Today we’re going to talk about how a lot of what is passed off as diversification does not actually provide much in the way of diversification. To illustrate this we will look at two equity allocations. The first is “diversified.” It owns all kinds of stuff. REITs. Developed market international equities. EM equities. Even ex-US small caps. Wow!
The second portfolio, meanwhile, consists solely of vanilla US large cap equity exposure.
Source: Portfolio Visualizer
You might think the first allocation would show meaningful differentiation versus the second in terms of compound rate of return, as well as drawdown and volatility characteristics.
And you would be wrong.
Check it out.
Source: Portfolio Visualizer
Source: Portfolio Visualizer
From a statistical point of view these portfolios behave virtually identically. (Feel free to noodle around with the data yourself) To the extent there are differences here they are probably just random noise.
How can this be?
It’s because correlations across these assets are high.
Source: Portfolio Visualizer
As you might expect, correlations are especially high across the three US equity buckets. A full 65% of the portfolio is invested across these three market segments. Just because you have exposure to a bunch of different colored slices in a pie chart does not mean you have exposure to a bunch of differentiated sources of risk and return.
Now, I’m not Jack Bogle telling you to invest only in US large cap stocks. Limiting exposure to country and sector-specific geopolitical risks or asset bubbles (see the early 2000s above) is one good reason to own a global equity portfolio. However, I AM telling you if you want to meaningfully alter the risk and return characteristics of a portfolio, tweaking weights at the margins in this kind of allocation isn’t going to do it.
Perhaps you think manager selection will do it.
LMFAO.
Maybe if you allocate to three or four managers and leave it at that; and the managers all perform to expectations (well enough overcome any expense drag); and because of that stellar performance you don’t make significant mistakes timing your hiring and firing decisions… maybe then manager selection will move the needle for you.
But most of us don’t build portfolios concentrated enough for it to matter all that much. And most of us pick a few duds here or there. And we are terrible at timing decisions to hire and fire managers.
Much of the time we spend hemming and hawing about the minutiae of asset allocation and manager selection is therefore wasted. Should emerging market equity be a 5% or 7.5% weight in the portfolio? I don’t know. More importantly, I don’t care. It’s a 250 bps difference in weight. Just do whatever makes you (or your client) feel better.
In fact, if you’re going to add EM at a 5% max weight because some mean-variance optimization shows it marginally improving portfolio efficiency, you officially have my permission to avoid it all together. The same goes for your 2.5% allocations to managed futures and gold.
I think there are four main reasons why this state of affairs persists:
Many folks, even professionals, don’t understand how the math works. Most people I’ve shown this kind of analysis are surprised how little difference there is in the above performance characteristics.
Many folks who do understand how the math works see the truth (rightfully) as a potential threat to their job security.
Advisors and allocators sometimes worry if they don’t futz and fiddle with things at the margins or throw in some bells and whistles, clients may question what they’re paying for. (My friend Rusty Guinn refers to this as adding Chili P to the portfolio)
At the same time, advisors and allocators can’t futz and fiddle so much they look too different from their peers and the most popular equity indexes, lest impatient clients fire them and abandon their otherwise sound financial plans during a temporary run of weak performance.
All these are valid concerns from business and self-preservation and behavioral finance perspectives. But they don’t change the math.
If your goal is to harvest an equity risk premium and play the averages as cheaply and tax efficiently as possible… then do that.
If you want to concentrate your bets in hopes of generating massive gains and you’re comfortable with the idiosyncratic risk that entails… then do that.
If you want to employ a barbell or core-satellite structure to balance cheap beta exposure with a selection of (hopefully) substantial, alpha generative bets… then do that.
Because if you waver, and you combine this and that and the other philosophy because you’re simultaneously afraid of looking too different and not differentiated enough… then you’re going to end up with something like the world’s most expensive index fund.
This is a quick post to share an update of this running model of expected S&P 500 returns using Federal Reserve data. As of March 31, the model predicted an 8.12% annualized return over the next 10 years. This has likely come down a bit further since then as the market rallied. As of today, we might be somewhere in the 6-7% range.
Data Source: Federal Reserve
Given there’s so much wailing and gnashing of teeth over macro risks these days it’s worth emphasizing a couple points.
First, this model is useless as a short-term timing signal. Don’t try and use it that way. If you’re looking for short-term signals you need to be looking at trend following systems and such.
Where I think there’s some utility here is as a data point you can use to help set longer-term return expectations and guide strategic asset allocation decisions (particularly when used alongside other indicators like credit spreads). When the aggregate equity allocation is close to 40% or above, it signals lower expected returns and argues for taking down US equity risk. Between 30% and 40% it signals “meh.” Probably not worth making any adjustments in this range. At least not on the basis of this model. At or below 30%, however, the model argues for adding equity risk.
