Gyroscopic Investing

I came across HB about 6 months ago and have been drawn to the PP strategy for its simplicity and agnosticism to future events.  I struggle, however, with implementing the PP as prescribed in the present conditions, mainly because I do not see the potential for LTT to provide the same asymmetry to the portfolio that has benefited the strategy over the past 40 years. 

In the present environment, it is more comfortable for me to be short LTT as a diversifier of prosperity.  Presumably rates would rise should economic conditions return to a growth.  It is similarly more comfortable to me to be short equity as a diversifier to deflation.

I realize this is a negative carry position, but the drag is relatively low in the present rate environment.  Managing short positions is also tricky in that the negative convexity forces unprofitable rebalancing.  Nonetheless, it seems to me that there a case to flip long equity and LTT positions as rates approach the lower bound. 

I have not yet back-tested the portfolio, but I imagine that a short equity/short LTT/cash/gold PP would have performed admirably during the 1970’s stagflation.  I also imagine that the short equity/short LTT PP would have been wiped out during the growth/falling rate environment of the 80’s and 90’s.  As such, it would be necessary to flip from long to short and back again if implementing the strategy over the long-term.  I realize this requires market timing skill, which I do not claim to possess.  A lower bound threshold for rates (e.g., 30yrs under 3%) could prove an adequate guidepost for flipping positions. 

All of this likely violates HB’s simplicity principle, but I can’t help but think that a short equity/short LTT/cash/gold position in the present environment will prove to be on the right side of history.  I would be interested in thoughts and comments.

You could get crushed if equities continue to run on a tear, Bernanke keeps rates low (QE4?), and gold drops because people flood into equities. Is this scenario that far fetched? I am not explicitly betting on it (I have the vanilla PP) but it seems perfectly in the realms of possibility. Whenever you are shorting a major asset class, you are betting against history. That would make me very uncomfortable.

SmithBrook wrote:
In the present environment, it is more comfortable for me to be short LTT as a diversifier of prosperity.  Presumably rates would rise should economic conditions return to a growth.  It is similarly more comfortable to me to be short equity as a diversifier to deflation.

This is not the Permanent Portfolio. This is a speculation. Rates can stay long for a long time (ask Japan). Stocks could shoot through the roof if the economy turns around. Bond interest rates may go up, but only modestly, in response and gold could crash. Etc.

Anytime you are shorting something, you are taking on large risks if you are wrong. IMO. Losses are potentially unlimited and it is also expensive.

melveyr wrote: You could get crushed if equities continue to run on a tear, Bernanke keeps rates low (QE4?), and gold drops because people flood into equities. Is this scenario that far fetched? I am not explicitly betting on it (I have the vanilla PP) but it seems perfectly in the realms of possibility. Whenever you are shorting a major asset class, you are betting against history. That would make me very uncomfortable.

Yes, anything is possible.  Though in the QE-infinity scenario, with stocks rallying on Fed monetization, I find it difficult to imagine a flood of capital concurrently leaving gold.  It’s conceivable to me that gold could rally with stocks in that scenario, as we’ve seen in the last few years.  With that said, managing short exposure is undoubtedly tricky.  It may be preferable to use put spreads or out of the money calls rather than an outright short in order to manage the downside scenario. 

I don’t disagree that it is a bet history - at the last 30 years of history - but when is that a reasonable bet to make?  In his radio show HB references LTTs reaching 1% in the Depression.  Should we hold out for the last 30% from here?  What then?  Would HB have still recommended 25% in LTTs in the present rate environment?  It seems to me that he valued the power of a winning investment to carry the entire portfolio, and IMO, LTTs have lost a great portion of that potential as there is simply a limit to how low rates can go. 

I understand the basis of your proposed strategy, but it seems highly speculative to me.

The most common response to the PP from new followers is basically "Well, I'm pretty sure that's about to stop working because of X", and yet somehow "X" never actually stops the PP from working.

Maybe you should set up a PP with a small portion of your wealth and just see what happens.

