Permanent Asset Allocation

Short run Intermediate Long Run
Nominal Real Nominal Real Nominal Real
Stocks + + small – big + 0
Bonds 0 0 0 + 0
Cash + + +
Gold 0 + small +
Short run Intermediate Long Run
Inflation Real Inflation Real Inflation Real
Stocks + 0 – small – big + +
Bonds 0 0 + +
Cash + 0 + 0 + 0
Gold 0 + small – small + 0

(Note: Nominal = Real + Inflation)

This article is meant to tie up some loose ends, and suggest the outline of what might be a clever way to do asset allocation.  Who knows?  At the end, there might be a surprise.

I’ve done two articles recently on the effects of inflation expectations and real interest rates on two asset classes in the short run — gold and stocks.  Tonight, I want to extend that two directions, to bonds and cash, and whether the effects aren’t different in the long run.

Einhorn’s FOF Re-positions Portfolio, Makes New Seed Investment In Year Marked By “Speculative Exuberance”

david einhorn, reading, valuewalk, internet, investment research, Greenlight Capital, hedge funds, Greenlight Masters, famous hedge fund owners, big value investors, websites, books, reading financials, investment analysis, shortselling, investment conferences, shorting, short biasIt has not just been rough year for David Einhorn's own fund. Einhorn's Greenlight Masters fund of hedge funds was down 3% net for the first half of 2020, matching the S&P 500's return for those six months. In his August letter to investors, which was reviewed by ValueWalk, the Greenlight Masters team noted that Read More

First, bonds in the short run.  Interest rates rise, bond prices fall.  Interest rates fall, bond prices rise.  Doesn’t matter whether that comes from real rates rising, or inflation.  That’s pretty simple, because most bonds are mostly interest-rate driven.

Second, cash in the short run.  Leaving aside financial repression, for the most part cash assets return in line with inflation.  Cash is simple… so what happens in the short run is also what happens in the long run.

Okay, now let’s lengthen the time horizon.  In the long run, gold keeps pace with inflation, nothing more, nothing less.  Bond returns rise if interest rates rise over the long term because of higher reinvestment rates for cash flow, and again, it doesn’t matter whether that comes from inflation or real rates.  Opposite if interest rates fall.

Think of 1979-82: by the time bond yields were nearing their peak levels, bond managers were making money in nominal terms with rates rising because the income from the coupons was so high, and it set up the tremendous rally in bonds that would last for ~30 years or so.

In that same era, stock multiples collapsed.  But eventually stock prices stopped going down even with competition from bond yields, because the earnings yields were so large that book values roared ahead, supporting prices.  That also set up the tremendous rally in stocks that would last for 18 years, until it finally overshot, giving us the present lost decade-plus.

But high rates, whether from inflation or real rates, presage high future bond and equity returns.

One nonlinearity here: in the intermediate-term, rises in real rates kill stocks, but rises in inflation nick stocks.  Why?  Inflation may improve nominal revenues at the same time that it raises the cost of capital, but rises in real rates indicate capital scarcity, raising the cost of capital with no increase in revenues.


Harry Browne proposed a “permanent portfolio” back in 1981, composed of equal portions of cash, bonds, gold, and stocks.  Reading about the idea in Barron’s in the late 1980s, I did not think much of the idea.  I think differently now.  After my last few articles on related issues, mentioned above, I realize that each of the four asset classes react differently to macroeconomic stimuli in the short run, with a lot of overshooting.  A mean-reverting strategy has a lot of power in this context, and it is double-barreled, in that it lowers volatility and raises returns.

My clients will receive the full details on this as an asset allocation strategy, but my readers have enough from this that if you want to do a little work you can figure this all out yourselves.

All that said, I am surprised at how well the strategy works.  Too easy, and easy strategies rarely work.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.