“Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett.
“Alternative investments should have positive expected returns and very low correlation to traditional assets” – Cliff Asness
Our investing approach for 2018 is unique. In this post we provide our strategy for obtaining true diversification and positive skew despite investing in a global financial asset bubble.
We think the conventional wisdom of investing in “diversified” stock+bond index fund is dangerous. It is dangerous precisely because most every “reasonable” academic and professional advisor supports such an approach. Investors have, for the most part, agreed with the experts and decided they no longer need to think critically about their investments as indicated by the explosion of index funds, extermination of hedge funds, and lowly status of anyone that calls herself a “stock picker”. When everyone agrees that a particular investing strategy is “best”, that strategy necessarily becomes over-priced. The result today is a global investment community that seems willing to buy stocks and bonds at any price.
The traditional 60/40 stock+bond portfolio is not as diversified as many “experts” make it out to be. As competing financial assets, both been driven up by an increasing abundance of wealth and fiat money. Global economic growth has been gradually slowing since even before the Financial Crisis leaving fewer financial assets with which to invest. Relative to earlier periods in history we have all grown up in a world largely void of conflict. The result is increasingly high asset prices as growing concentrations of wealth bid down yields on scarce financial assets.
We are living in a global financial asset bubble characterized by an increasing correlation between stocks, bonds, and nontraditional assets like real estate. The evidence for this bubble is mostly notably visible in long maturity government bond yields which are lower than at any point in history save the 1930s. This trend is likely to continue in 2018, but we have identified three risks that could make the bubble pop including war, inflation and populism. Most investors believe that hedging against these risks means giving up yield, but we don’t.
We constructed our portfolio to benefit if the global asset bubble continues to grow while also benefiting in the event that one of these three risk scenarios cause asset prices to broadly fall. We do this through stock selection and by including several non-traditional assets that help to provide true diversification and positive skew. Here is how our portfolio differs from the traditional 60/40 stock+bond portfolio:
- Overweight stocks with particular emphasis on weapons (military) such as Lockheed Martin $LMT, platform technology such as Twitter and Amazon, and monopolies with large amounts of cheap and fixed rate debt.
- Zero exposure to assets that are broadly considered “risk free” … specifically sovereign bonds and bonds of companies with very low credit risk. These assets provide almost no upside and would drop significatly in value if inflation expectations rose even modestly.
- Select cryptocurrencies such as Ether $ETH and ZCash $ZEC which provide differentiated technologies. However, we are waiting for prices to fall considerably from current levels before making our investment.
- Consumer debt via the platforms LendingClub $LC and Prosper … these companies allow retail investors to make loans to other individuals (i.e. Peer-2-peer lending)
- Gold $IAU and select gold mining companies including Barrick $ABX and New Gold Corp $NGD. Gold has no historically consistent relationship to other financial assets, but we think the unprecedentedly low stock volatility and paper gains of 2017 will eventually cause investors to rebalance some into this asset with a 5,000 year track record of holding value (unlike Bitcoin).
Importantly, this is an extremely risky allocation with a goal of maximum growth over 30 years. Do not simply accept opinions from anonymous blogs when deciding how to invest your hard earned money. Consult an financial planning professional before making any important financial decisions.
To understand our approach we suggest that readers first become familiar with our views on the global asset bubble, why it came about, and scenarios that are likely to make this bubble burst (see our manifesto).
In short, the industralized world has exhibited several trends that cannot continue much longer. Global debt as a percent of GDP is higher than at any point in recorded history. This has only been possible because interest rates have been falling for three decades and now sit near zero across most of the industralized world. Low interest rates are also the justification for record high stock prices. Global wealth has been rising while global economic growth has been slowing since WWII. This imbalance of wealth relative to positive yielding assets is at the heart of why interest rates and dividend yields are are so low.
