What causes the Permanent Portfolio to go down?

[Plurimus]

Dear Clive

I studied your spreadsheet (http://www.jfholdings.pwp.blueyonder.co.uk/us_pp.xls) a bit and I am still flabbergasted by your Rebalancing formula.  I will have to lock at it with a large cup of coffee to activate all my little braincells to understand!  Impressive work!

I found 2 discrepancies between our approached and I can't decide yet, which one is more correct or if simply both work depending on how one sees the world. 

1. You included dividend (your yahoo price feed does that as you mentioned) and I didn't include dividends. In general I think you are right to include, but maybe some people say that they might lose up to 50% in withholding tax, if they are non-US domiciled and then pay on the rest income tax of up to ??% depending on where they live.  I added an extra sheet with the dividend&interest data in my spreadsheet (see www.plurimus.net/blog/update-uspermanen ... iobacktest)
2. We did the Draw down calculation different.  While I did it backward looking putting the price one year ago relative to current price, you put the price of one year in future relative to current price. I don't really know,  what effect it has. 

[craigr]

Most of your answer reverts to hedging again. I get the hedging. I like the hedging. Put the hedging aside.

The portfolio makes gains in three ways as explained by Browne and others:
1) Dividends
2) Interest
3) Capital appreciation

That's a bit like saying the gain comes from gains, no? But how so with the components purposely hedged against each other? If I buy TSM, short TSM and buy bonds, you wouldn't say my overall portfolio gains are from those 3 items because you'd clearly see that only bonds contribute overall gain in such a portfolio. It is quite complicated to understand what the overall weighted bet in PP is.

The components are not perfectly hedged against each other. What has generally occurred is as one component goes down another tends to respond and grow. Over time these gains overcome the losses in the other parts of the portfolio. The markets are not perfectly synchronized. The components that gain tend to grow 100, 200, 300 or more percent over time. But the losers rarely drop more than 50% even in a very bad bear market.

I don't believe Browne's mechanical explanation that the reaction simply outweighs the action and returns some profit.

Browne's analysis is, I feel, correct. I've been an investor for almost 20 years now and I can see from first-hand experience that the market's reaction to events is often overreaction both up and down. Or sometimes events you think could shock the markets are simply shrugged off. I think it was investor Benjamin Graham that famously quipped (paraphrasing): "In the short run the market is a voting machine. In the long run it's a weighing machine." So over time the natural direction of the market is towards growth of profits, dividends, interest. In the short run though it can be appear to be very sporadic and bumpy and this is where holding non-stock type assets can really smooth out the ride.

It is natural to want to go back and develop a narrative to match events of the past. But a narrative may or may not be correct. In regards to the market we still have debates even to this day about the great depression and what caused it and why it lasted so long. Each person will have their own narratives about these events and even in modern markets we see these narratives each day. "The markets went down today on account of the Greek riots." Etc. Well that's all well and good. But unless these reporters are doing a survey of all the market participants about why exactly they did what they did then it's just a wild guess. Even if these narratives were valid then you have to look at the other side of the transaction. Why did someone buy an asset on that day that few, it seemed, wanted? These questions are never asked because it would make the story too unclear and people want clear answers.

But there is no clear answer which is the point of the portfolio. I think Browne did a good job identifying the basic economic cycles that occur. Then assets were chosen to take advantage of those cycles no matter how or when they happen. Now it may be that there isn't a rational explanation why people all of the sudden want gold, or bonds, or stocks or Pokemon. We may want to put a narrative on it but there really is no way to show the narrative to be correct as we are fitting the story to the facts after the event.

So the Permanent Portfolio basically punts on this issue because attaching a narrative to these past events doesn't really matter. For instance the portfolio doesn't care that it was a massive banking crisis in 2008 that caused LT bonds to spike. All it cares about is that deflation was a threat and it held an asset to protect against it.

I think it's probably more fair to say that the portfolio takes advantage to a certain degree of the volatile and unpredictable nature of the markets. When LT Bonds spiked in 2008 for instance an investor could have sat and analyzed or try to attach a narrative to it. But the right action was simply to rebalance and buy stocks. No analysis of the situation would have been useful because events could have unfolded in a million different ways. Instead of reading the news and looking at the past the right choice was simply to ignore it, accept that there are gains that were given out for whatever reason, and move on. I don't think it is magic that it happens. I think it's just taking advantage of the situation when it presents itself.

