Gyroscopic Investing

As always Dr. Hunt hovers above the blathering bologna nit heads and gives real meat to chew on.

http://www.hoisingtonmgt.com/pdf/HIM2013Q2NP.pdf

Enjoy

That is my opinion precisely.  It's not popular, but IMHO it is right.

That's why buying long term treasuries has not bothered me in the least in recent years, even as people have repeatedly assured me that the 30 year treasuries component was obviously the stupidest part of the Permanent Portfolio.

I too believe interest rates could easily go further down but I'm not willing to bet my money on it.
In the US the long-term rates are still acceptable (especially compared to savings accounts and inflation) but in Germany the rates are already close to 2%.
Would you still hold on to long-term bonds if rates dropped below 2%?
As a diehard PP investor you probably will but what would be your reasons? I might learn something.

To me that's the beauty of the permanent portfolio.
I don't have to constantly keep guessing on the prices of gold.stocks,bonds and cash.
I don't have to be a market timer.
And it's worked.Sure bonds looked over priced.
For years.

annieB wrote: To me that's the beauty of the permanent portfolio.
I don't have to constantly keep guessing on the prices of gold.stocks,bonds and cash.
I don't have to be a market timer.
And it's worked.Sure bonds looked over priced.
For years.

That's nice about any lazy portfolio.

But what if long-term bonds hit the 0%? Isn't that the end of buy-and-hold for long-term bonds? Sure, you could hold them, but that would be kind of silly, right? And if there are situations when you have to sell your bonds, where do you draw the line?

Or consider this current Dutch situation:

long-term German bond yield: 2.4%
10 year german bonds: 1,6%
5-year CD yield: 2.3%
Savings account: 1.9%

Would you still hold on to LT bonds? Is it still market-timing to move out of long term bonds under such circumstances?
I don't think so. But this might be a part of the PP I don't fully understand yet.

Absolutely I'd buy long-term bonds in that scenario.  We don't buy them for the yield; we buy them for their responsiveness to changes in interest rates.  If the long-term yield went from 2.4% to 2.0%, the value of those bonds would skyrocket.  None of the other instruments you listed respond in that way at all, except for the 10-year bond, which does so much less.

koekebakker wrote: But what if long-term bonds hit the 0%? Isn't that the end of buy-and-hold for long-term bonds? Sure, you could hold them, but that would be kind of silly, right? And if there are situations when you have to sell your bonds, where do you draw the line?

Although this may not literally be very plausible, this does raise a very interesting question: If the yield on long-term bonds were to hit zero, does it make any sense to hold them in any portfolio...even the Permanent Portfolio? Wouldn't it make more sense to take profits, perhaps go from 25% to 50% or more cash, and wait for a reversion to the mean?  At that point, it doesn't seem like market timing any more because the market's effectively ceased functioning in any normal manner.

cnh wrote: Although this may not literally be very plausible, this does raise a very interesting question: If the yield on long-term bonds were to hit zero, does it make any sense to hold them in any portfolio...even the Permanent Portfolio?

Haven't people already bought T-bills at negative rates?

Xan wrote: Absolutely I'd buy long-term bonds in that scenario.  We don't buy them for the yield; we buy them for their responsiveness to changes in interest rates.  If the long-term yield went from 2.4% to 2.0%, the value of those bonds would skyrocket.  None of the other instruments you listed respond in that way at all, except for the 10-year bond, which does so much less.

It's a double edged sword off course, and that's what you usually want for the PP. But what if long term rates went further down, to 1% for example. Does that change anything for you? Where do you draw the line?

Although this may not literally be very plausible, this does raise a very interesting question: If the yield on long-term bonds were to hit zero, does it make any sense to hold them in any portfolio...even the Permanent Portfolio? Wouldn't it make more sense to take profits, perhaps go from 25% to 50% or more cash, and wait for a reversion to the mean?  At that point, it doesn't seem like market timing any more because the market's effectively ceased functioning in any normal manner.

This is the point I'm trying to make. As long as there are markets for cash, gold and stocks it's hard to think of any scenario where it doesn't make sense anymore to invest in them. For LT bonds this seems different to me.
Off course you can buy them at 0% but shorter term rates need to go pretty far below zero for that to make any sense. And even in that case cash makes seems much more attractive to hold.

If LT bond rates are 0%, it's probably shrewder to replace them with a 30-year mortgage on a house rather than more cash.

The psychology of bond yields is funny.

As I have watched bond yields over the last 15 years or so, I have always been assured by smart people that wherever they happened to be at a particular point in time, they really had nowhere to go but up from there, and yet they always went down instead.