These trends cannot continue because at the heart of our global economy are many people who have been left behind, and the people (which seem increasingly frustrated by their elected officials and stagnant wages) have the power to redistribute this wealth. New technologies are displacing jobs faster than folks can be retrained and re-enter the work force. The burdons of this trend on our social safety nets have been hidden by rosy forecasts from pension funds, governments, and quantitative easing (printing money). There is no realistic scenario that allows for these trends to reverse themselves without a major shock.
Investors will be in for a rude awakening when these trends break. Regime change will usher in new relationships between asset prices. Textbook investing rules like the safety of bonds, negative correlation between bonds and stocks, the importance of central banks and their ability to stave off disaster to major currencies like the Euro, and the importance of the dollar to global financial stability…all of these (and more) could break down. There are been periods when bonds and stocks moved together…we just haven’t experienced one of these periods in a while. Over the past 30 years investors have become accustomed to a world in which major currencies never fail, bonds provide safety, and the dollar is central to the world economy. Its hard to imagine how the world will change until it does. No one knows when, but the question most certainly is when, not if.
When the global financial bubble bursts investors will realize that their traditional portfolio is not truly diversified. True diversification requires exposure to assets that perform well in all potential regimes. This approach is similar to that of Ray Dalio’s “All Weather” fund although we believe he leaves some critical regimes out of his current allocation. His approach identifies four regimes. Half these regimes involve inflation at levels the industrialized world has not experienced in any strength since the 1980s.
We add conflict as another regime although war often coincides with inflation because of the increase in debt levels, demand for raw materials, and disruption of supply chains. We also add the possibility that new forms of technology, including cryptocurrencies and software platforms like Amazon and Twitter, further disrupting how we do business and interact with others. Technology can create entirely new regimes. It is entirely possible that much of today’s stock market capitalization is build on legacy technology and old sources of demand that are doomed to die through creative destruction. Market cap weighted indexes like the S&P 500 correct for this by dropping firms from the index that become too small and adding new ones that reach sufficient size, but this is backward looking and potentially costly. The trend is clearly toward more tech domination of GDP, not less. Moreover, cryptocurrencies provide an entirely new means of creating value. Without exposure to this new asset class, investors are not diversified and are therefore at risk if existing businesses are disrupted.
True diversification requires exposure to assets that will perform in all potential future states. This starts with a recognition of risks…particularly those risks that have not occurred in recent memory.
Risks of 2018
Recognizing these risks and hedging against them is the key to our 2018 strategy. We identify three that we believe are not fully priced into financial assets that could cause the traditional portfolio to implode:
Most everyone that has lived through real conflict in the industrialized world is no longer living. Many believe that the unprecedentedly long period of peace and prosperity that we have enjoyed since WWII will continue because the threat of nuclear weapons is too great to contemplate. But the real reason for peace was the United States. Since WWII the US has played the role of world policeman (often for better but sometime for worse). This served the interests of American’s during the Cold War and helped ensure access to Middle Eastern oil upon which the US was dependent. Neither interest is important to the American voter today.
The Cold War is over. Shale Gas technology has removed any real need for the US to spend billions ensuring safe international trade. This is partly why the US has been winding down defense spending and willingness to play world policeman. Russia’s annexation of Crimea marked the first time since WWII that a major country aggressively took territory. China’s development of militarized islands is going unchallenged. Saudi Arabia and Iran are fighting a proxy war in Yemen. We expect these aggressive trends to continue. It’s only a matter of time before one of North Korea’s missiles is fired with the intent to destroy a city, or some other tragic event, and the true nature of this predicament will be factored into our minds … and asset pricing models.
Since the beginning of civilization the tendency of men with power has been to accumulate power. The only reason this hasn’t happened in large scale since WWII is because, for the first time in recorded history, the global superpower used its power to secure peace and facilitate trade. The US derives a smaller percentage of its GDP from international trade than just about every other industrialized country. The rest of the world would suffer from the US stepping away from its role as world policeman, but the US would be just fine. Its this lack of incentive to prevent War that makes the threat of War real.
