Gyroscopic Investing

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Thanks for posting the link here, I had been meaning to generate discussion about Wade Pfau's post.

Stocks are a powerful engine when the markets are performing well. The Permanent Portfolio is way to diversify some of their inherent risks. The main thing really for me when looking at the issue is to just remember how volatile stocks can be and be sure you have a way to deal with problems when they show up. This can either be a diversification strategy that can absorb the losses or a mental outlook that allows you to hang on for dear life and hope things get better. The history of non-US markets in particular have been strikingly bad at times.

I'd be interested to know at what times in history gold and silver have behaved much differently from each other.

I'd like to believe that in a time of world-wide-war and very, very negative real interest rates that gold would have exploded against fiat currencies at the time.

moda0306 wrote: I'd be interested to know at what times in history gold and silver have behaved much differently from each other.

I'd like to believe that in a time of world-wide-war and very, very negative real interest rates that gold would have exploded against fiat currencies at the time.

Moda, I totally agree. Wasn't silver in a somewhat peculiar situation at the time since it was still available in large stockpiles from the days when it was the predominant monetary metal and yet was no longer much used as a monetary metal. Since then, black and white photography has consumed the silver stockpile. I do think though that major wars always entail major confiscations to fund them. If push came to shove, I don't suppose a government would let people evade paying for a war by holding gold or whatever.

Very interesting.

Clive's analysis using silver as a gold proxy in a PP still shows that a mix of volatile assets protects reasonably well against past financial calamities, albeit with some years of real losses.

Are there any mixes of investable assets (available throughout those periods) that would have done better than that PP proxy over those periods?

I should have said "...done better..." on a real basis.

Clive wrote: Tomorrows UK papers look like they're going to follow the Telegraphs lead (http://www.telegraph.co.uk/finance/econ ... gilts.html) and have front page (minor) coverage of 100 year Gilts possibly being issued 'to exploit current low yields'.

I have this gut feeling that once large amounts of treasury's have been issued that pay perhaps 3% yields, some time not too far down the road there will a whoops - oh look inflation has spiked to double digit amounts for two or three years whilst treasury yields are suppressed to 0 to 4% type levels. After 30% to 50% has been lost in real terms (raided from pensions and savings) inflation declines again and large amounts of the debt will have been 'paid off' at the expense of those pensions and savings.

I see that risk as being the greater compared to deflationary risk. That might be at least in part mitigated by holding a relatively high proportion of inflation bonds (perhaps in a manner as I outlined in my previous posting) or a proxy for inflation bonds (staples, commodities, oil, defensive etc.).

I too share your concern for suppressed yields in the future.  One tweak is to substitute cash for farmland in the PP.  See my thread regarding farmland in the PP.  Love to see your critique.

Clive

Couldn't you actually experience real (although perhaps not nominal) losses if you go heavily into inflation bonds (either alone, in an FTM portfolio, or in a 75% inflation bond 25% 3x leveraged portfolio) in an attempt to "get ahead" of impending inflation? Three possible scenarios come to mind:

One, the Fed (or Bank of England, or whoever) raises rates sooner than expected after double-digit inflation hits and the rate hikes kill the capital value of bonds. This doesn't matter if you hold the bonds directly (bond funds are a different story) UNLESS you have to rebalance when your bond values are down. Then you end up selling (say in order to buy the other asset/s that were even more depressed in value by the rate hike) inflation bonds at exactly the worst time.

Two, what if the central bank decides to do another QE and this time targets inflation bonds? They could drive inflation adjusted yields to negative real levels by overpaying for the TIPS/inflation bonds/etc. In QE2 the Fed did buy some TIPS but they weren't the main target; nevertheless there were stiil times when TIPS (the short-term ones) had negative real yields.