MediumTex wrote: I understand the basis of your proposed strategy, but it seems highly speculative to me.

The most common response to the PP from new followers is basically "Well, I'm pretty sure that's about to stop working because of X", and yet somehow "X" never actually stops the PP from working.

Maybe you should set up a PP with a small portion of your wealth and just see what happens.

It might seem counterintuitive, but it feels speculative to me to invest in LTT today with the expectation that it will be powerful enough secure the portfolio in a deflation.  If 30yr rates fall to 1.7% (think Japan), there is the potential for a +20% gain on 25% of the portfolio, during what is likely an unfavorable scenario for equities and gold.  IMO, the package of investments no longer offers the same degree of security as rates approach the lower bound.  Would you disagree with this thinking?

I could try the vanilla PP with a small portion of assets, but it seems to me that at best that would provide me with direct experience for a certain period of time.  I would then presumably establish an availability bias and extrapolate that experience to gain comfort.  With all due respect, I do not believe this approach would give me much comfort.

I do not mean any of this as a takedown of PP.  I am generally a fan of the concept and appreciate your comments and the opportunity to test my own understanding of truth. 

SmithBrook wrote:

MediumTex wrote: I understand the basis of your proposed strategy, but it seems highly speculative to me.

The most common response to the PP from new followers is basically "Well, I'm pretty sure that's about to stop working because of X", and yet somehow "X" never actually stops the PP from working.

Maybe you should set up a PP with a small portion of your wealth and just see what happens.

It might seem counterintuitive, but it feels speculative to me to invest in LTT today with the expectation that it will be powerful enough secure the portfolio in a deflation.  If 30yr rates fall to 1.7% (think Japan), there is the potential for a +20% gain on 25% of the portfolio, during what is likely an unfavorable scenario for equities and gold.  IMO, the package of investments no longer offers the same degree of security as rates approach the lower bound.  Would you disagree with this thinking?

I could try the vanilla PP with a small portion of assets, but it seems to me that at best that would provide me with direct experience for a certain period of time.  I would then presumably establish an availability bias and extrapolate that experience to gain comfort.  With all due respect, I do not believe this approach would give me much comfort.

I do not mean any of this as a takedown of PP.  I am generally a fan of the concept and appreciate your comments and the opportunity to test my own understanding of truth.

You may be on to a very good speculative strategy.

If you try it out please keep us posted about how it works.

craigr wrote: This is not the Permanent Portfolio. This is a speculation. Rates can stay long for a long time (ask Japan). Stocks could shoot through the roof if the economy turns around.

I would argue that this is already happening. Here's a graph of VTI:



Stocks have more than doubled in the last 4.5 years. Not too shabby! Someone who shorted stocks anytime in the last few years would have gotten crushed. What I would ask to anyone preparing to do so now is, what makes you think this trend is going to immediately reverse?

Pointedstick wrote:
Stocks have more than doubled in the last 4.5 years. Not too shabby! Someone who shorted stocks anytime in the last few years would have gotten crushed. What I would ask to anyone preparing to do so now is, what makes you think this trend is going to immediately reverse?

In fairness, I don’t think it is appropriate to look at a single investment in isolation and claim that anyone holding it long or short would have been crushed.  What matters is the package of investments.  Using ETF Replay, an equal weighted portfolio of 25% long SHV, 25% long GLD, 25% short TLT and 25% short VTI produced a +22.1% total return with 9% std dev since August 2007. 

Yes, this underperformed the vanilla PP over the same period (+65%/9% std dev).  IMO, this is neither here nor there when determining the most appropriate package of investments for this point in time and going forward.

My objective is to find a package of investments that are both 1) tied to specific economic conditions and 2) offer the potential to bouy the entire portfolio during specific economic conditions.  IMO, it is risky to not at least give consideration to valuation of bounded assets such as LTT when attempting to put together this type of package.  Maybe the vanilla PP is this package today, but what if LTT rates were at zero?  Would LTTs still offer the same potential to secure the portfolio?  If not, at what point would it make sense to consider other investments to meet the dual criteria?

