It certainly wasn’t planned, but I rather like where the portfolio is positioned today. There is still nearly 100% notional exposure due to the leverage, but a 20% cash position. On the surface, this looks like a lot of hassle just to match the Morningstar Large Cap Index (similar to the S&P 500). But the underlying portfolio here is much, much better diversified than that index. Even within the equity bucket, nearly half of the exposure is ex-US. For perspective, ACWI (which is a reasonable investable proxy for market cap weighted global equity exposure) is -5.50% YTD.
Time for the usual monthly rebalance post. No changes this month. Technically, I should add a bit more cash based on trailing 12-month volatility. But the excess volatility versus the target threshold is pretty marginal, so I’m not going to worry about it this month.
Performance YTD and since inception remains solid. The characteristic performance pattern of this strategy is evident in the last few months. Equity returns with less drawdown. You get the downside protection when it counts, but tend to lag in strong equity rallies.
Of course, the real power of this approach is that it provides a source of liquidity for buying into significant market dislocations. For my personal portfolio, I pair this with a sleeve of concentrated individual positions.
I don’t write about that portfolio on here much, for a number of reasons. But pairing it with the leveraged permanent portfolio has allowed for an exceptional year thus far: +14.93% on an IRR basis, and +13.89% since inception about three years ago on an IRR basis. I use the IRR here because I control the cash flows into and out of this sleeve of the portfolio. The TWRs are lower, at +4.47% and +9.10%, respectively. Still nothing to sneer at, though.
The dramatic differences in IRRs compared to TWRs here illustrates the power of having a source of liquidity to buy into major market dislocations. I am increasingly convinced that there is not as much “irrational” panic selling in market dislocations as we might like to think. Most investors know they should be buying into crashes. They just can’t. They don’t have liquidity, either because they run fully invested or because they tend to experience other calls on cash during crisis periods. There is only so much you can do about the latter. Clearly, the former can be addresses through portfolio construction.
The other concept this illustrates is the time dilation we experience in markets. In periods of highly compressed market time, such as March, there are opportunities (risks) to generate outsize gains (losses). I believe it was Lenin who said: “there are decades where nothing happens and weeks where decades happen.” March 2020 was one of these times. A few weeks in March both made and shattered investment careers. This had very little to do with financial modeling skills and everything to do with the ability to adapt to the shifting tempo in the financial markets.
There are lots of ways to think about volatility from a conceptual view. Mostly it’s thought of as a risk measure. That’s a bit reductive. Volatility isn’t a measure of risk, per se. But it tends to be correlated with risk. It is better to think of volatility as a measure of time compression in the markets. When volatility is high, market time is compressed, and risks and opportunities are elevated. When volatility is low, market time stretches out, and risks and opportunities diminish. There is not enough written about the concept of tempo in investing. Maybe I will work on changing that.
“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
I have not written much since the coronavirus outbreak blew up. Not because I’m not thinking about things. I simply haven’t had much to say. I have no unique perspective to add regarding epidemiology or public health policy. Sometimes the best thing to do is simply hang back and reflect. This post contains some thoughts on where we’ve been, and where we might be headed.
One indisputable consequence of this pandemic is that we have quickly transitioned from a disinflationary or even (I would argue) mildly stagflationary regime to a deflationary economic regime. The duration of this new regime is an open question. Policymakers, particularly on the monetary side, have reacted as expected. They did MOAR. And they will continue to do MOAR to backstop financial markets, so long as they deem it necessary.
Unsurprisingly, this has done wonders for financial assets. Particularly duration-sensitive assets such as long bonds and growth equities.
Some dominant themes/narratives I think we will grapple with as this evolves:
The transformation of financial markets into political utilities is complete. It has always been a mistake to assume markets are a prefect reflection of the real economy. Now, markets are probably less a reflection of the real economy than ever before. A consequence of MOAR is that markets (or at least pockets of them) have seemingly become completely untethered from the real economy. There are sensible reasons for this, of course. Ultra-low discount rates. The fact that solvent businesses with liquidity to draw on should not see long-term impairment of value as a result of the virus, etc. But as with the financial crisis, policy geared toward owners of financial assets has been implemented quickly and decisively. Much more decisively than policy geared toward vulnerable small businesses and their employees. This will likely have social and political consequences.