[Roy]

Most of your answer reverts to hedging again. I get the hedging. I like the hedging. Put the hedging aside.

The portfolio makes gains in three ways as explained by Browne and others:
1) Dividends
2) Interest
3) Capital appreciation

That's a bit like saying the gain comes from gains, no? But how so with the components purposely hedged against each other?

The components are not perfectly hedged against each other. What has generally occurred is as one component goes down another tends to respond and grow. Over time these gains overcome the losses in the other parts of the portfolio. The markets are not perfectly synchronized.

Craigr, is correct.  The asset classes are not perfectly negatively correlated, else there would be no return. The portfolio return has come primarily as rewards for its component risk premia, and also as correlative portfolio return—in the forms indicated by Craigr.  Three of the four PP components take advantage of various risk premia—the extra return above "riskless" T-bills.  In order of risk, these are Stocks, LT Treasuries, 2-year Treasuries (if using it as the CASH component).  Risk premia exist for good economic reasons—not because of past returns.  However, it is true that the deep past has demonstrated this economic reasoning, rewarding the risks with "respectable" returns.

This is true with other asset classes (else Fama could not have realized his findings in the 3-Factor model, and more importantly, Markowitz could not have realized his findings regarding the primacy of the portfolio as a whole—thus it is possible to have greater returns at less risk by combining risky assets).  Of course, there is no assurance of robust continuance of any asset class, especially over shorter periods (like the last 10 years, for example, with Stocks), else there would be no risk and hence no premia—for anything. 

There is no portfolio magic here—or in any portfolio design.  In one sense, what has happened with the Permanent Portfolio—the broad-based last 38 years—is similar to what would have occurred if the portfolio used just 25% Stocks and 75% IT Treasuries (The 50% bonds in the PP is roughly equivalent to IT Treasuries). 

CAGR                8.94%
Standard Dev      7.3%

It improves when approximating the PP using CCFs as 25% of the portfolio using ST and LT Treasuries:

CAGR                9.66%
Standard Dev      7.77%

(Drawdowns have been pretty good too, though Gold has performed better than CCFs in monetary crises and hyperinflation.)

This heavy weighting to bonds and CCFs has "hedged" the bigger premia "bet" made in the stocks (stocks have much heavier weight in a portfolio and Standard Deviation than bonds).  It has done this because bonds have done particularly well, in general, and Treasuries are a flight-to-quality item—thus improving correlation when it matters most.  In fact, 3 of 4 of the PP classes are often viewed as "safe havens", including Gold (and Commodities), to which is more difficult to assign risk premia.  So, it is not just the correlations but it is when the correlations converge or diverge that  have mattered.  Thus, I view the role of Treasuries, and certainly Gold as more complex than slotting them neatly into an economic condition, though sometimes they fit-in quite nicely. 

Regarding portfolio-as-whole, this can be seen when adding a portion of Stocks to, say, LT Treasuries.

100% TSM
CAGR                9.39%
Standard Dev      18.85%

100% LT Treasuries
CAGR                8.76%
Standard Dev      11.23%

25% TSM plus 75% LT Treasuries
CAGR                9.31%
Standard Dev      10.2%

Here we see the combined portfolio as having essentially the same or more return—at lower risk (SD is one form of risk)—than either asset class independently.

While Browne designed his portfolio with the various "economic cycles" in mind, that is just one way to view the results (though his is certainly a valid way).  I see the last 38 years as simply a reward for risk taken, in varying degrees, and the work of Markowitz showing its effects in portfolio-as-whole.  Quality Bonds have benefitted most, and Gold has performed well in many crises, dampening the overall portfolio volatility (to a lesser degree, CCFs have done likewise).  Portfolios heavy in quality Bonds have done OK—over the long term.  Put that all together however you wish, providing the equity portion was kept low with lots of Treasuries, and  the last 38 years have been a fairly smooth ride, rewarding the various premia that are founded on good economic sense.

Roy

[stylo]

Thanks for the helpful replies.

I don't believe Browne's mechanical explanation that the reaction simply outweighs the action and returns some profit.

Browne's analysis is, I feel, correct. I've been an investor for almost 20 years now and I can see from first-hand experience that the market's reaction to events is often overreaction both up and down.

I don't see any evidence of that producing a profit. Offhand, logically reactions would cancel each other out over time - even if lopsided, due to opposites occurring. Such a "magical" notion obscures the obvious reality that the PP is weighted towards certain bets which happened to make money over time.

