The Weird Portfolio

I wrote a book describing my passive approach to investing, the Weird Portfolio.

I was originally going to publish this on Amazon, but decided to give it away for free. I really want to get the message and ideas out there to a mass audience, so I thought this was the optimal approach.

I put the whole thing up on Medium for free. It’s a short book. It’s designed to be read in a couple hours on a Saturday afternoon. It’s an easy, breezy, read. It’s free so hopefully that’s a consolation for the typos that are probably in there.

You can read it here. I hope you enjoy it.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Is it crazy to own gold?

I hope you had a great July 4th!

Gold is a controversial asset.

Feelings about gold tend to be separated into two camps:

  1. Stock people who hate the asset. They don’t understand why anyone would invest in an asset that generates no income with no future prospects for growth. Stocks pay dividends and generate earnings. Bonds at least pay interest. For gold, there is no intrinsic value other than what other people are willing to pay for it. I was in this camp for a long time.
  2. Perma-bears who love the asset. The Fed is destroying the monetary system and blowing up bubbles. So, the only safe haven from a dollar that is being slowly decimated by the Fed is a hard asset, like gold.

My asset allocation has a 20% allocation to gold. I don’t go all-in the asset, but I think it serves an effective role in a portfolio. It tends to cushion drawdowns, although not as well as treasuries.

Long term treasuries remain the champion of performance during massive stock drawdowns:

With that said, I’m not comfortable putting 40% of my portfolio in treasuries. I don’t believe treasuries are truly “risk free.”

The greatest risk to treasuries is inflation. Inflation would prompt the Fed to increase interest rates, which would crush treasury prices. Inflation would also make the interest and principal payments more and more worthless.

I previously had TIPS in my asset allocation as my inflation protection, but this is flawed because TIPS rely on official government statistics on inflation.

If the US government wanted to hurt TIPS investors, it could simply manipulate the inflation statistics and change the inflation yardstick. I’m not going full “shadow stats” and don’t think the government is currently doing this, but I don’t think it it outside of the realm of possibility in the future.

Meanwhile, gold is a defensive asset. Like treasuries, gold can cushion drawdowns. Unlike treasuries, it has a track record of performing well during periods of dollar weakness and high inflation.

I don’t advocate a massive allocation to gold and I don’t think that the global economic system is about to unravel because of the Fed’s insanity, but I have 20% of my portfolio in gold because inflation (and a weaker dollar) is a real danger and gold is also an effective way to contain this risk.

I think a good way to demonstrate the usefulness of gold in a portfolio is to look at it through the perspective of a truly crazy portfolio: 50% US market cap weighted US stocks, 50% gold.

This portfolio is indeed crazy. I don’t actually advocate putting 50% of a portfolio in gold, but I think that this crazy portfolio helps demonstrate why gold is a useful asset in a portfolio.

Before I looked at the data, I assumed that a massive allocation to gold would weigh down on returns. Shockingly, it does not. In fact, the 50/50 portfolio slightly outperforms the returns of 100% stocks with less severe draw-downs and less volatility.

On its own, gold is an absolutely terrible investment. Massive volatility, an extremely long drawdown & recovery (gold entered a drawdown in 1980 and didn’t fully recover until 2007), and it has little promise to ever outperform US stocks.

But – in a portfolio – gold can do extraordinary things. It helps reduce drawdowns and it tends to do well in decades when stocks are not doing well.

Gold demonstrated extraordinary performance during the 1970’s, but it also did well during times like the early 1930’s. Gold prices tend to rise during periods of growing fear, as investors flock to “hard assets.” The flock to hard assets is what occurred during the Great Depression. As people gathered gold, the price rose, rising from $20.63 in 1929 to $26.33 in 1933, a 27% increase during a period when stocks were down nearly 80%.

When rebalanced with stocks, it helps deliver a great result: less volatility and cushioned drawdowns.

The interaction between stocks and gold in the 50/50 portfolio is something I’ve noticed with a lot of asset allocations: an investor gets a result that is greater than the sum of the parts.

One would assume – for instance – that the return would simply be an average of the return for the two asset classes. Gold has a CAGR of 7.8% since 1972. Stocks have a CAGR of 10.25%. Averaged together – it is 9.025%.

However, in a portfolio, the actual result is 10.29%. It’s greater than the expected average of 9.025%. It’s greater than the return of either asset. The result is greater than the sum of the parts.

As David Swensen points out, asset allocation is the only free lunch in investing.

This is because gold and stocks are truly uncorrelated. They are almost inversely correlated.

By regularly rebalancing, an investor is able to sell gold when it is up and then buy stocks when they are down. This regular process of rebalancing enhances returns by buying each asset class after poor performance and selling each asset class after strong performance. Meanwhile, thanks to the interaction of the asset classes with each other, drawdowns and volatility are reduced.

Just to reiterate: a 50% allocation is too much for my tastes, but I think this is a useful experiment to show how an allocation to gold isn’t completely crazy and it can serve as an effective defensive asset in a larger portfolio.

For my portfolio, my defensive allocation is split between long term treasuries and gold. Long term treasuries perform better during large drawdowns. However, long term treasuries will be decimated in a period of rising inflation and interest rates. For that reason, I split the “defensive” slice of my portfolio between both gold and long-term treasuries. You can read about my passive allocation here.

Random

U2 at Live Aid in 1985.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q2 2020 Update

Performance

Year to date, I am down 17.77% and the S&P 500 is down 3.9%.

This is actually pretty good in context of my deep value strategy. VBR, the Vanguard Small Value ETF, is currently down 22% YTD. QVAL, the deep value Alpha Architect ETF, is currently down 26% YTD.

