In last Friday’s Barron’s Jason Zweig penned a birthday salute to Warren Buffett, whose 90th birthday was Sunday August 30. Let me join in his appreciation for a man who has made such a difference in so many ways. Buffett is not just a investor. He is also a great writer. His Shareholder Letters, Partner Letters, and occasional OP-EDs demonstrate the principle that clear thinking makes for great writing. He is a teacher who is exceptionally good at breaking a problem down into a few simple principles. As a philanthropist and advocate for generosity, he has encouraged all of us to have gratitude for good fortune and empathy for those less fortunate. Very few teachers have set so many students on the right path.
Entitled “Warren Buffett and the $300,000 Haircut,” the Zweig piece is built around observations in Buffett’s January 18, 1965 Partner Letter that if you are lucky to enjoy a long life and stick to “stable, attractive” investments, compounding will do the rest of it for you. With compounding taken into account, Zweig argues, you could end up $300,000 better off just by investing what you save by having less frequent haircuts. Like Buffett and many others, I have used COVID distancing to test this premise letting my hair grow out to a length not seen since I entered the army. At the senior discount rate plus a tip, dispensing with professional haircuts saves me $60 investable bucks a year. Going forward I plan to rely on my wife’s steady hand with scissors applied as I sit shirtless in front of our garage. Now all I have to do is eat veggies and exercise while chasing Methuselah’s record.
Well, not quite all. There’s that thing of finding “stable and attractive” investments. We’re living in a peculiar time. I’m having a hard time finding investments that are both stable and attractive at the present price. Buffett himself is clearly having the same problem. The pandemic and the Fed’s response to it are part, but not all, of the reason.
Every Asset Class Is Now Expensive Or Risky
This is a uniquely difficult moment for conservative long term investors in the primary asset classes. In important ways it is exactly symmetrical with the situation when the great end-of-century bull market began in 1982. That year marked the peak in interest rates and the final defeat of ruinous inflation. Bonds had been “certificates of confiscation” for over a decade as persistently rising rates reduced their value to an extent that overwhelmed the coupon return. Stocks performed similarly, as stocks went down miserably and overwhelmed their dividend return. There were several recessions in the 70s and early 80s, but average earnings growth was fine. Stocks were pulled down mercilessly by the shrinking price earnings multiple, which declined steadily from a peak well above 20 to a final low of 6.
From 1982 to 2000, combining bonds with stocks did not really represent diversification. Except for brief periods, the two major asset classes performed about the same – the reason being that they were driven by the same motor. What powered both bonds and stocks was declining inflation and interest rates. Over the 18 years from 1982 to 2000 both had compound returns in the high teens. An investor did roughly the same with either asset class by itself or any mixture of the two. The famed 60-40 portfolio supposedly made its bones in that era, but in fact the effort to select a proper ratio of stocks to bonds was essentially trivial and pointless.
The present moment is the exact flip side of that 1982 market moment. The great bond bull market is probably over, or if not, close to the end. There just isn’t much more space for rates to decline. Bonds have now rallied for almost 40 years so that the coupon rate is trivial and the real rate is negative. Because risk free Treasury rates serve as the discounting factor for stocks, investors must deal with a market in which the long term cumulative value of earnings and cash flow streams is essentially incalculable. For growth stocks, as long as they continue to grow, the discounted value of any year of future earnings has more present value than current earnings. In fact, the discounted value of future earnings grows every year until the company’s earnings growth slows to the discount rate.
As for fixed income, the expected return is easy to calculate. The return is the coupon. Here are a few coupon returns to consider:
- 2-year Treasury: .11%
- 5-year Treasury: ..22%
- 10-year Treasury: .56%
- Average 10-year Treasury: 4.43%
- 20-year Treasury: 1.01%
- 30-year Treasury: 1.23%
- 10-year Aaa Corporate: 2.46%
- Average 10-year Aaa Corporate: 6.71%
A couple of things are obvious. Treasury bill, note, and bond yields are awful, offering little return at all maturities. They are safe but very far from attractive. The real yield – yield after inflation – is negative all the way out to 30 years.
Corporates aren’t much better at 2.46% for the ten year, something like a point above inflation expectations. Yields on both the 10 year Treasury and the 10-year Aaa Corporate yields are a fraction of their long term averages. To make the corporates even less attractive, the risk spread above the 10 year Treasury is less than half the long term average.
Bonds, in short are an utterly unattractive asset class. I own none and plan to own none possibly for the rest of my life. The only thing worse than the above table is the yields on European and Japanese bonds which are negative in nominal yield far out on the yield curve. In other words, the lender has to pay the borrower to hold the money.