Also, what I like about this model is that unlike indicators such as the CAPE or market cap/GDP what you are really measuring here is the aggregate investor preference for fixed income versus equities. When investors are very comfortable owning equities they bid up prices and expected returns fall. When investors are not comfortable owning equities they sell, prices fall and expected returns rise.
That’s the ball game.
No macro forecasting is required.
You don’t have to make any judgment calls on valuations, either.
What I would love to do eventually is run this for countries outside the US. What I suspect is that the ex-US models would show similar efficacy but with different “preferred” bands of equity exposure based on the culture of equity ownership in each country and whether or not there’s a significant impact from “hot money” flows from foreign investors.
I’m not aware of a straightforward way to find the data needed to do this. But if anyone has suggestions, please drop me a line.
May afforded an interesting opportunity to test the leveraged permanent portfolio strategy out of sample. (For previous posts on the permanent portfolio, see here and here) Below is data showing the results for two different leveraged permanent portfolio implementations, compared to the Vanguard Balanced Index Fund (an investable proxy for a 60/40 portfolio) and SPY. You can do a deeper dive into the data here.
NTSX’s laddered Treasuries provided better downside protection than the StocksPLUS bond portfolio here. But the gold exposure was also a major help, with GLD returning +1.76%. Obviously this is just a single month of performance, but the results are consistent with what you might expect based on backtests of the strategy.
Notice that the performance pattern is similar during the 4Q18 drawdown. In each case, the drawdowns are less severe than even those experienced in the 60/40 portfolio due to the diversifying impact of the gold. Because again, where the leveraged permanent portfolio shines is downside protection. You aren’t capturing all the upside of a 100% SPY allocation, but you’re capturing only a fraction of the downside.
Since December 2004, the PSPAX/GLD portfolio has captured 60% of the upside of SPY but only 43% of the downside. The asymmetry means PSPAX/GLD slightly outperforms SPY over this time period, but with less volatility. More importantly, the max drawdown is only a little more than half as bad.
Still, in my view the biggest problem the leveraged permanent portfolio presents for investors is precisely that its outperformance comes in down markets. This isn’t a sexy way to make money. It’s not the kind of thing that impresses people at cocktail parties. The behavioral challenges this presents should not be underestimated.
But personally, I’ll take a 10.62% safe withdrawal rate over cocktail chatter any day.
Last week’s permanent portfolio post generated some great questions and feedback, so I wanted to do a follow-up post addressing some of the most common issues raised.
That’s a big allocation to gold. What about using REITs instead of gold?
Admittedly, gold has a lot of issues as an asset. The biggest issue with gold is that it’s a negative carry asset. Not only is there no yield on gold, but there are also costs associated with storing it (fun fact: your primary residence is also a negative carry asset unless you rent out a room or two).
In theory, it would make a lot of sense to allocate to REITs in place of gold. In an inflationary environment, the real value of the properties would increase while the real value of any debt on them would decrease.
I was able to pull US Equity REIT return data from NAREIT back to 1972 and run a new backtest looking at two different approaches to a REIT allocation. (h/t to @IrvingFisher15 for pointing me to this data on Twitter) The first portfolio swaps half the gold allocation for REITs. The second portfolio swaps half the US equity exposure for a dedicated allocation to REITS. I compared both to a 100% US Equity allocation.
By swapping some gold for REITs you improve the portfolio’s return and volatility profile but at the cost of greater drawdowns and greater correlation with the US equity market.
Source: Portfolio Visualizer
To me, a decision on this comes down to each investor’s preferred risk exposures.
In a barbell approach to portfolio construction such as the one that I favor, I would opt not to replace gold with REITs, because the whole point is to mitigate drawdowns in the “core” sleeve of the portfolio. The opportunistic sleeve of the portfolio will necessarily contain a significant amount of equity risk. This may include real estate exposure.
Someone who is implementing the permanent portfolio as a standalone portfolio, however, would likely prefer the return profile where REITs replace some of the gold.
In the basic permanent portfolio, there’s not enough equity exposure.
Usually I find when people say “there’s not enough equity exposure” what they’re really saying is “the CAGR is too low relative to my return hurdle.” We’ve been conditioned to believe that when CAGRs are too low the only solution is to take more equity risk. But that’s not necessarily true.
This is where the leveraged permanent portfolio concept comes into play. To illustrate what this might look like for a DIY investor, I backtested a simple implementation of a leveraged permanent portfolio.
Portfolio #1 is a 50/50 allocation to PIMCO StocksPLUS and GLD. The PIMCO fund uses a bond portfolio to collateralize a 100% net long exposure to S&P 500 futures for 200% notional exposure. So, at the portfolio level, this portfolio is 50% bonds, 50% stocks and 50% gold for 150% notional exposure.