Three, what happens if the Fed doesn't do another QE and buy TIPS but your fellow investors do the Fed's work for them? By this I mean the following: Think of a series of years like 1945-48; inflation was in the high single to low double digits. If investors finally get wise to this many of them may decide to by some "protection" in the form of inflation bonds. The only problem is if enough investors do this they will drive TIPS prices through the roof. Since TIPS (whether on the secondary market or at TreasuryDirect) are sold in competitive markets (TreasuryDirect does competitive bid auctions and in the secondary market you have to pay whatever sellers demand or go home empty handed) they CAN be bid up way beyond par. If investors expect, say, 8% inflation they may bid a 3-year TIPS up to maybe $115 or even $120 when its par value is $100; this seems absurd but if fixed non-inflation adjusted short term Treasury rates are at, say, 0.50% when inflation is at 8% (welcome to financial repression) then buying a $100 bond (for $120) that should be worth $123 or $124 at maturity due to inflation is better than buying a 3-year T-note and ended up with a real loss of 20% or more after inflation...HOWEVER, this only holds true if expected inflation materializes; if it does not (say inflation comes in at only 3% per year for those three years instead of the 8% investors expected) then the TIPS will only be worth about $110 in nominal dollars but anyone who paid $120 for it would experience both a nominal and a real loss. For that matter, what's to stop the central bank/Treasury/government from saying inflation is "only" 4 or 5% when it's really 7 or 8%...that would nerf your TIPS real returns as well.


FarmerD,

How exactly does one rebalance farmland? How did farmland do in the 1945-1948 period?

Clive wrote: Replacing the 25% Total Stock Market with Small Cap Value, but otherwise keeping the PP as-is would seem to have performed a lot better during the 1936 to 1952 period when treasury yields were held down and inflation raged in the upper 1940's years.

Perhaps small and value might both have high levels of debt such that inflation is a relatively good thing for those asset classes as the debts are eroded in real terms.

That's an incredibly interesting observation, Clive.  While it's of course difficult to be sure of the cause, your explanation for the relative outperformance of SCV during those low-interest, high-inflation periods makes sense.

Clive and Lone Wolf,

I'm not sure if using SCV in lieu of TSM is enough protection in times of high inflation and suppressed yields. Looking at the graph of real returns for the 25% SCV, 25% silver, 25% 5-year Treasury ladder, and 25% LTT it seems that anyone who bought into this blend in 1935 or 1936 wouldn't have broken even (much less made in money) until early 1942. That pales, though, in comparison to what happened to someone who bought in January or February of 1946 would have experienced; they would not have even broken even in real terms until around 1954 (even assuming their income and stock/silver capital gains were tax-sheltered....which is highly unlikely as IRAs/401Ks didn't exist back then; if the assets were held in taxable accounts they would have been decimated by inflation as the investor was forced to pay real taxes on nominal gains-that actually were losses once inflation was taken into account!). Considering that in the US (I understand that in the UK they were even worse) taxes started in the 18% or 20% bracket (and went up to around 90% of income) during most of this era, the "tax on illusory gains" tax would have had a terrible effect on one's portfolio.

Also, I'm not so sure that "SCV stocks will do well in high inflation/suppressed yield/financial repression environments as the real value of their debts are washed away by inflation" hold true all the time. It was absolutely true during the 1970s inflation when yields on safe assets were kept below anything that would give a real return (well, they were until Volcker came in) but doesn't appear to have helped much during the post-WWII inflation.

I have divided the 1937-1953 era into four periods as follows:

1937-1940 = 1937-38 recession and its aftermath/recovery (the economy didn't fully recover until WWI)

1941-1945 = WWII

1946-1948 = postwar inflation

1949-1953 = beginning of postwar boom and '49 to '67 bull market


Inflation during these four periods

1937-1940 = 0.33%

1941-1945 = 5.16%

1946-1948 = 10.23%

1949-1953 = 2.17%


Returns of SCV vs LCG vs S&P 500 (actually S&P 90 as the S&P 500 index didn't exist until the 1950s) during these periods:

http://imageshack.us/photo/my-images/7/ ... ominal.jpg

http://imageshack.us/photo/my-images/53 ... ksreal.jpg

As you can see, while inflation on average outstripped safe asset yields somewhat from 1941-45 and soared beyond yields from 1946-48, only during the WWII years did SCV outperform large-cap growth or a large-cap index. While it is true that if you had invested in SCV in early 1937 and sold it in 1953 you would have made more than if you had invested in the S&P or in large-cap growth, ALL of this outperformance was due to the WWII years; during the postwar years of high inflation when suppressed yields would have hurt the most (1946-48) SCV actually did worse than the index. As such, how do we know the SCV performance advantage was not due in large part to either:

A. Small cap value stocks, being by their nature mostly ignored ( "small fry" too small of market cap for most investors to care about or even know about) and left for dead ( "valuey" deeply depressed price for some reason or another) took off like a rocket (much more than other stocks) when the economy, employment, GDP growth, and demand (albeit mostly government created demand from defense spending) perked up sharply during WWII?