The deep value universe of stocks with an EV/EBIT multiple under 5 is currently down 30% YTD.

17% isn’t all that bad in this context.

Due to my large cash position going into the crash, I was only down 26% at the lows, while most of this universe was in a nearly 50% drawdown.

With that said, I missed my chance to gobble up bargains at the lows because I thought the worst wasn’t over.

A Mixed Bag: Good Decisions & Bad Decisions

In the last year, I made some key decisions. Some of them turned out to be good moves and some look like mistakes.

I started accumulating cash last year when the yield curve first inverted. I thought we were going to have a run-of-the-mill recession and I thought due to the overvaluation of the market that this would be enough to cause at least a 50% crash.

I went into the March crash nearly 50% cash. This was a good decision. When I saw that the recession wasn’t going to be a run-of-the-mill affair and was turning into the worst recession since the Great Depression, I started selling my cyclical positions aggressively. By the bottom, I was nearly 80% cash.

I was also convinced that the selling wasn’t over. I saw an index at internet bubble valuations hitting the worst economic event since the Great Depression and assumed that the crash would continue. Value stocks aren’t a place to hide during a crash, so to stay market neutral, I bought a position in an S&P 500 inverse ETF to stay market neutral. This was not a good decision.

What I didn’t anticipate was the extent to which fiscal and monetary policy were going to go full-throttle in an all out effort to boost the stock market and the economy. As a result, the S&P 500 rocketed upward and my short position was beat up.

As a result, I lost about 15% on the short position. I finally got out of it when the S&P 500 went above the 200 day moving average. Fortunately, it wasn’t enough to hurt my overall YTD results.

At the lows, net-net’s started to re-appear and the number of stocks below an EV/EBIT multiple of 5 increased. I didn’t buy any of them, thinking that the economic downturn was going to continue melting down the market with no regard to valuation. I didn’t buy enough at the lows. This was not a good decision. There were many stocks I should have bought and I didn’t.

One position I bought near the lows has worked out marvelously – AOBC, which has turned into SWBI. This is a gun manufacturer. You can read my write up here. I noticed that AOBC was trading at a low multiple to book value while simultaneously background checks were surging due to COVID. Gun sales continue to be strong, and this continues to skyrocket due to the unrest currently gripping the country.

I’m currently up 189% on this position. Obviously, buying SWBI was a good decision. I sold a piece of this position when it grew to 10% of my account from 5%. I plan on doing the same thing once this happens again.

I recently purchased a net-net, Friedman Industries. You can read my write up here. It is yet to be seen if this was a good decision, but I think that the risk-reward makes sense.

Looking Ahead

Currently, the market continues to be strong and seems invincible.

I’m not short after getting my butt kicked in my short position, but I’m still not bullish. I’m currently 80% cash and still only have a handful of positions.

It’s still yet to be seen how COVID is going to shake out.

I am finding it hard to figure it out. On one hand, the lockdowns worked, we flattened the curve. On the other, now that the economy is being re-opened, cases are surging. Skeptics say that this is simply because of more testing. Those who sounded the alarm on the virus say this is concerning.

I don’t know how this shakes out. What I do know is that the the present state of the economy is not good. Unemployment looks poised to reach its highest levels since the Depression in the 1930’s. Many businesses have been completely destroyed, and the number of businesses that are being destroyed continue to mount.

On the other hand, unprecedented levels of fiscal & monetary stimulus might create a new economic boom as the economy re-opens.

I don’t know how the economy shakes out, either. My instincts tell me that the economy is screwed, but my instincts can be wrong. We went into this with unprecedented levels of leverage and the only way that a lot of businesses are surviving is by taking on even more debt, making them even more fragile. On the other hand, the fiscal & monetary stimulus might work.

I don’t know how the virus shakes out and I don’t know what’s going to happen to the economy. The way I see it, the current situation is replete with massive uncertainty.

Uncertainty is something that an investor should get paid for with a cheap valuation.

Investors aren’t getting paid for that uncertainty.

What I know for certain is that the market is not cheap by any stretch of the imagination. From a market cap to GDP perspective, the market trades at 147% of GDP. At the peak of the internet bubble, we were at 140%. That’s right – we are beyond the valuation of the most extreme bubble in American history and we’re in the midst of the worst economic calamity since the Great Depression.

If the market were to return to 100% of GDP – the S&P would crash to near 2,000. If we were to return to the lows of the last two nasty bear markets, we would fall to nearly 1,500 on the S&P.

The CAPE ratio is at 29 – higher than the peak of the real estate bubble although not as high as it was during the internet bubble.

Looking at the value universe I operate in, it is currently only an average opportunity set. There were many stocks in the EV/EBIT < 5 universe at the lows, which was a pretty decent opportunity but not as big as 2009. There are now 75, which is a pretty average opportunity set.

An average opportunity set and a market trading at internet bubble valuations is not compelling. It’s definitely not an opportunity when we face the wide range of possible outcomes that we face today.

As a result, I’ll continue to be cautious and hold a lot of cash. If I find more stocks like SWBI or FRD that look like big opportunities, I’ll buy. What I won’t do is fill up my portfolio with subpar opportunities.

The large cash balance definitely weighs on my mind. Cash is a terrible investment long term, but I want to have the dry powder if the market crashes again.

I’ve considered deploying it into my passive asset allocation that you can read about here, but haven’t made up my mind on that yet.

My goal when I started this blog was to focus on Ben Graham’s low P/E, low debt/equity strategy during the good times. When the bad times arrived, I was going to buy net-net’s. The net-net’s started appearing in March and I didn’t buy enough of them. I barely had time to research any of them before they disappeared.

My instincts tell me this isn’t over and I’ll get another chance to buy them. We’ll see.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.