What is the Value in a Non-Equity Portfolio?

In David Swensen's appearance on the Connie Mack show, Swensen talked about diversification and the high regard he has for TIPS. I started thinking about the debate over whether we may or may not have big inflation or serious deflation, whether equities are dead and all of that. I thought it might be worthwhile to explore a the notion of a non-equity portfolio.

It should be no surprise than many people are in the process of giving up on equities. As Eddy Elfenbein mentioned, equities are down 39% decade-to-date so it is reasonable to ask a few questions.

If you are going to give up on equities you still have to address the potential loss of purchasing power. If deflation wins out over the next few years, ok, but at some point inflation will matter again. At a 3% inflation rate our expenses will go up 50% in 15 years and if some inflationistas turn out to be correct 3% inflation will fall short of reality.

Avoiding the stock market can't mean all cash. The obvious answer might be all TIPS. Well maybe, but the idea of 100% in any single type of thing no matter how "safe", seems straight up crazy to me. I'm not likely to be the guy to see the complete breakdown of how TIPS function ahead of time but anyone can avoid having a complete breakdown wipe them out by not going 100%.

Obviously part of the inflation story would be the dollar getting weaker against other currencies. This makes a lot of sense but just as it seems obvious, what might the US dollar do in the face of some sort of geopolitical event? Just because the US seems willing to let the dollar devalue does not mean that five years from now there can't be some sort of big dollar rally, like in 2008, even if it is counter trend. So putting everything into a basket of foreign currencies (either just the forex or via t-bills) is not something I would do either.

Commodities will very likely be a big part of protection against eroding purchasing power. If you read enough articles you will find recommendations for 20% or even more in commodities. I have what I think of as a lot of exposure to commodities and that is in the low to mid single digits (which is very low to some folks). If someone can stomach the volatility of 20% in commodities why not just have some equity exposure? While its is true that commodities cannot go to zero, the plight of crude oil over the last year shows us they can go down 70%.

Some combination of all of the above and (with a nod to Jim Rogers and Marc Faber) a little farmland will allow for sidestepping some of the vagaries of equity markets like bad earnings reports, poor management decisions, options scandals and the like. However, avoiding equities does not mean avoiding diversification, does not mean avoiding home work and does not mean avoiding volatility.

While some folks may not want to hear this, I think avoiding equities in the context of this post is a mistake. We've endured a bad run. That bad run may have more to go but the equity market has had bad runs before and after the last two events like this one the stock market skyrocketed. Maybe a better plan is to tell yourself now that you will sell your stocks when the S&P 500 gets to 3300. Think that's nuts? Well maybe it is but from a low of 96 in April, 1942 the Dow went up (not in a straight line) to 987 in January, 1966. Then from a low of 808 in July, 1982 the Dow went to a high of 11,700 in January of 2000. So SPX going to 3300 would be a five bagger off the low compared to precedent for ten baggers.

To be clear I do not think equities are forever broken and if the SPX were to go up five fold over the next 20 years I would expect foreign markets to do much better than that which is why I have been planning to increase my foreign exposure slowly, but steadily.

Comments

[Another View:]

Swenson said he could not translate what he did at Yale into a strategy for individuals. Since he has no track record except with his investments at Yale, I took what he said for individuals with a grain of salt... it was his "guess" at what would work. He also emphasized "newly issued" TIPS. He said that a couple of times. Obviously, he did not even begin to touch the tax question on these instruments. All-in-all, I got very little from his interview.

May 26 11:47 AM

[goalposts:]

Excellent article, Roger. I think an equity-less portfolio now and perhaps some foreign equities later makes a lot of sense; but you are a lot more optimistic about the US market than I am. If stocks can go down and stay down for 20 years in Japan, why can't that (or worse) happen here? I think the popular perception that the US is indestructable is fading.

May 26 12:21 PM

[CLH:]

I certainly agree with you Roger. The market may have some downside left but history tells us it not much. However, the upside is infinity. Negative people are never winners.

May 26 07:01 PM