You probably are aware that gold has gotten taken to the woodshed recently. YTD it is still up 9.8% (as measured by client holding GLD) but it is down over 15% since peaking in August.The chart is a very near term comparison of the SPDR Gold Trust (GLD) and Bank of America (BAC). For the last couple of weeks the correlation between the two is pretty tight. If you zoom out for just about any other period the correlation is very low and often is negative including for most of 2011.
Obviously there is not much information in a two week chart but it does serve as an example of the extent to which correlations can change. In 2008 there was a stretch from March to October where GLD and the S&P 500 took different paths to the same 25% decline. What has started recently may or may not continue (obvious statement) which makes the point that the various relationships between asset classes can and do change periodically.
The bigger threat looming out there in this regard is the relationship between iShares Barclays 20+ Year Bond ETF (TLT), and other similar products, and domestic equities. TLT did very well in 2008 rising 23% (most of that coming in the last two months of the year) making for another year where the Permanent Portfolio performed quite well on a relative basis.
I think a lot of people are relying on the relationship between long bonds and equities to continue as it has. Predicting that the relationship might change is obviously difficult to do and not really my intention so much as to point out that if interest rates were to go up a lot and stocks were to go down a lot at the same time that it would cause market pandemonium the likes of which not too many of us have seen.
I've made the case numerous times that prices for bonds are very high and I would have thought rates would have started going up by now. While this has obviously been incorrect, the prices are still high and so the risk is still there.
Zooming out a little it is a good idea to understand what assumptions your portfolio is relying on and what the consequence would be if the things you are relying on do not go your way by some magnitude. For a dramatic example all those mutual funds that were grossly overweight financials in 2008 got crushed not just in absolute terms but also relative terms. This year we were right about being underweight financials and having cash raised but were wrong for the year for having a lot of foreign exposure netting out to an incredibly unremarkable result versus the benchmark.
An ongoing part of my process is trying to understand what would happen if the assumptions embedded into the portfolio don't work out for some finite period of time. I believe long term portfolio success comes from not getting blown up on the occasions where you are wrong--staying disciplined to a defensive strategy and avoiding a large chuck of a big decline helps too.
15 comments:
Nice post on Seeking Alpha this morning.
thank you
Will you comment a little further on deflation, disinflation and inflation? With gold on a slide, the euro approaching parity, world deleveraging, and the US consumer only shopping the "blue light specials" - seems that the economic climate is vastly more complicated than ever before and deflation may be taking hold. Thoughts?
Paul, that makes for a good blog post (for tomorrow).
Thanks Paul
Glad I can provide fodder!
Paul said:...seems the economic climate is vastly more complicated than ever before...
Roger, can you add some historical such as oil embargoes, the U.S. going off the gold standard, a president resigning in disgrace, a V.P. indicted and thrown out of office and on the bright side, a 15 trillion dollar GDP in an economy that has been growing ever so slightly for the past 22 months. Hysteria is one thing but IMHO, things are not nearly as bad as some other periods.
Excellent risk management article Roger. Asset correlations are definitly in flux, but mostly becoming more positive. This is making diversification harder to achieve. Some of the increasd correlation can be attributed to the Risk ON, Risk OFF Trade. I have writtin an article titled "What is the Risk On, Risk Off Trade and How Has it Affected Asset Correlation" for anyone interested at:
http://blog.arborinvestmentplanner.com/2011/11/what-is-the-risk-on-risk-off-trade-and-how has-it-affected-asset-correlation
Complicated doesn't necessarily mean "bad" - just more moving parts.
I don't feel like looking up the exact numbers, but don't the rolling 1-year correlations between stocks and bonds range between -0.7 and +0.7? I would see nothing unusual with both going down at the same time.
Rich
Roger. A few thoughts (my concerns) that you may wish to consider in your post for tomorrow: probably in the middle innings (baseball analogy) of resolution of the worst financial crisis since the Great Depression (you have said this before), industrial countries' governments have routinely spent more than they collected in taxes since the 1960s and now have massive public debts to at least service if not pay off (heaven help us if/when interest rates increase to normal levels), taxes must rise, government services must decrease, standards of living--meaning discretionary money left over after paying for essentials and taxes--may (probably will) fall, inflation (hidden tax) may be a/the resolution, increased productivity may help. Thanks, I look forward to your post.
Rich, you are correct but I don't think people remember that correlations change and I think that if we do have a period of stocks and bond prices both going down it will catch a lot of people positioned incorrectly.
Anon 9:48, I think you are pointing out the lack of political will to do the obvious. I've referred to this as something having to give, or as you point out a couple of things having to give. Tough decisions mean lost elections (I think) and so until that changes I don't know how the tough decisions will be made which makes for a rougher and forced resolution that negatively impacts more people than had the govt done the right thing.
Hi Roger,
Long Term bonds are going to move depending on interest rates, not what stocks are doing. So I think there is not much of a reason to worry about asset class correlations. Only the interest rates matter.
I actually disagree with the idea of asset class correlations strongly and feel that economic environment is the best predictor of asset movements. I wrote up a blog post explaining my thoughts here:
http://crawlingroad.com/blog/2011/06/13/asset-class-correlations-its-all-bunk/
i tend not to believe that valuations are much of a predictor of anything. knowing something is cheap does not mean it has to go up. of course there are arguments that the market is not now cheap.
I see it similarly to craigr.
I think it is very important to consider the difference between causation and correlation. Stock prices going down does not cause bond prices to go up.
The causation occurs at the macro-economic level. Macro-economics conditions are the causations driving the correlations that we see in asset prices.
When the worry is primarily around deflationary forces, then stocks and long-bonds will generally exhibit negative correlation.
However, if the worry is about inflationary pressures then they generally have a positive correlation.
The asset classes don't have a defined relationship with each other, but instead a relationship with the underlying economy.
From this conceptual framework, it is very hard to imagine a disaster scenario for the PP. What underlying economic condition would drive stocks and bonds to both be dropping for an extended period of time? I would imagine inflation. Which is why the PP holds gold.
The price of gold rises with fear, declines with stability. Recent levels of fear have been high. In ten years time fear might be low and the price of gold could have declined a lot from present levels.
Buy a 2.8% yield 30 year treasury now and in ten years time a 20 year treasury might be priced to a 5% yield and have declined -28% in price, wiping out all of the income.
With gold and long dated treasury's perhaps not even providing positive nominal gains, let alone real gains, and pre-tax cash barely pacing inflation, and stocks beating inflation by perhaps 7%, a Permanent Portfolio in total might just barely pace inflation, let alone have grown in real terms - whilst stock investors might have seen their money double in real terms.
The PP has performed well and pulled relatively ahead, accumulating followers in the process. There's no guarantee that that trend will continue. If anything the good fortunes (and number of followers) could see a reversal of trend over the next decade.
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