How 2 assets with negative returns and negative correlations can make money

[MachineGhost]

So the PP carries Stocks, LT Treasuries, ST Treasuries, and Gold?  And only Stocks produce real returns over the long run?  Then why does it generate a return that's competitive to the 100% Equities allocation?  And why does the 60/40 Stock/Bond portfolio also generate a similar long-term return as well?

It's because both stock and bonds were in a simultaneous bull market (positively correlated) for the vast majority of the PP back to 1968.  So you've had a tailwind of bonds juicing up the stocks.  When that ends, the PP will fall back to the stocks providing the real return.

As I demonstrated in another thread, bonds do not always go up when stocks go down.  Sometimes gold takes on the role instead.

Rebalancing is basically an excuse to cut the momentum short of an asset, so by definition the longer you avoid rebalancing, the more total gain you will have.  A better approach may be to deal with the momentum of the assets individually than a one-size-fits all rebalancing band threshold.

[MachineGhost]

For instance I think given the current economic situation there is a much greater likelihood of strong and sustained inflation over the medium to long-term (5-10) years. That would imply it's probably better for returns if you don't reblance as stocks move up and gold shoots up (sometime ).  Better to just let them ride for a long time rather than rebalance into cash or bonds that will be losing value in real terms.

Highly doubtful stocks will "move up" in an inflationary environment enough to for gold to "shoot up".

[iwealth]

It's because both stock and bonds were in a simultaneous bull market (positively correlated) for the vast majority of the PP back to 1968.  So you've had a tailwind of bonds juicing up the stocks.  When that ends, the PP will fall back to the stocks providing the real return.

I feel that this point is akin to something you hear people whispering about in a corner until you approach and then the subject gets changed.

[Kshartle]

For instance I think given the current economic situation there is a much greater likelihood of strong and sustained inflation over the medium to long-term (5-10) years. That would imply it's probably better for returns if you don't reblance as stocks move up and gold shoots up (sometime ).  Better to just let them ride for a long time rather than rebalance into cash or bonds that will be losing value in real terms.

Highly doubtful stocks will "move up" in an inflationary environment enough to for gold to "shoot up".

I think there's an extra "to" in this sentence and it's making me unsure of your point.

Are you saying that an amount of inflation large enough to cause gold to shoot up would make it doubtful that stocks would also go up?

I'm speaking strictly nominally here and not in real terms although I do think if the inflation doesn't get absurd, stocks (particularly non-US) can squeak out gains in real terms.

Look at non-US stocks in the 70s. They would have protected US investors from the high US inflation although global markets have increased correlations. It seems foreign markets are selling at a discount to US right now.

[MachineGhost]

I feel that this point is akin to something you hear people whispering about in a corner until you approach and then the subject gets changed.

Yep, so the pink elephant in the room is what will happen when the PP reverts to the new normal of stocks providing the real returns, but stocks are priced to deliver negative real or slightly nominal positive returns in the future in midst of a bond bear market or a dead QEternity market like Japan?  Unless the 1970's repeat -- which may be totally unique because of the gold depegging and wage hike contracts -- I fear it will be very tough rowing for the PP.  I expect we'll have to halve the expected returns we've come to expect from the PP.

[MachineGhost]

I think there's an extra "to" in this sentence and it's making me unsure of your point.

Are you saying that an amount of inflation large enough to cause gold to shoot up would make it doubtful that stocks would also go up?

Yes, if negative real rates get too low, stocks will be crushed as they were in the 1970's and gold will "shoot up".  Look at the situation now, negative real rates are low but lack of demand from China overwhelms that fundamental.  Still, with both stocks and bonds in bubble territory, whats left but gold and cash?  We're certainly closer to a bottom in gold than a top, but any hint of Chinese deflation will crush gold even more.  The PP continuing to work all banks on gold recovering upwards.  It will be the first true litmus test without extenuating circumstances.

I certainly would not bank on foreign stocks offsetting domestic.  The world is entirely too capitalistic and interconnected now.  There's no longer the Evil Empire and its country's of influence.

