose in 2009.

You understand that despite the drop in TLT, the other assets offset all the losses and the portfolio still pulled in about +8% for the year?

And you also understand that in 2010 TLT was up +9.2% and helped with final portfolio gains of +14.5%?

Then in 2011 when rates "couldn't go any lower" the TLT fund posted a monster +33% gain driving most of the portfolio returns of +11% for the year?

So there was no 50% haircut. Only if you looked at the assets in isolation was this the perception. But the perception was wrong. Only total portfolio value matters.

[systemskeptic]

So there was no 50% haircut. Only if you looked at the assets in isolation was this the perception. But the perception was wrong. Only total portfolio value matters.

You are right, the PP has performed amazingly in the last 10 years.  If you backtest back to 2003, you find:

VBMFX/VTI/GLD/CASH:    8.9% CAGR with 7.3% std deviation
TLT/VTI/GLD/CASH:        9.8% CAGR with 7.6% std deviation

My argument is that if I can match the performance within 0.9%, while better mitigating the risk of a interest rate hike, what's wrong with that?  It's not a true PP, but I think it is a valid alternative now that interest rates are under 3%.

In 2009 the rest of the portfolio lifted the losses in TLT, but stocks played a large role in that.  16% year over year gains in VTI are not sustainable, and personally, not something I see moving forward.

Then again what do I know? that's why I am 25% in each of the asset classes -- I'm just choosing what I think is maybe a more conservative route.

[BearBones]

Since 2003, the CAGR of VBMFX vs. TLT was 5.5% to 8.8%.  I can swallow a 3.3/4 = 0.825% reduction in overall performance in the PP if it means I don't get a 50% haircut in TLT in only 6 months as happened when rates rose in 2009.

Is the 3.3% difference really the reason why the PP holds LTTs, or is it because of volatility in price? If you are confident that the portfolio does not need the deflation protection that LTTs provide, then go for it. But realize that what you have done is a PPish VP. It is not an agnostic portfolio anymore, as Craig and MT have discussed before.

[systemskeptic]

If you are confident that the portfolio does not need the deflation protection that LTTs provide, then go for it.

My main concern with deflation is a deflationary spiral where the government defaults and you go into a SHTF scenario.  LTT offer no protection in this case.

The duration of VBMFX is 5.09 compared to 16.87 for TLT.  So it is true that TLT does offer 3x more protection if rates drop, but how much protection do you really need from negative inflation rates if you have net assets as opposed to net debt?. 

I think you need to factor this into the equation -- simply holding assets is a hedge against deflation because the value of everything you hold rises.  The opposite is true with inflation (and thus rising rates) so I think it does not make sense to weight the impact of inflation and deflation at 50:50.  Also to consider is that in a fiat regime, you spend what, 90% of your time trying to devalue the currency?

Not knocking the PP, just trying to make it's implementation fit my personal situation (no access to LTT in my 401k plan).  I do think more thought needs to be put into the effects of stagflation though.

[moda0306]

What I found interesting about the debt ceiling debate, is that just when I expected my LT treasuries to possibly go to crap, they performed amazingly.

It made me wonder if the USD is so trusted, that if viewed as a continuum from reserve cash all the way to 30-year bonds, even if there is an expected default, only the date-ranges expected to default will underperform (as we saw at the debt ceiling deadline), and everything else will perform amazingly.

I don't think if we actually came to default that this would happen, but it was incredibly interesting to see that fear of default was explicitly limited to the duration right after the debt ceiling deadline.  I never thought people would view duration x of treasury debt a good hedge against default of duration y of treasury debt, but it almost seems like that's what happened.

That said, if there is a rejection of our debt, this could, within reason, strengthen the dollar (people no longer sees treasuries as liquid and try to trade them in for dollars), OR possibly even cause the exact opposite... rejection of the currency abroad and inflation.

It's odd that both ends of the monetary spectrum are both reasonably plausible.