If the future is uncertain and unpredictable, why accept an assumption that stocks will rise and rates will fall in the long-term?

I’m not trying to convince anyone to change the way you are doing things.  These are just questions that come to mind when I think about implementing the strategy.

If LTT rates were literally 0%, I would replace that portion with cash; at that point, what's the difference? But if that ever happened, anyone still holding a 30-year bonds, even ones at very low rates, would see ridiculous explosion in the value of their still-terrible-but not-as-bad-as-0% bonds.

But of course, I don't know if that will happen, and Japan shows us just how long low rates can persist, which is why I'm long everything. Shorting individual asset classes is entirely speculative; who knows which asset classes are going to go up or down? You're implicitly assuming that you know the answer to that question. I suppose you could short the entire portfolio, but that would be a bet against world prosperity.

Pointedstick wrote: If LTT rates were literally 0%, I would replace that portion with cash; at that point, what's the difference? But if that ever happened, anyone still holding a 30-year bonds, even ones at very low rates, would see ridiculous explosion in the value of their still-terrible-but not-as-bad-as-0% bonds.

But of course, I don't know if that will happen, and Japan shows us just how long low rates can persist, which is why I'm long everything. Shorting individual asset classes is entirely speculative; who knows which asset classes are going to go up or down? You're implicitly assuming that you know the answer to that question. I suppose you could short the entire portfolio, but that would be a bet against world prosperity.

Well, ridiculous explosion is defined by bond math.  If LTT rates collapsed to zero today, you would see 65% appreciation on 25% of the portfolio (+16% CTR from LTTs).  While cash may not lose value in a deflation, it is also unable to bouy a portfolio.  It seems to me that the security of the vanilla PP breaks down as rates approach the lower bound. 

I agree that no one knows what assets will go up or down.  If that is true, why is a short investment entirely speculative, while a long investment is not?  I think you hit on the point exactly, that vanilla PP is inherently a bet on prosperity.  I’m not saying this is wrong or a bet not worth accepting, just that it is the reality of the package of investments.

SmithBrook wrote: I think you hit on the point exactly, that vanilla PP is inherently a bet on prosperity.  I’m not saying this is wrong or a bet not worth accepting, just that it is the reality of the package of investments.

I would say that the vanilla PP is a bet that central banks will continue to be successful in their gradual devaluation of all currencies.

Prosperity is clearly not required for the PP to perform as advertised.  It's actually had its best years when there wasn't much prosperity reflected in the performance of the stock market.

You're not wrong, SmithBrook. But anyone who shorted Japanese bonds out of a desire to implement your very reasonable worries has been waiting a very, very long time for their investment to pay off as rates have bounced around between 0 and 1%. Certainly at some point rates are going to rise, but will it be soon? That's sort of the question. If you short US bonds in anticipation of rates rising in the next few years and it doesn't happen for 20, will you have the fortitude to stay in the position? If you want to talk about bounded gains and losses, keep in mind that your losses from short selling are potentially infinite.

I think the question here is what economic conditions might there be going forward and what assets perform well in which ones.

The traditional HB PP is based on there being 4 possible conditions (with transitions between them): prosperity, inflation, deflation, and "tight money" recession.  I think we all know which assets are designed to do well in which of these conditions.

If, instead of being long stocks and LTT, we're short stocks and short LTTs - what happens?  There's no difference with respect to gold or cash.

During a period of prosperity, instead of a portfolio gain from increasing stock prices we'll have a portfolio drag from shorting stocks.  Would we expect any gain from shorting LTTs during prosperity to offset this loss?

During a a period of deflation, instead of a portfolio gain from increasing LTT values, we'll have a portfolio drag from shorting them.  Would we expect any gain from shorting stocks to offset this loss?