[Kshartle]

I certainly would not bank on foreign stocks offsetting domestic.  The world is entirely too capitalistic and interconnected now.  There's no longer the Evil Empire and its country's of influence.

I feel a need to diversify in case Gold in fact plumments. The problem is at this point I think if Gold does fall significantly from here it will be due to deflation that will crush stocks far worse. I probably need to re-asses and add more cash, it's just difficult to hold dollars here and settle in for a clear loss in real terms. The governments are promising inflation and I think they'll succeed.

I'm basically talking myself into either all PM or half PM half currencies.

The reason I have the foreign stocks is they are at a significant discount to the US and should have more upside and less downside at this point today.

[buddtholomew]

I certainly would not bank on foreign stocks offsetting domestic.  The world is entirely too capitalistic and interconnected now.  There's no longer the Evil Empire and its country's of influence.

I feel a need to diversify in case Gold in fact plumments. The problem is at this point I think if Gold does fall significantly from here it will be due to deflation that will crush stocks far worse. I probably need to re-asses and add more cash, it's just difficult to hold dollars here and settle in for a clear loss in real terms. The governments are promising inflation and I think they'll succeed.

I'm basically talking myself into either all PM or half PM half currencies.

The reason I have the foreign stocks is they are at a significant discount to the US and should have more upside and less downside at this point today.

Why don't you and MG create a separate topic in the Other Discussions section of the forum as neither of you follow the PP strategy as outlined? All of the discussion around market timing purchases is clouding established PP principles and reducing my overall confidence in the portfolio.

[MachineGhost]

I feel a need to diversify in case Gold in fact plumments. The problem is at this point I think if Gold does fall significantly from here it will be due to deflation that will crush stocks far worse. I probably need to re-asses and add more cash, it's just difficult to hold dollars here and settle in for a clear loss in real terms. The governments are promising inflation and I think they'll succeed.

A small real loss is preferable to a 40-60% nominal loss.  If you keep at it, you will eventually talk yourself into doing the PP.  Because bonds are what you're looking for for deflation protection.

[Kshartle]

I feel a need to diversify in case Gold in fact plumments. The problem is at this point I think if Gold does fall significantly from here it will be due to deflation that will crush stocks far worse. I probably need to re-asses and add more cash, it's just difficult to hold dollars here and settle in for a clear loss in real terms. The governments are promising inflation and I think they'll succeed.

A small real loss is preferable to a 40-60% nominal loss.  If you keep at it, you will eventually talk yourself into doing the PP.  Because bonds are what you're looking for for deflation protection.

I've written quite a bit on that subject. I think this entire phase of the global monetary system will likely result in a deflation, possibly a major one after a lot more inflation. The deflation will make it impossible for the governments to repay though and they will just outright default. Their debt levels are too high to permit deflation without default. I don't think the bondholders are going to come out better than the cash holders and maybe even worse if they get a haircut.

[MachineGhost]

I've written quite a bit on that subject. I think this entire phase of the global monetary system will likely result in a deflation, possibly a major one after a lot more inflation. The deflation will make it impossible for the governments to repay though and they will just outright default. Their debt levels are too high to permit deflation without default. I don't think the bondholders are going to come out better than the cash holders and maybe even worse if they get a haircut.

That doesn't make any sense.  Inflation whittles away the real value of debt by decreaseing debt levels which is why inflation is so useful.  A lot more inflation will whittle away the impact even further.  So why would the monetary system then end in deflation, especially when it is a completely avoidable result under a fiat system?  Viewing deflation as an automatic death sentence from debt is like saying hyperinflation is an automatic death sentence from inflating.  I think your continual inability to understand Monetary Realism is blinding you.  Japan may not be the definition of deflation that you envision, but it is highly preferably and gold actually saved the PP over there.