Portfolio #2 is a 100% allocation to SPY as an investable proxy for the S&P 500.
Vanguard Balanced Index is included as an investable proxy benchmark for a traditional 60/40 allocation.
While this is a relatively short time period, I find the results quite compelling. The leverage allows you to increase portfolio returns without adding equity exposure. While the addition of leverage does increase portfolio drawdowns, you’ve gotten a slightly better return than a 100% SPY portfolio with drawdown characteristics similar to a 60/40 portfolio. And again, in the bargain you’re much better protected from an inflationary regime than you would be using either of the alternatives.
One of the most significant shifts in my thinking around asset allocation over time has been to embrace the use of a modest amount of leverage to build more diversified portfolios that are still capable of meeting investors’ return hurdles. I guess I am slowly but surely transforming into a risk parity guy. Of course, the REIT-for-gold switch discussed earlier in this post is also a form of levering a portfolio (REITs are leveraged assets).
Anyway, I’d be remiss to move on without commenting on what I believe is the biggest issue with implementing a permanent portfolio, either levered or unlevered, for an actual client. Particularly a retail advisory client. The issue is that the portfolio massively underperforms equity markets in strong bull markets. So it’s absolutely critical a permanent portfolio investor remain focused on absolute returns in these types of environments. Otherwise, envy will lead to FOMO and FOMO to bailing out of the strategy at EXACTLY the wrong time.
The permanent portfolio truly shines when equity markets are getting hammered, either due to inflation or deflation. It’s not a sexy way to generate returns. The behavioral challenges this presents for investors should not be underestimated.
And for what it’s worth, I don’t think there’s a “solution” for this. Either people are willing to accept the potential opportunity costs of the strategy and cultivate the discipline necessary to stick with it through thick and thin, or they’re not.
What about replacing the gold allocation with trend following or Bitcoin or other uncorrelated alternatives?
By all means! Knock yourselves out. Gold was merely the easiest uncorrelated alternative for me to backtest, and also (probably) the easiest for the DIY investor or retail financial advisor to actually implement at this time. Furthermore, it doesn’t require the investor to bet on a specific investment manager to implement.
But I think it’s perfectly valid to replace the gold allocation with other uncorrelated alternatives. A word of caution, however: in my view the use of other alternatives should be biased toward strategies that perform well specifically in inflationary market regimes. That’s the whole point of owning gold here.
Why no credit exposure?
As alluded to above, this exercise was based on the K.I.S.S principle (Keep It Simple, Stupid). I have mixed feelings about how best to integrate credit in a permanent portfolio. Investment grade credit probably has a home in the bond bucket, though it will introduce a bit more equity-like sensitivity to deflationary conditions.
The lower down the credit quality spectrum you go, or the more you get into hybrid securities like preferred stocks, the more you take on equity-like risk. So to the extent assets such as high-yield debt and bank loans and preferred stocks have a place in the permanent portfolio, it’s actually in the equity bucket.
The permanent portfolio is all about balancing risk exposures in light of their potential patterns of correlation across different macroeconomic and financial market regimes. Asset classes get sorted into buckets based on their historical sensitivities to those regimes and (hopefully) how robust those relationships may prove to be in the future.
This is precisely the same intuition that underlies most flavors of risk parity, including Bridgewater’s famous All-Weather portfolio. The advantage Bridgewater and other large investors have here is that they have access to the full toolbox of financial instruments for portfolio construction. Smaller investors have to hack something together based on the investments they can access.
If you’ve read this blog for any length of time it’ll come as no surprise to hear that I’m rather disillusioned with the prevailing wisdom around asset allocation. It goes something like this:
Adjust a 60/40 split based on your age and risk tolerance and close your eyes for 40 years or so and the world will probably be a better place when you finally open them again. Here are some charts showing “long term” equity returns to make you feel better about enduring 50% drawdowns.
Here are my key issues with the prevailing wisdom:
Prevailing wisdom is biased heavily toward equities based on historical experience. This is the market Skinner box in action. There are no physical laws requiring future equity returns to look like past equity returns over any particular length of time.
Equity risk drives outcomes within most portfolios, despite these portfolios appearing more diverse when visualized in a pie chart.
The notion of “the long term” is at best squishy. “Long term,” we’re all dead. No one’s investment time horizon is infinite. We ignore sequence risk at our peril.
