12/2019 Permanent Portfolio Rebalance

I deliberately held off on the 12/2019 rebalance for the leveraged permanent portfolio in order to sync the rebalancing checks with calendar month end dates going forward. However, ultimately it was another boring month with the portfolio falling well below its 12% risk target over the one-year lookback period. You can check the one-year trailing data here.

Realized performance for the live strategy since inception is below.

201912_pp_perf
Source: Morningstar; Demonetized Calculations

Despite its brief length this is an interesting time period to examine the live strategy as it demonstrates exactly the performance profile you’d hope to see over longer time periods: limited downside capture with solid upside participation. Since the inception of NTSX in September 2018, this portfolio has actually outperformed the S&P 500 on both an absolute and risk-adjusted basis (you can play with the dates in Portfolio Visualizer if you click the above link). I would not expect that type of outperformance going forward. However, over very long time periods I suspect realized performance will compare favorably with a diversified equity portfolio, due to the strong downside protection.

Grim Tidings

193Q_est_SP_returns
Sources: Federal Reserve Z.1 Data & Demonetized Calculations

I have updated the (corrected) S&P 500 expected return model for the recent 3Q19 Z.1 data release. The good news: it shows a modest increase in the forward 10-year return estimate, to 4.18%. The bad news: this is almost certainly lower today given how US equities have rallied over the last quarter. (12/19/19 EDIT: I hacked together an estimate as of today and it’s about 3.03%)

Now, I don’t think this model is at all useful as a market timing tool. But it is definitely arguing for lower forward-looking return expectations. This is partly why I’ve implemented the leveraged permanent portfolio with a significant portion of my net personal net worth. Make no mistake: there will come a day to be all-in on equities again. You’ll know it because people will be screaming bloody murder and trumpeting the death of buy-and-hold like they did from 2009 to 2012. (Remember this when your friends and/or financial advisor are pitching you on expensive liquid alternatives some day)

I’ve mentioned before that one of the weaknesses of this model is that it isn’t macro-aware. It doesn’t “know” anything about credit or interest rates. The underlying intuition is simply that as an increasing proportion of assets are “financed” by equity, expected equity returns decrease. In a world of very low or even negative interest rates, it’s possible we’ll see a structural shift in investor preferences for equities. In a regime where interest rates stay very low for a very long time, it makes sense for equity valuations to remain elevated. One should not underestimate the persuasive power of No Good Alternatives (I have been guilty of this, personally). Recall that we tried the whole “normalize interest rates” thing in 2018. We didn’t even get to 3% on Fed funds before the Fed backed off.

There are, of course, many possible futures. The three I think most about:

The Great Jihad. This is a situation where the transition back to a multi-polar world order, combined with domestic political divisions, results in wars and violent revolutions. Scary, but not worth thinking about all that much from an investment POV. In this future just focus on staying alive. Don’t sweat the markets. In fact, you might as well go all-in, because you’ll be scooping up assets at steep discounts.

Muddle Through. Here everything just kind of works out. Rates and returns stay low, but policymakers effect a “soft landing” and everything works out. In a world where economies can be run with mechanical precision, this can probably be engineered just fine. That’s not the world we live in, however. We live in a world where economic reality must be made politically palatable. Politically, we seem to be headed to a world that is more hostile toward trade, and where there is strong pushback against policymaking elites. I therefore assign a relatively low probability to muddling through.

Stagflation. This is a situation where we have lower economic growth but higher inflation. This is quite frightening from a financial perspective as you have to invest very differently from what is now conventional wisdom to come through stagflation okay. Avoid bonds and cash, as well as equities without pricing power. Real assets are pretty much the only game in town here. Maybe some alts. Personally, I believe we are close to stagflation today. I am one of those loony Inflation Truthers who believes “real” inflation (as experienced by real people in their daily lives) is higher than the CPI numbers trumpeted in the news, because CPI is restrained by things like hedonic adjustments for the improving quality of goods. But I’ll leave the details for macro wonks to fight over.

