Rising Rates, Valuation, and Bias: Round 2 with the Meb Faber Podcast
Meb was kind enough to geek out with us for almost an hour about a wide variety of topics. In this second of two posts (here’s the first one), we’ll cover some interesting snippets related to specific asset classes and portfolio formulations, including:
- How the Global Market Portfolio combines all the world’s biases in a single portfolio;
- Why the Permanent Portfolio is a reasonably good proxy for risk parity, with some notable flaws;
- How interest rates impact risk parity strategies;
- What valuation can tell us about future returns;
- Why most portfolios would benefit from holding some gold, even if gold produces zero long-term return.
Of course, this is just a small sample. We strongly suggest you take the time to listen to the show. It was a trip!
How the Global Market Portfolio Combines All the World’s Biases
Meb: If you look at the Global Market Portfolio (GMP), it’s invested around 50% in global stocks, 40% global bonds, of which a chunk is corporates, and then maybe 10% other. But it’s pretty darn close to 50/50 stocks/bonds. No one invests in that and there’s probably reasons why. You guys talk a little bit about this, maybe you could speak about your ideas there and also the inherent biases that people have and how they implement it.
Michael: Yeah, that’s an interesting one. I love the whole idea that the Global Market Portfolio is the combination of all the world’s biases. Every country in the world suffers from a pretty significant home country bias and that combines into a Global Market Portfolio which no one is tracking towards.
So I think one of the main reasons no one uses it is because of the massive tracking error between what they might think is their goal or what their friends are doing versus what the GMP is achieving. And that unwillingness in most people to invest in the GMP creates a pretty substantial opportunity for the select few who are willing. And when you think about all the asset classes out there, I’m pretty sure most portfolios don’t include things like emerging markets sovereign bonds, or, you know, international real estate as pieces of a well-diversified portfolio that will add benefit in the long-term.
Why the Permanent Portfolio is an Excellent Example of Economic Regime-Based Structural Diversification
Meb: One of the cool things about studying history, one of my favorite charts in your book is that you examine asset allocation models. People assume that equities always outperform bonds. But there’s been very many periods of 20 to 40 years in the U.S. where equities don’t outperform bonds. And there’s a couple of markets right now where over the past 20 years, Japan being one, Canada being another, where bonds and stocks have roughly the same return.
But the chart you have in your book is…you say, “Look, let’s apply some asset allocation models in Japan.” It demonstrates how they would have performed because most traditional asset allocation models in Japan would have done horrible over the past 20, 30 years.
Adam: Absolutely, you know, the Japanese model, the experience of Japan over the last 30 years, I don’t think it can be discounted that the developed world is in the process of experiencing some very, very similar dynamics as Japan. And that’s why we felt the Japanese example was maybe more relevant today than many people would like to admit.
So, the Permanent Portfolio classically from Harry Brown was 25% cash, 25% gold, 25% treasury bonds, and 25% stocks. Of course, Japanese stocks over the past 30 years or more are down about 60% or 70%, but the Permanent Portfolio delivered positive compound returns over that period. This is a powerful example of where thinking about diversification from an economic regime standpoint – even using very simple diversification rules – can really pay off.
Michael: I think it’s worth stating, though, that the Japanese experience is the diversification that you like. On the other hand, if you think about the Permanent Portfolio from an American’s perspective over the last, I don’t know, 5 or 10 years, that’s the diversification you don’t like. And it’s a strange thing because you have this opportunity to be diversified in a Permanent Portfolio and we highlight Japan, but an American investor today looking at that type of diversification may shun that because their 60/40 has done so well.
Valuation-Based Stock Return Estimates
Meb: Maybe we’ll shift gears a little bit here, but in your book you guys also talk a lot about valuations. So my question is “Do valuations come into play at any point in your portfolio construction process?” And then, I would love to hear a little bit about how you guys construct your valuations for, say, for U.S. equities and your current estimates are.
Adam: Meb, let’s face it, you’re sort of the king of updating these global valuation metrics and I follow your publications on that every time that comes out, it’s great. Especially with the CAPE stuff. And valuation is such a contentious topic. Everybody is using valuation or mostly will use valuation basically just to confirm whatever their pre-existing market view is, right?