Btw, when I say "magical portfolioism" I certainly don't mean there is a trick or scam involved in the PP; rather that it is discussed far too much as a portfolio that simply works out and returns a profit without discussing the overall weighting. My whole point is that we can only begin to evaluate if the PP is a good portfolio going forward once that is done.

This heavy weighting to bonds and CCFs has "hedged" the bigger premia "bet" made in the stocks (stocks have much heavier weight in a portfolio and Standard Deviation than bonds).  It has done this because bonds have done particularly well, in general, and Treasuries are a flight-to-quality item—thus improving correlation when it matters most.  In fact, 3 of 4 of the PP classes are often viewed as "safe havens", including Gold (and Commodities), to which is more difficult to assign risk premia.  So, it is not just the correlations but it is when the correlations converge or diverge that  have mattered.

So, again, a certain bet which needs to be evaluated given current and anticipated conditions. If gold & stocks trend down over the next 5 years, and interest rates have no where to go eventually but up, affecting TLT negatively, then I can't see the PP returning a profit as it has in the past. Without those 3 components trending up over the long term... ?

[craigr]

I don't see any evidence of that producing a profit.

But it does produce a profit. The latest example is 2008 where LT bond prices spiked during the panic. If you sold down the bonds back to the 25% level and took the profits and bought your stocks back up to 25% during that time you made money.

Offhand, logically reactions would cancel each other out over time - even if lopsided, due to opposites occurring.

The markets are not always logical. This is why all assets are held all the time and no market timing is attempted. There is no cancellation of returns because the assets are not perfectly negatively correlated against each other.

Such a "magical" notion obscures the obvious reality that the PP is weighted towards certain bets which happened to make money over time.

The Permanent Portfolio is weighted towards prosperous times because 50% of the assets are in stocks and bonds. Both of those assets tend to do well when interest rates are relatively low and stable. Both of them however do poorly when rates are rising rapidly. Stocks also do poorly if rates are collapsing due to a sudden contraction in the economy (although LT bonds do quite well).

Btw, when I say "magical portfolioism" I certainly don't mean there is a trick or scam involved in the PP; rather that it is discussed far too much as a portfolio that simply works out and returns a profit without discussing the overall weighting. My whole point is that we can only begin to evaluate if the PP is a good portfolio going forward once that is done.

The weighting issue still does not tell you what the future is going to do. If you think the future is going to be one of very high inflation then we could argue the gold weighting is far too low. If we think the future is going to be a re-hash for the 1980-2000 bull market in US stocks (greatest in history) then we could say the stock weighting is too low.

But we don't know these things which is why an equal split among the assets is generally considered a good idea.

So, again, a certain bet which needs to be evaluated given current and anticipated conditions.

You can't anticipate the market direction in the future. That's the sticking point. I can pull up articles from a decade ago saying stocks will have an anticipated return in the 10% range the next 10 years. But they were all wrong!

[stylo]

But it does produce a profit. The latest example is 2008 where LT bond prices spiked during the panic. If you sold down the bonds back to the 25% level and took the profits and bought your stocks back up to 25% during that time you made money.

No, that doesn't show it mechanically produces a profit via an over-reaction as Browne claims, which was the point discussed. You might have lost more or the same on another item going down. That is an example of rebalancing making a profit (perhaps, if it all goes the right way).

But we don't know these things which is why an equal split among the assets is generally considered a good idea.

But as agreed, they're not "equal" - it is a bet weighted a certain way. They're only equal in % not in hedging.

So, again, a certain bet which needs to be evaluated given current and anticipated conditions.

You can't anticipate the market direction in the future. That's the sticking point. I can pull up articles from a decade ago saying stocks will have an anticipated return in the 10% range the next 10 years. But they were all wrong!

Ahhh, we're going in circles here. Just saying over and over that we can't definitively know the future is NOT a point in favor of the PP or any other portfolio. It's a point in favor of nothing, or severely hedging, any hedging, and the PP in the sense that its hedges worked in the past, but that's a logically separate matter from evaluating the PP and its weightings. It might be a terrible portfolio into the future given present valuations. You don't know until you at least attempt to evaluate things. And if you don't, you've taken the position that it will continue to work as it did before!

Walking slowly toward a cliff blindfolded worked great in the past - doesn't mean it will in the future or is better now than turning left. But if I think I've been climbing up and can suddenly smell the ocean, I might turn. If not, you're betting to continue as-is - which is still taking a position on the future, not at all avoiding one as you keep saying.

