Economic uncertainty is always present, but today’s level of economic uncertainty is unlike anything most of us have experienced. Decades-long government deficit-spending policies, combined with actions aimed at diffusing the 2008 financial crisis, have created an investing climate that calls for fresh thinking about how to minimize risk without giving up the opportunity for attractive returns.

Stocks, bonds, and gold have had major moves up in recent years, and too many look overpriced. The million dollar question is this: “Where does one invest in a world where everything looks expensive?” There are certain foundational investment rules, such as – the older you get, the more your investments should shift away from stocks and towards bonds. This advice worked beautifully in recent decades as bond yields have fallen from the mid-teens to the low single-digits. As these yields have fallen, bond prices have risen, producing strong, stable returns year after year.

My concern recently has been that bonds will no longer provide the downside protection – the safe-haven aspect – that I have counted on to provide for clients. With bond prices at all-time highs as a result of the Fed pushing yields to unnatural lows, it’s safe to say the U.S. bond market has never been as overvalued as it is today.

Meanwhile, government borrowing has exploded. Like a rubber band wound tighter and tighter, a limit will eventually be reached. At some point, lenders will look at the massive debt loads that even “credit-worthy” borrowers such as the U.S. government are carrying and will demand higher returns (read higher interest rates) for the added risk. Bond yields will eventually rise, and bond prices will eventually fall. While higher rates will be welcomed by those on fixed income, it will bring a corresponding drop in principal. The only question is when.

Extreme Economic Uncertainty

Unfortunately, there’s no such thing as a permanent safe haven in investing. This may come as a surprise to those who have watched money flood into U.S. Treasury bonds at every sign of trouble over the past decade. But we’re reaching the point when government finances have become the source of the trouble. That point has arrived in Europe already, and eventually it’s coming here too.

The dominant financial issue of our time is how to deal with the massive amount of debt that governments around the world have amassed. The problem has been building for decades, but the tipping point was reached in the aftermath of 2008’s financial crisis. The pressure is on to reduce these debt loads as a percentage of the national income. The question is no longer whether something needs to be done, but how to deal with it and specifically when.

This “deleveraging” process – reducing debt in relation to income – can be attempted in different ways. One way is to cut spending, which is often referred to as “austerity.” This has been the approach taken in Europe the past few years. What we’ve learned from watching their efforts is that austerity in the face of an already weak economy is extremely painful. This path has caused dramatic recessions in much of Europe, creating a vicious cycle of lower income, leading to lower tax revenues, leading to even greater government debt. This process is deflationary by nature, meaning prices and wages fall as unemployment rises and demand for goods declines.

Not only does austerity cause great economic pain, it also gets democratically elected politicians voted out of office. This lesson hasn’t been lost on politicians in other countries, as we’ve witnessed in the recent U.S. election and subsequent negotiations regard the fiscal cliff. Significant spending cuts, in today’s environment, are political suicide. Deflation and recession may well win out anyway, but the powers that be aren’t going to surrender without fighting for more deficit spending.

An alternative approach to stimulating an economy has been what the central banks have been trying to do with their “quantitative easing” programs. To this point, these massive efforts have barely succeeded at keeping the global economy slightly above stall speed. The risk, of course, is that eventually inflation in ignited by these stimulative measures. It hasn’t happened to this point because the deflationary impact of recessions and deleveraging have been overwhelming the otherwise inflationary policies. But this could change, perhaps without much warning, particularly if real economic growth did begin once again. Ironically, governments currently welcome modest inflation, as it helps them repay their debts in cheaper dollars. But this is a dangerous game, as inflation is not easily tamed once unleashed. Despite the obvious potential risks ahead, it’s surprisingly easy to build an optimistic case, at least for the short term.

