Investing & The Permanent Portfolio (Amagi Podcast @ Think Liberty Episode 6)

Nima and Dylan discussion a diversified investment strategy called the “Permanent Portfolio”, conceptualized by former Libertarian Party presidential candidate, author, and radio host Harry Browne.

Sources:

Failsafe Investing: Lifelong Financial Security in 30 Minutes (www.amazon.com/Fail-Safe-Investi…ity/dp/031226321X)

A Portfolio For All Occasions (beinglibertarian.com/growing-your-w…onomic-cycles/)

Debt: The First 5000 Years (www.amazon.com/Debt-First-5-000-…ars/dp/1612191290)

Regarding the Kalecki Equation: What Does the Market’s Response to Trump’s Election Tell Us About Investor Expectations?
(www.economicsjunkie.com/markets-respo…expectations/)

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What Does the Market’s Response to Trump’s Election Tell Us About Investor Expectations?

What I find helpful about investing in the permanent portfolio fashion, is that the assets observed together give you a good big picture overview of investors’ expectations about important macro data such as corporate profits, interest rates, and inflation.

The permanent portfolio consists of 4 equally weighted assets: stocks, gold, long government bonds, short government bonds (or cash).

We observe the following important movements since November 8th:

US stocks are now up about 6.2% since the election:

US Stocks since Trump election

Gold is down about 8.2%:

Gold price since Trump election

Long government bonds are down about 8.5%:

Long bonds since Trump election

On the short end rates are also up a bit as certainty a coming rate hike on December 14th has moved close to 100%:

To summarize: We have seen a selloff in safe haven assets like gold and bonds, and a surge in stock prices.

These are not hard and fast rules, but helpful for speculation:

Gold generally tracks consumer price inflation pretty well historically, but also becomes more desirable as a haven asset when expectations about corporate profits and interest rates on government bonds fall, diminishing the one big benefit that corporate stocks & bonds offer.

Long term government bond rates are a mix between government policy (bond buying or selling programs, future expected policy rates), corporate profit expectations (since high profit expectations encourage a move from bonds into stocks and low profit expectations do the opposite), and inflation expectations. While it is true that theoretically rates on government bonds in a sovereign floating fiat money system are entirely under the control of the sovereign government, most people including high level policy makers are unaware of this due to lots of misinformation on the topic, and we have to speculate accordingly, with that misinformation in mind. More on this in my post Why the National Debt Doesn’t Matter (And Why It Does).

Stock prices generally track investor expectations of corporate profits, but discounted by the rate on risk free government bonds. For example, you can see that since Q4 2014 corporate profits have trended down, yet stocks have actually edged up a bit over the period (even excluding the Trump effect post November 8th):

This can be explained by the observation that the rate on risk free options, namely long term government bonds, have also hit new all time lows in that same period:

Investor Expectations

So in summary, it looks like investor expectations of inflation remain low, while their expectations of corporate profits have jumped significantly, prompting them to sell gold and long bonds, while adding to their stock positions.

You can read more on the components contributing to aggregate corporate profits in this post about the Kalecki equation, which basically reveals that mathematically aggregate corporate profits can only be derived via the following spending/saving decisions made by different entities:

Corporate Profit = Investment + Dividends – Household Saving – Government Surplus + Export Surplus

There are several reasons why investors expect boosts to corporate profits, just to name a few:

Donald Trump has promised a significant corporate tax cut, which, all else being equal, will boost corporate profits noticeably. (In the equation above it would manifest itself in the form of a smaller government budget surplus or a larger deficit).

Furthermore, the elimination of arbitrary and scientifically unwarranted CO2 emission restrictions will likely boost domestic investment in oil, coal, and natural gas, which again, all else being equal, constitutes a net positive for corporate profits. (In the equation above this would affect the “Investment” component.)

It remains to be seen where household saving is headed, and also what happens to the trade balance, and other government spending programs which, if unmatched by tax hikes, could provide a further boost to corporate profits.

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Consumer Goods vs. Factors of Production

The recent consumption business cycle in the US  can be easily quantified.