During a period of inflation (rising interest rates), instead of a loss from LTT values (presumably offset by increases in gold and stock values) our stock short will create a loss and our LTT short (and gold) will increase.  Will the result be net positive?

During a tight money recession, instead of nothing but cash doing particularly well we'll presumably see an increase from our stock short. 

By swapping long stock and long LTT with short stock and short LTT, it looks to me like we win in a tight money recession, inflation and possibly deflation may be a wash (historical data here would be interesting), and we probably lose in prosperity.  My impression is periods of prosperity are more likely than periods of recession (recessions are typically shorter) - so long term shorting stocks and LTTs is probably a losing proposition.

As Craig says, even doing this short term (perhaps based on macro signals like LTT interest rates) is significantly risky as well.  Rather than limited downside (long stocks and long LTTs can go no lower than 0) and unlimited upside (long stocks have no upper limit) you'd have unlimited downside (short stocks have no lower bound) and limited upside.  All in all, this seems like a bad deal.

Regarding whether LTTs have enough oomph left to carry the portfolio if we have further deflation going forward - this has been discussed before, see http://gyroscopicinvesting.com/forum/ht ... ic.php?t=2

Rickb – Yes, you have reframed my question perfectly and I appreciate the link to the other discussion on rates.  I did not turn that one up in my previous search.

I agree with your general assessment of the possible conditions, potential asset performance and risks.  There are ways to mitigate some of the complexities of managing short exposure, but I would not trivialize that complexity. 

On balance, the question I need to answer for myself is whether the potential security in tight money recession, inflation and possibly deflation offsets the complexities, risks and costs of managing short exposure, AND whether or not that strategy is preferable to other alternatives including vanilla PP.

Backtesting this across various intervals would be interesting.  The "Simba" spreadsheet doesn't seem to include "short" versions of LTTs or stock indices.  I'm not aware of easily available sources including short data.  I'll note that the long term bias of both stock and LTTs is up, so replacing these both with short versions creates a long term negative bias.  I'll also note that determining what macro economic condition we're currently in (let alone what condition we might be in in the near future) is significantly difficult - this is much easier in hindsight - so a strategy that shifts these assets between long and short based on a switching signal seems bound to be wrong at least occasionally. 

Zooming out a bit - what is the goal here?  Are you convinced we're in for a period of rising interest rates and therefore don't want to be holding 25% of your assets in LTTs?

Prediction is very difficult, especially about the future - Niels Bohr (although probably not original)

Bill Gross was convinced interest rates had nowhere to go but up, sold out of long term bonds in 2011, and as a result PIMCO's funds got trounced - see http://www.ft.com/cms/s/0/dbe0ab88-d24b ... PrH8i  Are you sure interest rates have nowhere to go but up?  Are you sure they will go up in the near future?  Are you sure you're smarter than Bill Gross about this?  Ad Orientem has a blog where he mentions the rising interest rate issue, see http://ad-orientem.blogspot.com/2012/06 ... turns.html .

For many of us here, one of the most appealing aspects of the PP is that it completely relieves us of the necessity to predict what happens in the future.  Stocks go up - we win (because we own stocks).  Stocks go down - we win (because we own gold and LTTs).  Interest rates go up - we win (because we own stocks and gold).  Interest rates go down - we win (because we own LTTs).

In a Las Vegas analogy - we are the house.  Yes, there are some lucky people who will make more money, but we'll do OK pretty much regardless of what happens.  There are certainly no guarantees, although if you have (say) $1M what else are you going to do with it to have a better shot at a low risk, inflation+ return?

My overriding goal is to protect the purchasing power of the capital that is precious to me.  Growth is a secondary objective.  I accept that the future is uncertain and unpredictable and that I do not have a crystal ball.  I’m not seeking to express a directional view on rates or on equities.  I am seeking a package of investments that will survive any event, even the unthinkable things that I don’t think are likely to occur.  HB’s thinking and portfolio construction is appealing to me in that it offers the potential to provide this security, while also relieving the burden of needing to anticipate the future.

