Keep the Faith

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.”

– Benjamin Graham, The Intelligent Investor.

The ‘controlled demolition’ of the western monetary system seems to be spiralling chaotically away from those notionally charged with executing it. Bond markets globally are showing signs of distress (not before time) – emerging markets in particular. Governments via their agent central banks have boxed themselves into a corner. They can’t realistically lower interest rates any further to stimulate the economy. And they can’t realistically raise policy rates to curb surging inflation without crashing the stock and bond markets. Perhaps the private sector will do so instead; The Telegraph reports that British banks have increased their mortgage interest rates by a third in the space of a week, a trend which is unlikely to be entirely supportive of house prices. Energy prices are surging – given the domestic cap on UK retail energy bills, 17 wholesale suppliers have gone bust since the start of September. And while the economy and financial markets are burning, the Johnson administration is fiddling around with climate change commitments at the grotesque COP26 summit – a festival of the Big State waltzing with unsettled science at the people’s expense. Our favourite pertinent film quote derives from No Country For Old Men, at the point when the sheriff and his deputy stumble upon a drugs deal gone bad, with a valley full of guns, dead men and dead dogs:

Deputy: It’s a mess, ain’t it Sheriff ?

Sheriff: If it ain’t, it’ll do ‘til a mess gets here.

In response to the economic travails of the 1970s, the author and libertarian Harry Browne once advocated a four-factor portfolio that would protect any investor “no matter what the future brings”.

Such a portfolio would have to cater, at least in part, to four separate economic outcomes:

• Prosperity: a period during which living standards are rising, the economy is growing, business is thriving, interest rates are typically falling, and unemployment is declining;
• Inflation: a period during which consumer prices are typically rising;
• Tight money or recession: a period during which the growth of the supply of money in circulation is slowing. This usually leads to a recession;
• Deflation: a period in which consumer prices are declining and the purchasing power of money grows.

Just four types of investments would cover all these separate bases in Browne’s so-called ‘Permanent Portfolio’:

1. Cash would be most profitable during a period of tight money – as a liquid asset offering purchasing power when income and investments might be coming under pressure.
2. Bonds would also perform tolerably well during a period of prosperity but would come into their own during a deflation.
3. Stocks would thrive during a period of prosperity.
4. Gold could be expected to perform well during times of intense inflation, though less well during periods of prosperity, tight money or deflation.

The investor simply needed to allocate 25% of his capital to each investment – and keep it there.

For an extended period, the ‘Permanent Portfolio’ approach served its investors well. For the nearly three decades between January 1970 and December 1998, for example, the portfolio delivered average returns of 9.9% per annum, a comfortable 4.5% per year above inflation.

The portfolio continued growing through every economic environment it faced. It even gained in real terms during the inflationary 1970s.

The portfolio was also remarkably stable. In the course of 29 years the portfolio lost value in only three: it lost 6.2% in 1981, 0.7% in 1990, and 2.4% in 1994. Those happened to be years in which most investors suffered poor returns. But each of the portfolio’s three losing years was followed by gains that quickly erased the small losses it had previously incurred.

On October 19, 1987, when the Dow Jones Industrial Average fell by 22.6% in a day, the Harry Browne portfolio lost 4.3% of its value. It still returned a gain of 5.3% for the year.

And maintenance of the portfolio would be simplicity itself:

“For most investors, this portfolio requires no more than one short day to set up. Thereafter, you need to monitor it only once a year – merely to determine whether changes in investment prices have unbalanced the portfolio’s mix of investments.”

The fail-safe portfolio didn’t require any insight into the future; it didn’t require market-timing of any kind; it didn’t require any form of switching investments at all.

For over 40 years, Harry Browne’s ‘Permanent Portfolio’ served investors well.

Unfortunately for the investor of today, the central banks have shot it through the heart.

In a world of zero or negative interest rates, a portfolio that allocates fully 50% of its capital to cash and bonds is no longer fit for the purpose of capital preservation or income.

