Gyroscopic Investing

This is a question I had asked (perhaps not very clearly) in the thread over @ the Bogleheads forum.  I was positing a scenario along the following lines:

• US government obligations continue to grow at a rapid rate, causing ever increasing deficits
• US government interference with markets and segments of the economy continues to grow, causing eventually shrinkage rather than growth in GDP (or at least, relative shrinkage compared to growth in expenditures)
• In order to cover obligations, the US government increases tax rates significantly, causing a further hit to the economy
• In order to make it easier to cover obligations, and try to jumpstart the economy, Bernanke (or his successor(s)) continue using a Keynesian approach, using QE, very low interest rates, etc., causing the dollar to lose value relative to other currencies and to commodities.

In this scenario, I'd expect the four elements of the PP to perform as follows:

• The stocks component would lose nominal and real value due to GDP shrink/reduced profitability and revenue of companies.
• The LT component would lose nominal and real value due to currency debasement.  Low interest rates would normally be bullish for LT, but it is hard to get much lower than we are now.  If the bond market started demanding higher premiums due to endless QE etc., that would hit the LT component significantly.
• The cash component would lose real value due to bullet 4 above.
• The gold component, being a commodity, would increase in both nominal and perhaps real value

To me that is one component doing well (gold), and two to three doing badly.  Does the PP really protect in this scenario?

One counterargument was that the US was still the "flight to safety" and that the USD was the reserve currency, but isn't it possible that this may gradually cease to be the case?  China is already settling some trades with RMB, Euros are starting to be accepted by some OPEC countries, etc.

P.S. Please note that I am not trying to get into a political argument here - I just want to understand how the PP protects against a particular scenario.  

fnord123 wrote: This is a question I had asked (perhaps not very clearly) in the thread over @ the Bogleheads forum.  I was positing a scenario along the following lines:

• US government obligations continue to grow at a rapid rate, causing ever increasing deficits
• US government interference with markets and segments of the economy continues to grow, causing eventually shrinkage rather than growth in GDP (or at least, relative shrinkage compared to growth in expenditures)
• In order to cover obligations, the US government increases tax rates significantly, causing a further hit to the economy
• In order to make it easier to cover obligations, and try to jumpstart the economy, Bernanke (or his successor(s)) continue using a Keynesian approach, using QE, very low interest rates, etc., causing the dollar to lose value relative to other currencies and to commodities.

In this scenario, I'd expect the four elements of the PP to perform as follows:

• The stocks component would lose nominal and real value due to GDP shrink/reduced profitability and revenue of companies.
• The LT component would lose nominal and real value due to currency debasement.  Low interest rates would normally be bullish for LT, but it is hard to get much lower than we are now.  If the bond market started demanding higher premiums due to endless QE etc., that would hit the LT component significantly.
• The cash component would lose real value due to bullet 4 above.
• The gold component, being a commodity, would increase in both nominal and perhaps real value

To me that is one component doing well (gold), and two to three doing badly.  Does the PP really protect in this scenario?

One counterargument was that the US was still the "flight to safety" and that the USD was the reserve currency, but isn't it possible that this may gradually cease to be the case?  China is already settling some trades with RMB, Euros are starting to be accepted by some OPEC countries, etc.

P.S. Please note that I am not trying to get into a political argument here - I just want to understand how the PP protects against a particular scenario.  

Fnord,

We just don't know what will happen in the future. Whenever I get down on how the US is being managed I just remind myself that many other countries are worse.

I do suspect however that serious problems in the dollar would make gold go through the roof simply because the wide scale use of the dollar as a reserve currency. With so many people running for the exits in a drastic scenario there aren't many places for the dollars to go and it is likely that assets like gold would benefit greatly.

But as you point out, as much as people think the US is a problem they still want their bonds when the chips are down. The markets also have a way of correcting/punishing bad actors. One day the people in DC may find it becomes too expensive to finance new debt and service the existing one. Perhaps some real changes will be forced upon them. So the death of the dollar may in fact not be inevitable

One last thing is in the 1970s stocks, bonds and cash were all lackluster or outright bad performers. Yet the gold did in fact carry the entire portfolio. Although we have to remember that history doesn't repeat, we at least have some empirical evidence that gold (or any single asset in the portfolio) could protect you.

I think the short answer is what I have said before--if the U.S. is losing, who is winning?

The U.S. only looks bad until you look everywhere else.

A U.S.-based PP might break down at some point, but until it does I'm not worried about it.

MediumTex wrote:A U.S.-based PP might break down at some point, but until it does I'm not worried about it.

But to me the beauty of the PP is that if one invests now, one hedges against lots of future scenarios.  I don't like the thought of being in the PP and discovering down the road that I've lost 30% due to being in an area it doesn't hedge against.  The PP's protection from a variety of scenarios is its chief strength!

craigr wrote:One last thing is in the 1970s stocks, bonds and cash were all lackluster or outright bad performers. Yet the gold did in fact carry the entire portfolio. Although we have to remember that history doesn't repeat, we at least have some empirical evidence that gold (or any single asset in the portfolio) could protect you.

Thanks Craigr - that is the sort of information I was looking for.   I'm not trying to assert the scenario I described is likely (I don't know the future) - I was trying to simply explore if the PP hedged against it as it hedges against many other scenarios.

So it sounds like the main hedge here is via the gold, and that gold alone can potentially carry the portfolio.  

