Gyroscopic Investing

Does the historical record of the portfolio give us an idea of how it would perform in an environment of economic stagnation with slowly rising interest rates due to monetary and commodity inflation starting from a period with historically low bond yields?

My primary concern with the portfolio has been and continues to be that even during the stagflation of the 70's the portfolio was able to perform because bond interest rates were raised to at least approximate the level of inflation in the economy. Today, with the potential for a similar environment due to increasing commodity costs, there seems to be an inability for bond interest rates to increase much because of the larger issues this would cause trying to fund our massive yearly deficits and overall debt.

I have allocated some of my assets out of US dollar to try to protect against this type of devaluation scenario but I was wondering if anyone could venture to guess what might occur under a traditional 4 way split. My guess is a number of years of flat or lackluster returns....

I think the 70s were the perfect period of time to test the PP under a series of stagflation, recession, and rising interest rates.  As they say, history doesn't repeat itself, but it sure does rhyme from time to time...

I am seriously thinking that 2010-2020 may just be exactly the same (or very close to the same) as 1970-1980.  We have slowly rising interest rates (check, although recent trends indicate falling interest rates), declining employment (again, subject to speculation - employment rates may rise and fall throughout this time period), as well as a new interest in precious metals - in the 1970s it was because the dollar became unpegged from the gold standard, but in the 2010s, it is because the general public has just discovered that gold has real monetary value again (as if it ever didn't ;-)

I'm thinking that the safe decision, the 99% I'm going to get a good return decision, is to play things exactly the same as 1970 (invest in the PP).  You could always make a bet that history doesn't repeat itself and do something else, but you would be taking the 1% bet that history doesn't repeat itself, or even rhyme with itself...

As always, your mileage may vary (YMMV) - but I know where I'm placing my bets.  History WILL repeat itself, and even rhyme with itself from time to time...

doodle wrote: Does the historical record of the portfolio give us an idea of how it would perform in an environment of economic stagnation with slowly rising interest rates due to monetary and commodity inflation starting from a period with historically low bond yields?

I would wait for interest rates to start rising before worrying about any of that.

Given that the probability of rising rates in a period of secular deleveraging is extraordinarily low, you probably won't have anything to worry about along the lines of the scenario you describe for a LONG time.

What we are in right now is NOT like the 1970s.  The 1970s were triggered by a combination energy/monetary crisis.  There was no asset bubble and subsequent deleveraging.  The two periods were similar in some ways (both periods had really crappy economies), but what we are in now is fundamentally deflationary, and the 1970s were fundamentally inflationary.

I think Japan is where we are headed.  It's hard to imagine any other course--both countries have the same underlying conditions and the same kind of people running monetary policy.

The inflation you are currently seeing is going to be short-lived.  People will simply run out of money to pay higher prices (since wages are not rising) and the economy will head back into recession as higher prices lead to demand destruction, which will set the stage for more QE.

If we are heading for an environment akin to 1990 Japan, things could be ugly. The CAGR for the PP in Japan during this time was .5% ouch!

See attached picture:



Any ideas on variable portfolio investments that would counteract something like this???

doodle wrote: If we are heading for an environment akin to 1990 Japan things could be ugly. The CAGR for the PP in Japan during this time was .5% ouch!

Any ideas on variable portfolio investments that would counteract something like this???

What bonds are being used in that backtesting?  I think that Japan was only issuing ten year bonds at that time.

I think that part of what hurt Japan from a PP perspective was that gold was still in its secular bear market worldwide in the 1990s, so there wasn't that asset to prop things up.

Also, the 1980s Nikkei behaved much like the 1990s NASDAQ in its bubble.  When starting at 1990 (right when the Nikkei started to collapse), the Japanese PP probably looks worse than if you had started it in 1980 (where you could have captured huge stock market gains).

A couple of ways of protecting yourself against a Japan-style experience when using the PP is to perhaps use some zero coupon bonds in your LT treasuries allocation, and perhaps use 15% or so of international stocks in your equity allocation.  Those two steps would have helped the Japanese PP investor a lot.

I think that the argument for a little (10%) international equity exposure and possibly a little foreign currency exposure would be beneficial to an entirely domestic PP to avoid a Japanese style PP situation.

The other big concern that I have going forward is the fact that humans are potentially beginning to butt up against the resource limitations of the earth. Studies by EIA seem to suggest that we are reaching a top in oil production worldwide around 85 million barrels a day despite rapidly growing demand from emerging markets. This is going to be the big story of the next 10-20 years and it will have far reaching economic consequences.

The question is whether it would not be smart to supplement part of the gold portion of the portfolio to more strategic commodities....maybe 5% of total allocation.

