April 21, 2024
The topic for this issue focuses on portfolio management in an era of less structural disinflation, and more broadly how a portfolio can be improved relative to the basic 60/40 portfolio.
The 60/40 Portfolio
The benchmark portfolio concept that many investors use is the 60/40 portfolio, which refers to 60% stocks and 40% bonds. Younger investors might start with a higher stock allocation to increase expected returns, and older investors might dial the stock allocation lower to decrease expected volatility, but either way stocks and bonds represent the two primary components of the popular portfolio.
The idea behind it is straightforward. Stocks outperform over the long run, but can be very volatile, especially during recessions. Meanwhile, bond yields usually fall during recessions (meaning bond prices go up), and so bond prices tend to go up in the years where stock prices go down. Putting both stocks and bonds together results in strong performance but with only mild volatility.
However, this concept is based on some really narrow assumptions, with a lot of recency bias built in.
-The 60/40 portfolio became popular during a four decade structural decline in interest rates, which directly meant that bond prices were structurally going up. This also indirectly supported ever-higher equity valuations along the way, since the nominally risk-free discount rate kept falling.
-The United States has had the best-performing stock market in the world for the past four decades. The same portfolio concept tried in most other countries would have much weaker results. Many global investors, especially in developing countries, tend to focus more on real estate than equities for this reason.
Now that interest rates are no longer structurally declining, and large amounts of global capital are already stuffed into U.S. markets (which was not the case four decades ago), the expected rate of return for a 60/40 portfolio is likely to be lower for the next forty years. It doesn’t mean that the portfolio must do poorly, but it has a high probability of being less exceptional.
Plus, the 60/40 portfolio has historically seen disappointing results, especially in real terms, during periods of high inflation.
The energy and commodity sectors tend to be very cyclical, with huge decade-long ups and downs. During periods of limited supply and high energy/commodity prices, plenty of producers deploy capital to bring more supply online, but eventually overdo it, and result in a supply glut and lower prices. A long period of low prices drives away capital, and eventually the supply/demand balance tightens and results in another wave of high prices and supply limitations. And then borrowing costs go higher in response to high inflation, which leads to higher costs of capital for many types of businesses. Higher prices eventually entice capital to come back to develop new supply, starting the cycle anew.
During those major energy and commodity price bull runs, the 60/40 portfolio tends to perform poorly. This included the 1910s, 1940s, the 1970s, and the 2000s decades. This is because inflation was higher, corporate margins were pressured, and bonds were either falling in price and/or their yields were failing to keep up with inflation.
Historically, the way to protect a portfolio against that scenario is to own energy assets, commodity assets, or hard monies, but the 60/40 portfolio lacks much exposure to them. It’s heavily geared toward disinflation rather than inflation.
Waves of Inflation
Here’s a chart of the change in the oil price and official CPI that stretches back over a century. It shows the cumulative percent changes over 5-year rolling periods, to filter out 1-year noise:
Usually, high oil prices and high inflation go hand-in-hand. All periods of high inflation during this period had high oil prices. The other direction is not quite as consistent since there was one exception: the 2000s decade had high oil prices but not-so-high inflation, because that was the peak growth period of China which brought a big disinflationary wave of low-cost manufacturing to the world and offset a lot of the energy-driven inflation.
As the oil/inflation chart shows, the notable historical bull runs in energy and inflation were the 1910s, 1940s, 1970s, and 2000s.
Not surprisingly, large cap equity growth indices did poorly during those four periods of 1910s, 1940s, 1970s, and 2000s. This was always the case in inflation-adjusted terms, and usually the case in nominal terms as well.
Chart Source: Multpl
So a 60/40 portfolio historically offers little protection against waves of inflation driven by energy/commodity capex cycles and related issues. It is purely geared toward the expectation of structural disinflation.
And part of this is because the equity component in a 60/40 portfolio is usually weighted by market capitalization. After a couple decades of disinflation, the stocks that make up the majority of the index are big growth-oriented consumer or tech companies at high valuations, while energy and commodity companies are diminished to a tiny percentage of the index after a long bear market in them. At the start of the next energy/commodity bull market is precisely when investors have the least exposure to energy and commodity companies as a percentage of their portfolio.
Bonds and Growth
Many people benchmark bonds against official measures of price inflation, but there are other measures that are better. This is because as an investor, you don’t just want to keep up with prices; you want to keep up your share of total economic output and asset prices.
