November was a relatively quiet month for the leveraged permanent portfolio (at least on a relative basis). It was a tremendous month for equities, and the portfolio will tend to lag the equity markets when they rally sharply. There will need to be a rebalance this month as gold is a bit underweight after November’s moves.
After running this strategy for a little over a year, in pretty varied market conditions, I am going to make a change and abandon the 12% volatility threshold for triggering moves to cash. This has always been an arbitrary threshold, and it is only intended to safeguard against one specific risk: panic liquidation that sends all correlations to one.
We got a taste of this in March at the nadir of the Covid drawdown. But the volatility threshold didn’t help much. It only triggered adjustments after the fact. In the future I may manage this risk on a discretionary basis instead. TBD.
30% S&P 500
20% Laddered Treasury Futures
30% ex-US equity
~114% notional exposure
Again, on a relative basis, overall performance has lost ground to US equities recently. Nonetheless, it remains plenty attractive on an absolute basis. Since late 2018, a static allocation version of this strategy has handily outpaced SPY, with a 60/40-like drawdown and volatility profile. As I’ve written many times, I would not necessarily expect the strategy to outpace a 100% equity portfolio over very long time periods. But I think it will remain competitive. On a risk-adjusted basis, on the other hand, I don’t think there will be any comparison. The leveraged permanent portfolio will dominate 100% equity portfolios on a risk-adjusted basis.
Bill Murray: [cries in pain] Ow, I’m on fire! Ouch!
Tallahassee: You’re not a zombie, you’re talking and… You’re okay?
Bill Murray: The hell I am.
Wichita: I’m sorry. I didn’t know it was… It was “you” you.
Tallahassee: Are you…? What’s with the get-up?
Bill Murray: Oh, I do it to blend in. You know. Zombies don’t mess with other zombies. Buddy of mine, makeup guy, he showed me how to do this. Corn starch. You know, some berries, a little licorice for the ladies. Suits my lifestyle, you know. I like to get out and do stuff. Just played nine holes on the Riviera. Just walked on. Nobody there.
I have been pretty depressed lately.
This is not just election fatigue (which is bad enough). It’s the feeling of watching a slow-motion train wreck. This is technically a Trump thing. Or, if you prefer, a corrupt Democrat/Deep State thing. It matters far less whether Joe Biden or Donald Trump ends up being president than it matters whether the perceived legitimacy of the electoral process is preserved. Trump’s intransigence and the Russiagate nothingburger are two sides of the same coin here. Does that mean they’re equally bad? I don’t know. For the purposes of this post, I don’t particularly care, either (if you would like to spend endless hours litigating this topic I recommend Twitter and the PredictIt comments section).
What both interests and disheartens me is that politically, these are two variants of the same strategy: subverting electoral outcomes as the ultimate arbiter of political power in the United States.
Regardless of the actual outcome, the common knowledge that elections are the ultimate, and more importantly, most legitimate arbiter of political power relations in the United States is dying a painful death. It is difficult to understate how massive a blow this is to the metastability of American society.
A superficial reading of metastability might make it seem like a breakdown in law and order. That’s not quite what I’m talking about here. Law and order might break down within an otherwise metastable social system. Whenever there’s a riot in an American city, for example, law and order break down. But a riot in and of itself does not alter the core values and mythology shared by American citizens.
A social system remains metastable as long as there is a reasonably broad consensus regarding its core values and mythology. Without this consensus, metastability weakens. Put another way: first-order threats to social stability, such as isolated riots and street crime, are risks that lie in the body of the distribution of outcomes, both for individuals and society. Metainstability is a higher-order threat. The risks associated with metainstability lie in the tails of the distribution.
At the moment, the core modern American myth that is dying a slow and painful death is that the electoral system can more or less be trusted to produce a legitimate outcome and that outcomes should be respected as such. Of course this is a myth. Politics-as-it-is is basically the “lite” version of organized crime [insert your favorite Hillary Clinton joke here]. That’s the nature of the accumulation and exercise of political power.
Today, the nascent common knowledge forming around US elections is that The Other Side is so debased and so corrupt that any procedural end-around is justified to attain the desired outcome. And not just the desired outcome, mind you: also the just and morally correct outcome. It’s a rationalization of prisoner’s dilemma logic. We better defect. Defection isn’t really reflective of our moral character, of course, but The Other Side is going to defect anyway. So we gotta. Legislatively, this has been going for years. Its extension to the legitimacy of our elections is a natural, and ultimately more dangerous, evolution.
Joe Biden winning the presidential election does not change this.
Donald Trump overturning the result of the presidential election does not change this.
As my friends at Epsilon Theory have written endlessly, it is a very stable equilibrium.
Welcome to the future.