We are all MMTers now. Government deficits will never matter again. Well, at least not unless/until an inflationary bill is acknowledged as having coming due. Central Banks are explicitly engaged in debt monetization. This is mainstream. It is accepted. Yes, there are a different flavors of it. There is the progressive flavor, with its Green New Deals and job guarantees. Then there is the “fiscally conservative” flavor, with its tax cuts and its endless promises of shrinking government (government is never shrunk in a material way, ‘natch). I’m not interested in arguing over whether this dynamic is right or wrong at this point. All I care about is acknowledging is that it IS. Because it matters. It matters a lot.
Politics is going to get nastier. The United States government is now explicitly in the business of choosing winners and losers in the economy. As usual, owners of financial assets have been selected as winners. As usual, those who do not own financial assets are deemed losers. I expect the long-simmering political conflict between Capital and Labor to further intensify as a result. Political rhetoric will become more extreme. Politicians will become more ridiculous. Congress will become even less effective (difficult to imagine such a thing is possible, I know). Fun times.
Investment-wise, it’s going to be MOAR of the same. Outside of the obligatory post-recession bounce, there will not be mean reversion in value versus growth factor performance. Long duration growth bets will continue to perform well, because there is no opportunity cost to making them. I suspect that long duration bonds will also continue to perform well in the short-term, against all odds. Because I believe we will test negative interest rates here in the US before we test higher interest rates. And convexity is a thing people seem determined to refuse to understand.
But how does it all end? I see a few very different endings to this story. The first, of course, is some kind of inflationary or stagflationary regime triggered, in part, by relentless monetary easing. But people like me have been worried about this for a long time. And it’s never shown up. A second possibility is that some kind of transformational technological innovation on the order of the internet allows us to return to much higher trend growth rates. This would be ideal. Perhaps the darkest scenario is that the political conflict described above spirals completely out of control, and we get to live through a reprise of the 1930s and 1940s.
This is not a very hopeful post. It is not hopeful because I do not have a very positive outlook on the macroeconomic and political trends of the day.
That said, this is also not an argument for bearish positioning in a portfolio. If you follow me on the Twitter, you may recall my exhortation to “dare to be smart enough to be dumb.” Flexibility is key here. I can forgive people (myself included) for not grasping how monetary policy would impact financial market behavior post-2008. That mistake is less forgivable today. In my opinion, it is nigh on impossible to invest today without accounting for the gravitational pull of monetary and fiscal policy.
To be perfectly explicit, as things stand today:
Quantitative value (owning cheap things because they are cheap) is at best a tactical trade.
Economic policy will hamper mean reversion.
Trends are our friends for the foreseeable future. Not all of them are likely to be positive. But forewarned is forearmed.
Despite the strong rally in April the portfolio came in above the 12% volatility guardrail in April (upside volatility counts as much as downside volatility). Each individual asset is above the 12% threshold (though gold not by much). Cash needs to move to a 20% weight. To do this I will trim from everything but gold.
NTSX – 29%
GLD – 25%
VIESX – 13%
JOHIX – 13%
Cash – 20%
Which means the underlying allocation is approximately:
S&P 500 – 27%
Laddered Treasury Bonds – 18%
Gold – 25%
EM Small Cap – 13%
Ex-US Dm Large Cap – 13%
Cash – 20%
(98% notional exposure)
I remain quite pleased with year-to-date performance. The interesting thing about this recent signal is that it is de-risking the portfolio after a strong rally. As mentioned above, volatility as a measure does not discriminate between up and down moves. It is just showing you the sea is choppy. The intuition here is very simple. You de-risk when the seas reach a certain level of roughness, even if the most recent moves happen to have been up.
Despite some tense moments, the leveraged permanent portfolio has held up pretty well through the recent market turmoil. With the announcement of unlimited Fed liquidity support, I added a decent chunk of gold exposure back to the portfolio. This was another discretionary decision. However, the rationale was consistent with the philosophy underlying this strategy. At the time, I believed that the Fed’s policy interventions would do much to end liquidation behavior and, hopefully, reduce correlations across equities, bonds and gold.
Today, the portfolio is:
~29% S&P 500 Futures
~18% ex-US Developed Market Equity
~17% ex-US Emerging Market Small Cap Equity
~19% Laddered Treasury Bond Futures
(~110% notional exposure)
Over the standard 1-year lookback period, this puts me just below the 12% volatility threshold that would trigger adding more cash. So, in the absence of the resumption of indiscriminate liquidation behavior in financial markets, this will be my allocation through the next rebalance check.