I see this as incredibly unlikely, but the idea that ST bonds AREN'T as good as cash could cause a situation where 1-3 year treasuries do quite horribly, but cash itself is increasing in value.  I have said it before, but I think in ultra-low rate environments it pays to have a lot of your cash in the mattress, not in a bank account or treasury bonds.

Lastly, despite the potential strengthening of the dollar, gold could do alright.  I can't imagine a situation where treasury debt is being defaulted on and gold isn't at least holding its ground.

[MediumTex]

This is an interesting exchange, but I don't think it points toward any modification to the PP.

At any given yield on long term treasuries that is north of 0%, the value of long term bonds can go up or go down, and that is why we own them.

Here is a pop quiz: What were the top three years in terms of overall performance for long term treasuries in the last 40 years?

Answer: 1982-40.4%, 2008-33.4%, and 2011-33.56%

Think about that.  In the last 40 years, two of the three BEST years to own long term bonds were years in which yields dipped below 3%.  Conventional wisdom would have said that only an idiot would buy a 30 year treasury bond with a yield under 4%, and yet it was the periods in which yields were under 4% that the best long term bond price action of the last several decades occurred.

Now we are at around 3% yields, and everyone is saying there isn't much additional gain to be harvested from LT treasuries. 

Here's what I think will happen: For the next few years we are going to bounce between 2% and 4% yields, and the PP will continue to harvest huge gains from LT bonds when they near the 2% mark and buy them back a year or two later when yields "spike" up to 4% and the process will repeat.

One of the most consistent themes I see with the PP is "I like the concept but I'm going to modify it a little because I want to reduce my risk."  A year or so later that same person comes back and says "My returns were half of the PP's returns because the asset I lightened up on was the PP's best performer." 

Don't overthink the PP.  Just let it do its thing.

[systemskeptic]

Answer: 1982-40.4%, 2008-33.4%, and 2011-33.56%

Just to play devil's advocate, you also have a big loss in 2009: -26.5% what does that mean for 2012: ?  As someone just switching into the PP, buying LTT after a 33% run-up to rates under 3%, maybe that's a bit tougher to swallow.  Best-case scenario is what, rates drop to 1% and we post another 30% gain?  I would lump 1% 30  year rates in with a SHTF scenario.

Tough times, it seems...

[MachineGhost]

This is where intuition meets science because you're potentially engaging in emotional-based market timing.  The only way with a high level of confidence to be sure of your convictions that you are being "conservative" with your tweak is to make sure you stress-test the change over many different economic climates.  The Butterfly Effect is quite real with the PP.

MG

So there was no 50% haircut. Only if you looked at the assets in isolation was this the perception. But the perception was wrong. Only total portfolio value matters.

You are right, the PP has performed amazingly in the last 10 years.  If you backtest back to 2003, you find:

VBMFX/VTI/GLD/CASH:    8.9% CAGR with 7.3% std deviation
TLT/VTI/GLD/CASH:        9.8% CAGR with 7.6% std deviation

My argument is that if I can match the performance within 0.9%, while better mitigating the risk of a interest rate hike, what's wrong with that?  It's not a true PP, but I think it is a valid alternative now that interest rates are under 3%.

In 2009 the rest of the portfolio lifted the losses in TLT, but stocks played a large role in that.  16% year over year gains in VTI are not sustainable, and personally, not something I see moving forward.

Then again what do I know? that's why I am 25% in each of the asset classes -- I'm just choosing what I think is maybe a more conservative route.

[systemskeptic]

Sure, but don't you have to acknowledge that unlike stocks and gold, there is a real floor value for LTT?  I've seen here several times that "rates can always go lower" but I don't buy it.  What would a world look like at 0% interest rates for 30 years bonds?  Are you honestly telling me if LTT were at 0% you would put 25% of your net worth in it?

For some the lowest-possible rates they would accept may be different, but at some point don't you have to accept the fact that a 200, 300% loss vs. a 15-30% gain just does not make sense in terms of risk-reward -- no matter how much of a "role" it has to play in the portfolio.  For me maybe the floor is 3%, for others it's 2% or 1% but honestly I think there is a point everyone here is going to get squeamish about 25% LTT if the rates converge to zero.