[Kshartle]

I've written quite a bit on that subject. I think this entire phase of the global monetary system will likely result in a deflation, possibly a major one after a lot more inflation. The deflation will make it impossible for the governments to repay though and they will just outright default. Their debt levels are too high to permit deflation without default. I don't think the bondholders are going to come out better than the cash holders and maybe even worse if they get a haircut.

That doesn't make any sense.  Inflation whittles away the real value of debt by decreaseing debt levels which is why inflation is so useful.  A lot more inflation will whittle away the impact even further.  So why would the monetary system then end in deflation, especially when it is a completely avoidable result under a fiat system?  Viewing deflation as an automatic death sentence from debt is like saying hyperinflation is an automatic death sentence from inflating.  I think your continual inability to understand Monetary Realism is blinding you.  Japan may not be the definition of deflation that you envision, but it is highly preferably and gold actually saved the PP over there.

Deflation is the result when the inflationary cycle ends because all the bad loans and credit created during the inflationary boom is exposed as unsustainable/payable.

What do you think causes deflation? The seeds of deflation are sown during the inflation. Read some Browne, he explains it all very clearly.


Inflation will continue to slow the growth of debt in real terms but it will only slow it. The debt is still growing and a rate faster than the government can inflate away. Also, since inflation drives up the prices the government has to pay, the deficits get bigger and bigger, growing the debt even faster. At some point the inflation is so high that no one will accept bonds except at increasing interest rates. The debt will also be growing at pace that makes even the debt service a larger and larger part of the budget, requiring even more inflation.

the government cannot stop printing because it can't collect enough or borrow enough at low enough rates to maintain it's position. It has to either go all in and print until the dollar is destroyed or allow deflation which crashes the economy and slashes tax revenues and causes the real value of the debt to move up.

The point is the government can never pay off the debt at this level without inflation that's well above the interest rates. If they go the non-inflation route the economy will crash and the deficits will get even larger. They will have to discount the principle they're going to pay back on the debt.

Look at the result of the last minor deflation in 2008, the debt has doubled in 6 years. Has the GDP doubled? There is no way out except default through printing or honest default.

In either scenario I don't see how bondholders can get anything other than losses.

Can you think of another scenario? I've put forward a few such as the government selling off assets but I think you're more likely to have "greedy bondholders get haircuts and pay their fair share rather than take from the people. We're all in this together!"

I can hear the campaign slogans. Maybe even the greedy banks will be blamed.

[MachineGhost]

Look at the result of the last minor deflation in 2008, the debt has doubled in 6 years. Has the GDP doubled? There is no way out except default through printing or honest default.

In either scenario I don't see how bondholders can get anything other than losses.

Can you think of another scenario? I've put forward a few such as the government selling off assets but I think you're more likely to have "greedy bondholders get haircuts and pay their fair share rather than take from the people. We're all in this together!"

Bonds made money in 2008, so you're not really talking about deflation per se, but some kind of sovereign debt crisis that causes people to lose confidence as happened back in the 1930's under the gold standard.  Post-1971, deflation is not negative for a sovereign fiat issuer; only those entities that have binding monetary constraints such as the EU, the states, private sector, etc..  Anyway, we don't really consider inflation to be a hard default around here, even though it will be pretty nasty to have a 80-90% real loss on bonds.  That's what the gold is for.  As I've said many times, if you have stock, then you need bonds to hedge it and then you need gold to hedge that and then you need cash to hedge the gold.  If you don't want to be part of the trinity because you think stocks are currently priced to deliver negative long-term returns, then there's no reason to be part of it.  Stay in cash and implement the full PP when the S&P goes back below 1000.  That's essentially more or less my plan.

[Kshartle]

Stay in cash and implement the full PP when the S&P goes back below 1000.  That's essentially more or less my plan.

What events would cause you to re-examine that price target?

For instance, the Dow started the 1970s at around 19 P/E (similar to today) according to Browne's 1981 book and ended the decade at almost the same price but inflation had driven up the nominal earnings such that the P/E bottomed around 8.

