Troubled Waters Ahead for the PP

[MachineGhost]

Now that I've committed to investing in the strategic PP, I've turned a laser-sharp keen eye to the realities of the risk involved as opposed to just the arm's length theoretical.

It occured to me that theres two major risk issues with the PP, both related.

First, the PP was only developed in its present formulation by HB in 1982.  Everything before then is in-sample data and is not valid for verification purposes (i.e. hindsight bias and recency bias).  What happend during 1981-1982 was a deflationary double recession event due to the Fed's tight money policy and Mexico's sovereign debt implosion.  However, as stocks and bonds had been in the dumps for almost a decade, they were driven to their final lows and were outstandingly undervalued.  Only gold had been in a bull market.

Second, over the next 18 years after 1982, the PP had its out-of-sample performance which consisted only of a gold bear market and bull markets in two assets.  Now, the PP currently finds itself in an out-of-sample environment very much like the in-sample environment of the stagflationary 1971-1982.  They key difference now vs then is that as opposed to being in bear markets, both stocks and bonds are now in bull markets, along with the expected gold.

In other words, the PP has yet to be tested in-sample or out-of-sample when three bull markets simultaneously end in a deflation.  The PP experienced a moderate decline in the 1982 deflation with a 20% peak-to-trough drawdown, yet that loss was recovered very quickly only because stocks and bonds were at generational lows.

Some analysts believe the stock market is actually 50% undervalued at present relative to the rate of inflation and relative to the "yield chasing" that will force Boobus Americanus out of their bond funds into stock funds, precipitating the true mother of all bubbles over the next several years.  Indeed, it looks so far this year that the outflows from bond funds to stock funds have begun.  Words could not fully describe what is coming, if this is true.

And lastly:

[quote=http://www.hussmanfunds.com/rsi/policyportfolio.htm]Worse, without a collapse in an already low rate of inflation, bonds may not provide the same offset to declining equity values like they have in recent equity bear markets. As Peter Bernstein suggested, a more flexible and opportunistic investment strategy is going to be demanded until bond and stock valuations once again become attractive.[/quote]

[dualstow]

Are you going to change your strategy?

[buddtholomew]

What is the alternative? Today is going to be a blood bath as well. Rising yields, falling gold prices and an increase in equity that doesnt come close to offsetting the losses. I wish I was 100% invested in a traditional 60/40 allocation.

[WildAboutHarry]

I don't think there is anything wrong with posing the questions MG has raised.  The HBPP was born and "grew up" in a particular set of circumstances that was far removed from the present-day situation.  Harry Browne's ideas about a "permanent" portfolio evolved over time, and the "permanent" part was only relatively permanent.

The actual mix of assets in a "permanent" portfolio are only a portion of the total HBPP philosophy:

• Buy, hold, rebalance asset classes with low correlation
• Hold a significant portion of your assets in precious metals
• Direct ownership of assets, where possible (i.e., avoid counterparty risk)
• etc.

This is pretty radical stuff, relative to conventional stock/bond portfolios.

It is obviously impossible to know what Harry would have thought about the unusual investment circumstances we find ourselves in today, but I suspect the "permanent" portfolio might look a bit different if he were around.

[notsheigetz]

What is the alternative? Today is going to be a blood bath as well. Rising yields, falling gold prices and an increase in equity that doesnt come close to offsetting the losses. I wish I was 100% invested in a traditional 60/40 allocation.

I've also been sharing the feeling for a while that we might be heading into some uncharted territory for the PP both figuratively and literally. I've never been one to pay close attention to things financial but based on what I have casually observed through the years I do not recall a time like this before.

I have no intention of abandoning the plan but I kind of like that I have most of my new money going into 401k stock index funds. If equities continue to rise I know it will be a challenge if I hit the re-balancing bands so I plan on following HB's advice and only checking it once a year.

[MomTo2Boys]

Boobus Americanus

That? Is awesome.

[dualstow]

I think there was a thread last year in which the question was asked, "What would make you abandon the pp?" And if I remember correctly, Medium Tex's answer was something like "3 consecutive years of (a loss)." I'm doing to adopt the same checkpoint. But, I've seen dramatic drops in equities and I keep going back like Rihanna.