Prevailing wisdom is robust to neither inflationary nor deflationary busts. Which are really the conditions that ought to keep us up at night. Particularly inflationary busts. Because other than a few cranks no one is prepared to invest in a highly inflationary environment these days. (What? You think the inflation of the early 1970s or 1980s can’t happen again? LOL. Just Google MMT )
So this is going to be a post about the permanent portfolio, which is where I’ve landed as an alternative to the prevailing wisdom. This post should absolutely not be taken as investment advice. There are opportunity costs involved here and they may be significant. Particularly if your inclination would otherwise be to allocate 60/40 to US stocks/bonds and US equity continues its run of strong returns for an extended period of time. See my disclaimer for more on why making investment decisions based on random blog posts is an incredibly stupid thing to do.
Fundamental Assumptions & Principles
There are some key assumptions underlying my views on all this. I want to lay them out explicitly up front, because many of these can be debated endlessly. I’m not trying to argue all of this is capital-t Truth. This is simply the framework I’m operating within.* So for example, if you’re a guy or gal who wants to own five stocks forever, I’m not trying to convince you to do it differently. And you’re probably not going to agree with any of this. That’s fine.
We should build portfolios as regret minimizers and not utility maximizers. Note that regret minimization is subjective. We can regret both realized losses AND foregone gains. The exact “regret function” will vary with each individual. The first sentence of this bullet is in bold because it’s the foundation for everything else. I’d hypothesize that human beings in general tend more toward regret minimization than utility maximization. But I can’t prove that.
The starting point for any portfolio should be wealth allocation. A wealth allocation consists of at most three buckets. It is possible and sometimes even desirable to have fewer. Wealth allocation is consistent with regret minimization.
Equity ownership is absolutely essential for preserving and growing purchasing power over long time periods. However, equities can go through substantial and lengthy drawdowns. Major drawdowns are problematic in a number of ways:
They create sequence of returns risk for the portfolio (e.g. massive drawdown immediately prior to retirement)
They may encourage poor investor behavior (buying high and selling low)
The portfolio will have the least liquidity and buying power when expected returns are highest (e.g. at the trough of a major drawdown), preventing opportunistic purchases of assets subject to forced selling, etc.
Reliably forecasting economic cycles for the purpose of tactical asset allocation is impossible.
Traditional methods of hedging tail risk are frequently expensive and can be a significant drag on returns if utilized in meaningful size. They can also be extremely challenging, if not impossible, for individual investors to implement.
Ideally what we want is a core allocation capable of delivering approximately 5% real returns while minimizing drawdowns across different market regimes. The regimes that are of particular concern are:
Inflationary Booms
Deflationary Busts
Inflationary Busts
The goal of this exercise is not to build an Armageddon-proof portfolio. In the case of extreme tail events (nuclear war, zombie apocalypse, socialist revolution) your portfolio is going to be the last thing you’re worried about. And anyway, what you’ll really need in those situations are food, medicine and bullets.
The Permanent Portfolio
I think the permanent portfolio offers a solution. The investment analyst Harry Browne devised it specifically for robust performance across a range of different economic conditions. In its original form the permanent portfolio consisted of:
25% US Stocks
25% Long-Term Treasuries
25% Cash
25% Gold
The underlying intuition is a model of parsimony. This is a combination of assets where “something should always be working,” regardless of the macroeconomic environment. Long-term Treasuries and gold are less correlated and often negatively correlated with equities. Long-term Treasuries do well in deflationary busts. Gold does well in periods of high inflation.
I do have some quibbles with the permanent portfolio in its original form:
It holds too much cash.
It is under-allocated to equities.
It is strongly biased toward the US.
But perhaps we can address these issues through portfolio construction.
Analyzing The Permanent Portfolio
I used Portfolio Visualizer to run some analysis using historical data. I compared two different permanent portfolio implementations with a 60/40 allocation to US Stocks/US Treasuries. I set the portfolios to rebalance any time an asset class reached +/- 10% of its target weight.
I’ll walk through a couple observations in this post but if you’d like to explore the analysis yourself here is the link to exactly what I ran. (aside: I can’t recommend Portfolio Visualizer enough as a free analytical tool) Below are my three portfolios.
Source: Portfolio Visualizer
I was able to backtest these allocations back to 1986 with the available data. Unfortunately, the periods where the permanent portfolio really shines versus 60/40–the stagflation of the 1970s and the high inflation and interest rates of the early 1980s–lie outside this time period. If you drop the international equities you can capture the late 1970s and early 1980s, however.
Starting in 1986, Portfolio 1 rebalanced 7 times. Portfolio 2 rebalanced 9 times. Below is a growth chart comparison.
Source: Portfolio Visualizer
This 30-year period has been truly extraordinary for US stocks and long-dated Treasuries. It comes as no surprise that the permanent portfolios have lagged a 60/40 allocation. And, of course, the permanent portfolio with ex-US equity exposure lagged even more.