You will note that I have omitted an inflationary boom from the list. The reason for this is that developed world demographics do not appear to support much of an inflationary boom. What could change this? Well, obviously population growth could suddenly increase. Or, we could start encouraging lots of immigration (not going to happen in the current political climate–and this can’t work for every country in the world simultaneously, anyway). I don’t think either of those things is particularly likely. But, there is always technology. Historically, it has not been great positioning to be short human ingenuity. Maybe Elon gets us to Mars or somewhere else in the solar system and we start colonizing other planets. Who knows.

So anyway, what’s an investor to do?

Adapt.

I am more and more convinced that the average person or institution’s asset allocation should be managed with a trend following and/or volatility targeting overlay (note that this stuff can also work as a risk management tool in more idiosyncratic portfolios). The point here is not to market time (that is impossible to do profitably as far as I’m concerned). The point is to detect regime changes, and to make sure you end up more or less on the right side of them.

Do not be the guy who is short equities for 10 years into a bull market.

Do not be the gal who goes all-in on equities at the top.

Do not be a permabear, or a permabull.

Be biased toward being long, and biased toward bullishness, but with some sense of proportionality and a framework for risk management. As a saver, or an institution that is more or less a saver, you don’t have to catch every market move to make money. You just have to be roundabout, directionally correct about the relationships between economic growth, inflation and valuations.

Identify the regime you’re in. Then make sure you own the right stuff.

Don’t overthink it.

10/19 Permanent Portfolio Rebalance

This post marks the second rebalance check for my leveraged permanent portfolio. Based on some feedback from Twitter, I am making a small tweak to the volatility targeting overlay, and increasing the lookback period from 1 month to 1 year. The intention here is to make the portfolio less sensitive to sharp, short drawdowns in the underlying assets. The purpose of the volatility and trend overlays is not to avoid these types of drawdowns, but rather to adapt to regime changes.

Here is the current portfolio:

201910_pp_rebalance

On a 1-year lookback this gives us a 9.2% return and 10.33% volatility.* Below the 12% target for the portfolio, despite being fully invested. You can nerd out on the lookback data versus a global 60/40 portfolio and SPY here. In an ideal world, if I had access to the full investment toolbox, I would actually leverage the portfolio to reach the risk target. But, as a small investor, being fully invested will have to suffice.

So, no changes this month.

Below is net performance since inception versus the S&P 500 (my actual allocation differs from target slightly due to transactional frictions, but not in a material way). Again, I wouldn’t normally expect the portfolio to perform this well against a 100% equity allocation over any arbitrary time period. But I think this time period offers an excellent out of sample test of the strategy’s efficacy and in particular its ability to tamp down risk.

201910_pp_performance

* Fun Fact: 10.33% volatility for the portfolio in spite of the fact that individually, each asset in the allocation had a volatility above 12%. This is the magic of true diversification.

 

It’s Worse Than I Thought

Over the last couple days I’ve had the pleasure of corresponding with David Merkel of The Aleph Blog over differences in our S&P 500 expected returns modes. (Mine was much higher than his). Upon comparing models, I discovered I’d made a huge mistake. I’d essentially included only corporate debt in my calculation, excluding a huge swath of government liabilities from the total figure.

After adjusting my numbers to correct for this, and updating the model, I get a 3.74% expected return for the next 10 years. This is consistent with David’s 3.61% estimate. The small difference that remains is likely down to some minor differences in the time periods we used to estimate our models, as well as the type of S&P 500 return we use in the calculation (I believe David uses the price return and then adjusts for dividends, whereas I simply regress the S&P 500 total return against the “allocation” data).

SP500190630ERREV
Source: Federal Reserve Z.1 Data / Demonetized calculations / Corrections from David Merkel

Previously I’d been referring to my results as “A World of Meh.” I think I’m now comfortable revising that down to “A World of Bleh.” (“Meh” is kind of like an indifferent shrug, while with a “bleh” you are maybe throwing up in your mouth a bit)

I’ll give David the last word here, since I think his take on all this is a nice summary of the quandary investors face these days:

Not knowing what inflation or deflation will be like, it would be difficult to tell whether the bond or stock would be riskier, even if I expected 3.39% from each on average. Given the large debts of our world, I lean to deflation, favoring the bond in this case.

