I’ve finally had enough of the headlines, anecdotes, “anec-data.” Everyone thinks COVID is driving people crazy and ditching their city for the outskirts. I hear over and over that this is a new trend we need to watch.
Look, I’m not defending New York City. It is losing share of population. I’m pointing out a terrible narrative biasproblem. Narrative bias refers to people’s tendency to interpret information as being part of a larger story or pattern, regardless of whether the facts actually support the full narrative. In this case, COVID killed New York, or San Fran, or the office building, etc.
No. As they say, the 2010-2020 timeframe will mark the fifth consecutive decade in which population growth for the most dense states at that time ranked as the weakest quintile.
Where were these Miami headlines before when CT, NJ and NY were losing population share?
There are three other points I’ll make:
Talk to me when all of the allure of the major cities is able to turn back on, not when when it is closed.Similar to seeing E-commerce sales boost in Q2, we have to remember the alternative (brick and mortar) was largely shut down.Similarly, nearly all the benefits of a city have been taken away – colloboration in person at work, grabbing beers at 5pm on a Friday with everyone, going to the bars and great restaurants in general. Its no wonder to me that NYC is being cast out (with its current, stricter rules) in favor of Miami (which anecdotally seems like its operating back-to-normal).
Second, millennials. Millennials are finally aging into marriage and children age (the eldest millennials are nearing 40, while the youngest are mid-twenties). Households will be getting larger soon. No more living in the basement with mom and dad that was all the rage post financial crisis. Millennials now have enough savings to buy a home vs. the condo (especially with the drop in interest rates).
Therefore, it surprises me not at all that there is a boost in suburban sales.
Lastly, people have been congregating for thousands of years. In my sociology class in college, I learned the theory that if something has persisted for thousands of years in society, it probably has a purpose. I think humans will continue to congregate in cities, maybe just not the Northeastern or Western ones that have high taxes.
“But DD – we now have video conferencing! No need to go into the office!” We’ve had video conferencing for at least a decade. Everything thinks it works much better now. Maybe it does. But I think it works the best now because everyone is using it. Once half the team goes back into the office (including the Boss), people will start to not like it again. “Bill – you are on mute” isn’t as forgivable when everyone is in person except for you.
“Past performance is not indicative of future results” you say as you read this post. But it can be a tool for analyzing what asset allocation performed the best.
The markets are particularly tough to apply history to, though, because of the wide amount of factors involved. Interest rates, valuations, and broad based sentiment are very hard to control for. Imagine looking at the performance of the market in 1938, but not factoring some how for investor sentiment in a world about to enter WWII.
However, to think we can’t learn anything from studying history is non-sense.
Today, I’ll be taking a look at what performed best over recent cycles in the equity market and walking through some of the take-aways I have. Feel free to share your results as well in the comments! I’ll be using http://www.portfoliovisualizer.com which has some great tools.
My father is currently entering retirement and asked for some advice on how to manage his portfolio. As a retiree, he needs growth, but also needs to weather the downturns a bit better than the normal investor.
As such, I thought I’d take a look and see, “What asset allocation of sectors performed best over the past 2-3 business cycles?”
This brings up the concept that I call, “Win by not losing“. Let me explain. A lot of people enter the market thinking that they need to buy high growth stocks and want to ride the tidal wave in order to get rich. And quick.
But as we saw from the tech bubble, that can quickly go against you. While you may make a lot of money early on, if your portfolio declines by 50%, you need to go up 100% to be back to breakeven after that.
I don’t believe in timing the markets, but I do believe a good asset allocation can help performance in a variety of markets.
Alright, let’s head over to portfolio visualizer and I am going to go to their portfolio optimization section. Here, we can backtest how different allocations of sectors would have performed over different time periods. The great thing about this tool is we can also select what we want to optimize the asset allocation by.