But you’re still getting your 5% annualized real returns, with milder drawdowns than the 60/40 portfolio. And in the bargain, you’re better protected from an inflationary regime than you would be with a 60/40 portfolio.
Source: Portfolio Visualizer
Obviously, if you don’t believe in allocating to ex-US equity you will prefer Portfolio 2 over Portfolio 1. I don’t share that belief, personally. But I certainly can’t prove US equity returns won’t continue to dominate going forward.
We can also look at returns over rolling periods, which paint a similar picture.
Source: Portfolio Visualizer
If you’re willing to use volatility as a quantitative proxy for risk, you can see the permanent portfolios are significantly more diversified in their sources of risk and return than the 60/40. Equity risk dominates the 60/40 allocation. Imagine the extent to which it dominates in a 70/30 or 80/20 split.
Source: Portfolio Visualizer
The tradeoff here is simple: give up some upside for a more attractive risk profile.
But what if you could juice the returns a bit?
Because this strategy is robust across market regimes it should also be fairly amenable to leverage. In an ideal world I’d take the more diversified flavor (Portfolio 1) and lever it something like 1.25x to 1.50x. This is the intuition behind risk parity: take a well-diversified portfolio with the risk exposures you want, then lever them to reach your target return. So instead of being limited to 33%/33%/33% you would be allocated maybe 45%/45%/45% for 135% notional exposure.
Unfortunately, as an individual investor it’s not straightforward to lever a portfolio. So, there are some implementation issues to work around. The simplest solution appears to be to use mutual funds or ETFs that apply leverage via either equity or Treasury futures.** This essentially allows you to “bolt on” gold and/or other alternative strategies without having to cut back on your equity or fixed income exposure. I may do a follow-up on this analysis exploring this form of implementation in more detail.
The Permanent Portfolio In A Barbell Portfolio
There are a couple less obvious, ancillary benefits to the permanent portfolio structure I want to mention in closing.
First, because of the attractive drawdown characteristics, it may obviate the need for large cash allocations (e.g. “emergency funds” or “cash buckets” for individuals). There are significant opportunity costs associated with large cash allocations, particularly in real terms.
Second, in keeping with the above, the permanent portfolio provides an excellent stable core around which to build a satellite portfolio of opportunistic investments. For example, at the wealth allocation level you could implement a structure where 70% of the portfolio is permanent portfolio, and the remaining 30% of capital is allocated to private market investments, or high risk/high return single hedge fund investments, or concentrated single stock positions. From a wealth allocation perspective you would be looking at something like 0% Protect Lifestyle / 70% Maintain Lifestyle / 30% Enhance Lifestyle.
In the above configuration, you would also likely be able to use the permanent portfolio as a source of liquidity during major market dislocations, to fund opportunistic investments at precisely the times when expected future returns are highest.
In my view, this strikes a nice balance between staying rich, maybe getting a bit richer but without dying trying.
Essentially, what you’re doing here is building a barbell portfolio. You’re using the permanent portfolio to set a floor for the value of the overall portfolio. You’re then taking the “excess” capital and buying call options with it.
There are other ways for individuals to implement a barbell portfolio structure. You could just use cash to create the floor. Except that’s an extremely inefficient use of capital, in my view. You could also use an annuity.
My quibbles with the annuity approach:
A fixed annuity with a modest inflation escalator leaves you vulnerable to inflationary booms and busts.
I am deeply suspicious of variable annuities–in fact, any insurance product with bells and whistles designed to “protect” you from various risks. The pricing of the bells and whistles is usually opaque and therefore not a good deal for the buyer. It is a timeless truth of economics that opaque pricing always and everywhere obscures profitability (see: healthcare; college).
No matter what route you go the insurance company will extract its pound of flesh.
You give up the ability to opportunistically redeploy capital from the annuitized core of your portfolio.
That said, I think buying a simple fixed annuity with an inflation escalator is a straightforward option for individuals who want to implement a barbell portfolio, and who are unable or unwilling to go the permanent portfolio route.
*I’d encourage everyone reading this to spend some time writing out your investment framework as explicitly as you can. This is your Investing Code. Once you’ve written down your Code, compare it to your actual portfolio and see if they match. The results of this exercise may surprise you. Incidentally, my friend Rusty Guinn wrote a phenomenal series of articles on Investing Codes and portfolio construction, called Things That Matter/Don’t Matter. I can’t recommend it enough. It touches on the issues discussed in this post as well as many, many more.
