Our last few articles (here and here) dealt with the Permanent Portfolio, a widely embraced static asset allocation concept proposed by Harry Browne in 1982. To review, the simple Permanent Portfolio consists of equal weight allocations to cash (T-bills), Treasuries, stocks and gold to ward against the four major financial states of the world:
Japan as a Deflationary Case Study
The Permanent Portfolio Turns Japanese
Chart 8. Simple Permanent Portfolio Japan, Risk Parity, 7% target volatility, 1992 – 2012
The potential problem, as we see it, with any static asset allocation, including the permanent portfolio’s permanent equal weight allocations to stocks, bonds, gold and cash, is that sometimes everything is expensive all at once, and returns to all asset classes have the potential to be low or negative in tandem. The current environment may represent one of these periods, where certainly bonds and cash are more expensive than they have ever been, with yields on Treasuries lower than at any other time in the last 220 years (source: Bank of America). Cash yields essentially zero. We think stocks are expensive as well (see here and here), and gold is at best a wildcard, having rallied by 500% or more from its lows in 2001.
If we are right, and the permanent portfolio is vulnerable to synchronized losses, then it makes sense to explore some tactical or dynamic overlays to help avoid investing in asset classes in sustained downtrends.
Mebane Faber is credited with bringing moving averages to the masses with his Quantitative Approach to Tactical Asset Allocation whitepaper in 2005. In it, he describes an approach that applies a 10-month moving average to basket of 5 asset classes: stocks, Treasuries, commodities, REITs and international stocks. While there is nothing magical about the 10-month moving average, this approach is ubiquitously cited elsewhere, and in our testing we observed no material difference with other moving averages. The following simulations apply monthly rebalancing.
Chart 9. Simple Permanent Portfolio Japan, 10-Month MA, 1992 – 2012
The Japanese experience has clearly been very different from the U.S. experience over the past 20 years, as Japan has endured a persistent period of deflationary stagnation while the U.S. has so far experienced growth of both the deflationary and inflationary variety. This has had a profound impact on Japanese stocks and bonds, as well as the yen, which in turn impacted returns to Japanese investors from foreign assets like gold.That said, the traditionally implemented Permanent Portfolio would have served Japanese investors much better than stocks on their own, or even a balanced stock/bond portfolio over the past 20 years, with double the Sharpe ratio, higher returns, and much lower drawdowns.
Consistent with our findings in the U.S., techniques that manage the volatility of the individual portfolio holdings and/or target a total portfolio volatility delivered similar or better returns, and for the most part much lower drawdowns. The Risk Parity and Tactical approach with target volatility delivered the highest, most consistent returns with the lowest drawdowns.
Overall, passive Japanese investors were better served by the Permanent Portfolio than other traditional asset allocation models over the past 20 years, but even the best tactical and risk management overlays could only produce returns of about 5% per year. U.S. and other international investors might wish to consider this potential outcome in the context of retirement or institutional funding needs.