Punched In The Face

MikeTyson

I had never expected the leveraged permanent portfolio concept to be tested so dramatically, so soon after beginning this experiment. The speed of the coronavirus-induced drawdown in financial markets has been absolutely breathtaking. Truly a punch in the face. Through 3/20/20, my leveraged permanent portfolio has drawn down materially, though to a lesser extent than global equities. It has performed much like a 60/40 portfolio in these conditions, though much of this is actually attributable to the inclusion of ex-US equity in the allocation (a US-only variant would be down about 10%).

 

200320_pp_performance
Source: Demonetized calculations as of 03/20/20*

In the midst of the chaos, I made an important discretionary decision last week. I liquidated the entire GLD position and took it to cash well ahead of the next monthly rebalancing check (due 4/1/20).

Market conditions had deteriorated significantly, and there was a period where essentially all financial assets had become correlated (equities, Treasuries, gold). This increase in correlations is THE existential threat to the permanent portfolio and in my view it MUST be managed. There are basically two ways of doing this: 1) hedge, or 2) take a portion of the portfolio to cash. I opted for #2, and liquidated both the gold and a small residual emerging markets equity position.

Current allocation (based on a full lookthrough of NTSX’s exposures):

33% Cash

27% S&P 500 Futures

18% Laddered Treasury Futures

17% Large Cap ex-US Equity

16% Small Cap ex-US Equity

(78% notional exposure; 60% notional equity exposure)

There is an argument for reducing exposure further. For example, my Twitter friend @breakingthemark runs a somewhat similar strategy with a weekly rebalancing cadence, which has delivered extremely impressive performance. His strategy is tuned to respond more quickly to crashes, and is currently at 60% cash. I expect at 4/1/20 I will be adding more cash, as well as rebalancing some equity exposure back into gold.

 

* Differences between the total (time-weighted) and personal (dollar-weighted) returns are attributable to the timing of trades, as well as the fact that I reduced the overall size of this portfolio to opportunistically redeploy capital into my “lottery ticket” portfolio bucket during this period.

Silver Linings

The nice thing about big selloffs is that the lower the market goes today, the higher your future returns go for tomorrow. We have 4Q19 Fed Z.1 data now, which means I can try to roundabout ballpark S&P 500 returns for the next 10 years. As of 12/31/19 this estimate was 2.43%. After making some (very) rough adjustments for recent market moves, it has increased to 7.66% today.

200320estsp500

With interest rates as low as they are, and the possibility of negative rates looming on the horizon, I think a 700+ bps equity risk premium probably merits some buying, somewhere. DON’T GO ALL-IN. It is very possible things get worse before they get better. My own strategy has been to focus on the shares of companies that seem inordinately dislocated based on poor liquidity conditions. This is particularly evident in small cap stocks. In the US, these stocks had drawn down approximately 50% prior to the last couple days’ bounce.

Pulling the trigger on these things is not a trivial thing to do. It is uncomfortable knowing that you could be catching falling knives. I am not arguing that people are stupid for being cautious here.

I am, however, arguing that if you have liquidity (also far from trivial), and are willing to be a provider of liquidity in a dislocated market, there are spots where you can be compensated quite well for doing so. In small cap land, there are stocks trading at double-digit discounts to announced, all-cash takeout offers. This makes very little economic sense. Is Google going to bail on its FitBit acquisition because of the coronavirus? Probably not.

Admittedly, my truest investing self is “bottom-feeding contrarian.”

Right now, I think it makes sense more than ever to put money to work in a concentrated, “lottery ticket” portfolio alongside a more conservative core.

02/20 Permanent Portfolio Rebalance

Finally, some action!

If you are reading this blog you probably know that February was a wild month in the financial markets. So how did the leveraged permanent portfolio fare?

My verdict is “good, not great.”

0220_pp_performance
Source: Demonetized calculations

In the last rebalance post I asked the question: how does this portfolio break?

Answer: correlations go to 1 in a crisis.

Ironically (the markets do have an uncomfortable habit of throwing this stuff right back in your face), this is precisely what we saw in February in terms of the relationship between equities and gold. GLD finished the month down slightly. However, the monthly number obscures a sharp selloff that occurred in the last couple days of the month. Why did it happen?

I don’t know that anyone knows for sure (if any of you are traders or market makers with special insight, please leave a comment!). My personal hypothesis is that this was a function of investors rebalancing portfolios, taking down gross exposure and getting margin calls. Gold in particular has had a tremendous run over the last 8 months or so. Since I started running this portfolio, GLD is up 23%, while the S&P 500 has returned 2.77% and the BBgBarc Aggregate Bond Index nearly 9%.

Portfolios with a static allocation to gold are probably overweight it. And if you need to sell something for whatever reason, what makes the most sense to sell?

This is the kind of “real-world” trading activity that takes correlations to 1 in a crisis environment. And this portfolio is certainly vulnerable to it, as we saw in February (albeit to a relatively mild degree). It’s why volatility and trend are used as overlays for risk management.

Incidentally, the one-year lookback I use didn’t flag a need to add cash to the portfolio.* A one-month lookback would have, with trailing one-month volatility of about 15%. Equity exposure would have been trimmed to add the cash, with most equity market segments having crashed through their 200-day moving averages in February.

Why do I not use a one-month lookback? Originally, I did. However, I became concerned that such a short lookback period might be too sensitive to very short-term shocks, whereas the strategy is intended as a strategic allocation more geared toward navigating changes in market regimes.

Candidly, I’m not sure this is the right decision.

But we’ll see.

 

* Astute readers may notice that the portfolio weights in this update differ slightly from those in the previous update. There are two reasons for this. First, I trimmed and rebalanced an overweight to ex-US equity exposure that had crept in. Second, yesterday I sold some of the gold and NTSX exposure to make some purchases in my individual stock portfolio. If you’ve been following these updates since the beginning you may recall that I pair this strategy with a concentrated, high-risk, 10(ish) stock equity portfolio.

01/20 Permanent Portfolio Rebalance

With January over I ran the latest leveraged permanent portfolio rebalance check. Still in good shape from 12% volatility limit perspective. Relative performance versus the S&P 500 has diminished since 4Q18 rolled off the lookback period. But it remains quite strong versus a Global 60/40 comp.

Actual realized performance from my implementation:

2001_pp_performance

January is an interesting month because it demonstrates the diversifying power of uncorrelated assets (gold, Treasury futures in NTSX) in the face of macroeconomic event risk. In this case, coronavirus.

Recall that the whole purpose of this approach is to be insulated from unexpected macroeconomic or geopolitical shocks without having to predict anything. So far we’ve had two out-of-backtest opportunities to test this: 1) trade war anxieties in August 2019, and 2) coronavirus. In both instances, the strategy has performed as expected.

Which I suppose raises an interesting question: how would you “break” this strategy?

The strategy breaks if equities, Treasuries and gold become highly correlated in a period of sharply negative performance. It is difficult to imagine what would cause correlations to change in this way. I tend to believe it would be some kind of end of the world scenario such as nuclear war, suspension of private property ownership, or zombie apocalypse. I’m not sure portfolios can or should be built with such extreme scenarios in mind.

But anything is possible.

And that is why we set a volatility threshold for the portfolio. If pairwise correlations between equities, Treasuries and gold go to one, and the world has not ended, we would almost certainly see a sharp spike to overall portfolio volatility. At 12% portfolio volatility, we would effectively begin to be “stopped out” of risk assets, and would have to add cash to bring the portfolio back below the 12% max volatility threshold. In theory, if the world were truly turned upside down, this would give us the opportunity to re-allocate to other asset classes that are “working” in the new regime.

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.