Experts say inflation won’t come because years of printing money had no effect and economic growth will be moderate at best. They are talking about moderate inflation. We are talking about shocks. What experts fail to see is that inflation can result from instability. Inflation can occur quickly when trade is disrupted, key commodity prices like oil spike, or new political leaders shift policies toward wealth redistribution or government spending. Inflation shocks becomes increasingly likely in a world characterized by ridiculously high debt levels relative to GDP, populism, risks to international trade, and growing discontent of the voting public. Investors discount the probability of events that haven’t happened in recent memory because of “recall bias”. This actually makes the risk of such events higher because of complacency. This complacency leads to poor risk management on the part of governments, corporations, and individuals.
The result is a world today that is largely unprepared for a scenario like the Iranian Revolution of 1978 which stoked the double digit inflation shocks Paul Volcker finally put out by raising the Fed Funds rate to 20% in 1981. A Bernie Sanders 2.0 with the charisma of Huey Long is now a real possibility. Wealth inequality has never been higher. The only reason why inflation has remained subdued is because all the printed money has been going into the hands of those wealthy enough to own bonds or other financial assets…and all they did with it was buy more bonds and other financial assets… hence lower interest rates and higher asset prices. Put more money in the hands of people who actually need it and the money will be spent. The result will be more dollars chasing fewer goods and services. The next election cycle is far off, but asset prices are sensitive to expectations, not reality. The 99% control 99% of the votes. They know it. Rich people know it. The only people oblivious to this possibility are those who ignore history.
Ray Dalio has published an article addressing this topic. He gathered data going back to 1900 on voting patterns and found that populism is on the rise. He defines populism as, “a political and social phenomenon that arises from the common man being fed up with 1) wealth and opportunity gaps, 2) perceived cultural threats from those with different values in the country and from outsiders, 3) the “establishment elites” in positions of power, and 4) government not working effectively for them. These sentiments lead that constituency to put strong leaders in power.” He argues that this increases the risk of “disorder” and democracies becoming dictatorships. These clearly also relate to the first two risks of War and inflation.
We find his conclusions plausible, especially when combined with the Generations Theory constructed by Howe and Strauss. In short, most people today are spoiled. For most Americans, nothing really horrible has happened in their living memory and so people take the institutions and wealth they have for granted. The Revolutionary War, Civil War, WWI/II and now are all about 75-100 years apart for this reason. The pattern is characterized by increasing wealth inequality, debt accumulation, and political polarization. The only way to reverse the trend is a major shock that forces people to set aside petty differences and solve the now urgent problems they face (typically war and/or insurmountable debt). Democracies are clearly better than dictatorships, but they tend to only act boldly in a crisis. In other words, things will get worse before they get better.
There are many other risks you can read about in the mainstream media, but essentially none of them would cause the global financial asset bubble, which has been building since the late 1980s, to burst. Bad things happen all the time, but momentum is a powerful ally and investors have been trained to buy this recovery on the dip. We plan to buy the dip to unless the dip is caused by one of the risks above.
Given these risks we have constructed the following portfolio:
- Stocks (70%)
- Credit (10%)
- Gold (10%)
- Cryptocurrencies (10%)
Many believe that stocks are overvalued because valuations are much higher than historical averages. We disagree. Stocks are higher than historical averages for three reasons: better accounting and investor protections, better understanding of diversification and how to reduce unsystematic risk, cheaper transaction costs. This is why comparing historical valuations, such as the cyclically adjusted price to earnings ratio (CAPE) of about 30 from Black Tuesday 1929 (just before the Great Depression) to a CAPE of 32 today doesn’t really say anything meaningful about valuations.
Investing in stocks during the 1920s was a lot like trading cryptocurrencies in 2017. No one but the CEOs (developers) really knew what they were buying. All they had was a nice story written by the CEO without any accounting or accountability. Old school investors considered investing in stocks to be more like gambling than true investing (which they did via bonds). Investors bought single stocks because it was expensive to transact and theories like CAPM didn’t exist and the importance of diversification were not well understood.
