Gyroscopic Investing

I think that one of the keys to success with the PP is being able to mentally construct a bullish and bearish case for each of the PP's three volatile assets at all times.

At first this is hard because you are so attached to the accuracy of your own beliefs about what assets are likely to do.

With practice, though, it becomes easier to make the argument for and against each asset.  It's not that the argument in each case has to actually be persuasive to you; rather, what I am suggesting is that there is value in simply understanding how to articulate the argument in a serious way. 

For example, "gold is a stupid asset that is obviously in a bubble" becomes "the chart suggests that gold is in a multi-year secular bull market, and such markets have a way of going much higher than anyone would have ever imagined."  On the other side, "gold is the only asset to own because the entire monetary system looks like it's ready to fall apart" becomes "gold is a small market and even a minor shift in sentiment could easily change the demand for gold a lot, and after 10 consecutive years of strong gains some pretty strong pullbacks could easily occur.  Also, in the past when these parties end they can end pretty abruptly."

Once one understands that there is a rational case for and against each PP asset class at all times, it becomes easier to buy each of them when setting up your PP and easier to maintain the allocation even when one of the assets is behaving in a way that surprises you.

I think that the discussion in another thread about whether it would be time to bail on LT bonds if long term rates reached 0% is reflective of the fact that at 0% there really isn't much of a bullish case for LT bonds from there (apart from the sub-zero percent long term interest rates idea, which strikes me as farfetched), and if there really isn't any bullish case to be made for an asset (even one you disagree with), then I wouldn't be opposed to saying it was time to get out of that asset.  In this example, of course, there would still be a bullish case at long term rates of 1% or .50%, which seems like a more likely situation to find oneself in even under the worst deflationary conditions.  Note, however, that being able to conceive of a situation where there would no longer be a bullish case for an asset would only be relevant if you actually found yourself in that situation; the mere theoretical possibility of there no longer being a bullish case at some level doesn't suggest that a bullish case at another level is any less legitimate.

Preach it.  The PP works best when you're dancing on that little thin line between love and hate for all the assets.

I found this to be a great exercise for highlighting my own biases too.  Making the bullish case for LT bonds always leaves me with a strange, unsettled feeling in my gut.  Not unlike eating a bountiful lunch of baked beans and cabbage before heading into a 3-hour meeting.

Basically, I don't like LT bonds.  Even after they returned 35% in a year, I still look at them with the kind of sneering distrust you get when Rick Ferri spies a bar of gold.

No big deal, or at least so I tell myself.  We all have our biases and our blind spots and I count myself lucky if even half of mine will confront me out in the open.

By the way, do you have an interesting bearish case to make for LT bonds?

Totally agree. Similarly, one should also be able to construct an argument for and against the unadulterated PP. As Tortoise stated in this related thread on LTTs, the PP only benefits from such "kicking of the tires." In fact, isn't that what HBs career was all about? And if he were alive today, I would be very curious as to what he would recommend. 100% unadulterated PP? Would he still invest 25% of his assets if the LTT yield dropped to unprecedented levels? Would he still maintain 25% in a diversified equity index if the PE was 50? Would he keep only 25% in gold if the price dropped back to that of the 1970s?

Lone Wolf wrote: By the way, do you have an interesting bearish case to make for LT bonds?

LT bonds are clearly about to fall in value.  The multi-decade bull market is coming to an end.  We have tested the mid 2% range twice now and the market has shown it doesn't want to go lower.  The stock market won't trade sideways forever as it has for the past 11 years, and once it starts rising, LT bond yields must rise to compete with the capital moving into stocks.

On the monetary policy side, the Fed has made it clear that it is willing to accept inflation in the 3-5% range in exchange for economic expansion.  If you believe that the Fed will succeed in its inflation target and that real interest rates won't be negative forever, you must believe that LT bond yields belong in the 3-5%+ range (i.e, higher than they are now).

Politically, the U.S. is clearly in decline.  Owning the long term debt of a nation in decline is a sucker's bet.  Although the dollar probably has some life left in it, anything beyond about a 10 year bond is taking on huge "empire in decline" risks.

Financially, the U.S. government is also broke.  How long can any rational market continue loaning money at such low rates to such a reckless and moronic group of politicians?

Finally, the future looks to be characterized by natural resource related conflicts, with the U.S. continuing to try to play policeman to the world, which means war, war and more war.  Everyone knows war is inflationary, and inflationary expectations about the future will sooner or later translate into higher bond yields. 

How's that?

MediumTex wrote:How's that?

Care to take a stab at the counter-point?

This is a wonderful topic. To be honest with my own personal world of thinking, I imagine that our shoes are SHY (cash), our pants are TLT (bond), our dress shirts are GLD (gold), and belts/glasses/hats/etc. are VTI (stocks). It is important that we cover our nakedness with these so people do not think of us like a cave person.