At the end of the day the PP succeeds because it truly diversifies one against the most possible economic scenarios, but to pretend it is perfect and does not break down in some conditions I think is a mistake.

[craigr]

Sure, but don't you have to acknowledge that unlike stocks and gold, there is a real floor value for LTT?  I've seen here several times that "rates can always go lower" but I don't buy it.  What would a world look like at 0% interest rates for 30 years bonds?  Are you honestly telling me if LTT were at 0% you would put 25% of your net worth in it?

I guess I don't worry about stuff like this before it happens. Who would buy LTT at 0%? I don't know. But if they are at 0% you can be well sure things are really bad. But we're a long way from that.

For some the lowest-possible rates they would accept may be different, but at some point don't you have to accept the fact that a 200, 300% loss vs. a 15-30% gain just does not make sense in terms of risk-reward --

How are you going to lose more than 100% on a non-leveraged investment?

But this math isn't even as straightforward for rising yields on bonds. LT bonds have a lot of positive convexity. So the more the interest rates go up the less the duration becomes (making them less sensitive to price wise). The lower they go, the higher duration (and the stronger the price movements). Falling rates help Treasury bonds more than it hurts them going up. This is why the portfolio holds those particular types of bonds and not optioned bonds like mortgages or municipals that can be called.

And again in a rising interest rate environment I have to wonder where is the money going that's flooding out of bonds? Stocks? Gold? It's going somewhere and odds are I own some of it.

At the end of the day the PP succeeds because it truly diversifies one against the most possible economic scenarios, but to pretend it is perfect and does not break down in some conditions I think is a mistake.

It's not perfect. It's the same question that comes up a lot here. A corner case could be found for anything. But that doesn't mean that corner case is going to happen. I guess I'm looking at the data and saying I've seen a lot of stuff happen and it's been fine so why change a winning plan?

[systemskeptic]

I guess I don't worry about stuff like this before it happens.

And again in a rising interest rate environment I have to wonder where is the money going that's flooding out of bonds? Stocks? Gold? It's going somewhere and odds are I own some of it.

I can understand your perspective as someone who is already fully invested in the PP, and has already had their LTT holdings post big gains.  Maybe I am hand waving, but I think the perspective of increasing an asset allocation from 0 to 25% is different vs. staying the course when you are already up 30%.

As far as the money flooding out argument, I really do not understand it.  What about money implies a law of conservation, where money/wealth cannot be destroyed by falling prices?  If rates rise to 4% and never fall back down to 2%, when I sell my bonds for a 30% loss, where does my money go?  It doesn't go anywhere because it evaporated into thin air.

[craigr]

I guess I don't worry about stuff like this before it happens.

And again in a rising interest rate environment I have to wonder where is the money going that's flooding out of bonds? Stocks? Gold? It's going somewhere and odds are I own some of it.

I can understand your perspective as someone who is already fully invested in the PP, and has already had their LTT holdings post big gains.  Maybe I am hand waving, but I think the perspective of buying into an asset with 25% of your assets is different vs. staying the course when you are already up 30%.

Well it's more than that. I hear from people who were saying that at 4% bonds were too high and they weren't going to buy them. I told them the same thing that they could go lower. And they did. It's not that I'm sitting on 9% bonds myself. It's just that I've learned I can't predict these things.

And the thing is in 2008 LTT dropped below 3% and people thought it was going to be bad for the portfolio eventually. And the fact is they lost -21% in 2009. But the stocks went up something close to +30% and gold as well. So it was not a loss for the total portfolio and it gained value that year.

If someone were watching that in 2010 they'd probably think: "Gee bonds got killed in 2009 and I think rates are going to keep going up. So I'm going to stay short on everything."

And in 2010 they were wrong, and in 2011 they were really wrong! Rates are back down to 2008 levels.  

So I just don't know.

As far as the money flooding out argument, I really do not understand it.  What about money implies a law of conservation, where money/wealth cannot be destroyed by falling prices?  If rates rise to 4% and never fall back down to 2%, when I sell my bonds for a 30% loss, where does my money go?  It doesn't go anywhere because it evaporated into thin air.