I believe the vanilla PP has the potential to provide this security if the assets in the portfolio are both 1) directly tied to one of the four specific economic conditions and 2) have the potential to bouy the entire portfolio during a period that is devastating for one or more of the other investments.  Each of the four assets in the PP meet the first condition.  I am less confident, however, that LTTs meet the second condition in the prevailing rate environment. 

Ironically, part of the difficulty I have with vanilla PP is its previous success.  I have not done this analysis, but I wonder what percentage of overall portfolio returns have been contributed by LTT over the past 30 years as rates have fallen from the mid-teens to 2.7%.  Is it reasonable to expect the same type of contribution going forward?  Yes, conceivably, LTT rates could fall to 0%, or even turn negative.  What will I do in that scenario?  I am concerned that the model only has one solution even at the limits, long LTTs. 

So, what to do?

1) One can recognize and accept the prevailing risk/reward potential to LTTs and move forward with vanilla PP.  It is true that it has worked in the past.  It is true that rates can go lower from here.  It’s true that rates can stay low for a long time.  If LTT rates rise, it is either because of inflation (good for gold, maybe not for equity) or prosperity (good for equity, maybe not for gold).  It’s not clear to me that I would be able to preserve capital in that scenario. 

2) One can move more to cash as rates decline, as suggested in the other discussion, recognizing that cash does not provide the desired offset in a deflation.  Again, it’s not clear to me that I would be able to preserve capital with this allocation.  It’s possible to have stocks and gold go down while a significant cash position only dilutes the drawdown.

3) Is there an alternative solution to the model at the limit?  Is it possible to construct an alternative portfolio of assets that meet the diversification criteria and preserve the potential of each asset to carry the portfolio when conditions are at the extreme?  What would that look like?  Presumably rates would rise from zero in a period of prosperity.  Presumably, a deflation is a difficult environment for equities.  So, short LTT/short equity could be an alternative in limit conditions, although such a strategy introduces a host of additional complexities and risks.  Short credit might be another way to gain direct exposure to a deflation, eliminating the unbounded loss potential of short equities, at the cost of negative carry.  I’m not advocating any of this an ideal long-term solution, nor am I suggesting that any of this is without risk.  I’m just wondering whether up becomes down at the limit.

I'm not sure why this thread is not more active.  Perhaps most folks feel they've already said enough about the topic in previous threads, e.g.:

http://gyroscopicinvesting.com/forum/ht ... ic.php?t=4

http://gyroscopicinvesting.com/forum/ht ... ic.php?t=2

http://gyroscopicinvesting.com/forum/ht ... ic.php?t=5

I think the majority opinion might be that there is a risk, but no one has come up with a better alternative than a vanilla PP.

rickb wrote: I think the majority opinion might be that there is a risk, but no one has come up with a better alternative than a vanilla PP.

That's basically the way I feel. If LTT yields fall too low (< 1.5%), what I plan to do is rebalance out of a certain amount of LTTs and into STTs. I'd still be selling high, but reducing my exposure to an asset with less upside. Shorting bonds just feels too speculative to me, and it brings with it all the extra risks inherent with short selling.

Gold and stocks have limitless upside, so I always feel comfortable holding them. For those, it's probably best to stick with the Brownean approach of not trying too hard to guess the future.

SmithBrook,

It's not a horrible idea, but what are the costs to short?  You forgo dividend and interest payments, and pay a higher MER if you go with an ETF.  Am I correct to assume that the cost to short is at least 3% a year (2% dividend/interest and 1% MER)?  That's a lot of decay...

Have you tried comparing TLT and TBT, and SPY and SH... it is not a pretty sight.  Plus SPY and TLT don't have dividends/interest included in the price.

Gosso wrote: Have you tried comparing TLT and TBT, and SPY and SH... it is not a pretty sight.  Plus SPY and TLT don't have dividends/interest included in the price.

In fact, a full short PP is a beautiful exercise in reliable, consistent wealth destruction:



Kinda reminds me of the suicide portfolio thread.