Oil and Agriculture would seem on the surface to react similarly to gold in many respects in that world instability and inflation will send it higher...

I know if it isn't broke don't fix it but I cannot help but tinker. I prefer to stay away from the dividing of assets into two portfolios "variable" and "permanent" so I am looking for a total asset allocation that increases the protection of the overall portfolio by guarding against some of the risks that might arise from an entirely domestic allocation of assets.

Has anyone else come up with any good ideas on how to guard against the potential issues the PP faces from high exposure to one economy and at the same time incorporate these changes into a "permanent" place in their asset allocation.

doodle wrote: I think that the argument for a little (10%) international equity exposure and possibly a little foreign currency exposure would be beneficial to an entirely domestic PP to avoid a Japanese style PP situation.

Foreign currency exposure wouldn't have helped the Japanese PP investor.  The yen has been stronger than any other currency in the world in recent years.  Any other currency would have been a drag on returns.

The other big concern that I have going forward is the fact that humans are potentially beginning to butt up against the resource limitations of the earth. Studies by EIA seem to suggest that we are reaching a top in oil production worldwide around 85 million barrels a day despite rapidly growing demand from emerging markets. This is going to be the big story of the next 10-20 years and it will have far reaching economic consequences.

The question is whether it would not be smart to supplement part of the gold portion of the portfolio to more strategic commodities....maybe 5% of total allocation.

Oil and Agriculture would seem on the surface to react similarly to gold in many respects in that world instability and inflation will send it higher...

In a previous life I was one of the most dedicated "peak oil" researchers you will ever find.  I latched onto the concept like a pit bull about six years ago and was only separated from my inquiry by prying my mental jaws apart with a tire iron.  I know quite a bit about the ins and outs of peak oil theory and resource depletion issues in general.  Some of the stuff I sort of wish I didn't know, a great example of which is William Catton's devastating resource depletion analysis in his 1980 book "Overshoot."

Without writing a very long post, I can tell you that I view the PP as being more or less "peak oil proof."  The reason, basically, is that whether peak oil is a huge problem or not, we are still stuck with the four economic conditions Harry Browne described, and peak oil could just as easily take us down a deflationary path (due to constrained economic growth because of high energy prices) as it could take us down an inflationary path (due to fiat money devaluation in the face of rising commodity prices).

The key to understanding why no other hard asset works as well as gold is that virtually every other commodity is subject to stronger supply and demand dynamics than gold and isn't viewed as a monetary unit.  In many ways, the U.S. went on the "oil standard" when it went off the gold standard (see U.S. foreign policy in the Middle East since the early 1970s), but oil will still have periodic price collapses in the face of falling demand (see the drop from $150 a barrel in 2008 to $30 in a matter of months).  Stated differently, gold is a near perfect proxy for the entire commodity complex without the risk associated with most other commodities.  In short, if you think oil will go up in value, gold probably will too.

On the subject of peak oil and peak everything else, it's very hard to say how things will go, but if pressed I would say that peak oil, on balance, will have deflationary effects, simply because it is so hard to get robust economic growth with high energy prices (see oil price spikes that preceded every recession since 1970).

I know if it isn't broke don't fix it but I cannot help but tinker. I prefer to stay away from the dividing of assets into two portfolios "variable" and "permanent" so I am looking for a total asset allocation that increases the protection of the overall portfolio by guarding against some of the risks that might arise from an entirely domestic allocation of assets.

Has anyone else come up with any good ideas on how to guard against the potential issues the PP faces from high exposure to one economy and at the same time incorporate these changes into a "permanent" place in their asset allocation.

I have put the permanent portfolio to every hypothetical test I can conceive of and it has performed well no matter what I throw at it.  It's also important to remember that even if the PP were to underperform in a given unpleasant scenario, I suspect it would still out-perform everything else, which still makes it a good choice to me.

It's important for each investor to put the permanent portfolio through his/her own set of crash tests.  I am confident it will come out of any set of challenges more or less intact (including the scenario where everything turns out fine).

Remember, too, that our goal isn't perfect protection in all imaginable circumstances (if it were we would be wearing helmets and kevlar vests everywhere we went).  The goal is to enjoy life according to whatever values are meaningful to you.  Your investments should be one means of reaching the life experience you are seeking, ideally withouth being too much of a distraction along the way.  I think the permanent portfolio is "good enough" for the uncertain world we find ourselves in, and that's probably all we can realistically ask for.

[quote="doodle"]
If we are heading for an environment akin to 1990 Japan things could be ugly. The CAGR for the PP in Japan during this time was .5% ouch!
/quote]

Over what time period was the CAGR .5% (sorry, I can't see the picture).

