Why the Permanent Portfolio gains steadily over time

[Wonk]

I think most people evaluating the Permanent Portfolio ask the question, "if it's economic climate neutral, why isn't the expected return 0?"  One would think there would be no gain if there are 4 strings tugging equally from north, south, east and west.

I may be way off, but here's my take on why the portfolio performs as it does: productivity, or simply increases in GDP after adjusting for inflation.  Here's what I mean...

Only 25% of our portfolio is invested in economic growth (equities).  The rest is invested in a relatively stable storage of value (cash) as well as hedges on the real value of cash that offset each other during turbulent times of change.  In other words, if the real value of cash goes up (deflation), bonds work.  If the real value of cash goes down (inflation) gold works.  So we can make the case that in relatively calm periods, 75% of our portfolio is invested in stores of value and hedges on that value.  The point is that cash and gold have 0% real return, while long bonds are a pittance.

Value is what we all work for and store, but is in a constant state of flux due to supply and demand fundamentals.  It's esoteric in one sense, but largely rooted in history.  Since civilization began trading goods and services, there was a need for a medium of exchange.  Enter gold.  Ever since bankers figured out they could get rich off the backs of productive workers, there's been fractional reserve banking and paper currency representing claims on either gold or debt (t-bills, etc). 

The yin and yang of monetary policy create unstable short term environments that cause inflation and deflation in stores of value.  What makes our collective stores of value grow over time is the increase (and investment) in productivity in the economy.  In developed markets, that can range from 1-5% on average.  Add rebalancing benefits of perhaps .5-1% annually (buying low and selling high) and you have a long term expected return of between 2-6%, adjusted for inflation. 

It looks as though the worst performance of the Permanent Portfolio comes in environments where an economy is literally drowning in debt--usually from the public sector.  This debt acts like a leech that sucks capital away from productive private sectors that create productivity gains over time.  See Japan after 1989 and the effects of government preventing failures and subsequent liquidations.  Pre-bubble annual GDP had been 10% in the 60s, 5% in the 70s and 4% in the 80s while post-bubble GDP struggled mightily--only 1.5% in the 90s and a paltry 0.8% in the 2000s.  A Japanese permanent portfolio reflected this reduction in GDP, especially when compared to a U.S. based model (GDP averaging 2.7% annually).

So where an economy is relatively unencumbered with oppressive regulations and burdensome public debt, you'll see the largest increases in productivity and the growth of a permanent portfolio.  If my thesis is correct and the U.S. (and the majority of western civilization) is following in the footsteps of Japan, a permanent portfolio should continue to produce positive real returns--albeit less than what the past 40 years have yielded. 

At least that's my take on it.

[Roy]

A great deal of the historical performance of the portfolio is due simply to the risk premia being realized.  Since 1972, Equities and LT Treasuries have both delivered.  ST Treasuries (if not using CASH) also delivered.  That's 3 of 4 asset classes realizing their risk premia—behaving sort of as expected over the "riskless" asset.  

Risk premia aside, the Treasuries (50% of the port.) also blend nicely with the Equities, tending to do well in Equity crisis, when such performance matters most (a bit better than equivalent Corporates, for example).

Then there's Gold, which can't always be viewed in these ways but should probably be seen as a correlative success during the entire time, especially as Stocks, Treasuries, and Gold rarely tanked together for any extended period (I think just one year since 1972).

Roy