If we compare bond yields to GDP growth, for example, there are structural periods where GDP growth is completely outpacing bond yields (the yellow areas in the chart below), and historically during those periods it’s way better to own almost anything else than bonds. Conversely, there are periods where bond yields are nearly as high or even higher than GDP growth, and so owning bonds is actually not a bad trade.
The secular rise in bond yields from the 1950s through the 1970s was a bad time to own long duration bonds compared to almost anything else. In contrast, long duration bonds did pretty well from the 1980s through the 2000s, especially compared to cash, and that’s when the 60/40 stock/bond portfolio became popular.
If we enter a structurally flat or structurally upward period in bond yields from low levels, then bonds are unlikely to be the portfolio ballast that they historically have been.
That doesn’t mean that bonds won’t have good years. I expect that they will, and I expect that we’ll see headlines about how “the 60/40 portfolio is back” during those years. But structurally and probabilistically, the 60/40 portfolio should be expected to produce worse results during the next several decades compared to its prior golden period.
A Broader Portfolio
There have been many alternative portfolio models suggested for decades.
Decades ago, Harry Browne popularized the Permanent Portfolio, which he described as 25% stocks, 25% bonds, 25% cash, and 25% gold. Notably, this became popular after a period of high inflation throughout the 1970s, where the 60/40 portfolio would have performed poorly and this 25/25/25/25 portfolio would have done way better (although gold was illegal for Americans to own from the mid-1930s to the mid-1970s).
In 2009, Meb Faber and Eric Richardson wrote The Ivy Portfolio, which is another portfolio concept. This portfolio consists of five slices of 20% each in U.S. stocks, international stocks, intermediate bonds, commodities, and REITs. And importantly, you only stay in a slice if they are in a structural uptrend (for example, above their 10-month moving average), and go to cash for that slice otherwise. This was written after a decade of weak U.S. stock market returns, where owning commodities, REITs, and foreign assets would have been better. I like this portfolio concept quite a bit, and more broadly I like Faber’s work in general.
You can find all manner of investors’ and authors’ portfolio concepts here. What they mostly have in common is that they introduce a commodity or gold segment to what is otherwise a stock/bond portfolio. This is because during those inflationary decades, that segment is what tends to do well as both stocks and bonds perform poorly.
I previously highlighted the 1910s, 1940s, 1970s, and 2000s as weak decades for both stocks and bonds in real terms. During those decades, energy assets invariably did well. Gold and silver usually did well. Copper and other commodities usually did well. The benefits of diversification in that sense are clear throughout modern financial history, both logically and quantifiably. The higher prices of these base materials are what’s pressuring stocks and bonds during those periods, and so it helps to own the base materials and/or their producers alongside stocks and bonds.
I have been recommending what I have called the “three pillar portfolio” during this period of fiscal dominance. It has been a cornerstone concept of how I have been investing in the macro sense. For me, the three main pillars consist of 1) profitable equities 2) commodities/producers and hard monies and 3) cash-equivalents.
Profitable equities do the best when there is a period of disinflationary economic growth. Commodities and their producers do the best when there is a period of inflation or stagflation. Cash-equivalents hold up well during disinflationary credit contractions, when almost everything else is falling relative to society’s unit of account that most debts are denominated in.
This three pillar portfolio has been geared toward the expectation of above-target inflation, and from a starting point of long duration bond yields being very low and unattractive (I wrote about bonds likely being in a bubble near their peak back in 2019, which drove some of my investment decisions). Replacing the long duration bonds in my portfolios with a combination of cash, short duration bonds, and gold has been helpful in what has turned out to be the worst period of performance for long duration bonds in modern history from that bubble high.
There are multiple ways to structure a portfolio like this, but what I would emphasize is having some sort of commodity or hard money slice that is separate from the others. Right when hardly anybody wants exposure to things like gold, bitcoin, energy producers, or commodity producers, is precisely when they tend to start doing well. As inflation picks up, energy and commodities perform well when stocks and bonds do not. And as bonds perform poorly, investors flee to harder money alternatives.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I dollar-cost average in over time.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- Replaced KMI with HAL.
Portfolio Returns:
The portfolio is a globally-diversified multi-asset portfolio, and so for my benchmark I use the iShares Core Aggressive Allocation ETF (AOA), which is a globally-diversified 80/20 stock/bond portfolio. This portfolio is my implementation of a three-pillar portfolio compared to the typical stock/bond benchmark.