But what about stocks? The short answer is that stocks are priced to a significant degree in line with the risk-free measure provided by bonds. In that respect they are similar to corporate bonds, and they are priced similarly. We have to guess a little on their expected return. Stocks are riskier than bonds, so we might expect them to have a higher earnings yield. Earnings estimates are given on so many different bases that we should probably make do with an estimate of a 25-30 PE at the moment, meaning an earnings yield of 3.3% to 4%. That’s nominal return. Real return, after inflation, is probably something like 2-2.5%.
It’s easy to see why the returns of the traditional 60-40 portfolio seem likely to be miserable. Stocks look a little better. This is why Jeremy Siegel, a long term supporter of the 60-40 ratio, recently moved to 75% stocks and 25% fixed, for which he would likely prefer cash to bonds. It’s easy to follow his argument that stocks will do better than fixed income. It’s harder to understand his expectation that stocks will do well by historical standards.
I can imagine the thoughts of many readers. Some are thinking, gee, I could do (have done) a lot better than that with growth stocks, maybe Alphabet (GOOG)(GOGL) and Alibaba (BABA), which I bought in March when they seemed reasonably priced at 30% below their present price, or even Amazon (AMZN) which I unfortunately didn’t buy. But there’s that other thing, the ugliest of four letter words: RISK. Risk comes with higher PEs which demand perfect execution – not just for next quarter’s report but for years stretching well beyond our ability to estimate the future.
Then some of you are thinking, ah, but I have dividend stocks which return more than that 2.5%. Yes, but many stable dividend payers are also expensive for low-growth or no-growth companies. What if the market as a whole experiences multiple contraction accompanied by rising rates? Would they be spared? There’s a hint in the fact that they have not performed very well in the recovery market this year.
Small caps, maybe? Great economic sensitivity. Special dividend situations offering 8-10% return? I see the headlines of articles touting such returns every day here at SA. Pretty much all dividend returns that are significantly in excess of the aggregate expectation for stocks, or any other asset class, for that matter, come with special risks, obvious or hidden. One of the first stock market axioms is that out of scale prospective return comes with risks. The rule: don’t reach for yield. If you can beat the average expectation, more power to you.
My own feeling is that the returns of stocks or any mix of stocks and bonds is likely to be disappointing in meeting the investment goals of most people over the next five to ten years. So much for the traditional 60-40 portfolio, and just a caution about likely disappointment in the 75-25 portfolio. So where does that leave us?
One thing that has always interested me is the effort to put together an all-weather investment portfolio. What an all-weather portfolio attempts is to address all the major conditions which occur in the economy and the markets. The 60-40 and 75-25 portfolios are limited because they include only stocks and/or bonds in varying ratios. How about more esoteric and varied assets?
Esoteric Assets And An All-Weather Portfolio
One of the relatively simple efforts to put together an all-weather portfolio is Harry Browne’s original “permanent portfolio.” Browne was an engaging dude. He ran for President twice on the libertarian ticket and got about a half million votes despite the fact that he wouldn’t accept matching funds because he opposed them in principle. Something about him appeals to me when I am ready to throw up my hands about traditional government actions, but never enough to throw away my vote on a party which can’t win.
Without pictures, you might imagine Browne as resembling the nutty inventor in Back To The Future with wild hair and a beard. In fact, he looked like a mild mannered accountant or banker. His concept of an all-weather “permanent portfolio” sounds like something that might have popped into his head on a slow afternoon, but his model has actually worked surprisingly well for investors with modest goals and aversion to volatility.
The Harry Browne “permanent portfolio” is simplicity itself. It divides the investor’s assets into four equal buckets, 25% each:
- Common stocks 25%
- Bonds 25%
- Cash 25%
- Gold 25%
There is no pretense of shooting the moon with this. What it promises is solid returns over a the long run with very small drawdowns. It’s based on having an asset class which works for each phase of the business cycle. Here’s how this was described on the Bogleheads site:
- Stocks – for profit during periods of general prosperity and/or declining inflation.
- Gold – for profit during periods of bad inflation; during inflationary episodes gold bullion provides protection against a falling currency and other potential problems.
- Long Term Bonds – for profit during periods of declining interest rates; and especially during a deflation. Bonds also do reasonably well during prosperity.
- Cash – During a recession, no particular asset class is going to do well. The cash in a Treasury Money Market Fund offers stability.
Is the Harry Browne “permanent portfolio” both stable and attractive? Is it suitable for conservative investors? Yes and no. It did reasonably well over the two decades since the year 2000 (Browne died in 2006) providing returns around 6% over most periods. Drawdowns were few and modest. The current situation points up some difficulties, however.