That's a basic unavoidable logical point. There is no neutral choice.

Again, I have not concluded anything about the wisdom of the PP going forward. Just trying to understand exactly what it made a profit on in the past as the first step in evaluating it going forward.

Thanks for all your help in thinking about this.

[RickV42]

stylo~

RE:  Where does return come from?

In my mind, if assets do cancel themselves out over the very long term then you still get return from:

1.  2 points:  Rebalancing or reaping the energy of short term market mis-alloations (prior to market straightening them out).
2.  1-2 points:  From growth from equities (over time, there is probably at least some true economic growth here - some of which is paid  out in dividends).
3.  0-1 point:  From minor premium over inflation on combo of bonds or so over time.

I think this is where the 4 (or so) points over inflation come from.  I want to stress this is just my opinion in trying to imagine how returns are generated - I do not have data to prove the above and wouldn't now how to get if I wanted to. 

In the end, I moved into the permant portfolio in January of this year not because I could prove how returns are generated, but becuase I could not find anything better historical returns that was so smooth and allow you to hold a large portion of relatively safe assets.

Thanks again to CraigR and Med Tex. 

Rick

[craigr]

You don't know until you at least attempt to evaluate things.

The problem I'm having is in this attempt to evaluate the assets on guesses as to how they'll do going forward. In my world this simply isn't possible. Yes, we can make some educated guesses. However, our evaluation can be dead wrong and cause more harm than it could help. A mechanical approach to investing seems to provide better returns and a lot less worry than trying to guess the future of the market.

And if you don't, you've taken the position that it will continue to work as it did before!

Yes that's my position then. This is simply because I've not come across any arguments that present a better solution to the problem that don't have their own worse risks.

[Roy]

You don't know until you at least attempt to evaluate things.

The problem I'm having is in this attempt to evaluate the assets on guesses as to how they'll do going forward. In my world this simply isn't possible. Yes, we can make some educated guesses. However, our evaluation can be dead wrong and cause more harm than it could help. A mechanical approach to investing seems to provide better returns and a lot less worry than trying to guess the future of the market.

And if you don't, you've taken the position that it will continue to work as it did before!

Yes that's my position then. This is simply because I've not come across any arguments that present a better solution to the problem that don't have their own worse risks.

Much depends also on what one means when they say "as it did before".  Does this mean as it has for 38 years CAGR?  We have HB PP returns since 1972. Even in retrospect, every ten years you could have stopped and asked the same question on will it work as before?  And the answer will be yes and no for many reasons—including broad period returns, peak-to-trough assessments, valuations, interest rate and other monetary shifts, and a changing world that never presents the same crises, Bears or Bulls.

The asset class weightings and profits have already been explained, much of which, though not all, is based on well-founded risk premia.  (This is true for any portfolio that contains conventional components, as does the PP.)  There have been some rebalancing gains using the bands, but rebalancing is never an assurance of added profit;  it simply restores one's portfolio risk to original levels, else one allows the market to control that. 

Of course, if one accepts as inevitable, a priori, some hypothetical conditional that all asset classes (save Cash) will decline for many years, then it appears likely that this portfolio—or any other buy-and-hold strategy—will not  "perform as it has in the past," as such a future would be very different than experienced.  Then, any strategy might be "bad" going forward. 

On valuations, differences in opinion hardly constitute unique or usable information, even if "valuations matter".  Valuations experts have left corpses nightly on CNBC and elsewhere.  In 1996, Stocks were so highly valued that Irrational Exuberance was proclaimed.  Anyone then moving from equities to cash lost out on the next 3 years of spectacular returns.  This has applied to other asset classes too (Bonds, say), and for much longer periods, as has been discussed repeatedly.

This all leaves either riding it out, sitting in Cash, or tactical asset allocation based on whatever "strategy" one can conjure.  For me, I pick a conservative plan that hopefully permits me to stay a course and avoid capitulation.  There is more than one way to do this but the HB PP seems good as any and better than many.

Roy

[pplooker]

Of course, if one accepts as inevitable, a priori, some hypothetical conditional that all asset classes (save Cash) will decline for many years, then it appears likely that this portfolio—or any other buy-and-hold strategy—will not  "perform as it has in the past," as such a future would be very different than experienced.  Then, any strategy might be "bad" going forward. 

This is a great point.  I'd say it more simply that any plan can fail, but failure to plan is planning to fail from the onset.

Can't win the game if you don't even play.