Right now, the 4.25% level on the 30 year bond feels like a pretty tough barrier to break through on the upside, and yet I remember in early 2008 when it was common knowledge that only a complete moron would buy a 30 year treasury bond that only paid 4.5%, since rates obviously had nowhere to go but up from those ridiculously low levels.

I have noticed that even people who would seemingly really, really, really need to understand the way the bond market works without the distracting market noise often don't.  And I'm talking about money managers, actuaries, loan officers and people like that who really should know.  Often, when I start talking with them about the magnitude of bond pricing moves at different points on the yield curve based upon similar changes in yields, they often just seem to get lost, and the whole reason I would have brought it up in the first place was because I was wanting to learn more about it from them.

Even something simple like talking about the difference in volatility between the 10 year and 30 year bond based upon similar changes in yields is often a concept that isn't completely intuitive to people who are supposed to understand how the bond market works.

Back in the early 1980s when 30 year treasury bonds were yielding over 10%, defined benefit pension plans were modeling future employer contributions based upon an 8% expected future return on assets.  I often ask people who were working with pension plans back then whether it crossed anyone's mind to simply invest 100% of a pension plan's assets in 30 year treasury bonds and enjoy ZERO pension plan investment risk for the next 30 years, and actually enjoy a bump to earnings each year as better than projected pension plan earnings translated into smaller than projected employer contributions.  Under this approach, there would actually be ZERO interest rate risk as well, because all of the bonds would be held to maturity (because they were matched to the future liabilities in the first place by using a bit of laddering to match things up just right).  So far, no one has said that they thought of doing that, and even now it takes them a moment to grasp what I am saying.  That's weird to me.  I'm not a numbers guy.

As I have watched bond yields over the last 15 years or so, I have always been assured by smart people that wherever they happened to be at a particular point in time, they really had nowhere to go but up from there, and yet they always went down instead.
Right now, the 4.25% level on the 30 year bond feels like a pretty tough barrier to break through on the upside, and yet I remember in early 2008 when it was common knowledge that only a complete moron would buy a 30 year treasury bond that only paid 4.5%, since rates obviously had nowhere to go but up from those ridiculously low levels.

I completely agree. And the current rates for US 30 year bond bonds despite being historically low, still make long bonds a solid investment as part of the PP. But what about a 1% rate? Is there a low point at which long bonds shouldn't be part of the PP anymore? A 1% rate might seem extremely low but it's not unthinkable that some countries will hit that rate in the near future.

MediumTex wrote: Back in the early 1980s when 30 year treasury bonds were yielding over 10%, defined benefit pension plans were modeling future employer contributions based upon an 8% expected future return on assets.  I often ask people who were working with pension plans back then whether it crossed anyone's mind to simply invest 100% of a pension plan's assets in 30 year treasury bonds and enjoy ZERO pension plan investment risk for the next 30 years, and actually enjoy a bump to earnings each year as better than projected pension plan earnings translated into smaller than projected employer contributions.  Under this approach, there would actually be ZERO interest rate risk as well, because all of the bonds would be held to maturity (because they were matched to the future liabilities in the first place by using a bit of laddering to match things up just right).  So far, no one has said that they thought of doing that, and even now it takes them a moment to grasp what I am saying.  That's weird to me.  I'm not a numbers guy.

I remember learning something like this in Econ 101: the idea that high interest rates can discourage economic activity since people will just pile into any bonds that exceed the expected rate of return of their enterprises and take the higher and less risky fixed income payments.

It would be funny if this turned out to be false because most businesspeople didn't understand the bond market well enough.

Pointedstick wrote:

MediumTex wrote: Back in the early 1980s when 30 year treasury bonds were yielding over 10%, defined benefit pension plans were modeling future employer contributions based upon an 8% expected future return on assets.  I often ask people who were working with pension plans back then whether it crossed anyone's mind to simply invest 100% of a pension plan's assets in 30 year treasury bonds and enjoy ZERO pension plan investment risk for the next 30 years, and actually enjoy a bump to earnings each year as better than projected pension plan earnings translated into smaller than projected employer contributions.  Under this approach, there would actually be ZERO interest rate risk as well, because all of the bonds would be held to maturity (because they were matched to the future liabilities in the first place by using a bit of laddering to match things up just right).  So far, no one has said that they thought of doing that, and even now it takes them a moment to grasp what I am saying.  That's weird to me.  I'm not a numbers guy.

I remember learning something like this in Econ 101: the idea that high interest rates can discourage economic activity since people will just pile into any bonds that exceed the expected rate of return of their enterprises and take the higher and less risky fixed income payments.

