Tag: Economy

Diversification: A look at Ray Dalio’s All Weather Portfolio and the place for fixed income in the portfolio

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.

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
  • 30% stocks
  • 7.5% gold
  • 7.5% commodities

“The principles behind All Weather 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?”

The results are pretty surprising. Dalio says he’s back-tested the portfolio from the great depression, to the Weimar Republic when hyperinflation set into Germany. If you choose not to read Principles, then I implore you to read the white paper on Bridgewater’s website on the background of the strategy.

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”

PV All WeatherPV ALl Weather Chart

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.

Monte Carlo assumptions

Monte Carlo

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.

-DD

How to invest when inflation picks up

I recently got back from an industry conference and my main takeaway was that 2018 could be the year of inflation. What does that mean and how should we position our portfolios?

To start, why do I think inflation will be ticking up this year? Anecdotally, I’ve heard from many employers from this conference that wages are up 20% year-over-year. That is significant! Recall, that wage growth has been one area stuck in low gear since the crisis, even as employment levels have recovered. As wages increase, firms costs increase and also increases consumers’ income to spend more, which helps inflation.

Turning to actual economics, demand-pull inflation occurs when aggregate demand grows fast than supply. When the economy is at near-full levels of employment, as we are now, that leads to increases in price levels. Why do I think demand will exceed supply? For one, consumer confidence averaged ~97 for all of 2017. That is the highest level since 2000, and according to University of Michigan’s economist, Richard Curtin, “only during the long expansions of the 1960’s and 1990’s was confidence significantly higher.” Plus, the stock market is up and setting new records, home prices are up, and while these do not cause inflation, it causes a positive wealth-effect that encourages the consumer to spend more and can buoy economic growth. In other words, these are indirect causes of demand-pull inflation.

I also tend to think cost-push inflation will also occur in 2018. Take oil and its derivatives for example. While not back above peaks, as we sit with it hovering around $60/barrel, that is well above the average levels of 2015 and 2016. Similar to wages, higher costs of other inputs rising leads to higher prices.

There are a few offsets to these inflationary forces, however. The fed is raising interest rates. Higher rates in the US should drive up the value of the dollar, all things being equal. Higher interest rates attract higher foreign investment, which causes the value of the currency to rise, in this case the dollar. This makes US good less competitive on a global scale. On the flip side however, higher inflation in the US relative to other countries will cause depreciation in the USD relative to those with lower inflation. Therefore, the impact of higher interest rates is mitigated by the fact that the US has higher interest rates than some countries, such as Japan or countries in the Eurozone which are combating deflation. The US also has a pretty bad current-account deficit (that is when a country spends more on foreign goods than domestically produced ones). We likely will continue to spend more on foreign trade than we earn, which will decrease the value of the dollar.

In addition, firms in the US will be able to fully expense capex for tax purposes, instead of the depreciation expense for tax deductions. Firms could invest in automation, crowding out labor and keeping wages down. In essence, we shouldn’t underestimate the deflationary impact technology can have. However, I tend to think this will take time.

But if I had to bet, I think inflation will tick up, which will cause interest rates to rise.

So where should I position my portfolio? Let’s start where I do not want to be. If interest rates finally due rise, the one place I do not want to be is low coupon, higher duration bonds and bond proxies (i.e. stocks that are highly correlated to bonds, like utilities and REITs).

I also do not want to be in stocks that have a long tail. For example, some biotech stocks valuations are through the roof based on the expectation in 3-5 years they will come out with a blockbuster drug. As the discount rate increases, these stocks will get crushed considering their earnings are further out. Tesla is another example of this…

On that note, we should consider that the discount rate for all stocks will be increasing. That could hurt the valuations of a lot of names as the S&P grinds higher (e.g. the S&P historically traded at 15x EPS, but now trades at 18x. Could there be a reversion to the mean?).

Where would I invest in these times? I am tilting my portfolio towards commodities. Although they have had a big run in 2017, we are still well below levels seen in 2011 and 2012 for commodities. If inflation ticks up, these have room to run and can serve as a hedge to my equity holdings. Refer to the chart below to see where we sit in the commodities world compared to recent history (chart depicted is the Bloomberg Commodities Index, which is made up of energy, grain, metals, etc.) Full disclosure, I own XLE, the energy ETF, MOO, the agribusiness ETF, and am considering BCX, Blackrock’s resources and commodities closed end fund, which trades at a ~7% discount to NAV and yields 6%.

BBG Commodities Index

Second, a tertiary bet on commodities is countries that benefit from rising commodities. I am also adding to my position with exposure to Brazil. Brazil is still coming out of one of the worst recessions it has seen in a long time in addition to a crack down on corruption. As commodities recover, labor improves and consumer confidence builds following the corruption scandals, Brazil could have a multi-year run ahead of it. I purchased both EWZ as well as BRF, which tilts to small cap, consumer stocks in Brazil as a leveraged bet.

Lastly, while I am avoiding REITs since I believe investors who have been starved for yield have driven up valuations, I do like the building products sector. Real estate tends to perform well in period of inflation, supply remains constrained, and we are still below average housing starts since the last recession. Even if interest rates rose 100-200bps, affordability is also at great levels. As such, I think building products is the sector to be in for the US.

US housing Starts

-DD