So what I'm asking is, if you're staying essentially in cash until the S&P falls, you might end up sitting through serious inflation waiting for a fall that doesn't come. Is there a level of inflation or some other event (other than a 50% drop in the S&P) that would cause you to re-think the cash position?

[MachineGhost]

What events would cause you to re-examine that price target?

For instance, the Dow started the 1970s at around 19 P/E (similar to today) according to Browne's 1981 book and ended the decade at almost the same price but inflation had driven up the nominal earnings such that the P/E bottomed around 8.

So what I'm asking is, if you're staying essentially in cash until the S&P falls, you might end up sitting through serious inflation waiting for a fall that doesn't come. Is there a level of inflation or some other event (other than a 50% drop in the S&P) that would cause you to re-think the cash position?

It's not a price target so much as where the S&P will be priced to deliver 10%+/year returns again.  Depending on how long our current mini-bubble lasts, the price target could move up due to inflation.

I am waiting for a buy signal on gold so I can protect the cash if necessary.  It's too risky to leave it unhedged if gold takes off.

[EdwardjK]

What you are describing is called "pair switching" in its most basic form.

You identify two non-correlated assets, such as SPY and TLT, and move between them based upon some performance metric.  The two metrics I have seen used frequently are the 65-day return and the 85-day return.

There is a slew of research on this method in various on-line forums.  A recent addition comes from Frank Grossmann in Switzerland.  He has several switching strategies on his website:

http://logical-invest.com

[MachineGhost]

There is a slew of research on this method in various on-line forums.  A recent addition comes from Frank Grossmann in Switzerland.  He has several switching strategies on his website:

http://logical-invest.com

My Spidey sense is tingling at this site.  I remember when it was beta and there was virtually little to nothing in terms of content; now it's got a whole bunch of rotation strategies promising 40%+ CAGR?  What's wrong with this picture?  Besides the fact the strategies are curve fit to death on limited past history, I've never seen returns that high from rotation strategies before.   It also looks like virtually all of the "outperformance" is coming from emerging markets which had quite a historically unusual runup from 2003 to 2008, to put it mildly.

[Kshartle]

Besides the fact the strategies are curve fit to death on limited past history, I've never seen returns that high from rotation strategies before.   It also looks like virtually all of the "outperformance" is coming from emerging markets which had quite a historically unusual runup from 2003 to 2008, to put it mildly.

"The chart above shows the "hypothetical" returns you would have received employing this strategy."

Ahahaha, people love charts that have lines that move up smoothly from bottom left to upper right. Showing a nice is worth more than just about any other marketing tactic.

In one of his books Browne "proved" that people going to the movies causes inflation by showing a chart.

[MachineGhost]

I am currently in the process of backtesting to try and verify Grossman's returns.  I can tell you one thing so far: it is truly curve fit from every angle.  He basically eliminated any and everything that didn't give him the result he wanted.  It's not about robustness.  BUT, since it follows the PP concept more or less on a tactical basis, this may be its saving grace.

[MachineGhost]

It's only through sheer chutzpah that Grossman is selling access to signals without a real money track record.

The difference between buying at the close and at the open (as in reality if you get the open price which is questionable unless you use a MOO order) is about 20%-30% CAR (commissions take away another 1% CAR or so).  Grossman admits this fact but then proceeds to go ahead anyway and buy the next day with real money using future contracts!  And only "live" since 2010.

But the real kicker is this...  Grossman has curve fit the system so finely that 1 day more or less is the difference between a 22% MaxDD and a 50% MaxDD.  The problem is in the giving back of the triple digits gains of the EDV in early 2009 just before the stock market bottomed.  Its a nice problem to have but I don't know anyone who could weather that without ice cold blood.  This "filtering" seems to be an artifact of only selling/buying at end of the month.  I suppose if you knew what the next top rated ETF would be beforehand, you could put in the order 15 minutes before the close of each month, after selling.  It's unlikely that anything would change within 15 minutes to close...  but EDV is hellishly volatile.  No room for errors.

But like Dennis Miller says, "Of course that's just my opinion, I could be wrong."