Sure wealth can be destroyed by falling prices. But rising interest rates are not going to happen in a vacuum. They will do that because people are selling those bonds and taking the money for better purposes.

And if rates rise 2% and you take a loss you aren't selling them for a loss unless it is for tax reasons. You'll probably be rebalancing back into them with other profitable assets. In 2009 I sold out of some stocks to buy bonds which had fallen in price, just to name one example.

But again you're looking at the assets in isolation. Truth is with the Permanent Portfolio that a lot of times one of the assets is a real stinker and one or more is doing OK. And if you think about diversification that's what you want. I don't want a portfolio where everything is gaining at once. That means they can all go down at once as well. I want an asset that is lagging my winners where I can park profits and buy it on sale when nobody wants it!

I guess I'm an odd bird because I think volatility in the assets is fine and dandy. Frankly, the Perm Port does best in volatile markets. Those assets swinging up and down make for interesting buying and selling opportunities. But again only the total portfolio value matters and total portfolio value in the portfolio has been growing in a range of markets for a long time.

[MediumTex]

If you are person who is in the habit of worrying, the PP will always give you something to worry about, because at least one PP asset will always be drifting sideways or falling in value.

You must focus on the portfolio as a package.  If you look at the assets in isolation it tempts you to start worrying.

[stone]

This "conservation of money" issue is vital. IMO the key thing to understand is that private debt can be paid down/default (ie margin debt based asset prices can vanish). BUT government created money can only be destroyed by taxation being greater than government spending (budget surpluses). So if there is a government debt, that is all going to be sitting there either as bank reserves or as treasuries. There are mountains of bank reserves now (thanks to QE). The "traditional" way to get increasing short term interest rates was to have a high demand for bank reserves because the flow of transactions to and fro between banks was so high that "friction" caused a shortage and gave them a scarcity value. IMO with a vast glut of bank reserves flooding the system it is MUCH harder to imagine such a shortage even if the dire economic problems do get addressed to create an economic recovery. I really do think we need to look to Japan's experience to see where we are.

[stone]

The other thing to remember is that you can have negative real (inflation adjusted) rates and yet steadily falling rates. That will mean that LTT mitigate inflation to some extent but STT do not. That is what happened in the UK over the past year where LTT have had a price increase of 37% but started off with a yield that was well below inflation (RPI 5.8% or something, yield before the price increase was 4.4%). I know that the yield to maturity will stay above zero but there is a way to go before that. To some extent the nastiness of the small gains/big losses potential is undoubtedly priced in. It might actually mean that LTT are a bargin given the very remote chance that rates will hike up a lot. I guess people were saying the same thing about tech stocks in 1999

[Lone Wolf]

Here is a pop quiz: What were the top three years in terms of overall performance for long term treasuries in the last 40 years?

Answer: 1982-40.4%, 2008-33.4%, and 2011-33.56%

Think about that.  In the last 40 years, two of the three BEST years to own long term bonds were years in which yields dipped below 3%.  Conventional wisdom would have said that only an idiot would buy a 30 year treasury bond with a yield under 4%, and yet it was the periods in which yields were under 4% that the best long term bond price action of the last several decades occurred.

Very interesting.  That's a humbling observation for a natural LT bonds hater like myself.  I had not put all of these pieces together (on 1982 in particular.)

[systemskeptic]

This is where we come full circle back to the original question of the OP.  If I look at Clive's table I see that it is very clear that the PP cannot perform when two of it's assets are under-performing. 

The question then is, how likely is this for the future?  Nobody can predict what will happen or when, but we can speculate some can't we  

One of the core concepts of the PP is that when stocks fall, LTT rise and vice versa.  If this relationship breaks, what does it mean for the PP?  Is it possible for this correlation to no longer hold?

[stone]

Someone (sorry I've forgotten who, perhaps FarmerD?) has posted on here saying ever since Japanese LTT fell below 1%, they have not provided much beneficial price movement for the Japanese PP. Perhaps 1% is a sensible cut off to re-evaluate?