This isn’t Harry Browne’s fault. He died in 2006. Never in his wildest imaginings would he likely have foreseen what central banks would do to depositors or bond investors during the years after his death.

Of the ‘Permanent Portfolio’ and its original four asset classes, only two now make any real sense, in large part because they are themselves real assets: stocks, and gold.

Stocks because there can be no investment rationale for owning negative-yielding bonds – and because stocks offer fractional ownership of real, productive businesses.

(We favour value stocks as the next logical step across a minefield of opportunities: escape the financial repression of nominal assets by embracing the most attractive, as in, least obviously overpriced, investments by way of productive, real assets. We place a special focus on solid cash generation, and little or no debt.)

Gold because there is still every reason to expect further inflationism and monetary debauchery from the world’s major central banks. But nominal assets make no sense when nominal rates are the plaything of increasingly desperate policy makers.

It comes to something when the concept of something as simple, democratic and socially beneficial as cash faces ongoing assault from academic economists. A recent trial balloon from the establishment came via Kenneth Rogoff in his fascistic essay The curse of cash, which advocates the abolition of cash on the fatuous premise that it can be used for the purposes of crime. By that reckoning we should shut down government.

This is not, of course, the fundamental justification for abolishing cash, just a convenient excuse to be marketed to the gullible. The fundamental reason for neo-Keynesian economists to lobby for the abolition of cash is as a necessary precursor to the imposition of negative interest rates. Savers will, rightly, be resistant to the idea of paying banks for keeping cash on deposit. The answer is to remove their right to hold money in the form of cash in the first place. Enter, stage left, the much-heralded concept of central bank digital currency. (And enter, stage right, private sector cryptocurrency. Let battle commence.)

We have gone a long way down the rabbit hole since the Global Financial Crisis. Clearly our monetary authorities have more experiments planned. As the writers at The Daily Bell point out,

“Giving a small group of individuals the power to decide on the value and volume of money is a ludicrous concept from any standpoint. But the problem is abetted by the mainstream narrative that never discusses the underlying lack of logic.

“And so we observe Jackson Hole, which is presented to us as a conclave of elite thinking but which is actually nothing more than high-brow propaganda for a system that has already failed and – as compensation for its failings – now contemplates even more radical “solutions” that will give rise to even worse problems.

“Conclusion: The mechanism of central banking is purposeful ruin. The end-result of this ruin is global governance. In the short-term this goal is disguised by an academic patina. But the long-term goal, an increasingly apparent one, is a brutal restructuring of the lives of seven billion people to benefit a handful of elite controllers.”

Harry Browne’s ‘Permanent Portfolio’ managed to survive the stagflationary 1970s, the Crash of 1987, even the death of Communism (in Soviet Russia at least, if not yet among the ivory towers of US economists). But it has been dealt a devastating blow by the financial repression of the past two decades, which has effectively dismantled two of its four pillars.

We never slavishly followed Harry Browne’s Permanent Portfolio, and in any event we wholly refined one of its four pillars, and have now removed another. This leaves us, today, with three pillars of investment wisdom, namely:

• Unconstrained value stocks from around the world. Again, with a real focus on cash flow generation and the maintenance of little or no corporate debt;
• Systematic trend-following funds, a momentum-based approach which has no real correlation to stocks or bonds but which offers the potential to make decent returns even in sustained bear markets;
• Real assets – tangible, non-financial things, notably the monetary metals, gold and silver, as inflation (and monetary crisis) hedges, and other commodity-related investments, primarily via listed businesses possessing the same value attributes highlighted above.

But we are wary of overmuch cash, and we despise bonds entirely. Ditch fiat, in other words, but embrace the productive and the real.

There is process, and there is outcome. Our process is, we hope, both appropriate for the circumstances in which we find ourselves, and transparent. In the short term, the outlook across all markets seems nothing less than chaotic. But for the medium term, we have enduring faith in the merits of diversification, defensible value, and inflation protection. We play the hand we’re dealt.