We need to select funds that capture each sector of the market. Unfortunately, ETFs haven’t actually been mainstream for that long, so funding sector ETFs that go back to 1985 is impossible. I can go back to 1999 though by selecting these funds:
XLV – Healthcare
XLF – Financials
XLE – Energy
XLU – Utilities
XLB – Materials
XLI – Industrials
XLY – Consumer Discretionary
XLP – Consumer Staples
QQQ – Tech
FREEZ – Real estate (no ETFs went back this far, so am using a fund)
FSTCX – Telecom (No ETFs with enough history. IYZ goes back to June 2000)
SGGDX – Gold (again, not ETFs)
This gets us enough history to go back to January 1999. That’s important because we can capture the end of the tech bubble, the early 2000’s recession, the recovery over the mid-2000s, the boom up until 2007, the great financial crisis, and the bull market since then (while also capturing all the wobbles in between including the european debt crisis fears, the interest rate fears, the commodity collapse, and so on). Would I like more history? Of course, but this will make do.
I will first equal weight all 12 of these funds (e.g. 8.33% each) and seek to find the “maximum return with the minimum volatility”. I will set the maximum volatility at 15% also make it so each fund is a minimum of 2.5% and a maximum of 25% (except gold, I will cap at 15% for practical purposes).
Realistically, we need a parameter like this because we can’t know if energy for example is going to tank in 2015/2016 after being super stable from 2011-2014. Housing during the 2000s too is another example. As such, we have to allow for some diversification.
I am not including global ex-US funds, but you can if you’d like. I may do this as a follow up post.
January 1999 – January 2019
Alright, in your mind, how do you think this asset allocation will perform against the S&P 500? For context, here is the current breakdown of sectors:
How does our equal-weight asset allocation stand a chance without the massive secular growth story of tech?
Well, lets take a look:
Wow… the equal weight portfolio crushed the S&P… Investing $10k in the S&P500 would have turned into $30k, but the equal weight was nearly $45k. But the red line crushed both. It ended with $54k in value.
What in the world did it allocate to?? I have to admit, I would not have guessed this:
Real Estate – 25%
Consumer Discretionary – 25%
Tech – 15%
Gold – 15%
Everything else – 2.5%
When looking at the annual returns for each asset class it starts to make sense. When tech was taking a beating in 2000 and down 36%, real estate was up 30%, so early on this diversifying factor helped. In 2008, people jumped to buy gold in panic, which also helped. I am a bit surprised the healthcare, staples and utilities were not weighted hire for their defensiveness qualities.
Let’s change the time series.
January 2005 – January 2019
Why this time frame? Because it feels relevant. The fed is raising rates (as it was then) and it is closer to being late in the cycle than being in the early part of the cycle (as it was then, thanks to my hindsight vision).
Again, I just want you to try to guess what would have outperformed against our equal weight portfolio. Spoiler alert: it crushed us.
The equal weight performed on par with the S&P, but the weightings of this portfolio really separated from the pack in around 2014 or so.
Ah, now it makes sense. Tech comes into the fold and starts crushing the rest of the market. An overweight in this sector definitely added to the out-performance of late (FANG).
I also think this might be impacting consumer discretionary to a certain degree given Amazon’s weighting in that index (it currently sits at ~21% of the XLY index weighting!). Healthcare performed well in 2008 and then experienced strong growth since then.
Here’s an interesting question… How would our top picks from the last backtesting performed in this back testing? Well, when you take out the performance of real estate early on from the year 2000, it puts it on track with the S&P500 (though it did perform well early on in the cycle).
Let’s take the gloves off. Allow me now to show the results of an asset allocation that may surprise you, but will hopefully tie things together. I want to allocate my portfolio in a way that I “win by not losing”. Here’s my allocation selection:
25.0% Consumer Staples
2.5% Everything Else
This is called “Portfolio 1” in the chart below and “Portfolio 2” is an equal weight of the sectors. I’ve selected re-balancing annually to keep the weights in check.
Over a long period of time, this crushes the S&P, which we’ll look at. It doesn’t seem to make much difference vs. an equal weight tough.
One stark difference though is that portfolio 1’s worst year was much better than the other two. So portfolio 1’s asset allocation protects from the downside.
So let’s look how this performed starting from 2005 instead of 1999.
Here the performance difference is much more stark and you can start to visually see why. Take a look back at the most recent sell off in Q4’2018. Portfolio 1 barely ticked down while the equal weighted and S&P500 suffered greater losses.
Last but not least, lets say again you think we are late in the cycle, but want to stay invested to meet certain fiscal goals. The analogue here is 2005 – late in the cycle and a recession looming a couple years out. Let’s see how stark the performance is up close, from beginning of 2005 to the end of 2012.