Gosso wrote: SmithBrook,

It's not a horrible idea, but what are the costs to short?  You forgo dividend and interest payments, and pay a higher MER if you go with an ETF.  Am I correct to assume that the cost to short is at least 3% a year (2% dividend/interest and 1% MER)?  That's a lot of decay...

Have you tried comparing TLT and TBT, and SPY and SH... it is not a pretty sight.  Plus SPY and TLT don't have dividends/interest included in the price.

Yes, there are costs to shorting, which may be more or less than 3% depending on how you implement the exposure.  I would not recommend a long position in any inverse ETF.  Those are mainly vehicles to enrich asset management companies.

IMO, yield/carry does not provide sufficient basis for an investment decision.  Shorting subprime in 2007 would have cost 2% per year.  Was it more speculative to invest long on the expectation of earning 2% per year, or to short subprime with a max downside equal to cost of the negative carry?  I’m not saying that LTTs today are the equivalent of subprime in 2007, only that valuation matters and that there is no diversification in owning an overvalued asset.

Yes, you can collect dividends and interest with long positions, but what are the full costs of being long?  Would you risk 30 in order to make 3?  Are you confident that a model with only one solution is applicable in all cases, at all times? 

SmithBrook wrote: IMO, yield/carry does not provide sufficient basis for an investment decision.  Shorting subprime in 2007 would have cost 2% per year.

That would have been a very smart move. But of course, it's easy to look at opportunities like that with the benefit of hindsight. A lot of people probably bought real estate or REIT funds at the same time. I wouldn't count on being able to make correct predictions like that very frequently. And making a prediction like that by shorting using margin is far, far riskier than buying a stock you think will go up.

The problem is that we don't know what the future holds. If we had crystal balls, then yes, the PP would probably be a pretty bad investment compared to shorting stocks that are about to crater and investing all the profits in stocks about to skyrocket.

SmithBrook wrote: Yes, there are costs to shorting, which may be more or less than 3% depending on how you implement the exposure.  I would not recommend a long position in any inverse ETF.  Those are mainly vehicles to enrich asset management companies.

IMO, yield/carry does not provide sufficient basis for an investment decision.  Shorting subprime in 2007 would have cost 2% per year.  Was it more speculative to invest long on the expectation of earning 2% per year, or to short subprime with a max downside equal to cost of the negative carry?  I’m not saying that LTTs today are the equivalent of subprime in 2007, only that valuation matters and that there is no diversification in owning an overvalued asset.

Yes, you can collect dividends and interest with long positions, but what are the full costs of being long?  Would you risk 30 in order to make 3?  Are you confident that a model with only one solution is applicable in all cases, at all times? 

Would it not be easier to convert some portion of the LTT into STT?  Or possibly just forego the barbell and buy intermediate bonds?  I realize this voids the warranty on the PP, but if someone is not willing to jump into the PP because of LTT, then I'd adjust things so that they are somewhat comfortable, while still remaining close to the original PP.

LTT still have some room to move...the Swiss 30 year is currently yielding 0.989%.  I have no idea if the US will ever see that, but the Swiss show it is possible.

I feel your pain in regards to LTT, I have actually increased the duration of my STT, and sold some of the LTT.  This gives me an average duration of around 5 years for the bond section of my portfolio, and that suits me just fine.

Gosso wrote:
Would it not be easier to convert some portion of the LTT into STT?  Or possibly just forego the barbell and buy intermediate bonds?  I realize this voids the warranty on the PP, but if someone is not willing to jump into the PP because of LTT, then I'd adjust things so that they are somewhat comfortable, while still remaining close to the original PP.

Yes, I agree with you on shortening duration.  I think that is a sensible first step along a continuum as rates compress.  By effectively lifting the deflation hedge in that way, IMO it may also be appropriate to start modifying equity exposure.  Flipping LTTs and equity to outright shorts is perhaps furthest out on the continuum.