It's funny how we already know the pp has lean years. We all know this. But as soon as the value of our holdings stop going up and up, we talk about jumping ship, and how the grass looks greener over in Equityland. 

[notsheigetz]

I think there was a thread last year in which the question was asked, "What would make you abandon the pp?" And if I remember correctly, Medium Tex's answer was something like "3 consecutive years of (a loss)." I'm doing to adopt the same checkpoint. But, I've seen dramatic drops in equities and I keep going back like Rihanna.

I remember that thread too and I think he eventually qualified it to say it would have to be significant losses and also that there had to be a viable plan to replace it with. It's always possible it could be sinking like a rock for 3 years and still be the best plan available.

As for me, the one thing I can think of that would really shake my faith in the PP to the core would be if MT or Craig abandoned it.

[Pointedstick]

If the PP is experiencing real losses, it's probably because one of two things is happening:

1. Stocks are attracting lots of money and rising quickly, but since stocks are only 25% of the portfolio, it's not enough to offset losses in the two flight-to-safety assets
2. Everything is doing poorly or drifting sideways, often failing to beat inflation

In situation #1, the economy is probably doing pretty well, and if you're employed it'll be easier to get a raise or promotion, or find a better new job. This situation could still be pretty painful if you're retired, unemployed, or underemployed, though.

In situation #2, there's no clear alternative to the PP that doesn't involve a great deal more risk.

[6 Iron]

I am convinced that the greatest risk in the Permanent Portfolio, and investing in general, is the investor, making a move at the worst possible time. The premise of our portfolio is sound, and there will be opportunities to buy out of favor assets.  Reading this thread, I am reminded of Bill Bernstein's review of Craig and MediumTex's book:

http://www.amazon.com/review/R20DI5V8YW ... I5V8YWKGZN

[rickb]

I don't think there is anything wrong with posing the questions MG has raised.  The HBPP was born and "grew up" in a particular set of circumstances that was far removed from the present-day situation.  Harry Browne's ideas about a "permanent" portfolio evolved over time, and the "permanent" part was only relatively permanent.

The actual mix of assets in a "permanent" portfolio are only a portion of the total HBPP philosophy:

• Buy, hold, rebalance asset classes with low correlation
• Hold a significant portion of your assets in precious metals
• Direct ownership of assets, where possible (i.e., avoid counterparty risk)
• etc.

This is pretty radical stuff, relative to conventional stock/bond portfolios.

It is obviously impossible to know what Harry would have thought about the unusual investment circumstances we find ourselves in today, but I suspect the "permanent" portfolio might look a bit different if he were around.

Perhaps nitpicking, but the assets are not chosen because of their low correlation, but because of how they act in specific macroeconomic conditions.  The theory is that the 4 conditions driving the choice of assets covers every conceivable macro environment. 

I think the question here is, did Harry miss a possible macro environment?

If you think the answer is yes, please identify what it is.  In particular, how can stocks, gold, and long term treasuries all go down in a deflation?  If it's a deflation or even a global depression, wouldn't long term treasuries go up?

[melveyr]

I think the question here is, did Harry miss a possible macro environment?

If you think the answer is yes, please identify what it is.  In particular, how can stocks, gold, and long term treasuries all go down in a deflation?  If it's a deflation or even a global depression, wouldn't long term treasuries go up?

I don't think it's really possible that he missed a major macroeconomic environment, but more likely that the weightings of the PP are not perfect and that ultimately there is no weighting that consistently will be perfect. For example, HB mentioned tight money recessions as a scenario, but that is terrible for every asset class except T-Bills or savings accounts. I think we all know that 25% in T-Bills is not enough to cover the losses of other assets in a tight money scenario, but would you be comfortable with 50% in T-Bills or 80% in T-Bills? I wouldn't.

I think if stock market rallies are the toughest to stomach for people than they might want to consider a stock VP in a separate brokerage account. Although it is probably increasing your risk, it helps you feel more part of the herd which many of us are instinctually wired to do. It's a form of emotional hedging. Having this outlet will probably keep from abandoning the PP because you will feel like you are "doing something." Also, it can provide a great outlet if you still have an inner stock picking bug like I do! 

