Permanent Asset Allocation

Short runIntermediateLong Run
Stocks++ small– big+0
Gold0+ small+
Short runIntermediateLong Run
Stocks+0– small– big++
Gold0+ 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.

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.