A Japanese PP investor would have a CAGR of .5% over the entire decade of 1990 to 2000.

Here is a link to the picture..maybe that will work for you. 
http://3.bp.blogspot.com/_bH_i2OLPOjU/T ... ENG_90.gif

As MediumTex indicated, I am not 100% sure what bonds where used for this analysis and this was during a very ugly market meltdown from the inflated level of over 35,000 on the Nikkei to under 10,000 that it is today.

In addition to this you had gold in a secular bear market in the 90's which was heading down as well.

Overall, I think this decade in Japan represents what is probably the worst possible investing scenario that one can face for the PP. I'm sure that many Japanese investors during this decade would have been thrilled to come out with a .5% return.

doodle wrote:
Overall, I think this decade in Japan represents what is probably the worst possible investing scenario that one can face for the PP. I'm sure that many Japanese investors during this decade would have been thrilled to come out with a .5% return.

That's what I was going to say but I'm sure that it would have been psychologically very difficult to hold the Japanese PP through that decade with those returns.

Nonetheless, it did do its job of at least protecting wealth reasonably well during a very drawn out deflation.

How would it have done from 2000-2010?

I mean, it's not like there were many better alternatives. And it's not like a Japanese investor knew what was going to happen. We can sit around and say that a Japanese investor would have done better speculating with x, y, and z...but, that's fantasy land. I think a Japanese investor would have been lucky not to lose everything in Japanese stocks. So, even despite the fact that the bonds weren't powerful enough for a PP, I think they could have done a lot worse.

Japanese, by tradition, are the worlds best savers. That mentality protected a lot of Japanese, but in a weird sort of way, it's also been one of the factors that's contributed to some of the deflation as well.

I don't see the Japanese PP as being representative of a US PP that holds 30 year bonds. 30 year Japanese bonds would have been be very desirable bonds to the Japanese — paying out coupons in a stronger and stronger Yen, mind you. I imagine the rate on a 30-year Japanese bond would have been very high in the 1980s. Those 30 year bonds would have caused rebalancing bands to trigger that aren't represented in the numbers you're seeing — potentially changing everything in the overall results.

I think we need to ask ourselves, in the face of a crippling deflationary recession and stock collapse, why 20 yr Japanese bonds, per Clive's chart, went from yielding 5.6% to 7% in 1990.

This makes no sense to me, and being seems quite counterintuitive, but maybe it was reflecting the world market and not the Japanese stock market.

This leads me to believe that (as MT partially mentioned) the nature of a Japanese (or most other smaller countries) PP isn't going to work as well or as predictably as a U.S. PP since the U.S. market moves more often drag down the world economy as a whole, and with gold being traded on world markets, and the dollar being a reserve currency around the world, our PP will perform much more along the macroeconomic lines we expect it to... hence the huge drag by gold during the period.

I'm still puzzled about those bonds though.  They're throwing a wrench in my macro-cognitive gears.

moda0306 wrote: I think we need to ask ourselves, in the face of a crippling deflationary recession and stock collapse, why 20 yr Japanese bonds, per Clive's chart, went from yielding 5.6% to 7% in 1990.

I think interest rates around the world ticked up during that period.

In 1990 I bought some one year bank CDs that paid 9%.  I had no idea how strange that would sound all these years later.

Clive wrote: Found this source for Japan 1 to 40 year rates - daily values going back to 1974

http://www.mof.go.jp/english/jgbs/refer ... /index.htm

Great find.  You are a researching machine.  Although... I have to admit that I'm now totally confused.  I didn't think that the Japanese government offered bonds of this duration... ?

Anyhow, it seems like this does at least give us some great data on calculating theoretical returns in a Japanese PP.

Lone Wolf wrote: I didn't think that the Japanese government offered bonds of this duration... ?

I didn't either.  What's with that?

Adam1226 wrote:

Lone Wolf wrote: I didn't think that the Japanese government offered bonds of this duration... ?

I didn't either.  What's with that?

They didn't. The CSV has blank entries for the longer durations, for most of the historical years. Look at the data.

"Date",1,2,3,4,5,6,7,8,9,10,15,20,25,30,40
"1980/4/10","-",12.084,11.657,10.486,10.574,10.637,10.669,10.651,10.467,"-","-","-","-","-","-"

Gumby wrote: They didn't. The CSV has blank entries for the longer durations, for most of the historical years. Look at the data.

Gotcha!  I was looking at data from the 2000s, when it appears that Japan offered a 30-year bond.  From this, it looks like the 30-year bond start in 1999.  The 20-year bond started in 1986.