So, you’ve got these studies that come out from some of the investor banks with 12 or 13 different valuation metrics, but most of them only go back to 1986. That’s only 30 or 40 years of data where…like, people need to remember that in 1994 the market went into a complete phase transition. We had never observed market valuations in history prior to 1994 like what we observed after 1994. And then once it busted through that top in ’94, it just kept going and going, and doubled and doubled again. And so, of course, at the peak of 2000 we had the most expensive markets that we’d ever seen in the U.S. The most expensive markets to my knowledge in the last century were in Japan in the very late ’90s, the peak of their bubble.
Our study showed that if you use a very long history – not just 30 or 40 years – that U.S. stocks go through very long cycles where the valuations rise, rise, rise for 15 or 20 years. We go through this secular multiple expansion, and then we peak, and then we go through this long secular multiple contraction.
And so all we did is we say, “Okay, let’s look at these valuation multiples. Let’s find ones that have very long histories,” like the cyclically adjusted P/E ratio from Shiller that you always talk about, the Q ratio that you can actually get from the Fed’s Z-1 report, the market cap to GDP, and a few other things. And then we look at them on a variety of different lookback scales and forecast horizons.
When you put it all together, you get what you kind of expect which is we’re at or near the peak of a cycle, stocks in the U.S. are expensive relative to history. And we know that valuations versus returns are kind of like a see-saw, so you get expensive valuations, you get lower future returns.
Now, it doesn’t mean that the market is going to crash tomorrow, probably it doesn’t. But over the next 10, 15 years for those who are trying to put together capital market expectations for institutional applications or for individuals trying to map out retirement income potential, our estimates inform their expectations and budget accordingly.
We’re in the process of updating our current reporting method, so we can publish it every quarter. We actually haven’t updated it since 2014, but we’re going to make this a regular report for people. You know, I’m gonna guess just based on where we are relative to then that we’re looking on the order of sort of 3% or 4% nominal, 1% or 2% real over the next sort of 10 to 20 years.
How Interest Rates Impact Risk Parity Strategies
Meb: One of the biggest criticisms of risk parity is that it’s had a large tailwind from global interest rates. I imagine your dynamic models answer this, but how do you think about risk parity portfolios that usually by definition end up putting more in fixed income investments than traditional portfolios?
Adam: Well, I’ll tell you, not one conversation comes up about risk parity where we don’t talk about the fact that it overweights bonds, and that we’re near all-time lows in rates. So there are a couple of different considerations. The first is the tailwind that bond investors have experienced over the past 30 odd years, 36 years, has also benefited every other asset class with cash flows, right? Because when you value an asset class, any asset class anywhere, you value it on the basis of the discounted value of future cash flows. Well, the discounted value is based on a discount rate, and the discount rate is the Treasury rate.
Now, different asset classes have different durations, and you’ll use different terms of treasury markets to discount, but at every term, the discount rate has steadily dropped for the past 30 odd years. And so every cash flowing asset around the world has had exactly the same benefit from that tailwind as bonds have themselves. And so that’s another reason why we think that returns going forward are going to be a lot lower because, you know, this very, very low discount rate has been priced across all different asset cases.
The other thing to think about is that risk parity, although it has a large capital allocation to bonds, is no more sensitive to interest rate risk or inflation risk than to any other type of risk. That’s the whole concept of risk parity: you’ll do equally well in a deflationary growth environment as you do in an inflationary stagnation environment. Just because you’ve got this large allocation of bonds doesn’t mean that risk allocation in the portfolio is heavily weighted to bonds.
When bonds go down, something else in the portfolio is likely to have a good year. Those other asset classes will provide ballast to the bond side if, in fact, we do go into a period of steadily rising rates. Remember: in every well-diversified portfolio, something is always killing it, and something is killing you. But on the whole, over time, the portfolio should predictably march in the right direction.
Gold: Great Diversifier, Poor Return Driver
Michael: We think of gold as a unique return stream and a diversifier. That’s it. We have loads to talk about as Canadians because everyone will remember what we said and they will just sit on the edge of every word on gold. If it adds diversifications, has a good return and trend, it will be in the portfolio. If not, it will be out of the portfolio. Though, you know, talking about it just is a losing conversation since it’s such an emotionally loaded topic.
Rodrigo: You should see how happy the Canadian Advisers we were talking to are now when they ask how much gold we have in our portfolio, and we say that we just added a 20% allocation. They couldn’t be happier, even though it could be gone tomorrow.
Meb: It’s one of the more polarizing asset classes because you have on one hand someone like Buffett who talks about it being a pet rock, and then someone like Ray Dalio who runs the largest hedge fund in the world, who is like, “If you don’t invest in gold, you don’t understand history.”
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