Year-to-date, performance is a bit worse than a standard 60/40 allocation. This is consistent with the behavior that a backtest of this type of strategy exhibited during the depths of the financial crisis (another period when “all correlations went to 1”). Note that in the below chart, the Morningstar Large Cap index has replaced the S&P 500. For some reason, S&P 500 returns are slow to pull through this tool now. The differences between the two indexes should be minimal, however.
Of course, my implementation of this strategy uses a global equity allocation. A fully-invested US-only variant (50/50 NTSX/GLD) would have finished March down only 7% or so year-to-date.
I’ve written before that there are endless variations of this kind of strategy. Personally, I am (perhaps irrationally) biased toward longer lookback periods and a more globally diversified equity allocation. However, I would not argue that those are necessarily optimal. Indeed, I am leaning more and more toward my friend @breakingthemark‘s compelling case for shorter lookback periods and more frequent rebalancing checks.
Nonetheless, I am pleased with how this strategy has performed since I first implemented it. The balance of upside participation with downside protection has been excellent. In addition to its standalone performance, it was able to serve as a source of liquidity when markets became especially dislocated in March, which I used to add to the aggressive, discretionary sleeve of my overall allocation.
I would never argue that this is a “perfect” investment strategy (there is no such thing). However, I think its recent behavior validates it as a very straightforward, DIY solution that even small investors can easily implement. I have no idea what the future may bring in terms of financial market performance. But I am very excited to see how the leveraged permanent portfolio holds up.
I had never expected the leveraged permanent portfolio concept to be tested so dramatically, so soon after beginning this experiment. The speed of the coronavirus-induced drawdown in financial markets has been absolutely breathtaking. Truly a punch in the face. Through 3/20/20, my leveraged permanent portfolio has drawn down materially, though to a lesser extent than global equities. It has performed much like a 60/40 portfolio in these conditions, though much of this is actually attributable to the inclusion of ex-US equity in the allocation (a US-only variant would be down about 10%).
In the midst of the chaos, I made an important discretionary decision last week. I liquidated the entire GLD position and took it to cash well ahead of the next monthly rebalancing check (due 4/1/20).
Market conditions had deteriorated significantly, and there was a period where essentially all financial assets had become correlated (equities, Treasuries, gold). This increase in correlations is THE existential threat to the permanent portfolio and in my view it MUST be managed. There are basically two ways of doing this: 1) hedge, or 2) take a portion of the portfolio to cash. I opted for #2, and liquidated both the gold and a small residual emerging markets equity position.
Current allocation (based on a full lookthrough of NTSX’s exposures):
There is an argument for reducing exposure further. For example, my Twitter friend @breakingthemark runs a somewhat similar strategy with a weekly rebalancing cadence, which has delivered extremely impressive performance. His strategy is tuned to respond more quickly to crashes, and is currently at 60% cash. I expect at 4/1/20 I will be adding more cash, as well as rebalancing some equity exposure back into gold.
* Differences between the total (time-weighted) and personal (dollar-weighted) returns are attributable to the timing of trades, as well as the fact that I reduced the overall size of this portfolio to opportunistically redeploy capital into my “lottery ticket” portfolio bucket during this period.
The nice thing about big selloffs is that the lower the market goes today, the higher your future returns go for tomorrow. We have 4Q19 Fed Z.1 data now, which means I can try to roundabout ballpark S&P 500 returns for the next 10 years. As of 12/31/19 this estimate was 2.43%. After making some (very) rough adjustments for recent market moves, it has increased to 7.66% today.
With interest rates as low as they are, and the possibility of negative rates looming on the horizon, I think a 700+ bps equity risk premium probably merits some buying, somewhere. DON’T GO ALL-IN. It is very possible things get worse before they get better. My own strategy has been to focus on the shares of companies that seem inordinately dislocated based on poor liquidity conditions. This is particularly evident in small cap stocks. In the US, these stocks had drawn down approximately 50% prior to the last couple days’ bounce.
Pulling the trigger on these things is not a trivial thing to do. It is uncomfortable knowing that you could be catching falling knives. I am not arguing that people are stupid for being cautious here.
I am, however, arguing that if you have liquidity (also far from trivial), and are willing to be a provider of liquidity in a dislocated market, there are spots where you can be compensated quite well for doing so. In small cap land, there are stocks trading at double-digit discounts to announced, all-cash takeout offers. This makes very little economic sense. Is Google going to bail on its FitBit acquisition because of the coronavirus? Probably not.
Admittedly, my truest investing self is “bottom-feeding contrarian.”
Right now, I think it makes sense more than ever to put money to work in a concentrated, “lottery ticket” portfolio alongside a more conservative core.
