Not much to report this month (performance as of intraday Monday).
Current allocation is roughly:
32% S&P 500 futures
21% Laddered Treasury futures
30% ex-US equity
115% gross exposure
A Brief Aside About Portfolios & Inflationary Regimes
Lately at work I have been helping a few people (and their clients) think about building portfolios to better withstand inflationary economic regimes. A recurring theme I come across is clients concerned about the potential impact of high inflation on their portfolios, whose first impulse is to cut or eliminate their equity exposure.
If anything, it is the bonds and cash they should be cutting. This is not to say that equities will do super well in an inflationary environment, but they are, at least in theory, capable of passing some inflation through to customers via price increases (what you really want to own in a high inflation period are companies with pricing power). Setting aside TIPS for the moment, bonds and cash are what are going to suffer badly in a highly inflationary environment.
What I think is happening here is that folks are thinking of high inflation as a Bad Thing and then thinking of Bad Things in deflationary terms. It is natural to think that if a Bad Thing is happening you ought to cut equity risk. Don’t do this! It may indeed be worthwhile to cut some risk. Just make sure you are cutting the right risk.
Again, this is not to say that equities will not suffer in an inflationary regime. It is important to disaggregate equities here. Equities I would be most worried about in an inflationary regime would be high multiple stocks with questionable pricing power and little to no free cash flow. These companies are going to be the most sensitive to substantial changes in the cost of capital/”discount rate.” They are the zero coupon bonds of the equity world.
I try to discourage people from positioning portfolios specifically for extremely high inflation or hyperinflation. Doing so requires them to dump their deflation allocation. We just don’t know whether/when significantly higher inflation is going to show up, and how many more deflationary episodes we might endure in the meantime. The basic intuition underlying the permanent portfolio concept is that we are bad at predicting things. Better to strive for a balanced portfolio capable of surviving many different regimes, even if it is not the best performer in any given regime.
I am changing the name of these posts going forward since I expect to be rebalancing much less frequently and keeping the allocation relatively static. Here is the current allocation:
This is about 117% gross exposure. Going forward, I’d expect these weights to remain pretty similar, with NTSX a little overweight relative to gold and ex-US equity just for leverage purposes. I will likely be due for a small gold-to-ex US equity rebalance soon. Performance versus US large cap:
You can see a longer-term snapshot of how this allocation would have performed here. This period favors the leveraged permanent portfolio versus a 100% equity allocation, given that it begins with a market drawdown and includes the Covid drawdown. Over time, I would expect the performance gap to narrow significantly, with a 100% equity allocation making up substantial ground in benign market environments (see the latter half of 2020 for a taste). However, I would also expect the leveraged permanent portfolio to continue to dominate a 100% equity allocation on a risk-adjusted basis.
I have written many times that I favor a portfolio that uses the leveraged permanent portfolio as a stable core to support a smaller, but much more aggressive sleeve of concentrated investments. The power of this approach was on full display in 2020 as I was able to trim from the leveraged permanent portfolio near the nadir of the Covid drawdown to buy certain individual equities at extremely attractive levels. The result was a 57% IRR in that more aggressive sleeve.
Overall, 2020 offered a magnificent stress test of the leveraged permanent portfolio concept, given the magnitude of equity market moves both up and down. The portfolio passed this test with flying colors. Performance remained robust across both mini-regimes, within an extremely simple package that required no market forecasting whatsoever. Decent drawdown performance allowed me to play offense when market sentiment was at its worst and I still captured the vast majority of the equity market rebound.
(Warning: this post contains graphic, zombie-related imagery)
This is a follow-up to my prior post, Zombieland. That post was a post dedicated to admiring a problem: the irreparably dysfunctional American political system. This post is about possible strategies for making one’s way in a zombified world.
The first and most important thing to understand is that there is no undoing the zombie apocalypse. It has already happened. You don’t reverse a zombie apocalypse. You don’t even really escape it (though you can isolate in increasingly remote locations, which is a strategy many are already pursuing). The goal here is survival. Maybe some day the dead will stop returning to life. But then again, maybe not.
Over the next few years, you will still hear the occasional voice calling to “restore the center” or “restore civility” to American politics. You can safely ignore these voices. Not because restoring bipartisanship is an unworthy goal, but because it is a waste of time. The Mitt Romneys of the world are zombie food. Assuming Joe Biden ultimately becomes president, the next four years will be an extended gore porn shot of zombies dismembering the corpse of bipartisanship.
If you buy the thesis underlying my zombieland scenario, you know that top-down strategies are doomed to fail. It’s axiomatic. If there were a broad consensus in American society around a vision for moving the country forward, we wouldn’t be in this position in the first place. To the extent there are political alternatives to the current status quo, they exist within grassroots movements on the right and left. The establishment center left and center right? Zombie food.
The center cannot hold in an environment where the dominant political strategy is defection. Bipartisanship is an unstable equilibrium. In this environment, cooperation is a terrible strategy. It is the strategy of suckaz. Just ask Mitch McConnell (all-defector par excellence).
