Sunday Morning Coffee

A reader sent me their version of the permanent portfolio and while I don't think my opinion was being solicited it got me thinking about trying to put together a version that did not rely on the typical funds but instead tweaked the idea. The intent is not to build something to actually implement but maybe to think about the attributes of various market segments beyond the obvious.

The original permanent portfolio was conceived by Harry Browne and allocates 25% each to whiskey, gun powder, beef jerky and..oh wait that is something else. The permanent portfolio actually allocates equal portions to gold, US treasury bonds, cash and US equities (via a broad index fund). The reader's idea was less diverse, focusing on various parts of the commodity complex. This post will be truer to the four asset classes.

The first component listed in the Browne original is gold. More than any other metal and more than gold mining stocks I would expect gold to offer the best chance of going up in the face of a panic like in the fall of 2001 and during parts of 2008 but panics are short lived events which opens the possibility of some other commodity that offers a low correlation to equities over longer periods of time.

I looked at ETNs for cotton, tin, nickel, coffee, cocoa, sugar, beef/pork and the ETFS Platinum ETF (PPLT). The two with the most promise were the iPath Coffee ETN (JO) and the iPath Sugar ETN (SGG). Tin and nickel would seem to be the most cyclical of the ones I looked at, I was really checking them to see if there was a surprise there but there wasn't. Cotton would seem to be a little less cyclical, which may be incorrect, but either way it offered very little zigzag versus equities and the platinum ETF might simply be too new.

Coffee, cocoa, sugar and meat all seem to play into the same potential trend of diets changing in emerging market countries. Cocoa and sugar play into dessert, meat the actual meal and coffee just because it is so good (insert smile). Seriously, I have mentioned coffee before with the belief that an uptick in consumption in China and India (from a microscopic number to a slightly less microscopic number) could put meaningful upward pressure on the price. While not a one way trade coffee has generally been doing well which is nice but it also has a negative correlation to the S&P 500 according to the correlation tracker at the SPDR site.

Given that US treasuries are at very high prices they are not attractive to buy and although creating inflation when you need it is very difficult to do the Fed is trying. Bond prices may stay high for a long time but buying high is buying high. The first thing I think of as a substitute is emerging market debt because many of the countries are on better fundamental footing than the US, big Western Europe and Japan. However just because other countries might be better off for now does not mean the dollar can't go up so for purposes of this exercise I would prefer the ETFs that own US dollar denominated debt over the new funds that own debt denominated in the foreign currencies (in a normal portfolio it would be the other way around). The yields are higher and there is no reasonable currency risk (the hopefully-unreasonable risk would be a country blows up for having too much debt denominated in other currencies).

There are two ETFs in this (dollar denominated) space; one from PowerShares with symbol PCY and one from iShares with symbol EMB.

For the cash portion the obvious answer is to seek out a foreign currency, at least for anyone worried about USD devaluation. If someone were going to take currency risk here then I really would avoid it in the fixed income portion because the dollar can go up when it shouldn't and if the all four of the segments are vulnerable to the dollar going up then the diversification is not so great. Between the commodity exposure and foreign equity exposure (below), I think that is enough vulnerability to the dollar going up.

The equity allocation is built on the idea that the US, big Western Europe and Japan will continue to be less attractive than smaller countries around the world. Anyone on board with that thinking could pick a country ETF or some sort of theme. For purposes of the exercise let's just go with one fund but in the real world I don't think there is any need to to have an entire equity allocation in just one fund assuming more than a couple thousand dollars invested.

For countries I would pick from Chile, Brazil, Norway, Australia and maybe one or two others. Each has pluses and minuses. Chile has been a low impact emerging market with constant local equity demand but the economy is vulnerable to a slowdown in copper demand. Brazil is similar except more volatile and more resource diversity. Norway has perhaps the firmest footing of any country out there but the North Sea has been in decline for a while and that will matter at some point. Australia has even more resources, not had a recession since 1991 (this is both good and bad) but the housing market is clearly overpriced (no subprime or equivalent though) and the political landscape has been very rocky of late.

There is an ETF for Chile from iShares with ticker ECH, Brazil has many ETFs, Australia has a couple of pure plays; EWA for large cap and KROO for small cap along with a few other funds out there that are very heavy in Australia. There is no pure play ETF for Norway. ECH and EWA are client and personal holdings.

For themes there is infrastructure, water, food, rare earths and any others you want to add. I would be hard pressed to pick just one from infrastructure, food and water. I threw in rare earths because the are getting more popular but I think the potential political risk due to concentration in China creates a variable that may not be manageable in the context of being the entire equity allocation. Clients have exposure to the three others through EMIF, PHO and MOO.

There are a lot of infrastructure ETFs. EG Shares has made a big commitment to the space, iShares has a couple and there are also funds from First Trust and SPDR and maybe a couple more I am forgetting. Many have different volatility characteristics because they capture very different things; the SPDR fund is very utility heavy and the First Trust fund is mostly engineering and construction.

The difference between the water funds and the agribusiness funds seem to be subtler to me. MOO has a negative correlation to JO and while that might ebb and flow that combo may not be the obvious poor diversification mix that it might seem.

As I think more about it picking just one seems less than ideal so I'll pass on that but feel free to opine in the comments. Anyone picking just one needs to figure the right balance for their own volatility tolerance while still having a chance at some sort normal (or maybe better than normal) equity return.

One reminder is that the concept behind the permanent portfolio is diversification for all seasons, to always have at least one thing going up.