** Thanks to @choffstein and @EconomPic for their help conceptualizing this via Twitter.
A Skinner box is a device used to study animal behavior. Its more formal name is “operant conditioning chamber.” It was originally devised by the behavioral psychologist B.F. Skinner. Skinner used his box to study how animals respond to positive or negative stimuli. For example, a rat can be conditioned to push a lever for a bit of food. A dog can be conditioned to salivate whenever a bell rings.
Lest you be inclined to dismiss operant conditioning as silly games played with animals, it’s worth considering that slot machines, video games and social media all make use of operant conditioning to shape our behavior.
The financial markets, too, are a kind of Skinner box.
Do you suppose we believe what we believe about investing because there are immutable laws, similar to physical laws, that govern the price action in markets?
LOL.
We believe what we believe about investing because we’ve been conditioned to believe it. Much of what we think we “know” about investing is simply rationalized, conditioned behavior (the endless and pointless debate over “lump sum versus dollar cost averaging” is a perfect example–the “answer” is entirely path dependent). We investors aren’t so different from Skinner’s rats, working their little levers for their food pellets. It’s just that we’re after returns instead of snacks.
Below is what an operant schedule of reinforcement looks like.
Bet on Market Factor -> REWARD (GOOD RETURNS, CLIENTS HIRE YOU)
Bet on Momentum Factor -> SMALL REWARD (MAYBE)
Bet on Value, Size, Quality -> PUNISHMENT (BAD RETURNS, CLIENTS FIRE YOU)
Data Source: Ken French’s Data LibraryData Source: Ken French’s Data Library
The “lesson” here is very clear:
BETA IS ALL THAT MATTERS
BETA IS ALL THAT WORKS
This is what public market investors are being conditioned to believe. And if flows away from active management (particularly low beta strategies) are any indication, the market Skinner box is doing an admirable job. Demand for investment strategies is all operant conditioning, all the time.
Of course, the markets are more complicated than Skinner’s box. Market price action is both the input and output of investor behavior. It’s more like a Skinner box where the collective actions of the rats influence the operant schedule of reinforcement (this is another way of thinking about the concept of reflexivity).
The idea of markets-as-Skinner-boxes is inextricably linked to the idea of market regimes: patterns of correlations for economic variables such as interest rates, economic growth and inflation. It’s also inextricably linked to the idea of the zeitgeist: “the spirit of the age.” The relationship between these processes doesn’t flow so much as interlock. Each process acts on the others.
This visualization isn’t ideal. It implies the interactions are mechanical in nature, and that the result is a straightforward, predictable system. It’s not. In reality it’s much more an interaction of planetary bodies and gravitational fields than clockwork mechanisms of wheels and gears. My friends Ben and Rusty describe this as the three body problem. But imperfect as the above visual may be, it gives you a rough idea of how all this interrelates.
The Fed’s 4Q18 Z1 data is out so I am able to update this little model of prospective 10-year returns for the S&P 500. If we could run this again today I suspect it’d be forecasting about 6-7% for the next 10 years, given how we’ve rallied in 1Q19. Not spectacular but not awful, either. Clearly, in the aggregate we bought the dip.
Data Sources: Federal Reserve Z1 Release & Demonetized Calculations
Below is the latest expected returns bar chart from RAFI. Definitely a less optimistic picture for US large cap equities, but I believe this is a (small) improvement over the last time I checked it. The “obvious” relative value play is of course ex-US equity and emerging market equity in particular. I put “obvious” in scare quotes here because there are real risks to tilting a portfolio this way, as I’ll discuss a bit more below.
Source: Research Affiliates
This is merely a brief analytical exercise for perspective. Like all models, these ones have weaknesses. The most significant, in my view, is they’re not “macro aware.” For example, the S&P 500 model above would not have given you any warning of the global financial crisis. Today, as far as the differences in relative valuation between US and ex-US equities are concerned, we live in a time where there is a strong argument to be made that globalization is unraveling. And if globalization truly unravels, the intuition underlying global equity investing unravels along with it.
The two risks I worry most about these days?
Geopolitical fragmentation. Taken to a certain extreme, this would break the idea of a globally diversified equity portfolio.
A major spike in inflation. This would break the traditional 60/40 portfolio, at least in real terms.
These risks don’t just represent asset price volatility. They represent regime changes. They represent changes in the relationships between financial assets–changes in financial gravity. My friend Ben Hunt has written what I think is the best piece about what an inflationary regime change means for investors. The short version is that it’s the death of the long bond as an effective diversifier.
Geopolitical risk is trickier. I’m extremely skeptical anyone can effectively handicap geopolitical risk. It’s not something you predict. It’s something you observe. You deal with it when it manifests in the real world, as it happens. Of course, in theory you can hedge this kind of risk. The folks who sell this protection aren’t usually in the habit of giving it away at firesale prices, though I guess it never hurts to check around. Every once in a while you will find something stupid cheap like VIX calls circa 2017 and early 2018.