It would be funny if this turned out to be false because most businesspeople didn't understand the bond market well enough.

Very likely for the small businessman, in my view....highly unlikely for corporate America...I think they hire very sharp MBAs?

murphy_p_t wrote:

Pointedstick wrote:

MediumTex wrote: Back in the early 1980s when 30 year treasury bonds were yielding over 10%, defined benefit pension plans were modeling future employer contributions based upon an 8% expected future return on assets.  I often ask people who were working with pension plans back then whether it crossed anyone's mind to simply invest 100% of a pension plan's assets in 30 year treasury bonds and enjoy ZERO pension plan investment risk for the next 30 years, and actually enjoy a bump to earnings each year as better than projected pension plan earnings translated into smaller than projected employer contributions.  Under this approach, there would actually be ZERO interest rate risk as well, because all of the bonds would be held to maturity (because they were matched to the future liabilities in the first place by using a bit of laddering to match things up just right).  So far, no one has said that they thought of doing that, and even now it takes them a moment to grasp what I am saying.  That's weird to me.  I'm not a numbers guy.

I remember learning something like this in Econ 101: the idea that high interest rates can discourage economic activity since people will just pile into any bonds that exceed the expected rate of return of their enterprises and take the higher and less risky fixed income payments.

It would be funny if this turned out to be false because most businesspeople didn't understand the bond market well enough.

Very likely for the small businessman, in my view....highly unlikely for corporate America...I think they hire very sharp MBAs?

For a second I thought you were serious.

And then I understood you must have been joking.

I have found almost no difference in sophistication in the management of pension plan assets between large and small employers.

At any point in time, many large pensions will believe that they are managing their money using more sophisticated techniques than everyone else, but in the fullness of time it usually becomes apparent that everyone was basically listening to and following the same conventional wisdom when it came to asset management. 

The problem that most pension plans, like most investors, have is that they don't fully comprehend that no matter how much money they spend hiring the smartest people, it's still very very very hard to consistently beat the markets.

A fascinating passage from the report:

The Fed has maintained the Fed Funds rate at near-zero levels, and it has tried to lower longer term rates through a series of quantitative easings. The effect of each of the quantitative easings was the opposite of the Fed’s intentions. During every period of balance sheet expansion long rates rose, yet when securities purchases were discontinued yields fell (Chart 6). The Fed cannot control long rates because long rates are affected by inflation expectations, not by supply and demand in the market place. This is extremely counter intuitive. With more buying, one would assume that prices would rise and thus yields would fall, but the opposite occurred. Why? When the Fed buys, it appears that the existing owners of Treasuries (now amounting to $9.5 trillion) decide that the Fed’s actions are inflationary and sell their holdings, raising interest rates. When the Fed stops this program, inflation expectations fall creating a demand for Treasuries, bringing rates back down.

The Fed’s quantitative policies have been counter productive to growth as interest rates have risen during each period of quantitative easing. During QE1 and QE2, commodity prices rose, the dollar fell and inflation rose temporarily. Wages, however, did not respond. Thus, the higher interest rates during all QEs and the fall in the real wage income during QE 1 & 2 served to worsen the income and wealth divide. This means many more households were hurt, rather than helped, by the Fed’s efforts.

Pointedstick wrote: A fascinating passage from the report:

The Fed has maintained the Fed Funds rate at near-zero levels, and it has tried to lower longer term rates through a series of quantitative easings. The effect of each of the quantitative easings was the opposite of the Fed’s intentions. During every period of balance sheet expansion long rates rose, yet when securities purchases were discontinued yields fell (Chart 6). The Fed cannot control long rates because long rates are affected by inflation expectations, not by supply and demand in the market place. This is extremely counter intuitive. With more buying, one would assume that prices would rise and thus yields would fall, but the opposite occurred. Why? When the Fed buys, it appears that the existing owners of Treasuries (now amounting to $9.5 trillion) decide that the Fed’s actions are inflationary and sell their holdings, raising interest rates. When the Fed stops this program, inflation expectations fall creating a demand for Treasuries, bringing rates back down.

The Fed’s quantitative policies have been counter productive to growth as interest rates have risen during each period of quantitative easing. During QE1 and QE2, commodity prices rose, the dollar fell and inflation rose temporarily. Wages, however, did not respond. Thus, the higher interest rates during all QEs and the fall in the real wage income during QE 1 & 2 served to worsen the income and wealth divide. This means many more households were hurt, rather than helped, by the Fed’s efforts.