Since I dollar-cost average into the portfolio, I calculate the returns compared to if I had instead dollar-cost average into AOA in the same amounts and on the same dates, and measure the gain over principal.
So far, a total of $61,000 has been dollar-cost averaged into the portfolio over the course of five and a half years, and as of the end of Q1 2024 it had approximately $97.5k in assets, thanks to a total $36.5k gain over principal.
If I had instead dollar-cost averaged into AOA on the same dates, I would have only had approximately $80k in assets, which would have been a $19k gain over principal.
Most of the excess returns came from replacing a small slice (typically 2-5%) of the equity portion with bitcoin-related securities, and by using a combination of shorter-duration bonds and precious metals for the 20% defensive portion instead of longer-duration bonds. These small changes to the baseline were the primary results that led to superior growth with a similar overall level of volatility and max drawdowns so far.
Past performance is no guarantee of future results; this is just an assessment of how the strategy has performed so far.
Bitcoin Note:
I use allocations to bitcoin price proxies such as MSTR and spot bitcoin ETFs in some of my brokerage portfolios for lack of the ability to directly buy bitcoin in a brokerage environment, but compared to those types of securities, the real thing is ideal.
I recommend holding actual bitcoin for those that want exposure to it, and learning how to self-custody it. I buy mine through Swan.com.
I don’t have a firm view on the bitcoin price over the next few months, but I am bullish with a 2-year view and beyond.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus, I have personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: Abundant vs Scarce
Most successful investing can be summed up as “go short abundant things and go long scarce things”. For example, you borrow (a.k.a. short) fiat currency which is abundant to buy properties and businesses which are scarcer and more energy/labor intensive.
Scarcity is not the only factor to consider (i.e. for an investment to be successful you generally also need the scarce thing to be desirable and growing or maintaining market share vs similar scarce things that fulfill a similar niche), but analyzing investments through the lens of abundance vs scarcity is a good first step.
In an era of fiscal dominance, bonds are among the most abundant things around. The U.S. government will be running $1.5-$2.5 trillion annual deficits for the foreseeable future, and going structurally upward from there. The Congressional Budget Office estimates that there will be $20 trillion worth of cumulative fiscal deficits over the next decade, and their assumptions are that interest rates will be lower than they are currently and also that no recessions will occur. If interest rates are higher than their expectations or some recessions occur within the next decade, then that $20 trillion estimate is likely to be exceeded.
This represents at least $20 trillion supply in new federal bonds for sale this decade, and even more the next decade, and even more the decade after that. That’s not an asset class that I want to be structurally overweight, even as it will likely have good years here and there.
In comparison, at current production rates and prices, somewhere in the ballpark of $2.5 trillion worth of refined gold will likely be mined and minted over the next decade. Changes in prices or production rates could change that, but gold’s production rate only changes slowly, which leaves price as the primary absorption mechanism if more or less capital wants to flow in.
Similarly, at current prices about $70 billion worth of bitcoin will be produced over the next decade. Its supply growth rate is fixed regardless of its price action, but changes in price can act as an absorption mechanism depending on how much capital wants to move into or out of the asset.
Stocks also represent a scarcer alternative to currencies and bonds, but only if purchased at the right price. For example, I’m not exactly rushing to buy stocks like Costco (COST) at 46x earnings here. It’s a great company, but everyone knows it’s a great company and so it’s already heavily owned by investors.
F.A.S.T. Graphs 101:
- black line: the current and historical stock price
- blue line: what the stock price would be if were at its own historically average price/earnings ratio
- orange line: a common measure of valuation (a 15x price/earnings in this case)
- white line: dividends paid that year (and the payout ratio is relative to the orange line)
- dark/light green: the transition between historical earnings numbers and consensus analysts’ forecast earnings numbers
Most equities that I look to buy have a dividend-adjusted price/earnings/growth ratio (“PEG ratio”) at 2x or below, and a business model that I expect to still be relevant a decade from now.
In other words, if a company has or is likely to have 8% annual earnings growth and a 2% dividend yield (a combination of 10%), along with a product or service that I expected to be as relevant or more in the 2030s as it is in the 2020s, then that’s an interesting company that I’d pay up to around 20x earnings for. Or as another example, if a company has 15% annual earnings growth and pays no dividend, then I’d consider it at a valuation of up to about 30x earnings.
I can vary those entry valuation limits a bit depending on the strength of the balance sheet and other investment opportunities that are around, but that framework generally presents a decent starting point for good returns with a margin of safety.
Best regards,