This is the most important slide to me. To me, it highlights that someone who played good defense ended up recouping their losses in the crises much faster than the S&P500 (which still did not make it back to its high watermark over this period).
Obviously, some of these sectors such as Utilities and Consumer Staples have benefited from lower interest rates over the past 30 years and its something to consider for asset allocation going forward. However, in a year when rates moved up considerably, these sectors still provided cover in 2018 (outperforming the S&P’s year by 110bps and suffering only a 7% drawdown compared to the 13.5% drawdown from Oct to December 2018 suffered by the S&P.
I’m going to end with a cliche and say sometimes, the tortoise (consumer staples) beats the hare (insert the “it” growth sector here). And maybe asset allocation should be set up that way too.
But coming back to the topic at hand – no one can predict interest rates, especially long-term rates. The former Fed Chief, Ben Bernanke recently said in late 2015 that he admittedly didn’t expect rates to remain this low for this long and followed that perhaps lower rates are here to stay:
“Certainly there has been a long-term downward trend in longer-term interest rates and every indication is that the equilibrium interest rate —the rate that ultimately will be consistent with stable growth — is lower than it has been in the past. So that’s clear. I expect the Fed will be very cautious and gradual, that’s what they’ve told us many times, and they’ll be looking for evidence that the economy has been able to accommodate the higher rate increases and still continue to grow.”
It is important to remember that demographics change.
People in the US are living longer and population growth is slowing. This puts a downward pressure on interest rates. The former causes pressure since people live longer = people need to save more and this may have a ripple effect (e.g. pensions need to adjust for longer life times than the past).
In addition, as people still retire in the 60-65 age range, but need their capital to be stable for retirement, they buy more bonds. Demand is greater than supply.
Low population growth also means slower GDP growth which pushes interest rates down.
Are we anchoring to high interest rates?
Look back at the interest rate in the 1960s. This followed WWII’s boost to America, creating a powerhouse economy, and encompasses most of the baby boomers being born (this ranges from early-to-mid 1940s and ends in early 1960s). From 1960-1965, the US GDP growth rate was anywhere from 5.5% to 10.7%, much higher than the 2% growth we target today. and yet, where was the rate on the 10 year treasury??
It was between 4.0%-4.5%.
Sure, that’d be nice to have if you want to put cash away in a safe place and earn 100-150bps more than what you get today, but the times were different then.
Ok, now that I can get off my soapbox and hopefully help you think somewhat differently about interest rates, I want to turn to the argument of why someone who chooses to invest in bonds is really adding a ballast to the portfolio.
While it’s tough to swallow a security that is guaranteed to only return ~3% p.a. if you hold it to maturity, I think it’s helpful to realize that you want something in your portfolio that will zig while everything else zags.
That is to say, when you invest in bonds, don’t look at just the coupon on bonds and think that is the only return you can get. If we hit a recession or there is fear in the market, these safer bonds will likely move up, while the equity market goes down. Indeed, since the Fed’s main tool here is to tighten rates in order to stimulate an economy going through a recession that is what we saw in 2008.
However, the counter argument that “interest rates may not help you in the next down turn because they are already low” is equally weak. At the end of 2013, the 10 yr treasury sat at 3.0%. It then went to 1.38% in the beginning of 2016. If one had chosen to invest in bonds at that time, it would have paid off.
For context on that, lets run through a case where you invest in bonds at the end of 2013: you buy the 10 year and sold it 2.5 years later when rates actually tightened. After 2.5 years, you have a 7.5 yr bond now with 3% coupon. The rate for 7 yr bonds at that time after some tightening was then 1.2% in 2016, which means your bond would’ve traded up to ~113 to match current on-the run rates.
Even though you bought a 3% 10 yr bond, it went up as people flocked to securities that are safe havens and that investment would’ve provided a ~8% IRR if you then sold it. Not too bad!
Comparison of Different Portfolios I’d like to show you a few scenarios. First, the results of a portfolio invested 100% in US stocks late in a cycle where a bubble bursts (tech bubble) compared to one that is 80 / 20 stocks to bonds as well as one with some allocation to gold to show the impact of non-correlated assets. I will also show this for 2008. This comes to an interesting tool I’ve been utilizing at www.portfoliovisualizer.com. I know I’ll get this comment, but obviously past results are not a predictor of the future, but do think it helps at what may happen in the future.