Fast forward to today and pretty much everyone with capital knows it’s important to diversify and can do it via Vanguard’s $VOO for a whopping 0.04% per year. The average equity risk premium over the past 100 years was about 6% in the United States. This means that stocks outperformed government bonds by an average of 6% a year. Obviously, if people had known this up front they would have invested more in stocks. The only way for everyone to get more exposure to stocks, and for this seemingly inefficient arbitrage to disappear, is for stock valuations to rise. Only then can realized stock returns drop to something more reasonable relative to government bonds like 4%.
With this in mind we place a majority of our portfolio in stocks amounting to 70%. However the placement of these stocks is key to our risk hedging strategy. Here is the breakout:
35% – Vanguard’s S&P 500 equivilant $VOO
This is the best way to get exposure the broad US stock market. Vanguard offers the best customer service and free transaction costs for their funds. We chose to use the ETF because there is a lower risk of paying for unrealized capital gains than the mutual fund equivalent.
15% – Select Technology Stocks $ADI $AMZN $GOOG $MXIM $MYGN $PYPL $SNE $SPLK $STM $TWTR
The S&P 500 underweights technology stocks. This makes it easy to justify adding exposure to technology companies. But we have another reason as well. Note the difference in top 10 companies today compared to 1950. The biggest companies today are technology companies, but they used to be producers of physical things. We expect this trend to continue in the future as we continue to value experiences and services more than stuff.
We chose these specific companies because they all provide a valuable product or service and appear to have strong moats. We believe that the stock market is mostly efficient most of the time so we don’t expect to massively outperform the market with these picks. However, we do expect to beat the market via tax loss harvesting. As long as we did as well as a monkey throwing darts (random) we should be able to outperform a buy an hold strategy on an index by simply selling our losers and holding our winners each year. Gains from our winners will compound over time. Tax savings from our losers will offset other short term capital gains. Mutual funds incur costs and realize capital gains when their index changes composition or when investors redeem shares.
10% – Defense (Military) Stocks $LMT $GD
In the event of a military escalation we expect valuations on Lockheed Martin $LMT and General Dynamics $GD to skyrocket. In the event of no military escalation we expect both companies to hold their value as the US can’t risk having these companies go out of business. They are, effectively, monopolies. When we compared the valuations of these companies to others with similar dividends we found no material difference. Thus, we appear to be getting this positive skew at no additional premium.
5% – Oil Producers & Refiners $PSCE $PSX
One of the more likely scenarios for an inflation shock would be a civil war in Saudi Arabia or other major oil producing countries in the Middle East. The shale revolution has insulated the United States from dependence on Middle Eastern oil, but global oil prices are still sensitive to this risk. We believe that asset pricing models are failing to capture this risk because it hasn’t happened recently. If it hasn’t happened than it won’t be in the data and is therefore less likely to be priced in. Small and mid-size oil producers, including some shale gas producers, are included in $PSCE and would benefit from such an event. Phillips 66 $PSX is a refiner owned by Warren Buffet and we think the Sage of Omaha still knows what he is doing.
5% – Housing $USG
We have been bullish on US housing for the past five years. Anytime a major shock occurs it tends to leave a lasting mark in investors that is exaggerated. For this reason, we invested in $USG. USG essentially has a monopoly on home building materials such as drywall in the United States. Warren Buffet owns this company as well.
We believe that long maturity government bonds are in a massive bubble. By bubble we mean that prices cannot be justified by a reasonably plausible scenario. Investors that buy these bonds are getting paid almost nothing and exposing themselves to the risk of inflation and currency devaluation. These risks are not properly accounted for in pricing models because interest rates have been falling for three decades and it has been even longer since a major currency has defaulted. Investors tend to discount risks that haven’t happened recently, but exaggerate risks that are fresh in their minds. The worst part about the risk of holding government bonds is that investors think they are “risk free” and so they are willing to receive essentially zero compensation. That’s called negative skew and we avoid it like the plague.