There is another factor in play here that I don’t consider so much a “risk” as a “force” that acts on everything else. That is fiscal and monetary policymaking–particularly monetary policymaking. Our friendly neighborhood central bankers have made it overwhelmingly clear they intend to remain supportive of financial markets. This will shape the market regime and therefore the relationships between financial assets. Like geopolitical risk, it’s not something you can effectively handicap. As I’ve written elsewhere:
Fed Watching is the ultimate reflexive sport. If you believe there is some kind of capital-T objective Truth to be found in Fed Watching, I am sorry to be the one to tell you but you are one of the suckers at the table. The Fed knows we all know that everyone knows the information content of Jay Powell’s statements is high. (We call them Fed Days, for god’s sake) The Fed plays the Forward Guidance Game accordingly. Sometimes it uses its “data” and “research.” Sometimes it speaks through one of its other hydra heads. The tools and tactics vary, but they’re all deployed to the same end: to shape the subjective realities of various economic and political actors.
I am critical of the current approach to monetary policymaking both in the United States and abroad. However, I do not think shorting the world or sitting 100% in cash or gold is a particularly good strategy. Two reasons:
If the world ends you are probably not going to have much fun collecting on your bet because it will be the end of the global financial system as we know it. You’re better off investing in guns and ammo and maybe a bunker somewhere to express this view.
You are betting against the combined fiscal and monetary policymaking apparatuses of every country in the world. Kind of like shorting a stock where the CEO has unlimited cash available to buy back stock.
Personally, I’m doing my best to balance cautious optimism with a healthy amount of paranoia.
If you’re a longtime reader, you may recall my little hypothesis about active mutual fund manager and hedge fund performance. The aggregate performance of active mutual fund managers and hedge funds will not, and cannot, improve while Market factor performance dominates everything else. You’ll certainly have individual managers perform well here and there. But in the aggregate, performance versus long-only benchmark indexes will remain unimpressive.
If you’re wondering exactly what the hell it is I’m talking about here, compare the pre-financial crisis and post-financial crisis periods on the below chart.
Data Source: Ken French’s Data Library
And just for fun, here’s another chart, focused on the last five years or so:
Data Source: Ken French’s Data Library
If there’s one thing you should take from this post, it’s this: the market is conditioning you to be fully invested and in particular to be long US equity market beta. We can certainly debate the “whys” and “hows” of this (for instance, how it’s the stated policy goal of our Friendly Neighborhood Central Bankers to keep us allocated to equities for the long run). But as a practical matter, if you’re overweight US stocks, particularly large cap US stocks, you’re receiving positive reinforcement. If you’re underweight US stocks, particularly large cap US stocks, you’re receiving negative reinforcement. And god help you if you’ve been significantly overweight small cap value stocks or ex-US stocks over the last couple of years. If so, you’re being subjected to corrective shock therapy.
I don’t say this to make value judgments.
I say this to explain what’s driving investment decisions all over the United States, and indeed the world. I say this to contextualize why the most common conversation I have with investors of all types lately seems to be: “why do we own foreign stocks, anyway?”
If you’re the kind of person who likes to extrapolate historical return data to make asset allocation decisions, all the data is screaming for you to be fully invested in US large cap stocks. You’d be a complete idiot to do otherwise. Perhaps you’ve told your financial advisor this. Perhaps you’ve fired your financial advisor over this.
And you know what? You might be right.
In my own humble opinion, the number one question confronting anyone allocating capital right now is whether or not this market is “for real.” If it is, and you decide to fight it, either as a private individual or as a professional investor, you’re toast. But if this market isn’t “for real”–if it’s all just an artifact of easy monetary policy, and you decide to “go with the flow”, and it all unwinds on you, then you’re also toast.
Notice I wrote “financial plan” and not “investment portfolio” above. From a pure portfolio perspective, you’re facing a no-win scenario. You have to handicap whether, when and how the whole QE-as-permanent-policy project comes undone. This is nigh on impossible. Investors have been trying and failing to do this for at least a decade now. When faced with a no-win scenario, your best strategy is to change the conditions of the game. In order to do that, you first have to understand the game you’re playing.
We investors and allocators like to believe we’re playing the investment performance game.
We’re not.
We’re playing the asset-liability matching game.
Investment performance only matters inasmuch as it helps us match assets and liabilities. You probably don’t need to “beat the S&P 500” to fund your future liabilities. You can probably afford to take less market risk. And investment performance is hardly the only lever we can pull here. We can increase our savings rates. We can decrease our spending. We can allocate some of our capital to the real economy, instead of remaining myopically focused on increasingly abstracted, increasingly cartoonish financial markets. We can start businesses that will throw off real cash flow, and own real assets.