[stylo]

http://www.etfreplay.com/backtest.aspx

Looking at past years, the PP looks like a muted expression of the SPY (S&P 500).

[Frank70]

If you want to understand what makes the Permanent Portfolio go up and down, look at the components in ETF form:

http://tinyurl.com/2apy2gx

nearly 4 years of performance history here and the comparison is just 0.50% off (which is about 0.12% annualized:  that is 12 basis pts).

Everything here is dividend adjusted.  I chose June 26, 2006 as the starting date because that was the inception date of the Swiss Franc Currency ETF.


chris
www.ETFreplay.com

[Pkg Man]

Today was one of the relatively rare days when all four PP investments increased.

[yankees60]

OK, a lot of numbers but here goes:

The worst peak to trough drop using the daily data that I have (and likely the worst ever, but I can't prove it) was -14.5%.  The value of a hypothetical $1000 invested in the PP on 28 Jan 05 (earliest date of one of the index funds used) was $1439 as of 17 Mar 08.  The low point was reached on 12 Nov 08, at $1230.

The portfolio was rebalanced when the 15% or 35% bands were broken, even if only slightly. As I understand it, this is what the owner's manual recommends.  I think, but someone can correct me if I am wrong, that the annual reference is more of a check and that you don't need to rebalance if all assets are within their bands.

While 14.5% decline in less than one year is sizable, it pales in comparison to the 47% peak to trough drop in the stock market during that year.  And for all of 2008 the portfolio actually ended up 1.5% (at least the way I figured it, using 28 Jan 05 as my starting point and 15-35 rebalancing).  Treasury Bonds, gold, and stocks all showed significant growth at the end of the year, with average growth of about 18% following a rebalancing on 20 Nov 08.  The stock market fell 37% in 2008 from the end of '07 to end of '08.

I used VTI, IAU, TLT, and SHY from Yahoo Finance for computations.  I'd welcome someone double check my math and post their results.

This seems to be another nugget.

States that the worst peak to trough drop was 14.5%.

Did not see anyone in this topic challenge or present an alternate amount.

However, this calculation was done nearly 10 years ago in May 2010. Does an updated calculation exist somewhere?

Vinny

[Kbg]

IIRC correctly both MG and I came up with something close to high 20s% MaxDD (e.g. 28-29% or something like that) when using daily data. That is my personal worse case for planning purposes. It should be noted that this occurred when gold went vertical and then crashed in the early 80s. All you had to do to make things seem a LOT less extreme was go back I think like 6-9 months and ignore the in between. Think Bitcoin like a year or so ago and that was pretty much what happened. Vertical up, cliff down. There hasn't been anything remotely like that since. Monthly and weekly data smooths a lot of stuff out.

I think a rebalancing study during that time frame would be very interesting, maybe one day I will do one.

[Xan]

IIRC correctly both MG and I came up with something close to high 20s% MaxDD (e.g. 28-29% or something like that) when using daily data. That is my personal worse case for planning purposes. It should be noted that this occurred when gold went vertical and then crashed in the early 80s. All you had to do to make things seem a LOT less extreme was go back I think like 6-9 months and ignore the in between. Think Bitcoin like a year or so ago and that was pretty much what happened. Vertical up, cliff down. There hasn't been anything remotely like that since. Monthly and weekly data smooths a lot of stuff out.

I think a rebalancing study during that time frame would be very interesting, maybe one day I will do one.

My recollection was that MG was saying 20% was the PP's max drawdown. Then he started being challenged to come up with a source for that, came up with a couple of links, and then it was pointed out that those links did not show a 20% drawdown. I think he ended up retracting it.

[Kbg]

I may be a bit high, but I don't think so. If someone really wants to know just dive into the data from Jan 80 to Jun 82. Gold alone pulled the entire portfolio down by ~10-15% from gold's high point. During this time the stock market was down ~25% and the Fed was still raising interest rates until the fall of 1981. In real terms, given the existing inflation rate at the time, I can see hitting high 20s easy. (Data wise LTT treasury returns will be the challenge...I think I had to hand crank the returns which is why I'm not going to spend time on it again.)

However, as noted earlier it all averaged out pretty quickly and the PP performed admirably.

Lastly, HB already wrote about what puts a hammer on the PP...tight money. In this situation 3 of 4 assets are probably headed south at the same time and unfortunately those assets are the volatile ones and that was exactly what was happening in the early 80s.

[InsuranceGuy]

[deleted]