[Tyler]

It's all about the timing. Lacking the ability to see the future, an active investor will always make changes a day late and a dollar short.

I understand the fear of losing money. But my own experience is that chasing the hot money is ultimately irrational and eventually ends painfully.  Now I may be more inclined when the PP is slow to tinker with a small VP to satisfy my need to "do something."  But I think it will take quite a sea change for me to believe that the PP has lost its safety firewalls and can no longer make a decent real return.

[Pointedstick]

One thing that's fascinated me about the portfolio is how it responds to interest rates as well as macro expectations. Often the macro expectations correspond to interest rate movements, but not always. If you have deflationary conditions, one would expect interest rates to fall, but if your "deflationary conditions" still allow for a slight positive level of inflation, then you're in negative real interest rate territory, and when that happens, gold goes bananas.

If there was anything that I think Harry under-emphasized, it was the long-term effects of gold and bonds moving together in a deflationary, negative real interest rate, flight-to-safety scenario. In true deflationary conditions, there's actual deflation, i.e. money held under the mattress increases your purchasing power. In this case, gold may or may not be attractive compared to cash. But if you have increasing expectations of deflation with actual inflation, then rates will be falling and eventually go below inflation, setting the stage for both gold and bonds to look attractive, which is what we've seen for the past near decade.

As the stock market picks up and the expectation becomes that we're entering a period of prosperity, bonds and gold both seem less attractive. So 25% of the portfolio has to carry losses in 50% of it. It remains to be seen how long this period of prosperity will actually last, or if stocks will rise fast enough to counter the consistent low-to-moderate losses we're seeing in gold and bonds. So far stocks have been doing a pretty good job of countering the losses.

Over the last 12 months, the PP is still in slightly positive territory, and the past 24 to 36 months have been even better.

[sophie]

Another thing to keep in mind:  everyone is reacting viscerally to the record high stock indexes.  They're pulling their money out of the safe haven assets and dumping them into stocks, which means they're selling low and buying high.  It's a blip, not a long term trend.

Also consider what the "all-time high" phrase means.  It sounds great, until you realize that it merely means that the stock market has finally gotten back to its previous high point from 2007.  In other words, stocks have given you nothing beyond dividends for the past 5 years, if you started in 2007.

I agree with melveyr, I don't think HB missed a macro environment. As HB would say, there's nothing so low it can't go lower, and there's nothing so high it can't go higher.  I agree that bonds are likely to go down at some point...but who knows when, and in the meantime they could still surprise you.  And there's no reason why gold can't go back up, or stocks back down.

[craigr]

It gets back down to the basic question:

If the Permanent Portfolio is being clobbered, what is doing better?

While I always tell people to look at the portfolio in total, it is still in fact made up of individual assets. If you are having problems across all those major assets of stocks, bonds, cash, and gold then there likely is no asset that is doing well anywhere.

I just looked at Morningstar where I track some model portfolios. Looks like the Permanent Portfolio is in the 0%-0.5% range this year so far. Gold and bonds have fallen while stocks are doing pretty well (up 9% so far). But this kind of thing happens all the time. You're going to get one asset that is doing pretty well and others that are probably not.

Yet if you are seeking out diversification, this is exactly what you want. I do not feel comfortable seeing everything going up all at once, because that means they can all go down at once and that kind of thing can be catastrophic in a bad market.

But these calendar year comparisons really cause a lot of problems because the world does not work on a fiscal calendar year. Even with that said, it's still only March and a lot can happen over the next 9 months!

Did HB miss something and would he change anything today? Well I don't know of course because he's no longer here. Each investor is going to have to evaluate this for themselves.

In my mind, I have not seen anything so major that I'm looking to change the game plan. The only time I'm going to look at the issue right now is if I see LT bond rates get near that 2% region. At that point I would probably want to really look at the risk/reward in that asset. Even then, I would say that the trip down to 2% from here would cause a massive price spike in bonds and it is likely you'd be selling them down due to rebalancing anyway and putting that cash elsewhere. So the portfolio would have done a lot of self correcting for you if you follow the strategy.