Agree. As MediumTex said, the bond market is one of the main unknowns in the financial industry. We just saw that with the japanese yields after the initial reaction to the bond purchase program:

http://www.bloomberg.com/quote/GJGB30:IND/chart

And it's funny to read some comments on the topic from the supposed experts:

http://online.wsj.com/article/SB1000142 ... 03382.html



Btw, about the discussion of small yields and the permanent portfolio, take a look to this excelent post blog from Craig:

https://web.archive.org/web/20160324133 ... y-and-you/

For me the only problem is that historically bond coupons were a good help for the total CAGR of the portfolio, but considering inflation and taxes maybe there is no big difference.

"Secular low in bonds not reached"

likely/maybe...but looks like 30 year rate headed back to other side of channel before they go lower....somewhere north of 4%

murphy_p_t wrote: "Secular low in bonds not reached"

likely/maybe...but looks like 30 year rate headed back to other side of channel before they go lower....somewhere north of 4%

I've been assuming this ever since MT predicted that rates would bounce between 4.5% and 2.5% for the appreciable future. Nearly everything I've seen him predict has come to pass.

MediumTex wrote:

Back in the early 1980s when 30 year treasury bonds were yielding over 10%, defined benefit pension plans were modeling future employer contributions based upon an 8% expected future return on assets.  I often ask people who were working with pension plans back then whether it crossed anyone's mind to simply invest 100% of a pension plan's assets in 30 year treasury bonds and enjoy ZERO pension plan investment risk for the next 30 years, and actually enjoy a bump to earnings each year as better than projected pension plan earnings translated into smaller than projected employer contributions.  Under this approach, there would actually be ZERO interest rate risk as well, because all of the bonds would be held to maturity (because they were matched to the future liabilities in the first place by using a bit of laddering to match things up just right).  So far, no one has said that they thought of doing that, and even now it takes them a moment to grasp what I am saying.  That's weird to me.  I'm not a numbers guy.

Are 30 year treasuries callable?  I think they were in the early 1980s but not now..

blackomen wrote:

MediumTex wrote:

Back in the early 1980s when 30 year treasury bonds were yielding over 10%, defined benefit pension plans were modeling future employer contributions based upon an 8% expected future return on assets.  I often ask people who were working with pension plans back then whether it crossed anyone's mind to simply invest 100% of a pension plan's assets in 30 year treasury bonds and enjoy ZERO pension plan investment risk for the next 30 years, and actually enjoy a bump to earnings each year as better than projected pension plan earnings translated into smaller than projected employer contributions.  Under this approach, there would actually be ZERO interest rate risk as well, because all of the bonds would be held to maturity (because they were matched to the future liabilities in the first place by using a bit of laddering to match things up just right).  So far, no one has said that they thought of doing that, and even now it takes them a moment to grasp what I am saying.  That's weird to me.  I'm not a numbers guy.

Are 30 year treasuries callable?  I think they were in the early 1980s but not now..

Regardless of whether or not 30 year treasuries were callable at the time, investing 100% of ones assets in 30 year treasuries and holding them to maturity is subject to inflation risk.  If there is high inflation during those 30 years, your principal, 30 years later, could be relatively worthless.  Yes, the projections they used showed 8%, but that was surely based on the historical performance of the investments they were making.  The PP is great because it should perform well when there is high inflation.  So, if 30 year treasuries were yielding 11.5% tomorrow, I would not sell my PP and buy 100% treasuries simply because the historical performance of the PP is 2% lower at 9.5%.  A critical aspect of the PP is that it consistently performs at 3 to 6% over the inflation rate, and even when inflation is very high, it generally outperforms the inflation.

jason wrote:

blackomen wrote:

MediumTex wrote:

Back in the early 1980s when 30 year treasury bonds were yielding over 10%, defined benefit pension plans were modeling future employer contributions based upon an 8% expected future return on assets.  I often ask people who were working with pension plans back then whether it crossed anyone's mind to simply invest 100% of a pension plan's assets in 30 year treasury bonds and enjoy ZERO pension plan investment risk for the next 30 years, and actually enjoy a bump to earnings each year as better than projected pension plan earnings translated into smaller than projected employer contributions.  Under this approach, there would actually be ZERO interest rate risk as well, because all of the bonds would be held to maturity (because they were matched to the future liabilities in the first place by using a bit of laddering to match things up just right).  So far, no one has said that they thought of doing that, and even now it takes them a moment to grasp what I am saying.  That's weird to me.  I'm not a numbers guy.

Are 30 year treasuries callable?  I think they were in the early 1980s but not now..