By some measures, the U.S. economy appears to be gaining strength. Corporations continue to see record earnings and are extremely well capitalized. And governments have shown an incredible ability to turn what seem to be crises into a long, protracted process instead. Even if a day of reckoning is coming, it still could be years away as politicians put duct-tape on the engine of the economy to try and keep it running. The Fiscal Cliff is behind us, and while it ended up as a non-event, the minimal results have probably caused each political party to dig in deeper for the debate on raising the debt ceiling. Having witnessed a year in which by all rights the stock market should have dropped dramatically, but was rescued time and time again by the Fed’s stimulative policies, I’ve determined once and for all that trying to predict the economic future is a losing game. But the stakes have rarely been higher, given the aforementioned valuation extremes in the bond market. If bonds are no longer an adequate safe haven, where else can we turn?

Finding Inspiration in the “Permanent Portfolio”

In the late 1970’s, investment adviser Harry Browne began promoting an investing strategy he called the Permanent Portfolio (PP). The main idea behind it is that economic conditions change over time, cycling unpredictably through extremes of prosperity, inflation, recession, and deflation. Each of these phases produces specific investment winners and losers. What you want to own during a recession may well be the opposite of what will perform well during an economic recovery, and so on. Browne’s solution was to divide a portfolio into four equal investments, each highly uncorrelated with the others (meaning the rise or fall of each does not depend on the other doing the same). One-fourth of the portfolio was to be allocated, respectively, to stocks, bonds, gold, and interest-earning short-term investments such as U.S. Treasury bills (referred to as “cash” for short). These were selected because each would excel under a different economic extreme. Thus, the portfolio would always have at least one of the four pieces completely in tune with the current environment. Other than rebalancing periodically, this mix was unchanging, thus the Permanent Portfolio name.

This exceedingly simple approach has performed quite admirably over the past three decades. From 1982 – 2011, such a portfolio gained roughly 8.2% per year. The S&P 500 gained 11.0% per year, but did so with significantly great volatility and risk. Remember, only 25% of the PP was in stocks. The real virtue of this approach was how little volatility it generated: only two years of negative returns, and the worst (2008) was just -7.2%. This type of smooth ride has appealed to investors who lost more than 30% in stocks during 2008 along, not to mention three consecutive years of losses between 2000-2002.

While there were many things to like about the PP strategy, there are two significant downsides. First, while it achieves my goal with clients of reducing risk, this system is even more conservative than many investors need. Allocating one-fourth of one’s’ portfolio to cash may have made sense in the late 1970s when that would earn 15% in a money-market fund. Today, cash earns virtually nothing, so permanently fixing a quarter of the portfolio there is not practical. To help counter this, there is a need to expand the basket of asset classes beyond the four proposed by Harry Browne. The second problem has less to do with the portfolio and more to do with human nature. The PP has looked great over the past decade or so, due to stocks being weak while bonds and gold have been soaring. It will always look its best following sharp bear markets in stocks, of which we’ve had two in the past dozen years. But there have been long stretches when the PP lagged the market badly. Many investors lack the willpower to stick with an approach like this when stocks are soaring in comparison to their PP. Stocks gained more than

20% for five straight years from 1995-1999, while the PP earned more than 11% only once. Investors simply don’t stick with systems at times like those – the emotional component, (of missing out on better returns, known as regret) is simply too powerful. And yet, the years that followed were exactly the time to embrace the Permanent Portfolio. Unfortunately, the idea of a static portfolio with no “switching mechanism” would have likely led many to miss the gains of 1995-1999, only to switch to stocks in time to experience the sharp losses of 2000-

2002. That said, “Is there a timing mechanism that makes sense?”

The Breakthrough: Adding a Timing Element

While a pure application of PP has the issues noted above, it does elevate the importance of using non-correlated asset classes in an attempt to achieve higher returns with lower risk. The following study was performed by the analysts at Sound Mind Investing (SMI), as noted here: “The breakthrough came when we started testing what happens when we own only the asset classes showing momentum at that particular time rather than owning all of them all the time.” By “momentum,” they mean owning three of six asset classes that have the strongest relative strength of the six and monitoring monthly to see if changes need to be made due to a change in momentum (or return). SMI continued, “After much testing and many iterations, we emerged with a simple but powerful strategy. Our roster of asset classes eventually expanded to six: the PP’s original four, plus foreign stocks and real estate.