The last point I think is pretty important because the portfolio holds enough of each asset to help you out, but not so much you can get really badly burned if one of them totally blows up. When discussing asset allocation it's easy to get enthralled with the hot performer (those stock portfolios are doing well so far this year). But if that asset turns against the investor they can get really clobbered. If an investor is OK with that risk, then they should just consider opening up a Variable Portfolio and putting more money into a broadly based index fund. There's nothing wrong with that if you are aware of the risks being taken.

[craigr]

I'll also just add that you saw very few people talking about how great stocks were in 2009 when they were the best time to buy. You only hear about it today when they are at all time highs! This is very typical investor behavior and mechanical rebalancing strategies like the Permanent Portfolio can really help in these cases to keep out of trouble.

[KevinW]

So many of these threads come back to

Rule #4: No one can predict the future.

There is just no way to know what is going to happen. However I think Browne's analysis is correct and that macroeconomic theory dictates that at least one of the PP assets will be in a rally at any given time. This is what I have observed both in backtesting, and watching my own portfolio through a few years of never-ending "unprecedented" conditions.

As humans we have zero control over future events, and as investors we have zero control over how those events affect the markets. All we can do is pick our poison and see how it all pans out. It's in our imperfect human nature to try to tie these things to a narrative or our egos ( http://en.wikipedia.org/wiki/List_of_cognitive_biases ) but really it's all random noise and luck.

***

On the in-sample/out-sample thing: I agree that it's difficult to backtest the PP thoroughly because it was designed for a fiat-currency economy in the 1980s, just after the US went off the gold standard in the 1970s.  So the longest US time window that makes sense is 1972-2012, which is not a very long period of time, and includes the period of time when Browne was advocating the PP and when the US was just coming off the gold standard, both of which in principle could taint the empirical data.

I think a few years back, Clive posted some backtest data that attempted to circumvent that. IIRC he tried using gold-like hard assets that were not pegged to currencies: silver or real estate. And IIRC he did the same thing for the UK going back at least a century. Sadly I believe those posts were deleted and I don't know where he got his data. 

I'd be interested to see a PP backtest going *way* back. The Netherlands has had a stock market since the 17th century, I wonder if there is suitable data for them, or UK, Japan, China, or even the Roman Empire.

[MediumTex]

The time to buy stocks was the spring of 2009, back when everyone hated them.

What does that suggest about LT bonds and gold right now?

[moda0306]

The time to buy stocks was the spring of 2009, back when everyone hated them.

What does that suggest about LT bonds and gold right now?

People's balance sheets have a long way to go before they're healthy again.  I would be surprised if the 30-year hit 4% any time within the next few years.

I'm surprised gold has been so tame.  We've had negative real yields for the last couple of years with little adjustment from gold.  I am not a "Gold $5,000" or "Gold $10,000" guy, but base on CPI and interest rates I would've expected Gold $2,000 by now.

[Kshartle]

Would you guys feel better if the PP was down 5% and S&P down 30% or PP up 5% and S&P up 30%?

I personally would feel much better about the former.

[dualstow]

Would you guys feel better if the PP was down 5% and S&P down 30% or PP up 5% and S&P up 30%?

I personally would feel much better about the former.

Hah, that's perfect. I want the pp to go up, but perhaps the former is more pleasing for some reason.

[Pointedstick]

Would you guys feel better if the PP was down 5% and S&P down 30% or PP up 5% and S&P up 30%?

I personally would feel much better about the former.

Absolutely the latter. I prefer a gain to a loss, and comparing my performance to the S&P is academic since I would never, ever have a 100% stock portfolio.

[buddtholomew]

I want both. Isnt that the objective?

[6 Iron]

Would you guys feel better if the PP was down 5% and S&P down 30% or PP up 5% and S&P up 30%?

I personally would feel much better about the former.

You bring up an interesting problem for human beings. Somewhere, I read a study  comparing the happiness of two different groups of people: (1) Those with an income of around 75K/year living in a neighborhood where the mean income was 50k, and (2) individuals with an income of 100K a year, but living in a neighborhood with a mean income of 150K. Despite making 25K less, those living in the more modest neighborhood scored higher on their measure of happiness and satisfaction. Throw in a little schadenfreude, and it is not hard to see how people can make bad decisions with improper priorities.

This world is better for me and my kids when the economy is humming. I will take the +5% with the knowledge that the good times never last forever.