I apologize if I digress.

MediumTex wrote: How's that?

A+, especially since I've seen you put together a very solid bullish case for them as well.  I figured you didn't bother with the bearish angle because, well, the line of financial pundits looking to take a dump on long-term Treasuries has been around the corner for years.

Odysseusa wrote: To be honest with my own personal world of thinking, I imagine that our shoes are SHY (cash), our pants are TLT (bond), our dress shirts are GLD (gold), and belts/glasses/hats/etc. are VTI (stocks). It is important that we cover our nakedness with these so people do not think of us like a cave person.

Your analogy comes dangerously close to making a case for dropping long-term bonds from the portfolio entirely -- as expressed in the following Venn diagram: 

WildAboutHarry wrote:

MediumTex wrote:How's that?

Care to take a stab at the counter-point?

LT yields are going to stay low for a LONG time and they will probably go a lot lower from current levels.

Financial crises are deflationary, and deflation is characterized, in part, by falling interest rates.

Until recently, Japan was the only example of a modern economy seeing ultra low rates (i.e., under 2% on the long end of the curve) on sovereign debt following the popping of an asset bubble, but now Germany is joining the act with LT yields currently around 2.4% and falling.  Thus, we see that there is nothing unique about Japan and when you combine deleveraging with poor demographics and a weak economy in a stable country you are likely to get falling rates wherever it occurs.  Under these conditions rates can fall to absurdly low levels, and the U.S. is likely to follow the same pattern as Germany and Japan, with LT yields just grinding lower and lower and lower.

There are only two things that would make LT yields rise: a rising stock market, rising inflation/inflationary expectations, or some combination of the two.  Right now, we have neither.  Offshoring of U.S. jobs has created structural unemployment that will crimp U.S. consumers' disposable income for years to come.  This structural unemployment will keep a lid on inflation as the amount of disposable income in the economy continues to shrink, while the U.S. stock market will see little upward pressure for years as the remainder of this secular bear market for stocks works itself out.

Peak oil will ironically result in lower interest rates around the world.  Here's why: peak oil means that the ability of the world economy to expand will be severely limited due to the lack of the ability to expand world fossil fuel production at will (which we have been able to do for the past 100 years or so).  This limitation on growth will be discounted in the form of bonds with lower yields because if the expected returns on most economic activities is in the low single digit range due to dramatically increased energy input costs, any bond with an interest rate higher than the expected rate of return on the project will not be "self liquidating" and thus will not be made.  This phenomenon will affect bond markets all over the world, but it will drive rates on the safest debt (i.e., U.S. treasuries) to "super low" levels.  The peak in global production of conventional oil occurred around 2005 and interest rates in the U.S. (the world's largest oil consumer) have basically gone straight down since then.  Think of peak oil as Mother Nature's form of deleveraging, with all of the unpleasant deflationary side effects.

From a technical perspective the near-30 year bull market in treasuries is still very much intact.  The chart suggests that from here we have nowhere to go but down.  The highs in yields will continue to be lower and the lows in yields will continue to be lower as well.  The tape tells the story.

Over the last 100 year period, we are actually only a little below the mean long term interest rate of 4% or so.  Given all of the deflationary headwinds the economy is facing, yields should probably be significantly below the 100 year mean.  Right now, something in the 2%-2.5% is probably about right.  

Given how long the fallout from the popping of a debt-fueled real estate bubble has lingered in Japan, it's probably fair to assume that such conditions will linger in the U.S. for many years.  Thus, very low rates on LT treasuries are likely to linger for perhaps another decade or more and are currently nowhere near their eventual lows.

How's that?

Must admit that I was skeptical about this thread on first read. Just a clever, oblique way of reciting the same old mantras, "Hey, I've been 100% invested in the PP for longer than most of you (5 years) and it has weathered all storms. Plus it can be backtested. Plus it was written by a truly Enlightened Being, perhaps deserving Deification. So just jump in, trust me, even if your intuition tells you otherwise."

Then I read your point and counterpoint, MT. And I found this to be one of the most helpful threads that I have read so far. I believed both as I was reading them, almost to the point of either abandoning LTTs altogether or placing all of my money into them. How did you do that? I think that this is termed Dissociative Identity Disorder..

Thanks.

Nice summary, MediumTex. It shouldn't be buried in a posting string.

BearBones wrote: Then I read your point and counterpoint, MT. And I found this to be one of the most helpful threads that I have read so far. I believed both as I was reading them.

It's like the investment equivalent of Paul McCartney's "Coming Up" video.

Seriously, though, for any large market there is always a coherent and persuasive bull and bear case for every asset.  Understanding each argument and the uncertainty inherent in such competing narratives should make it easier to embrace something like the PP.