Using these six asset classes, we applied a momentum screen at the beginning of each month, identifying the three asset classes we wanted to be in and – perhaps more importantly – the three we wanted to avoid. Each month we re-ran the screen and adjusted our holdings as required. The results were very impressive.”*

Exchange Traded Funds (ETFs) are the least expensive and purest way to own an asset class; therefore, the following ETFs represent each of the six asset classes:

U.S. Stocks – SPDR S&P 500 ETF (SPY)

Foreign Stocks – iShares MSCI EAFE (EFA)

Gold – SPDR Gold Trust (GLD)

Real Estate – Vanguard REIT ETF (VNQ)

Bonds – Vanguard L-T Bond (BLV)

Cash – iShares Barclays TB (SHY)

The key to DAA’s success and what I like is ‘winning by not losing.’ By dramatically reducing losses, this strategy is able to come out ahead in the long run, even though it doesn’t earn as much when stocks are soaring. Most importantly, this is a strategy that risk-averse investors can stick with. That’s crucial, as even the most profitable systems are worthless if investors can’t handle the volatility they experience along the way and end up selling everything out of fear.

Win by not Losing

t’s natural to scan the year-by-year results at the right and focus on the final results at the bottom of the columns. (These are back tested results using mechanical formulas. From 1982-2005, the results are those from investing in the asset class benchmarks; from 2006 – Nov 2012, the results are those from investing in the actual ETFs (most of which didn’t exist prior to that time). The “Dynamic Asset Allocation” (DAA) strategy’s 13.6% return for the 30 years is significantly better than the S&P 500’s 11.1%. That’s great, but it’s hardly the main story. Remember, the beginning point of this journey was to find a replacement for bonds as a safe haven for risk-averse investors. If boosting a portfolio’s bond allocation wasn’t going to provide the safety from future market storms that we’ve counted on in the past, we needed something else that would. That’s the real value of this new strategy.

Compare each year’s returns for the DAA vs. the S&P 500. A few things should stand out. First, DAA has only had one losing year, a loss of -6.6% in 1990. Now look specifically at 2000-2002 and 2008. While stocks were plummeting and investors were full of panic and fear, DAA investors would have been breathing easy. (It’s important to understand that we’re not saying there won’t be any losing years going forward. This is merely the picture of what has happened in the past using the mechanical rules we’ve established for the DAA strategy.) The DAA strategy outperformed the stock market while being

42% less volatile. This shows that indeed, slow and steady can win the race.

Summary

Back in 2005, after reviewing Momentum Theory and Relative Strength Analysis, I modified the DAA Strategy by adding 1 month returns to the 3, 6, and 12-month numbers. I found that this helped the strategy trade more quickly when the markets were moving rapidly. I call this updated version, Tactical Asset Rotation Strategy or TARS. There are more details in my book, “The One Thing.”

In addition to the Core TARS, I utilize the same relative strength analysis with Sector Funds. Sector ETFs are typically diversified in their number of holdings, but concentrate on stocks within the same category. For example, a Utilities Sector ETF might hold Duke Energy, Southern Company, Pacific Gas & Electric and forty other utility stocks. Each month I analyze available sectors (such as Biotechnology, Utilities, Aerospace, Semiconductors, Energy, Telecommunications, etc.), investing in the top two performing funds and then rotating out if they fall out of the top 25 percent. I also analyze 41 Country ETFs, which are essentially their versions of the US S&P 500 Index. I typically add two country ETFs to growth oriented clients. Again, while not guaranteeing positive returns, this strategy proactively moves out of funds whose relative strength is declining and into those that are rising. In a very real sense this turns the concern over “the markets are rising so much, where do I invest?’ into a positive versus a negative.

2021 Update

2020 was an unprecedented year, with the quickest Bear Market downturn in history of -37% by the Dow Index, followed by the quickest bounce back. In March of 2020 when the stock market was dropping, at the beginning of the Covid Pandemic, Core TARS was up +0.75%.

Here are the returns of TARS versus the S&P 500 Index since 2015, to add onto the chart on the previous page. 2022 was a very difficult year across all markets as every asset class except for gold was negative for the year.