Portfolios for Deflation, Inflation, and Good Luck

Posted on July 28th, 2009 by admin in How to Invest

We have written several posts about the macro state of the economy (Deflation, Neutral, Inflation) and how to invest under each scenario. This posting makes the ideas more explicit. Here, we offer three model portfolios to consider, as well as the method to construct a rigorous combination of all three. We are motivated by the frenzy of talk last week about the economy “recovering” and worried questions about whether it’s “too late” to re-enter the stock market.

(Please keep in mind all information and ideas presented on this web site are subject to our Terms of Use. We also remind you that nothing written here can be a recommendation for any particular person to invest. Please consult your own financial or investment advisor before you make any investments.)

Can the Fed Control the Money Supply?

The problem is this: Given the enormous amount of money Bernanke’s Fed has “printed” to restart the credit markets, there now is a substantial danger the Fed will not successfully retrieve that money. Bernanke needs to use all the Fed’s tools to raise interest rates sufficiently for banks to place money on deposit with the Fed, and out of the economy. The Fed must start, at a crucial time we’ll label TIME, a control policy of raising rates fast enough and high enough to attract money. This is a tricky balancing act. When the Fed pays interest, the amount and timing must not be so high or fast as to slow the economy into recession again and deflation, or be so low and slow as to enable inflationary expectations to squirt loose. There are thus three huge unknowns in this problem and all of them are beyond investor influence: TIME, interest rate level, and speed of change in interest rates. Perfection happens when Ben gets it exactly right, and the economy washes the excess money supply back with minimal impact on prices. But being wrong will launch deflation or inflation.

Under these conditions, how best to invest? We take a scenario approach. There are three main future economic conditions (Deflation, Perfection, Inflation) and four main investable asset classes to choose from. We need to pick the amount to invest from each class, depending on our beliefs about the future.

Main Investable Asset Classes

The main asset classes are roughly described this way, considering the variations within each class. First, cash. This ranges from cash in mattress, to money market funds and extremely short term T-Bills. Second, Fixed Income comprises all forms of bonds and ETFs/Mutual Funds based on bonds, both corporate and municipal, and various Treasury offerings, most particularly Treasury Inflation Protected Securities (TIPS). Third are corporate equities and ETFs/Mutual Funds based on them. Finally, we have hard assets. These consist of commodities (metals, precious metals, food products, animal products,…) and real estate (land, buildings, and Real Estate Investment Trusts (REITs)). REITs enable liquidity in real estate purchases, since one trades shares of corporations whose assets are interests in real property. Note that more esoteric asset classes, such as hedge funds and derivatives all can be fit into these categories, if you are willing to sit on top of the bag to close the zipper.

Model Portfolios

Let’s look at a straightforward way to invest for each scenario. Consider this table, which shows the amount of your investable assets to invest in each class, given the scenario.

Initial Allocations (%) for Model Portfolio, By Scenario

Initial Allocations (%) for Model Portfolio, By Scenario

These amounts were intuitively chosen. By applying the Markowitz portfolio optimation algorithm, one can create an optimal portfolio for all three cases based on one’s own specific ROI and risk assumptions.

Perfection

Under the Perfection scenario, the economy percolates along without undue influence of the money supply, and is what we call “normal”. Our nominal portfolio for Perfection consists of equal amounts of equity and fixed income, with lesser equal amounts of cash and real assets. Again, we note the specific assets in each class are chosen by the individual investor.

Inflation

With inflation, one wants to hold hard assets and inflation protected securities. The two most often named are gold and TIPS. Commodities generally gain in price with overall inflation. Stocks vary with inflation. Empirically, the equities evidence is mixed. Some firms win due to having price increases masked by inflation, while others lose since their purhases also rise with inflation. Surprisingly, cash tends to track inflation. So, compared to Perfection, the model portfolio has more cash and fixed income, with an increased dose of TIPS, less equities, and much more Real Assets.

Deflation

Under deflation, cash is king, and the model portfolio shows this bias compared to the Perfection condition.

Combination

Of course, these scenarios are mutually exclusive, and we can build only one portfolio of all our assets. To build the final portfolio, we have to assign a probability to each scenario, and then combine the asset classes according to the scenario weights.

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