Regardless of whether or not 30 year treasuries were callable at the time, investing 100% of ones assets in 30 year treasuries and holding them to maturity is subject to inflation risk.  If there is high inflation during those 30 years, your principal, 30 years later, could be relatively worthless.  Yes, the projections they used showed 8%, but that was surely based on the historical performance of the investments they were making.  The PP is great because it should perform well when there is high inflation.  So, if 30 year treasuries were yielding 11.5% tomorrow, I would not sell my PP and buy 100% treasuries simply because the historical performance of the PP is 2% lower at 9.5%.  A critical aspect of the PP is that it consistently performs at 3 to 6% over the inflation rate, and even when inflation is very high, it generally outperforms the inflation.

You have to understand, though, that what I am talking about is simply matching up future liabilities with current assets.  Inflation is irrelevant in this calculation.  That's the point I am making. 

If I have a future liability that I am trying to fund and my actuary tells me that I should use a long term investment return of 8% and I can get a guaranteed 11% return on a risk-free asset, why wouldn't I do that?  Remember that almost no pension plans pay COLAs any more, so for a lot of the liabilities I am talking about the single variable is what future employee pay is going to be, and it doesn't take an economist to see that future dramatic wage gains in the U.S. are very unlikely.

There is a sort of complicated relationship between the performance of pension fund assets and the profits of the corporate sponsor, but the bottom line is that ANY time you can guarantee an investment return in excess of the plan's projected investment return, the excess performance will show up on the company's books as extra profit and make the executives look like they were a lot smarter than they actually were.  This is what GE did for years, and it made Jack Welch look like a genius when the truth was that he was a man of more ordinary abilities who realized that you could turn a manufacturer into a bank and reap large profits during the transition, and who happened to have some very lucky managers running GE's pension plan investment strategy during that same period.

Starting in 2007, however, this process has been working in reverse as pension fund performance has lagged the long term projected returns, which has been a drag on corporate profits when they were already being pinched by softening demand because of the recession, financial crisis, etc.

I am learning to cope with this better, but for years any time someone told me how no one could have possibly seen any of this pension funding trouble coming, I would feel my blood pressure start to rise as I stifled the urge to say: "No, what you are saying is that YOU didn't see it coming.  For me, it was incredibly obvious that if corporate profits got squeezed at the same time that conventional investment strategies began to fail, a company's defined benefit pension plans could begin to act like an anchor around the company's neck."

I still get kind of hot thinking about how easy it would have been to avoid a lot of this pension funding trouble if there had been more PP-oriented managers running pension funds' investment strategies, rather than the slick gunslingers who charged 150 basis points to share their brilliance up through 2007, and who then reassured their clients when everything fell apart that "No one could have seen this coming.  No one."

MediumTex wrote: I still get kind of hot thinking about how easy it would have been to avoid a lot of this pension funding trouble if there had been more PP-oriented managers running pension funds' investment strategies, rather than the slick gunslingers who charged 150 basis points to share their brilliance up through 2007, and who then reassured their clients when everything fell apart that "No one could have seen this coming.  No one."

You're right of course but the pension fund managers would get fired if their returns didn't keep up with the herd

Mdraf wrote:

MediumTex wrote: I still get kind of hot thinking about how easy it would have been to avoid a lot of this pension funding trouble if there had been more PP-oriented managers running pension funds' investment strategies, rather than the slick gunslingers who charged 150 basis points to share their brilliance up through 2007, and who then reassured their clients when everything fell apart that "No one could have seen this coming.  No one."

You're right of course but the pension fund managers would get fired if their returns didn't keep up with the herd

How can you make a lot of money as a "fund manager" if your advice is always the same: 4x25%?

Mdraf wrote:

MediumTex wrote: I still get kind of hot thinking about how easy it would have been to avoid a lot of this pension funding trouble if there had been more PP-oriented managers running pension funds' investment strategies, rather than the slick gunslingers who charged 150 basis points to share their brilliance up through 2007, and who then reassured their clients when everything fell apart that "No one could have seen this coming.  No one."

You're right of course but the pension fund managers would get fired if their returns didn't keep up with the herd

When I talk to pension professionals about this they sometimes look at me like "Oh, so you know so much more than all of these other people, huh?"  My reply to this is no, I don't know any more than anyone. I am simply offering what seems like a common sense perspective that anyone should be able to understand, and if someone can't understand it, it's not because I'm that smart, it may be because they're just that dumb (remember the line about trying to get a person to understand something whose livelihood depends on not understanding it).

Does it really take one of these Ivy League Mensa CFA types to understand that if my own business profits are contracting at the same time that the broad economy is contracting, I really should have my assets invested in a way that they are not also going to be contracting?