Note that starting from the present moment cash, stocks, and bonds are all likely on the fundamentals to have low returns for a considerable period. If the average return of the 3 asset classes turns out to be only 2% or less, there is a heavy burden on gold to make up the difference. The large position in gold, however, is the most controversial element of the Browne portfolio. Gold does tend to dampen overall volatility, but it also tends toward somewhat erratic behavior – illustrating the Harry Markowitz principle that combining uncorrelated investments produces less portfolio risk (as measured by variance).
There’s a catch, though. A 25% allocation to gold is far higher than gold’s proportion of the investment universe. If everybody tried to do it, pension funds and all, there just wouldn’t be enough of it. But there’s a second catch. There is not likely enough return in the other assets to offset a very bad year in gold. This was the case in 2013 when a large decline in gold pulled overall return into the negative despite a terrific year for stocks.
My sense is that it’s possible to justify a position in gold which is closer to its proportion of overall universe of financial assets. That’s what I held thirty years ago in the form of American Eagles. Since then my overall portfolio has run away from my few gold coins in size. Owning gold but in modest size also appears to be what Buffett’s Berkshire Hathaway (BRK.A)(BRK.B) has done. I should note in passing that the size of the position also suggests that the purchase of Barrick Gold Corp (GOLD) may have been an action by one of Buffett’s lieutenants.
Some of Browne’s followers have modified the Browne portfolio so that commodities (including gold) replace gold by itself as the 25% allocation. Gold and commodities both mainly defend against significant inflation and also work well to offset a declining dollar. Both, however, spend long periods in zero-return dormancy, and they offer no income. Foreign stocks, ignored by Browne, also serve much the same purpose, especially emerging markets, but they also trade as stocks so that their purpose as diversifiers isn’t quite as pure as that of gold. On the other hand, their longer term prospects based on current valuation appear much better than the prospects of US stocks at this moment.
Bitcoin? We all know the pros and cons. Put simply, bitcoin is another wannabe currency with no track record and no history. It has its own esoteric risks, and I will need to see stronger proof of widespread use before taking it seriously. Until then, it’s just gold without material existence but with a few extra worries.
I have also used put selling and call selling at times to enhance income. Put writing has worked pretty well, but requires some skill and experience. My record on call writing has been mixed. I have been unlucky several times when all or part of a successful write has been called away early generating very undesirable and unexpected capital gains taxes.
How About A Portfolio To Play Defense And Survive?
Investing is ultimately about surviving. The Jason Zweig article cites the fact that Buffett acquired 90% of his wealth after the age of 65, an argument for the importance of survival. To build wealth like that means surviving as an investor in all sorts of markets, including the present one. With almost every asset class overpriced and/or risky, the theme of a long-term portfolio should probably be “defense and survival.” It’s not quite a “permanent portfolio” put in place forever with slight rebalances. Instead it’s a portfolio which reflects shifts in the opportunities the market offers. It includes assets held in “parking place” assets until circumstances change (perhaps a major bear market) improving the odds for longer term investments.
For those familiar with the principle, this is something like betting the Kelly Criterion, which argues for betting edge/odds. This sort of thinking derives from optimization of bets at the racetrack (I think I have bet two dollars lifetime.) In the financial markets “odds” are what the universe of investors think, as expressed in valuations. “Edge” is your own convictions, properly discounted.
This is what Professor Siegel is doing when he raises the stocks to bonds ratio from 60-40 to 75-25. He is saying that, taking everything he knows into consideration – and he knows quite a lot – he thinks stocks will outperform bonds meaningfully from this point. The 25% left in bonds amounts to saying, yes, I think stocks will do better, but I am sometimes wrong, and I should attach a 25% estimate to the possibility I am wrong this time. If Jeremy Siegel’s portfolio allocation reflects his awareness that he is sometimes wrong, all of us should perhaps factor in that awareness of fallibility. I certainly do.
A “Defense And Survival” Portfolio
Here’s a possible “Defense and Survival Portfolio” including suggestions about some defensive “parking place” assets that offer a small return:
- US stocks: 30%. This happens to be my present allocation and also happens to be roughly the recommended allocation for individuals of my age (76 in three weeks). I would have a larger allocation in normal times, however, in part because of fixed income from Social Security and a pension.
- Bonds: zero per cent. See above.
- Other fixed income: 70%. This is currently my parking place/future opportunity space. Like the Harry Browne follower who updated the fixed side of the Harry Browne “permanent portfolio,” I lump bonds and cash into one category. Currently I would commit all fixed income into short duration securities.
- Gold: possibly as much as 5%, funds coming from fixed allocation.
- Foreign stocks: possibly as much as 25% after a correction, funds coming from fixed allocation.
