Gyroscopic Investing

I made an animation that clarifies the breakdown of growth/recession combined with inflation deflation. Often times we fall into the trap of saying "prosperity, recession, inflation, or deflation" which is not totally accurate. It's a combination of two axes.



The animation goes from 1972-2011.

My take:
Gold does particularly well if the black dot is expected to be moving towards the upper left quadrant. Long-duration Treasuries do best when the black dot is expected to be moving towards the lower left quadrant. Equities do well if the dot is expected to be on the right side of the graph. Finally, T-Bills are held because occasionally the Fed tightens to a level where no asset class is attractive. 

Slotine wrote: That's an awesome visualization.

Care to do one for Japan?  That bottom half seems so unloved

Hah, maybe if I figure out how to do it in python. This one was a little bit too manual to create. Don't hold your breath but I might 

I'll admit I'm having a bit of trouble matching this visualization up with the historical real-world performance of the four assets. It looks like the dot is on the right side nearly all the time, and I can't help but see how that would endorse an extremely stock-heavy portfolio. And the dot doesn't ever seem to be in the bottom left quadrant and often moves farther away from it, yet we've seen a 3-decade bull market in treasuries.

Or is it this a demonstration of how market expectations rarely line up with reality?

Pointedstick,

I think usually the market expects the dot to be in the top right quadrant. Any movements in the direction of another quadrant are often a big surprise to the market. I think it is really important to emphasize that changes in expectations are what drive asset class returns.

Just think about the 1980s. We actually had some inflation in the 80s yet gold still tanked. Why? The high gold price in the late 1970s was reached because people had expectations about big inflation in the future. When the inflation was not as extreme as the market had priced in gold crashed.

That's an interesting observation. It might be more useful to express the dot instead an an arrow originating from its previous position and pointing at the new one. And instead of the quadrant it's in, what really matters is the direction the arrow is pointing in.

Just wondering. We have 2 axes : a prosperity axis going from very hard recession to incredibly booming economy and a price axis going from deep deflation to hyperinflation. Some points in this 2D space can't be reached I suppose (I can't imagine an amazing prosperity with a 5 digits inflation rate, for instance) but you can have :
- prosperity with inflation (very good for stocks, not that good for bonds, bad for cash & gold),
- prosperity with deflation (very good for bonds, good for stocks, good for cash, very bad for gold)
- recession with inflation (very good for gold, bad for stocks & cash, very bad for bonds)
- recession with deflation (very good for cash & bonds, bad for gold, very bad for stocks)

But I'm wondering about prosperity + deflation : why own LLT for this case ? I mean, sure they are going to be worth more as they produce fixed amounts of cash on the long term, but that amount of cash is quite low. Wouldn't be high yield bonds more adapted to this situation ? I mean, high yield bonds can produce a better fixed amount of cash than LTT and the overall prosperity widely reduces the credit risk. Aren't HY bonds the obvious choice for prospere deflation ? Wouldn't them perform a little better than LTT during prospere inflation ?

Of course, I don't advise to swap LTT & HY, because HY will hurt a lot during recession + deflation (because of credit risk, of course) so that is not worth the risk, but I don't understand why LTT is said to be the #1 asset to hold during good deflation.

k9 wrote: Of course, I don't advise to swap LTT & HY, because HY will hurt a lot during recession + deflation (because of credit risk, of course) so that is not worth the risk, but I don't understand why LTT is said to be the #1 asset to hold during good deflation.

The stock market would still do well during a "prosperous deflation".  If deflation was running at 5%, then the stock market only needs 0% nominal returns to produce a 5% real return.  I'd be very happy with that.  Also STT and LTT would be returning the same 5% real (assuming nominal rates stay above 0%).  If this occurred on a global scale then gold would not do well, but if this "prosperous deflation" was a local phenomena then gold could hold it's own.  Gold is always a wild card since it is a global asset currency.

I'm not sure prosperous deflation is even possible, at least not at significant levels of deflation.  I struggle to imagine a scenario where businesses are constantly being forced to get requotes from their suppliers in order to avoid a 5% hike in the cost of their inventory.  I don't see businesses being able to cope with more expensive inventory, massively higher labor costs, and still have "prosperous" returns.

I'm not an economist, but I thought that "prosperous deflation" occurs when technological progress in a thriving economy drives down prices (http://pages.stern.nyu.edu/~ekerschn/pd ... lation.pdf).  This phenomenon is opposite of the "bad deflation" that occurs when the economy slows down and prices fall due to a reduction in demand.

Whenever there is price instability, there are people who suffer, such as the workers who are displaced by the technological progress (http://en.wikipedia.org/wiki/Luddite) or the people who are laid off because their employers are losing money from the reduced sales.

If interest rates fall during deflationary periods, long-term bonds should do well because they will appreciate.  Cash should also do well because it can buy more stuff.  I would expect stocks to do OK during "prosperous deflation" because their dividends can buy more stuff and not OK during "bad deflation" because their sales and profits are down.

If gold is an insurance policy against extreme outcomes, I would expect gold to do well during "bad deflation" because people are scared.  I would expect gold to do poorly during "prosperous deflation" because people are happy (except for those who are thrown out of work because their skills are either overpriced or no longer needed).

