When Nothing Works, What Do We Do?

by: Dale Roberts

What do investors do when the major asset classes both stink the joint out? It can happen. It has happened. In the period of 1966 to 1981 bond prices and especially bond funds were at the mercy of interest rates that were rising at a stomach churning rate. Bond prices, especially longer dated bonds and bond funds were getting hit hard. Inflation was eating into any income that was generated.

Those practicing asset allocation and hoping that the equities in their portfolio would pick up the slack were sorely disappointed. While stocks and bonds can often offer low or negative correlation, there's no guarantee. The S&P 500 from 1966 to the early 80s delivered very little.

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In fact, according the returns function on moneychimp.com that adjusts for inflation, the S&P 500 (with reinvested dividends) returned nothing - nada. That goes back to one of my first articles "No One Makes Money From The Stock Markets". There are periods when investors make some decent returns in the markets, but there are also extended periods when they largely do not make money - especially when we factor in inflation.

I used the risk asset allocation tool on the Vanguard site where one is able to change the asset mix of stocks to bonds to cash. For that period in question, I tried everything. But no matter how I rearranged the asset mix of stocks and bonds, and even being aggressive with the cash allotment - nothing worked. I was fighting a losing battle. I simply did not have the weapons to battle an environment of weak equity markets, rising (and crippling) interest rates and high inflation. At least not in static asset allocation form.

Here's an example of the returns for the period utilizing a balanced asset allocation. The portfolio consists of 60% stocks, 30% bonds and 10% cash.

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AS we can see from the graphic above, the asset mix is not delivering any consistent or positive trend.

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And from the graphic above we can see how each asset class delivered over the period. Nothing is working. The stocks are not delivering. Ditto for bonds and cash.

And here's a chart that tracks the progress of each asset class over that time period. The black line represents the balanced asset mix portfolio.

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Bonds were certainly the worst performer of the bunch. But of course equities did little as well. And as demonstrated above, equities did not deliver against inflation. There also appears to be limited opportunity for the standard rebalancing of the equities to bonds. There was little opportunity for the rebalancing to force the practice of buying low and selling high. 1969 appears to offer an opportunity when stock prices were rising and bond prices were falling. But largely the phenomenon of "nothing works" seems to be happening in concert.

It would perhaps take a more tactical or aggressive tactical asset allocation model to boost returns over the period. This article examines basic and active allocation models that claim to boost returns. In essence it suggests selling the rips and buying the dips. As we can see from the first chart in this article, the equity markets delivered four opportunities. There were four aggressive short term bull moves. If an investor had some pre-set thresholds for selling into those rallies, they would have been able to lock in some profits and hunker down ready for the next equity correction and then subsequent short-term bull market.

By coincidence, that is a strategy that I have deployed over the last few years. I sold out of the Canadian equity rally that reached its peak in 2011. I am now using conservative asset allocation to fund broad index and dividend growth ETFs. I am happy to slowly ride his market up and even increase my equity exposure along the way. My equity exposure was reduced to a meager 32% and has increased to 40% plus and is still increasing. When a major market correction comes I will be ready to aggressively buy the equity markets and more of those dividends (and likely companies and markets on the cheap). It will certainly take patience, as investing often occurs in slow motion.

Another investing style worth considering is the Permanent Portfolio. It is built to prosper and protect in all of the broader economic conditions- inflation, deflation, robust economic growth and economic contraction. The portfolio consists of 25% stocks, 25% bonds, 25% cash and 25% gold.

The portfolio model is examined and relevant after 1971 - after the U.S. dollar was removed from the gold standard. Since that event, the Permanent Portfolio has delivered equity like returns with only three very small down years over that 40-year plus time period. Truly incredible.

So how did that model perform from 1971 to 1981?

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The Permanent Portfolio came through, and largely thanks to the asset class known as gold. When the equity markets had their really bad years, gold turned in 70% plus performance. Gold appears to feed off of fear just like those monsters in the wonderful animated film Monsters who scare little children at night so that they can capture the energy from the fear. It was just another day in the office for Gold in 1973 and 1974.

Cash was very solid throughout, taking the place of bonds as the portfolio shock absorber.

What to do when nothing works - final thoughts.

Traditional asset allocation and rebalancing will not help us in the above scenario.

When nothing is working over a longer time period, one option is to go along for the ride when equity markets go on a tear and then take your profits - and wait. There were aggressive equity rallies that offered moves of 40% and 50% to the upside. There are obvious moments when equities become ridiculously cheap. But only the truly brave can pull the trigger. And certainly we cannot pick the tops and bottoms. One may have to sell in to any rally in stages. And one would have to have a predetermined buy strategy based on price declines, and the valuation of underlying equities.

And of course, there's that 'ol standby the Permanent Portfolio. It's simple. But it worked very well for a decade during that period. It worked, when nothing else was working.

Got gold?

Disclosure: I am long DIA, EFA, EWC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. Streetwise Portfolios offer Canadians low-fee, complete, index-based portfolio options. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.