Positioning a Portfolio for a Lousy Economic Environment

Many people have asked me what to do in this market environment, and I have sat and thought about it. My own personal portfolio is around 60% equities, 15% my home, and 25% cash.

I think probabilistically. I don’t focus on just one scenario. I try to balance across a wide number of scenarios, and ask what will do the best. In a foggy situation like today, that answer is not easy.

I will give you an example. 8.5 years ago, the leaders of my church came to me and said “Would you invest the money for our congregation’s building fund?” My initial answer was “no.” I don’t like investing money for friends, generally. They came back again, and said, “Please?” I felt ashamed, and said, “Okay, fill out this risk questionnaire.” They gave me a series of answers that essentially said, “We don’t know when we need the money, but get a good return for us.”

Ugh. In May of 2000 went back to Ben Graham’s 50/50 (stocks/bonds), and then adjusted it, taking 10% from the area of the market that I liked worst, and added it to the area I liked best. I took growth stocks and sold them and bought long term corporate bonds.

Since then I have made further adjustments. The current portfolio is:

• 5% Energy stocks [VGENX]
• 5% Gold stocks [VGPMX]
• 25% International stocks [VINEX]
• 25% TIPS [VIPSX]
• 20% Intermediate Investment Grade Corporates [VFICX]
• 20% High Yield [VWEHX]

Much as I like Vanguard, I am not endorsing any of their funds here; they are an example for asset allocation. I am very light on US stocks here, and intentionally so. This portfolio has an anti-inflation bias, and will do better against a weaker dollar. The corporate bonds, both investment grade and high yield, replace equity exposure. Corporates are cheap relative to common stocks, and they have better protective characteristics as well. Though I don’t have any closed-end corporate floating rate funds here, they could be interesting if their leverage was low enough, which isn’t common. As for the international developed market stocks, a basket of different countries will likely do better than a simple US exposure, even if the dollar continues to fall.

TIPS has been a fatal attraction for me, and I hope to have a post out in the near term explaining their value in this environment where inflation is negative for now. My view is that the Fed will eventually monetize the debts they are incurring. Also, as the dollar gets weaker, inflation will get imported back into the US.

What could go wrong here? We could have a trade war, or the US government could take actions to protect the value of debt held by foreigners (not likely). If the equity markets rally, investment grade corporates and high yield will not be far behind, but this portfolio would lag.

No portfolio is perfect. This one certainly isn’t, but it is my attempt to position for what I view as a lousy economic environment that will eventually yield inflation.

Full disclosure: long VIPSX, and my church long what is listed above.

Comments

[OldLimey:]

Whilst many writers post well-argued articles on SA, it's relatively unusual for somebody to detail precisely how they have structured a portfolio to reflect their views and uncertainties. Thanks for an interesting and open piece.

2008 Dec 18 10:10 AM

[anarchist:]

ditto to what OldLimey said but my answer is to sell put options of stocks I wouldn't mind owning that have a dividend and at a strike price near or below their 52 week low (MCD @ 52.5is an example). I actually got that idea here on SA from someone but a person could have a pretty good income steam and worst case scenario own some great stocks at a hell of a discount.

2008 Dec 18 10:51 AM

[Hedged In:]

Excellent article -- typical of David Merkel.

2008 Dec 18 04:52 PM

[auto credit:]

David, you said your portfolio is 15% your home... i always struggle with how to account for the value of my home (and rental real estate) in my portfollio... for allocation purposes with real estate, do you think in terms of total asset value or equity?

2008 Dec 18 06:14 PM

[Obama is Bu...:]

David -- when you talk about TIPs, could you please discuss the following:

1) Why you think CPI will accurately reflect cost of living increases. Many people have written detailed articles of why CPI is a flawed measure of inflation. I have heard all the arguments that the money supply is collapsing and therefor these "experts" claim we are facing deflation right now. My grocery bill, health care costs, education expenses all say otherwise. Health and education have been increasing **at least** double the rate of CPI for two decades.

2) you talked in an earlier article about incentive problems. Well, the government's liabilities (TIPs, government employee wages and Social Security) all hinge on CPI, directly or indirectly. The government gets to define, and redefine, CPI at will -- and they have already major revisions during the Clinton administration (the Boskin Commission) and minor revisions during other administrations... Why would you buy a floating rate bond that pays off an index that is set by the debtor? This is a textbook case of conflict of interest

3) the implied par value "put" that is built into TIPs gives something of a floor on the CPI cashflow stream-- so this might make TIPs a good **trading** vehicle over the next year or two... but given that most people are not good at market timing, how do we know when to swtich out of TIPs?

4) please mention the tax problems of TIPs:
4a) if you buy them directly (not an issue if bought via a mutual fund). the TIP owner pays tax on the CPI "distribution", even though the cash payment is not made until maturity.
4b) taxes are assessed on the **entire** interest. You pay taxes on the CPI "payments" -- meaning that even if CPI were an accurate measure of the cost of living, you are not protecting purchasing power over time


It seems to me that most people would be better off avoiding TIPs, which are really nothing more than a floating rate Treasury bond that pay off a questionable index. If you don't like nominal Treasuries, than you shouldn't like TIPs either

2008 Dec 20 10:55 PM