RuralEngineer wrote: I'm not sure prosperous deflation is even possible, at least not at significant levels of deflation.  I struggle to imagine a scenario where businesses are constantly being forced to get requotes from their suppliers in order to avoid a 5% hike in the cost of their inventory.  I don't see businesses being able to cope with more expensive inventory, massively higher labor costs, and still have "prosperous" returns.

It could work, it would just require everyone to understand money differently.  Rather than expect an increase in salary, they should expect a 4% decrease, which still results in a 1% increase in purchasing power (assuming we have 5% deflation).  All manufacturers would have to lower their prices over time, since more goods and constant/falling money supply.  It would be extremely difficult for most people to initially accept, but after awhile it would become normal.

If it continued for a hundred years then a pack of gum that currently costs $2 would fall to 1 cent.  It would be the exact opposite of what we've seen over the past 100 years.  I see no reason for this to stop the economy from growing...other than cash being too valuable, and the national debt would become unbearable after awhile.

It's kinda like comparing the final scores of a soccer and football game.  Was the soccer game less valuable because there were only 3 points scored, and the football more valuable because it had 75 points scored?  I realize my audience is bit biased but in my mind both are just as fruitful.  Or imagine that over time the value of a touchdown and field goal were decreased by 10% a year...is the act of achieving that touchdown any less valuable than the previous year?  It doesn't matter that the touchdown is worth less, just as long as you have produced more than your competitor to win the game.  It still required the same amount of work to achieve and the results are the same, the only difference is the accounting is different.

However, I don't expect a prosperous deflation with Bernanke and Obama at the helm.

Gosso wrote: It could work, it would just require everyone to understand money differently.  Rather than expect an increase in salary, they should expect a 4% decrease, which still results in a 1% increase in purchasing power (assuming we have 5% deflation).  All manufacturers would have to lower their prices over time, since more goods and constant/falling money supply.  It would be extremely difficult for most people to initially accept, but after awhile it would become normal.

If it continued for a hundred years then a pack of gum that currently costs $2 would fall to 1 cent.  It would be the exact opposite of what we've seen over the past 100 years.  I see no reason for this to stop the economy from growing...other than cash being too valuable, and the national debt would become unbearable after awhile.

However, I don't expect a prosperous deflation with Bernanke and Obama at the helm.

I see what you're saying from a theoretical perspective, and I can understand how something like this could be tolerated if it was very short term or part of a fluctuating cycle where a true deflationary environment didn't last for years on end and wasn't significant (5% is significant).

I just don't see how it would work in the real world.  Major businesses that I'm aware of just aren't equipped to handle that.  At the end of the day their suppliers aren't going to consistently lower their prices, if they buy and hold stock for long periods to get volume cost savings they'll be losing money.  Most workers aren't going to accept yearly decreases in salary long term unless the labor market is very tight like it's been recently.

I don't see Obama leading us to prosperous anything, deflationary or otherwise.

RuralEngineer,

I'm not sure it could work in reality either, but it would have a good chance of succeeding if the expectation of deflation became the norm.  Businesses and peoples mindsets would adjust.  This is the only way I can imagine a prosperous deflation. 

If expectations are inflationary and the economy falls into deflation then this always bad, since the likely cause is a bubble bursting.  In this case LTTs will be the saving grace since interest rates will drop sharply.

Slotine wrote:

RuralEngineer wrote: I'm not sure prosperous deflation is even possible, at least not at significant levels of deflation.  I struggle to imagine a scenario where businesses are constantly being forced to get requotes from their suppliers in order to avoid a 5% hike in the cost of their inventory.  I don't see businesses being able to cope with more expensive inventory, massively higher labor costs, and still have "prosperous" returns.

Japan.

It's been bouncing up and down around that positive x axis.  One way to think of prosperous deflation is that its really is part of a zero price level with a lot of noise.  That is, it's not a steady state equilibrium - or at least you don't want it to be for those very reasons you outline.  But it can occur easily enough and for quite a long while as these cycles can last for many, many, years.

I can think of the computer industry, too. I know it's hard to imagine a general prospere deflation in a fiat-money situation, though.

But then, let's state deflation cannot be prospere. Since we hold one asset per economic situation, we have prospere inflation (stocks), recessive inflation (gold) and deflation ; why hold both cash & LTT for deflation ? We have 50% of our assets for just one economic situation, isn't that too much ?

k9 wrote: I can think of the computer industry, too. I know it's hard to imagine a general prospere deflation in a fiat-money situation, though.

But then, let's state deflation cannot be prospere. Since we hold one asset per economic situation, we have prospere inflation (stocks), recessive inflation (gold) and deflation ; why hold both cash & LTT for deflation ? We have 50% of our assets for just one economic situation, isn't that too much ?

STT and LTT are not only for deflation.  They can do quite well during prosperity, since there is a good chance they will have a positive real yield (ie 1980-2000).  STT can also be a very good inflation hedge, since the Fed should increase rates when inflation starts to creep up.  If the Fed doesn't then gold will do well since STT will have a negative real yield.

This thread started by Pointedstick may help to further explain things: http://gyroscopicinvesting.com/forum/ht ... ic.php?t=5