We don’t have to remain fully invested at all times. We don’t have to be 100% net long and unhedged with the capital we do have invested.
Data Source: Aswath DamodaranData Source: Aswath Damodaran
I’ve posted similar charts before. These are a bit different in that I switched them over to use an implied equity risk premium and cost of equity derived from discounted free cash flows instead of dividends. The result is some moderation in the steady state multiple. However, the general trends in the data hold.
Near as I can tell, at these levels you’re being roundabout fairly compensated for owning US equity risk. Yes, a near-term recession would send the market lower. But I’m not a recession forecaster, and I don’t adjust asset allocation on the basis of near-term economic data reads. The lower equities go, the more attractive the forward returns will become.
That said, if you pick individual stocks there are most definitely pockets of opportunity out there. It’s a great time to go bargain hunting if you were prudent about taking off some risk in the last couple years. Cash can be used to play offense as well as defense.
Right now, a lot of people are sitting out there trying to decide whether to dip-buy this market. They want to tick the bottom. Perhaps you are one of these people. In my own humble opinion, they are fools–fools engaged in a foolish game. Most will ultimately do more harm to their net worth than good, whipsawing themselves based on “sentiment” (a.k.a what they are seeing and hearing from the financial media).
For some perspective, I want to revisit forward-looking return expectations from a couple of different sources.
The chart below looks at prospective 10-year S&P 500 returns as a function of the equity share of US financial assets (a mouthful, I know). This is similar to the Buffett Indicator of stock market capitalization/GDP. The data runs through 3Q18, which is the most recent Z1 release from the Federa l Reserve.
(As far as I know, Jesse Livermore at Philosophical Economics was the first to do a deep dive into the efficacy of this model. David Merkel at Aleph Blog used to update it quarterly. Since David seems to have abandoned the project, I’ve decided to pick this up on my own)
Data Sources: Federal Reserve, Morningtsar
The predicted forward return bottomed in 1Q18, below 5% nominal. Since then, the proportion of equities to total assets has decreased a few points. This corresponds to a modest increase in predicted return over the next 10 years, to approximately 7%.
The second chart is an updated expected return bar chart from Research Affiliates:
Source: Research Affiliates
RAFI’s methodology is the simple model discussed in my post on investment return expectations. RAFI’s estimates are even less inspiring than the equity allocation model. Here US Large Cap is expected to return about 2.7% nominal over the next 10 years.
If we weight each forecast 50/50 to account for the inevitable errors and uncertainty, we get something like 4.8% as an expected return for US Large Cap Stocks over the next 10 years.
To which I say: “meh.”
This is neither a “run for the hills” number nor a “go all-in” number for someone whose investment strategy is oriented around asset allocation over a long time horizon. In fact, it’s rare to arrive at either of those conclusions from an exercise like this. Which is the whole point. For most of us, our reaction to most market moves should be “meh.”
Now, this certainly isn’t the only lens through which you can view financial markets. A trader or trend follower can safely ignore everything I’ve written here. Traders and trend followers are playing an entirely different game. Same for pure, bottom-up stock pickers.
However, most of us building portfolios for institutions and individuals are not traders, trend followers or pure, bottom-up stock pickers. We’re asset allocators who merely need to be directionally correct about the performance of a handful of different asset classes over a couple of decades.
How does a fundamentally-oriented allocator invest in a world of “meh?”
I’d suggest the following core principles:
Balance. Never make “all-in” or “all-out” calls. Investing is an exercise in decision-making under uncertainty. It’s a probabilistic exercise, except we don’t know the “true” probabilities of the various outcomes. Only fools make all-in, all-out calls when making decisions under uncertainty. And yes, gunslinging hedge fund guys, fools who make all-in, all-out calls can become billionaires.
Prudence. Don’t reach for yield or return. Our world is overrun with yield pigs, but they’re generally not being well-compensated for the incremental risks they’re running to juice their returns. And yes, middle market private credit investors, that’s directed at you.
Flexibility. As Henri Poincaré famously said, “geometry is not true, it is advantageous.” Asset allocation is similar. You become overly attached to particular asset classes, strategies and their historical performance at your peril. And yes, “VOO for the long run” investors, that’s directed at you.
Creativity. If the financial markets are giving you “meh”, consider changing the way you play the game. For individuals, that could mean saving more, or starting a business to generate wealth through “real world” economic activity. For institutions, it’s tougher to make those kinds of changes, but mostly for political reasons.
It is a frustrating thing, to be stuck in a word of “meh.” But recognizing it and acting accordingly is a hell of a lot more productive than staring at your E-Trade account trying to tick the bottom for SPY.