On the positive side, I am pretty skeptical of a worst-case outcome like Civil War 2.0. As depressing as the current climate may be, I think we’d have to fall an awful long way yet to get there. Rather, where I suspect we’re headed is the vague nothing-land of semi-permanent acrimony and sclerosis. Zombieland. In zombieland, no one ends up in a re-education camp (sorry in advance to resistance LARPers of all political flavors). When it comes to getting a tee time, or yolo’ing on Robinhood, things in zombieland are, on the face of it… kinda okay. For a lot of us, maybe even good. Even politics is just a matter of throwing on the corn starch and shambling around with the fellow zombies of your political tribe. Zombies don’t mess with other zombies, after all.
Trying to make 1:1 historical analogies is dangerous. But I do believe it is helpful to consider some historical analogues to get to grips with what this environment may look like:
Interwar France (my personal favorite)
Interwar Germany (overdone in the popular consciousness, IMHO, but definitely a worst-case case study)
Pre- and post-Civil War US (the Reconstruction era in particular)
Due to my personal background, I have come to think of our current trajectory as the Egyptification of the United States (I spent a year in Cairo immediately preceding the fall off the Mubarak regime).
You would think that chaos and revolution would feel pretty ominous and post-apocalyptic. It doesn’t. Mostly it feels weird. Your sense of time becomes distorted. Everything seems to slow down, because it’s a high information environment and it’s difficult to filter signal from noise. But you can’t revolution all day. You gotta eat. And you gotta try to figure out who’s still got booze. And if you are a young single guy you are still thinking about trying to get laid. It’s much more Zombieland than Dawn of the Dead.
Anyway, the defining characteristic of economic and political life under late-stage Mubarak was stunted sclerosis. To call the government inept was to miss the point. It wasn’t even trying.
Now, in Egypt circa 2009, the government wasn’t even trying because it was preoccupied with the maintenance of the regime and skimming off the economy.
In the US circa 2020, our so-called leaders aren’t even trying because they’re preoccupied with zero-sum power games, and skimming off the economy (one need look no further than the farce that has played out around a second Covid stimulus package).
History doesn’t repeat, but it rhymes.
I am still thinking through the investment implications of all this. My base case is now what I have called “the zombification of everything.”
MOAR dysfunction. MOAR debt. MOAR government intervention in capital markets (to hedge the political class from the financial consequences of its own ineffectiveness, ‘natch). Low rates, low growth, (alleged) low inflation, as far as the eye can see. The market narrative cartoon of this regime will be disinflation. In reality, I think it’s more of a stagflationary regime. But the cartoon is what matters for your returns. So somewhat paradoxically, this is GOOD for risk assets. Particularly long duration assets.
What would make me bearish?
Less. Less debt, less government intervention in capital markets and less dysfunction would, paradoxically, be BAD for risk assets. (Okay, maybe not value stocks) There is, therefore, very little economic incentive for the incumbent political class to go this route. From an economic policy perspective, we have a pretty stable equilibrium.
Up is down. Black is white. Such is life in zombieland.
The allocation changed materially this month because I had some excess cash to invest and there are some frictions with asset location as these positions are held in both retirement and non-retirement accounts. Data here.
Overall the current allocation is approximately:
27% US Large Cap
29% ex-US Equity (mix of DM & EM, large and small cap)
18% Laddered Treasury Futures
~104% nominal exposure (tiny amount of leverage)
Technically I am supposed to be adding cash to bring trailing volatility back to 12%. However, the longer I run this strategy the less enamored of the volatility threshold I have become. Perhaps it is my stubborn contrarian tendencies rearing their head. Candidly, I just don’t feel like messing with it to shave off a couple points of trailing volatility. In a significant, sustained risk-off event I would likely add cash to counteract spikes in correlation. But for this to make much of a difference the event would have to be of enormous magnitude. Even during Covid this portfolio’s max drawdown was only about 10%. So for now I am just letting it ride.
Overall performance remains in line with expectations. Again, we are getting US Large Cap returns with 60/40 drawdowns and volatility, in a much better diversified portfolio.
One thing that these performance reports do not capture particularly well is the portfolio’s growth equity tilt. In fact, this is precisely what has kept my ex-US equity exposure from being overly detrimental to performance. I haven’t written about it much in these posts, but for portfolios designed to harvest market betas (of which this is definitely one), I am in strongly in favor of underweighting traditional “value” strategies due to the prevailing global macro environment. Getting deep down into the weeds on this is beyond the scope of this post, but in my view the key headwinds for traditional value strategies are:
Persistently low trend economic growth
Ultra-low interest rate policy (provides greater benefit for long-duration assets)
Muted inflation (at least in the public consciousness)
In a sustained inflationary or (acknowledged) stagflationary economic regime I would likely make a tactical adjustment and reintroduce some traditional value equity exposure back into the portfolio. All this just goes to illustrate that there are infinite variations on the permanent portfolio concept.