For those of us who are inclined to grassroots political activism, there will be opportunities to get into the politics game. Opportunities to make a mark, even. Today’s technology and zeitgeist are well-suited to political entrepreneurship. Personally, I’m not inclined toward political activism, so I’m not going to pull much on that thread here. However, budding political activists will be well-served by boning up on their meme skills.
I am, by nature, an “insulator” and not an “activist.” I simply do not trust large groups of highly emotional, ideologically-driven humans. My gut reaction to dysfunctional situations is to disengage. Maybe you disagree with me on insulation versus activism as a survival strategy. That’s fine. It’s just important for me to acknowledge this up front, because the rest of this is implicitly written for insulators.
Here is how you survive in zombieland: small group cooperation.
If you are reading this post, I bet you are pretty disillusioned with the political climate in the United States. I also bet that when you put down your phone and walk out your door, you are able to connect with friends and neighbors in your community. Even friends and neighbors you disagree with politically. Local cooperation and coordination are the keys here. Locally, we can work around the zero-sum zeitgeist through repeated plays of various smaller scale coordination games. Locally, the stakes are real in a way that they are not for elected officials hundreds and thousands of miles away. Or, god knows, the dumpster fire of the internet.
A wise man once said: “life finds a way.”
Even in zombieland, on a local level, life can find a way.
In my prior post I wrote about Egyptification. The Egypt I lived in briefly, years ago, was a kind of zombieland. In that case, it wasn’t political acrimony so much as an ineffectual, ossified administrative state that was responsible for zombification. It is difficult to understate how poorly the Egyptian administrative state functioned (it has probably gotten worse in the intervening years). Someone once asked me whether I paid much in income tax to the Egyptian government. Truthfully, I wouldn’t have known how to pay income tax if I’d wanted to. This was not a failed state, per se. But it was absolutely a zombie state. Nominally, it did all the things a state was supposed to do. Practically, it accomplished very little (one of the few areas where it was truly exceptional was in facilitating the looting of the economy by the regime and its cronies).
Ordinary people dealt with this through a vast, informal economy. One of the things that foreign observers chronically failed to internalize about the popularity of the Muslim Brotherhood was that it was visibly more effective in providing and coordinating local community services than the Mubarak regime. You simply could not rely on the government to solve problems, big or small. And if someone did throw an official obstacle in your path, the most expedient solution was usually bribery. Bribery functioned as a kind of informal parallel income tax system, greasing the wheels of an otherwise dysfunctional administrative state. I used to joke that Egyptian corporates must maintain enormous slush accounts specifically to pay bribes.
Life finds a way.
This is an admittedly extreme example. But it points the way. To survive in zombieland, you cannot rely on the state to solve problems. Hoping for policy solutions to problems? Wish in one hand and shit in other. See which one fills up first. (homework: Covid-19 as contemporary case study) One’s mindset must shift toward informal coordination. In zombieland, the administrative state is little more than an obstacle to be surmounted or bypassed.
Unfortunately, as ever, this kind of dysfunction hurts economically disadvantaged communities the most. I don’t have answers for that. I’m not sure there are answers for it. Historically, this has been a catalyst for significant social upheaval. It would be naive to assume away that kind of upheaval as impossible.
Which begs the question: is zombieland a permanent state?
No. Nothing is permanent.
Zombieland is a stable equilibrium, because again, “always defect” is a stable equilibrium (a Nash equilibrium if you want to be fancy about it). But if the payoff matrix of the game changes significantly, it might cause the players to change their strategies. Unfortunately, this kind of shift would likely require a major exogenous catalyst. Historically, these have been things like major natural disasters and wars. Obvious example: for the interwar zombielands of France and Germany, World War II cleared the decks.
Today, the “obvious” candidates for great power conflict are the US and China. The CCP would have to be awful dense not to exploit a paralyzed, zombified United States for maximum benefit. We simply don’t know what a great power shooting war looks like in the nuclear age. I shudder to think about it, personally, but there is no doubt it would have the potential to completely reshape the American political landscape.
Is an endogenous catalyst for a change in the payoff matrix possible? Certainly something like a revolution would count. Though in my view that’s little better than a big war. I suppose it’s also possible for a charismatic enough politician to reshape the payoff matrix. But that is a dangerous kind of politician. History has been kind to FDR, for example, but he was not shy about shattering procedural norms. I don’t think it’s much of a stretch to argue FDR was merely a “softer” alternative to the harder-core ideologies that sprung up elsewhere in the 1930s. And who knows how differently things might have played out if Huey Long hadn’t caught a bullet in 1935. We should never discount the impact of micro-level randomness on history. History is inherently, and horrifically, path-dependent.
For a long time I have despaired of not being able to “fix” zombieland. Only recently have I truly come to terms with the simple fact that there is no fixing it. Only now I am shifting to a survival mindset. Oddly, this has felt positive and empowering. I even have a little joke about it…
I used to make fun of those people you occasionally see on TV who live in an isolated cabin in the middle of nowhere with 50 guns.
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.