Ironically (the markets do have an uncomfortable habit of throwing this stuff right back in your face), this is precisely what we saw in February in terms of the relationship between equities and gold. GLD finished the month down slightly. However, the monthly number obscures a sharp selloff that occurred in the last couple days of the month. Why did it happen?
I don’t know that anyone knows for sure (if any of you are traders or market makers with special insight, please leave a comment!). My personal hypothesis is that this was a function of investors rebalancing portfolios, taking down gross exposure and getting margin calls. Gold in particular has had a tremendous run over the last 8 months or so. Since I started running this portfolio, GLD is up 23%, while the S&P 500 has returned 2.77% and the BBgBarc Aggregate Bond Index nearly 9%.
Portfolios with a static allocation to gold are probably overweight it. And if you need to sell something for whatever reason, what makes the most sense to sell?
This is the kind of “real-world” trading activity that takes correlations to 1 in a crisis environment. And this portfolio is certainly vulnerable to it, as we saw in February (albeit to a relatively mild degree). It’s why volatility and trend are used as overlays for risk management.
Incidentally, the one-year lookback I use didn’t flag a need to add cash to the portfolio.* A one-month lookback would have, with trailing one-month volatility of about 15%. Equity exposure would have been trimmed to add the cash, with most equity market segments having crashed through their 200-day moving averages in February.
Why do I not use a one-month lookback? Originally, I did. However, I became concerned that such a short lookback period might be too sensitive to very short-term shocks, whereas the strategy is intended as a strategic allocation more geared toward navigating changes in market regimes.
Candidly, I’m not sure this is the right decision.
But we’ll see.
* Astute readers may notice that the portfolio weights in this update differ slightly from those in the previous update. There are two reasons for this. First, I trimmed and rebalanced an overweight to ex-US equity exposure that had crept in. Second, yesterday I sold some of the gold and NTSX exposure to make some purchases in my individual stock portfolio. If you’ve been following these updates since the beginning you may recall that I pair this strategy with a concentrated, high-risk, 10(ish) stock equity portfolio.
In an ironic twist, I am experimenting with monetizing a blog called Demonetized. I have added a tip jar to the site. It will either display at the top right of the sidebar or the bottom of the list of posts, depending on the size of your device screen. It is marked with a charming little vector graphic of a piggy bank. Which is meant to represent my piggy bank.
I have a couple reasons for taking this step:
First and foremost, it would be nice to make more money.
Second, even a minimal amount of tips will help defray the (admittedly low) cost of site upkeep.
Third, I am interested in experimenting a bit with “business models” (that is being overly generous here) that might work well for my particular skill set. This blog is not, and never will be, paywalled in any way. But, candidly, I have considered launching something that would lend itself to some kind of subscription model. The tip jar is simple test of whether people think my work might be worth paying for.
With January over I ran the latest leveraged permanent portfolio rebalance check. Still in good shape from 12% volatility limit perspective. Relative performance versus the S&P 500 has diminished since 4Q18 rolled off the lookback period. But it remains quite strong versus a Global 60/40 comp.
Actual realized performance from my implementation:
January is an interesting month because it demonstrates the diversifying power of uncorrelated assets (gold, Treasury futures in NTSX) in the face of macroeconomic event risk. In this case, coronavirus.
Recall that the whole purpose of this approach is to be insulated from unexpected macroeconomic or geopolitical shocks without having to predict anything. So far we’ve had two out-of-backtest opportunities to test this: 1) trade war anxieties in August 2019, and 2) coronavirus. In both instances, the strategy has performed as expected.
Which I suppose raises an interesting question: how would you “break” this strategy?
The strategy breaks if equities, Treasuries and gold become highly correlated in a period of sharply negative performance. It is difficult to imagine what would cause correlations to change in this way. I tend to believe it would be some kind of end of the world scenario such as nuclear war, suspension of private property ownership, or zombie apocalypse. I’m not sure portfolios can or should be built with such extreme scenarios in mind.
But anything is possible.
And that is why we set a volatility threshold for the portfolio. If pairwise correlations between equities, Treasuries and gold go to one, and the world has not ended, we would almost certainly see a sharp spike to overall portfolio volatility. At 12% portfolio volatility, we would effectively begin to be “stopped out” of risk assets, and would have to add cash to bring the portfolio back below the 12% max volatility threshold. In theory, if the world were truly turned upside down, this would give us the opportunity to re-allocate to other asset classes that are “working” in the new regime.