One related question in light of the proposed scenario:  What reason is there for the PP to use S&P500/total US market for the stock component?  Why not use an entire world stock fund including the US (VTWSX) or even an entire world excluding the US fund (VFWIX)?  Doesn't that increase the diversification/hedging power of the PP?

If I recall, in this show Harry Browne discusses risk and how gold performed in the portfolio:

https://web.archive.org/web/20160324133 ... -10-24.mp3

Also this show I think he covered it, too:

https://web.archive.org/web/20160324133 ... -04-17.mp3

fnord123 wrote:One related question in light of the proposed scenario:  What reason is there for the PP to use S&P500/total US market for the stock component?  Why not use an entire world stock fund including the US (VTWSX) or even an entire world excluding the US fund (VFWIX)?  Doesn't that increase the diversification/hedging power of the PP?

The main issue with too much foreign exposure is currency risk. The portfolio foundation relies upon being tied closely to the economy where you happen to live. For instance in 2008 if you owned a bunch of foreign stock as a US investor you took additional losses when the dollar surged more than 20% in value during the crisis. It was salt in the wound.

With that said, I own a small amount of foreign stocks (5% intl. 20% domestic). It probably doesn't hurt, but I'm not sure how much it helps with the global reach of developed world companies today. The total world fund you list is also relatively new which is why I haven't been recommending it widely. It may work out fine for the portfolio but there isn't enough time behind it yet to know.

It seems the most popular question of late is: Can the 4x25 allocation really still be the safest allocation possible?.  There is tremendous skepticism amongst many that this could possibly be safer than 100% cash equivalents.  I am pesently about 90% cash and 10% gold.  I have been under the Prechter spell for about 9 months, (so far to the considerale detriment of my net worth).  According to Prechters "fortune telling"  my allocation is about optimal.  Clive says 4x25 is fine as long as you don't buy high.  Even HB himself says your buy-in price is very important (when discussing the variable portfolio).  It seems to many that all 3 volatile assets are presently high-priced. HB also says any trading system that has worked in the past will fail to work as soon as I adopt it (!)  Others have noted 10% drawdowns in the 4x25.  Some of us fear that multi year back to back drawdowns are possibile even though that hasn't happened yet.  HB says that anything can happen and nothing must happen.  I like the Japanese market backtests.  It might be informative to see a 1920 to 1960 British markets backtest as they transitioned from reserve currency to not. 

Hi Doug,

I don't put 100% of my money into anything. Whether it is cash, gold, stocks or pork bellies. I just don't have that much faith in any one asset to make such a bet because the world is just so unpredictable.

I don't know who Prechter is (he appears to be an Elliot Wave guy), but I just don't think fortune telling is a profitable investment strategy and I don't care who is doing it. You need to be diversified at all times because nobody knows what the future brings. If Prechter told people to stay out of the market the past year he was horribly wrong for instance. In December of 2008 I was encouraging readers to rebalance back into stocks if their allocation needed it.

https://web.archive.org/web/20160324133 ... rebalance/

If you are overweight on your bonds in the portfolio (e.g. they exceed 30-35% of your holdings), you should consider selling them down to 25% and using the proceeds to bulk up the other parts of your portfolio that are below the 25% allocation band (such as your stocks, cash and gold).

For those thinking their bonds have done great and don’t intend to rebalance, all I can say is be careful. It’s tough to sell a winning asset, but at any time your bond gains could be eroded as interest rates whipsaw upwards. If economist Higgs is right, the inflation we see could be quite bad. Instead of 30-40% profits in your bonds, you could be staring at 30-40% losses or worse.

By not rebalancing, you may miss out on large gains in your other assets by having too much of your money tied up in your current winners. Imagine missing out on a 20%, 30% or higher gain next year in stocks if the markets recover and things work out.

YES, I know that sounds impossible right now. But it’s happened before and YES it usually does it after a bad market crash.

Gains like I just mentioned happened after the early 1970’s recession (1975 +37%, 1976 +24%), after the recession in the early 1980’s (1982 +21%, 1983 +22%), after the early 1990’s recession (1991 +31%), after the early 2000’s Internet bust (2003 +29%) and they even happened during the 1930’s Great Depression (1933 +54%, 1935 +47%, 1936 +34%, 1938 +31%).

Yet, I'm not coming off as a fortune teller. This is just good strategy without needing to predict the future.

Does asset price matter? Sure. But you know the problem is you just don't know what the best price was until well after the fact (as in years). In March 2009 there were tons of investing gurus telling people that stocks were still priced too high. But look what happened! It may be that three of the four assets are too high now, but how do we know that? Maybe stocks could go up another 40% from here? Maybe bonds will have a 2008 redux. Inflation could come on strong and gold could go up to $2000 an ounce. Who knows?

The Permanent Portfolio does not guarantee anything (who does in investing?), but it has a long empirical track record of doing just fine through a variety of good and bad markets. I feel very comfortable having my life savings invested in it as I eat my own dog food. I've seen it work well personally. For me, if it ain't broke I'm not going to go fix it.

I should probably talk about this more in the future, but the 4x25 split is safer than many other portfolio allocations I've come across. The four asset classes it holds are radically different in how they respond to economic changes than a simple stock/bond split or market timing schemes. The odds of all four of the asset classes falling significantly in price at the same time, I feel, is very low. If it were to happen, I doubt it would last very long before economic forces cause one or more of them to rebound strongly back.

But even if this does happen, what is to say that other strategies wouldn't be impacted just as bad if not worse? If the stocks and bonds in the PP are being cratered for instance, then most other portfolio allocations are surely hurting just as bad.