B. SCV stocks having the most to gain (on a relative stock price basis) from lucrative "cost-plus-can't-lose-money" defense contracts...while a small company and a large one would both be helped by receiving such a government contract a large company (say....Ford, US Steel, or Douglas Aircraft) couldn't grow nearly as much as a small company because large companies have already reached a mature stage whereas small companies can easily double, triple, or more in value?

Just some things to think about.

D1984 wrote: FarmerD,

How exactly does one rebalance farmland? How did farmland do in the 1945-1948 period?

According to http://www.usinflationcalculator.com/in ... ion-rates/ inflation increased by 37% between 1944 and 1948.  According to the UNL website, farmland rose from $33/acre in 1944 to $56/acre in 1948.  That's a 70% increase from land appreciation alone.  Of course you'd also be getting a rent each year as well so it looks like farmland easily delivered a positive real return.  

Rebalancing is obviously a bit harder than rebalancing stocks or bonds but I don't think this is too big of and issue.  Since farmland generates a reasonably high rent, you'll use the rent proceeds to built up other portfolio assets.  Since the land itself has appreciated about 5.8% per year over the past 60 years, you probably won't really need to rebalance up very often.  

Overall that's somewhat like holding

18% stock
18% gold
36% currency
24% debt

Coupled with 88% in inflation bonds

Cllive,

What happens if the scenarios in my previous post as far as inflation bonds are concerned come to pass? Theoretically (hopefully? ) the leveraged gold would save your portfolio (although at 6% in 3X gold i.e. the equivalent of 18% in 1X gold as above I don't know if that's enough if inflation really takes off and nominal yields are kept at 2% or less levels like they were in the late 1940s).

If it doesn't, then any portfolio with 88% or 90% inflation bonds would be decimated

Clive,

My main concern was not how "inflation taxes" would effect such a portfolio; they would hurt it but it's only adding insult to injury in a situation where inflation is in the low double digits but nominal yields are kept at 1 or 2% (a situation where inflation was at say, 30% and yields were at 33% where one would be earning 3% real before tax but would be losing money after even a 15% income tax would be another story entirely since in that case it's not the artificially low yields of financial repression that's hurting you--since yields compensate adequately for inflation--but the taxation itself); if you can earn 2% on a bond when taxes are at 50% you'll earn 1% but with inflation at, say, 15%, earning 1% (assuming taxes are paid) vs earning 2% (assuming no tax) is still rather cold comfort; that extra 1% you get from not being a taxable investor (i.e. being a non-dom or a perpetual tourist or a legal citizen of an offshore tax haven) pales in comparison to the 15% purchasing power you just lost to inflation.

The issue was (taxes aside) what happens if inflation bonds get bid up so much (either by central banks or by investors desperate to protect themselves) that they no longer serve as much of a hedge and indeed if inflation doesn't remain as high as expected they could even lose money? How does the "3X" portfolio protect against that? Does it really have enough 3x gold (or I suppose 3X commodities/CCFs if one chose to use those in lieu of gold) to uplift it during times of seriously negative real rates?

What we (as investors) really need IMO is something like an I-bond but that is available in quantities of at least a few hundred thousand dollars per year per person (maybe set at $250K so as to be comparable with FDIC limits so as to give investors a choice between this bond or CDs); unlike TIPS, I-bonds CANNOT lose value due to rate increases and can never be bought at anything but par. The chances of any government making such a bond available are of course slim to none; if a governing entity is trying to melt its debts away (in real terms) through financial repression issuing bonds like the above would be like giving a level IV bulletproof vest with trauma plates to a condemened man right before he faced the firing squad--it would kind of defeat the whole purpose.

Clive wrote: In the UK there are means to add reasonable amounts into IBonds like holdings.

Hey Clive,  did you have something other than ILSCs in mind ?