The first results show what the value would be if you invested $10,000 in 1998 and rebalanced semi-annually.
Portfolio 1 = 80% US stocks, 20% 10-year treasury
Portfolio 2 = 60% US stocks, 20% 10-year treasury, and 20% Gold
Portfolio 3 = 100% US stocks
As you can see, portfolio 1 & 2 performed better over this time frame. Interestingly, portfolio 2 performed the best with its allocation to gold. It worst year was only a 5.7% drop as well, compared to 21% drop for Portfolio 3. Portfolio 1 & 2 underperform in bull markets, which might be obvious, but helped outperform during the bear.
Let’s again look at the 3 portfolios with a starting point of 2004 and ending in 2012. Again, portfolio 2 outperforms the all US stock portfolio as does portfolio 1. Portfolio 2 this time outperforms by a much wider margin since gold is seen as a hedge against extreme scenarios, like the one we saw in 2008. Remember from 2004-2006, the Fed was also raising rates.
I am a total Buffett follower and understand the difficulty buying gold since it is an asset that produces no cash flows. But from a portfolio perspective, I understand the rationale for buying. If your gold assets go up in a time like 2008, that gives you flexibility to sell it and buy stocks at very attractive valuations, which is flexibility I find valuable (though admittedly, I currently have no allocation to gold in my personal accounts). Also, you should watch this video I find humorous on Bernanke’s view on gold vs. Ron Paul.
At the same time, I also realize that a 30 year bond today that will fall 17% if rates go up by 1% may not be attractive despite the upside if rates tighten. The point of this analysis is to say that having a moratorium on bonds may not be the best idea either.
Bottom line: Do I think one should invest in bonds and even gold?Yes. Do I think they will return less than stocks over the next 10-20 years? Also yes. But the flexibility these asset classes may provide this late in the cycle may be attractive (much like insurance). You also have the option to buy corporate bonds which offer slightly higher yield than treasuries, but are still safe havens in times of distress.
I wanted to take some time to discuss 3 things when investing in Emerging Markets that are not widely discussed. The impetus for this article was driven by my blog post titled, “How to invest when inflation picks up“, in which I said that because I was bullish on commodity prices, I was going long Brazil.
Brazil has a very commodity driven economy (oil, metals & mining, agriculture) and my view was that a rebound in commodity prices would result in Brazil’s economy improving and its stock market should improve as well.
That call has not come to fruition yet, as shown by the Brazil ETF EWZ being down 21% since that call. And here are 3 lessons I think are important when investing in emerging markets, of which the first will relate to why my call on Brazil has been wrong so far.
1. Changes in currency can have a big impact on results
I would say a central reason why my call on Brazil has been wrong is because of currency.
What this has meant for my dollar investment is also depreciation…
Let’s use an example to see why: say a stock in Brazil was trading for 100 BRL when the USD/BRL rate was at 3.00. I place an $10,000 order, exchaning my dollars for 30,000 BRL and buy 300 shares. In local currency terms, lets say the stock goes up 10%, such that the quoted price is 110 BRL. I should have made $1,000 bucks on my investment, right?
Nope. If the BRL depreciated like it did in the chart above from 3.00 to 3.85, I’d be sitting on a pretty poor return actually, as shown below.
Alas, this would mean even though I was right on stock selection, the currency movements negatively impacted my returns. This is partially why with all the global currency volatility, currency hedged ETFs are launching all over.
When in investing in emerging markets, currency will be key.
Do I advocate for currency hedges? Sometimes. It depends on the time-horizon. A long term investor may look at the levels of the BRL to the USD and see this as a buying opportunity and therefore, you can be right on stock selection AND the currency may be in your favor which would boost returns.
However, I don’t think anyway can really tell me where a currency will be in 10 years, so I won’t opine on that. What I will say is that our return thresholds should be much higher when investing in Brazil than lets say the US or another developed economy like Germany.
I don’t know what the currency will do over the next 2-3 years, but what I do know is that the real will depreciate over time relative to the dollar. No one questions that the inflation rate in Brazil will be higher than the US over the long run and that should mean that over time, the real should depreciate relative to the USD.