Still, it’s a tough call because with forecast returns being so low, many entities will perversely go for the stocks because it gives them some chance of hitting their overly high return targets. If this is the case, there could be some more room to run for now, but with nasty falls after that. The stock market is a weighing machine ultimately, and it is impossible to change the total returns of the economy. Even if an entity takes more risk, the economy as a whole’s risk profile doesn’t change in the long run.

In the short run it can be different if strongly capitalized entities are taking less risk and and weakly capitalized entities are taking more risk — that’s usually bearish. Vice-versa is usually bullish.

Anyway, give this some thought. Maybe things have to be crazier to put in the top. At least in this situation, bonds and stocks are telling the same story, unlike 1987 or 2000, where bonds were more attractive. Now, alternatives are few.

2Q19 Expected Returns Update

2Q19 Fed Z1 data is out so I have updated my little S&P 500 expected returns model. The model and its origins have been discussed rather extensively here on the blog so I am not going to belabor its strengths and weaknesses going forward. From a long-term forward return perspective, the message remains: “meh.” As of June 30 it was predicting a 7.81% annualized return for the next decade.

2Q19SP500ER
Source: Fed Z.1 Data; Demonetized Calculations

It is interesting to note that the model disagrees with the dire prognostications of much of the investment world regarding forward-looking S&P 500 returns. Many shops out there are predicting low single digit or even negative returns over the next 7-10 years. These folks correctly called the tech bubble in the late 1990s but missed the post-crisis rebound. The model, meanwhile, caught both.

Given the output from the model, and the investment opportunity set more broadly, I’d bet with the model when setting expectations for the next 10 years.

What I think those shops are missing, and what the model captures, is the TINA Effect.

For many investors There Is No Alternative to owning equities.

Given that global interest rates remain very low, investors need to maintain high levels of equity exposure to hit their return hurdles. In the US, for whatever reason, the aggregate equity allocation typically bounces around in the 30% – 40% range. Unless something occurs to dramatically and permanently shift that range lower, I suspect forward returns will end up being a bit better than many people are predicting these days.

Not great. But not dire, either.

Meh.

09/19 Permanent Portfolio Rebalance

Today marks the second rebalance of my leveraged permanent portfolio with its volatility (12% target) and trend following overlays. I thought it might be fun to do brief posts on the monthly rebalances going forward, partly to keep myself honest and partly to record for posterity what it “feels like” to be invested this way.

Perhaps unsurprisingly, the portfolio is now below its risk target, with a trailing volatility of only 5.16%. So the cash position created at the last rebalance will now go back to work in ex-US equity (most segments of ex-US equity appear to have poked back above their 200-day moving averages). In fact, I need to be fully invested now and will STILL be below my risk target.

The new target portfolio looks like this:

201909_PP_Rebalance

When the leverage employed within NTSX is taken into account, you end up with:

28% S&P 500

19% Laddered Treasuries

32% Gold

4% EM Large Cap

4% EAFE Small Cap

14% EM Small Cap

15% EAFE Large Cap

~116% notional exposure, just shy of 1.2x leverage

Note that the weights of the portfolio as implemented will differ modestly from this “ideal” due to transactional frictions and such. For example, in an ideal world I would reallocate the two small Vanguard positions across the whole portfolio rather than overweight ex-US equity. However, I recently rolled this account over to a new platform and am trying to be mindful of transaction costs. And anyway, if you’ve read this blog for any length of time you’re no doubt familiar with my view that, in the grand scheme of things, these little overweights and underweights don’t materially impact portfolio performance.

Here is updated performance versus the S&P 500 for context as of pixel time:

201909_PP_Performance

Despite being so short, it’s an interesting period to look at live performance for the strategy (net of fees and transaction costs) as it exhibits precisely the type of behavior you would expect from backtests of both leveraged and unleveraged permanent portfolios. The portfolio protects well during periods of broad market stress but lags during sharp rallies. Additionally, it’s worth noting that gold has had an exceptional run during this brief period, which is a complete coincidence.