And in the early to mid 80s, the Japanese apparently offered bonds of duration 2-9 years?  Awful!

So it looks like the best play was to tough it out at 50% with that horrible 9-year (???) bond, then transition to the 20-year bonds in 1986 at 5.9%.  You could grab the 30-year in 1999.

Clive wrote:I'm not surprised that they weren't selling 30 years from after the 1970's high rates. Would you have if you were in charge of the economy?

I can't help but wonder if the Japanese economy would have been completely different if they had offered 30 year government bonds. For all we know, there would have been billions of Japanese Yen wrapped up in long-term high yielding "safe" bonds and less Yen pushing up risky short term investments during the 80s. As the bonds paid out high yields over their lifetime, this might have injected much needed inflation into the economy. We'll never know, of course, but I can't help but wonder if the Japanese amplified their problems by not offering more "safe" long-term investments with higher yields.

Clive wrote: I've just finished taking the 9 year Japan yield rate (as that was the longest duration that was consistently available) for the 1974 to current and calculated a fair price for each entry.

Clive, wouldn't the absence of a 30 year government bond skew everything in Japan? Rates reflected the fact that 30-year bonds didn't exist. Stocks reflected the fact that 30-year bonds didn't exist. They didn't exist.

So, even if you could calculate what the fair price would have been, we'd have no way of computing what the effect of the existence of a 30 year bond would have had on the Japanese markets. There's no way that everything else in the Japanese economy would have remained the same. I don't see how it could. Too many variables.

It's like in Back to the Future, when changing one single variable changes everything about the future. The existence of longer-duration bonds would have completely changed things in Japan that we can't possibly compute.

Gumby,

Good point on 30 years' affect on the market.

Since there was no "leveraged redundancy" (30-year bonds) in the market, the whole thing collapsed.  Kind of like an airbag doesn't protect you correctly if you don't have a seatbelt on to begin with.... maybe a bad analogy but it's the best I can do on a Friday.

moda0306 wrote:Since there was no "leveraged redundancy" (30-year bonds) in the market, the whole thing collapsed.

And the entire run-up to the collapse would have been different as well. Investors (and funds) would have had more options with higher yields and lower risks. Other rates and investments during the run-up would have reflected that as well. Their might have been less speculation, less money pushing stocks up all at once.

Why wouldn't the 20's have acted close enough to 30's in 1990?  Were they too recently offered to have enough people invested in them?

moda0306 wrote: Why wouldn't the 20's have acted close enough to 30's in 1990?  Were they too recently offered to have enough people invested in them?

You're focussing on the effect of 20 year bonds during 1990. I'm simply saying that 1990 would have been very different if there was a constant 30 year ladder of bonds running through the economy by that point.

Imagine trillions and trillions of Yen invested in 30 year bonds that were issued in 1980 at 11% or 12% or so. That means that in 1990 there would have been 20 year bonds at 11% or 12% on the secondary market — skewing competing borrowing rates and affecting other investments. And all that liquidity would have been pumped into the economy for another 20 years — contributing to inflation — offering more attractive safe options to investors all the while. Gold would have been different. Stocks would have been different. Bonds would have been different. And there would have been more Yen floating around to invest in all of those things as the bonds paid out.... 1985, 1990, 1995, 2000 all would have been very different in terms of where money was moving in and out of.

There's no way to compute the effect of a 30 year bond.

...and, in fact, we can't even compute what the 30 year rate, or 20 year rate, would have been in 1990 because the rates were skewed by the fact that no 30 year bond existed in 1980, 1975, 1970, and so on.

I see your point on "would the market crash even have happened," but I can't help but think since the market crash DID happen that 20-years should have done what our 30's did in 2008 to some degree.

moda0306 wrote: I see your point on "would the market crash even have happened," but I can't help but think since the market crash DID happen that 20-years should have done what our 30's did in 2008 to some degree.

They are too watered down. I mean, Harry Browne has always said that the 20 years aren't powerful enough to lift the portfolio upward in a Deflationary environment. And remember that 20 years would be the longest bond you could own. Many of your bonds would be shorter than 20 years as they aged — offering even less protection from Deflation.

I'm just saying that their economy is too different from ours to simulate an official PP with. It's like trying to backtest in Bizarro World — an alternate universe where the laws of economics are skewed ever so slightly to be able simulate accurately with.

We may look at a US PP that incorporates strategies of 20 year ladders and say that they are very similar to PPs with the standard 20-30 year Treasuries, but those hypothetical PPs exist in an economy that actually has 30 year bond ladders running through it — which has an effect on everything.