In sum, you have to be aware of currency, especially volatile ones. You’re taking a risk, so we should get paid for that.
2. Just because you’re buying a company’s stock, it does not mean you are afforded the same protections as the US.
Alibaba’s stock is up 25% in the past year and has roughly doubled since IPO’ing in 2014.
But did you know that if you hold BABA which trades on the NYSE, you actually don’t own Alibaba at all?
China forbids foreign investors from owning certain types of companies. As such, you aren’t really buying Alibaba. You are buying a holding company that has a claim on Chinese subsidiaries profits, but no economic interest. The risk here is that China comes in and says that is not allowed and guess what? You own nothing.
The New York Times reported on how China has not actually weighed in on this. You may also want to check out the risk factors of Alibaba’s 10-k entitled, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations”.
I don’t mean to pick on BABA here (Tencent, Baidu, JD.com each have this problem as well), but the risk here might be higher than you think. Lots of people would say, “look China is relaxing its command economy and moving more to a free market. They wouldn’t do something like that.”
Rule of law is paramount in the US, but often forgotten when investing in Emerging Markets because people just look at the low P/E ratios.
And to that I say, look at Russia. In the 1990’s, following the “end” of the Cold War, Russia issued privatization vouchers that allowed investors to actually own former State Owned Enterprises. This was a huge step for Russia and it seemed like the old communist power would be relaxing its grip on businesses. But I encourage you to study what happened when Russia deemed it needed to re-control “strategic sectors”. Yuko Oil Company is a fascinating case study.
In a very brief summary, Yuko went to the private markets and quickly adopted transparent rules and practices, became one of the world’s largest non-state owned oil companies, and even had 5 Americans on its board. The company was paying dividends and growing internationally as well.
When Putin came to power, things quickly changed. The CEO of Yukos was arrested for tax evasion and fraud and Yukos was slapped with a $27 billion fine which was higher than its total revenues for the past 2 years. Yukos was forced to break up and its shares were frozen (to prevent a foreign company like Exxon from buying them). Eventually, Yukos declared bankruptcy. Many viewed this as a direct attack on the CEO of Yukos who was gaining political power.
In sum, I think its important to remember these risk factors and not get too comfortable in international / emerging markets that are known to have limited privileges to foreign investors.
3. Active management makes sense in Emerging Markets
So much has been written on active vs. passive investing in the US, it is actually making me nauseous. But I think this is a good topic to end on for this post, because it sums up the previous points here.
An active manager can weigh the impact of currency on a potential investment. They can weigh the political changes that are happening in the base of a country. And lastly, they are paid to do work on changes in the tastes of the economy.
One area of research I always try to look for is primary work. That is, if I buy the stock of a company, particularly one oriented to consumers, I want to conduct surveys on what its consumer say about the actual product and understand if that helps or hurts the investment decision in any way.
It’s also important to remember that sometimes we take for granted the tidal shift occurring in the U.S. such as Amazon, Netflix, or Apple because we interact with those products and see them on TV everyday. But how can you tell what type of products they are using in India or China without being there? Did you know Netflix and Apple are not the primary sources of products in those countries? They have their own.
Tastes change and they change quickly, so in my view, unless you’re traveling to the country often, you are paying an active manager to do that work. Indexes are backward looking (i.e. they weight the companies that have performed the best in the past at the top in a market cap weighted index), so they do not always calculate the risks mentioned herein. Sometimes they don’t include the entire universe, which can limit returns or at least potential for higher returns.
And as a result, we can see in the chart below that it pays to pay the higher management fee for active. This chart (taken from AllianceBernstein) shows that “70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50%”.
Hope this was helpful for investing in Emerging Markets.
After reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point. Ray Dalio’s All Weather portfolio is something to consider.
Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?
Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters.
Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.
40% long-term bonds
15% intermediate-term bonds
“The principles behind All Weather Portfolio relate to answering a deceptively straight-forward question explored by Ray with co-Chief Investment Officer Bob Prince and other early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something completely different?”
Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.
The first is based on Dalio’s All Weather Portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.
Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.
But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”
This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,
“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”
For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.
Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.
I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.
I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.