Here is an example of what can happen to “risk free” government bonds. When the United Kingdom left the European Union (Brexit, 23 June 2016) the pound dropped 20% in 2 days. Yields initially fell as investors fled to bonds, but then rose 80bps over three months as inflation from higher import prices kicked in resulting in a 15% drop in 30-year UK government bond valuations. Shorter duration bonds are less sensitive to interest rate increases, but the average duration of both government and corporate bonds has been rising over the past 20 years.
For this reason our allocation to credit is quite modest. We have half our allocation in preferred stock and the other half in consumer loans via the companies Lending Club and Prosper. Both are higher yield which helps to reduce interest rate risk, but usually at the expense of higher credit risk.
5% – Preferred Stock $PFF $PSF
One of our favorite bloggers, @Jesse_livermore, wrote an article explaining why he believes preferred stock is underpriced. Preferred stocks provide a high yield (around 5%) in exchange for higher credit risk. Preferred stocks take losses just after common equity in the event of issuer bankruptcy. We accept that credit risk because we think it is already priced in and are more concerned about inflation; which we think it not sufficiently priced in. Much of the Preferred stock universe was issued during a period of higher interest rates and is therefore more likely to be called by the issuer. This reduces the interest rate risk because if interest rates rise the “call risk” drops along with the discount rate. The result is a high yield bond that is less sensitive to interest rates and inflation.
5% – Lending Club and Prosper Loans
Until recently, retail investors have not had access to consumer credit exposure outside of investing directly in banks. This changed with the creation of peer-2-peer lending platforms like LendingClub and Prosper. We invest primarily in borrowers that have credit scores of at least 700. The borrowers generally use these loans to pay off credit card debt that averages 20%. In exchange they pay us 10%. It’s a win-win for everyone but the banks.
Gold is a risky investment that has no consistent relationship to anything. There have been long periods where gold has been flat, such as the 1990s, and others when it has soared, such as during the Sovereign Debt crisis of 2010-2012. Gold prices are driven by narratives. We believe the narrative for gold in 2018 will be something like this, “I made all this money is the stock market…maybe I should diversify into gold just in case”. We have tweeted about several catalysts for Gold that we repeat here:
In 2017 our exposure to cryptocurrencies reached as high as 25%. We articulated our reasons for this in detail in the post below. We still see positive skew for some crypto in 2018, but most will lose value as there are simply too many relative to the amount of interest from investors. We like $Ether $ETH and #ZCash $ZEC because they offer a differentiated service. #Ethereum is the largest decentalized smart contract network in the world, although there are competitors like #Cardano $ADA and #EthereumClassic $ETC. ZCash utilizes specialized new technology called zkSNARKS.
Having strong network effects and/or unique technology will be key for a cryptocurrency to succeed in 2018. There are now more than 1,372 coins. Most are worthless. The rest are mostly slight technological changes or improvements over Bitcoin such as $BCash $BCH and #Litecoin $LTC. We think the days of easy money from crypto are over. From here on out it will require real work and understanding of a coins competitive moat and prospects for real world use.
Crypto investors that got in early would be wise to learn the origins of the Chinese saying, Shǒu Zhū Dài Tù … which literally means “to wait for a rabbit by a stump”. The phrase comes from a story about a farmer who witnessed a rabbit break its neck one day after running into a tree. The farmer was so overwhelmed with his good fortune that he stopped farming and instead waited by the same tree for another rabbit. Obviously, an explosion of a new asset class like cryptocurrencies doesn’t happen very often. As the space becomes more competitive the returns will necessarily drop. Investors that got in early will be at a disadvantage because they are used to easy money and rocket moons. Those that are used to the competitiveness of stock picking will do better because they are less likely to jump at something just because of the price action and then slowly lose everything as their investments dwindle to zero.
Don’t be like the farmer and Shǒu Zhū Dài Tù with crypto … do your homework, diversify, and limit exposure on any one bet.
Feel free to share your own thoughts on 2018. There is no better compliment you can give us than your thoughtful criticism. You can reach us at firstname.lastname@example.org, or follow us on Twitter @intuitecon
Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.