And A Few Ideas About Short Term Fixed Income
- I Bonds. In risk-adjusted terms this may be the best investment I ever made. I loaded up on them in the years around 2000 when you could buy $30K annually with real returns of 3 and 3.6%. Although I continue to buy the present $10K annual limit, often at zero real return, the large amount I was lucky to buy in the early years continues to overwhelm these annual purchases so that the portfolio real return is well over 2%. I Bonds are US Treasury instruments bought on the Treasury site, provide both inflation and deflation protection, and can be exited at any time with the loss of a single quarter of interest. Read more about I Bonds in many fine articles on this site by Tipswatch.
- CDs. Insured up to $250K per investor for each issuer. The 2-year maturities now offer .30% yield which beats any other safe stable asset. Insured CDs beat Treasuries at every maturity, and for all practical purposes are equally safe. Maturities longer than 2 years offer little extra benefit. Shorter maturities might work as part of a rolling ladder with the top rung two years out.
- Money market funds. I use the Vanguard funds, taxable and munis. That’s in case something sudden happens to the market and I want cash immediately to take advantage of an opportunity. Vanguard just did a small overhaul which may be useful to smaller investors, but read the fine print.
- Every now and then I look at short/intermediate bond funds and the Vanguard GNMA fund. I parked a large amount in the GNMA fund for my wife inside a profit sharing account and didn’t bother to look at it for at lest six or seven years. About a year ago when I finally took a look at the results I had a present surprise. One cautionary note: When you look at the past year’s return you will see that it far exceeds coupon return. This resulted from price appreciation of the individual bonds as rates fell. Don’t project that return into the future. In fact, if rates rise, that appreciation will turn around and run in reverse and you may well have a year or more of negative returns. The coupon will trend higher when and if rates rise, but until rates level off the marking down of bond prices may offset or exceed coupon returns. Owning the GNMA fund now is very much a long term commitment.
Bet Your Beliefs
I never gamble in the usual sense. Card games and race tracks don’t appeal to me. In fact, they bore me, and casinos, which I have had to walk through on cruise ships and a single business trip to Las Vegas, seem to me among the worst places on earth. Nevertheless, I have learned bits here and there from gambler thinking. The most interesting bit was from William Poundstone’s Fortune’s Formula, which explores implications of the Kelly Criterion as a guideline for “betting your beliefs,” meaning overweighting your bets in a measured way when you have good reason to believe you may have an edge.
My edge, if indeed it is one, is being old with 65 years of observing market events as well as learning from from hundreds of books on economic and market history and investment theories. I know, for example, that historically inflation and deflation move in long cycles in which the rate of change is relatively slow until the very end. In other words, inflation rarely jumps from virtual nonexistence to being red hot. The end of a deflationary era is a slow rounding bottom. The current COVID lock down is a large event, but in historical terms probably not large enough to suggest even a brief large inflationary event like the one in 1946-47 at the end of WWII.
My thoughts about a proper portfolio for this moment amount to betting my beliefs, which include:
- Where the available investment universe offers low probability for an attractive long term return, asset allocation should put a premium on flexibility. This is the most important of my current beliefs.
- I remember, though, that I’m sometimes wrong and should never bet any belief with 100% conviction. My 30% commitment in selected US stocks won’t kill me if the market is bad for a few years but will help quite a bit if I’m being overly negative about future 10-year returns.
- We could have either a continued deflationary tendency or inflation. It is unlikely, however, that we have inflation on a scale to require drastic defensive action. I Bonds defend against moderate inflation very well. A large cash position with some fixed maturities out to late 2023 provides a combination of the optionality of cash and protection against deflation and the kind of odd dislocations it has created in European bonds. A small amount of gold not greater than 5% of total portfolio might be warranted on the basis of a declining dollar.
- Dollar weakness and inflation are essentially the same event. Inflation is the condition when things go up in value as measured by dollars, including commodities and sometimes foreign currencies and foreign stocks. If this tendency seems well established and foreign markets look cheap, it makes sense to own them.
Don’t take my beliefs as some kind of textbook in which future market action is written. I reexamine my views daily and find that they shift in small ways over time. From time to time I still end up realizing with some suddenness that I am wrong about something in a major way and have to change my basic thinking.
What I suggest to others is to write down their thinking about areas of the market and the economy as I have done above. My overall thesis is that at the present moment no major asset class offer is both stable and attractive to an extent that warrants going out on a limb with a heavy overweight. At some point that will change. I keep a potential first move in my mind like a chambered round in a weapon, and currently that ready-to-fire round is foreign stocks. I noticed this week that Buffett appears to be thinking that way on a small scale.
Again, congratulations and eternal youth to the master on his 90th birthday and hopes for many more. For you, me, and Buffett, I offer the best wish a science fiction writer ever came up with: live long and prosper.
Disclosure: I am/we are long BRK.B. GOOG. BABA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Originally published on Seeking Alpha