It’s another pretty boring month for the leveraged permanent portfolio (data here). Technically, we’re still a bit above the target 12% volatility threshold, but not by much. So I’m going to continue to let it ride.
Performance-wise, US Large Cap Equities have made up some ground on the portfolio recently. However, the leveraged permanent portfolio remains much better diversified, including nearly 30% in cash and Treasury futures, and a further 26% in ex-US equities.
A: If we call things like long-biased equity long/short funds and private equity equities instead of alternatives, it will look to these people like they are 90% invested in equities.
B: But they ARE invested 90% in equities.
One of the more dangerous things you can do in the markets is engage in self-deception. This is particularly true from a risk management perspective. A hill that I will die on is that much of what we call “alternative” investments are just equity investments by another name.
Nowhere is this more obvious than private equity. In what “bucket” of an asset allocation would you put a thinly traded, leveraged microcap stock that is no-bid for an extended period? There is no debate. It is an equity security. The economic risk exposures of the security are equity risks. Now, this is not a particularly liquid equity. But it is an equity security nonetheless.
Likewise, on the other end of the spectrum, a “defined outcome” S&P tracker with an options overlay is an equity strategy, exposed to equity risk. The addition of a mark-to-market volatility mitigating hedge does not transmute this into some kind of alternative strategy. It is just watered-down equity risk (with watered-down equity returns to match).
For most allocators and private investors, I suspect fiddling with phony-alternative, pseudo-equity strategies is akin to the golfer who is afraid to commit to an approach shot because of some windage. He is afraid of the wind so he clubs down. But because that club selection is driven by anxiety, he doesn’t hit as firm a shot as he normally would have. So he misses short and lands in a greenside bunker.
Don’t miss short! Get it past the hole!
There is an insidious thing that happens when you do not call things by their proper names. Things-as-they-are are gradually replaced with abstractions. This is what is happening with obvious absurdities such as private equity being pitched as “higher returns with less volatility.” From an economic risk perspective, the whole idea is nonsense. But as an abstraction bolstered by “statistics,” it is true.
Of course, I can reduce the volatility of my public equity portfolio, too. I will just mark it once a year, to my proprietary fair value estimates. My down capture will look great versus the S&P. My numbers will be audited and everything. Beautiful!
It is in periods of extreme dislocation that things behave as they are. This is when it becomes obvious that your long-biased equity hedge funds actually capture a decent amount of downside; and your high yield bonds behave a lot more like equities than you thought they would; and that bright hedgie who did a really good job of getting his net down at the start of the selloff keeps it flat into a massive rally… sorry… I digress…
The most egregious portfolio failures, in terms of both missed return targets and poor risk management, result from a failure (or even outright refusal) to see things as they are.
You can call your pie chart slices whatever you want. They can display all the colors of the rainbow. It does not change the underlying nature of the things they represent.
(yawn) Not much to report this time. I had an influx of cash to invest prior to this rebalancing check, so these numbers actually reflect a mid-period rebalance, after which the portfolio became more fully invested. Technically, I should be taking a few percent of exposure to cash this time, but trailing volatility is not much above the 12% threshold I use for risk management purposes, and the portfolio is quite well-balanced. So I’m just going to let it ride this month.
Underling exposures, accounting for leverage:
30% S&P 500 Futures
20% Laddered Treasury Futures
12% EM Small Cap
12% ex-US Large Cap
~105% notional exposure
This month’s performance snapshot is quite representative of how the strategy should be expected to perform more generally. It trails equity markets in bull rallies, but makes that up with significantly shallower drawdowns. Over long time periods, you end up with something like a 100% equity return profile, but a 60/40-like drawdown profile in deflationary conditions. Of course, the gold exposure should ensure that the drawdown profile in inflationary conditions is far superior to a 60/40 portfolio. Granted, that’s not a macro regime we’ve had to deal with for some time.
Of course, the definition of “equity markets” is in the eye of the beholder. Below are the returns for ACWI as of 07/31. This is a much more appropriate investable benchmark for a globally diversified equity portfolio. The performance of the leveraged permanent portfolio compares quite favorably. Actually, the leveraged permanent portfolio has annihilated ACWI so far. Performance versus other permutations of the global 60/40 portfolio is similarly strong.
On an unrelated note, I’ve not posted much on here lately, partly because I’ve fully articulated a lot of the ideas around markets and asset allocation that I originally wanted to share on here. By no means do I intend to shut the blog down. But I consider myself in a bit of a “reset” phase in terms of ideas. I hope to be posting with more frequency again sometime soon. In the meantime, at a bare minimum I will continue to post these monthly updates.
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.