The chart below shows the development of private consumption, private investment, and government expenses in the US since 1947:

consumption-investment-government-expenses-in-us
Click on image to enlarge.

The output of a country, its GDP, is approximated by adding those three components up and adding exports and deducting imports. The logic being that if someone consumed something, then someone must of course have produced it. Items exported are not consumed inside the country and thus not captured, hence they are added. Items imported are reflected in the components above, but they are produced outside the country, hence they are deducted.

Consumption expenses give us an idea of how many consumer goods are produced in the country, investment expenses give us an idea how many factors of production are being turned out (duly accounting for exports and imports).

It is completely safe to assume that government expenses can be equated to consumption. It is true that the government spends a fraction of its money on investments such as roads and other infrastructure. However, this fraction is almost negligible when compared to consumptive expenses on goods that are used up immediately and don’t aid in any production processes, such as military products and health care.

The chart below shows the development of the percentage of consumer goods production in relation to the total output, GDP from the Great Depression through now:

us-consumption-as-percentage-of-gdp-1929-2008
Click on image to enlarge.

As can be seen above, the percentage of goods produced for consumption by the productive factors in the US has historically oscillated between 79% and 98% since 1929. The average has been 86.27%.

Another way to look at it is to only look at private consumption only:

us-personal-consumption-as-percentage-of-gdp-1929-2008
Click on image to enlarge.

It reveals a severe drop in personal consumption during World War 2 which was more than replaced with government consumption.

Where can we go from here? It is safe to assume that production of public and private consumer goods will at least fall back to the average of roughly 86%, but maybe even drop to around 80%, given the fact that corrections usually seem to overshoot that average and given the severity of the current correction.

A good indicator of when a true recovery is near will be when investment expenses stop to fall and begin to bottom or even rise again. Meanwhile, the production of consumer goods may continue to drop while employment in businesses that produce factors of production should begin to absorb the released resources at some point.

Businesses that produce this capacity may be attractive at that point. This includes in particular companies from the mining and drilling industries, such as the canadian energy trusts (examples: PVX, PDS, PWE, AAV). New AND old energy sources are likely to be explored and expanded. Alternative energy businesses, such as wind or solar energy may be worth looking into for people who understand the technological challenges that they are exposed to. Basic commodities should do well. Gold and silver should continue to act well so long as people consolidate their finances and demand cash to pay off their debt.

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Savings and Investment

The following scenario shall explain the significance of savings on any market system:

  • P1 produces A, P2 produces B, P3 produces C, all 3 produce these goods by transforming previously untouched land
  • Each of them can produce 3 units of their respective goods within 1 time unit
  • The period of exchanging goods is 1 time unit
  • Each of them trade 2 units against the other two goods and keeps one unit to himself
  • Each of them can last 2 time units without consumption after consuming 2 unis of any good

As long as they produce for immediate consumption only, the cycle would look like this:

Period Person 1 Person 2 Person 3 Event
1 AAA BBB CCC Production
2 ABC ABC ABC Exchange
3 Consumption
4 AAA BBB CCC Production
5 ABC ABC ABC Exchange
6 Consumption

After producing, exchanging, and consuming the goods obtained, the 3 individuals return to their initial state and produce the same amounts again over the next production cycles. No raise of anyone’s standard of living occurs.

If, however, P1 decides to save good A and only consumes B and C he will hold good A after the first consumption cycle is over. He can repeat the cycle twice and then hold three units of A. This will now enable him to last over 2 time periods during the first of which he can produce a machine M, a factor of production that enables him to produce twice the amount of A within 1 time unit. During the next time unit he can again exchange two units of A and consume all thee goods A, B, and C which leaves him with M. He has invested his savings in capital. From hereon he will be able to produce 6 units of A per time unit. He can now afford to consume more units of A or exchange more. His real income rises. He has accumulated capital:

Period Person 1 Person 2 Person 3 Event
1 AAA BBB CCC Production
2 ABC ABC ABC Exchange
3 A P1 only consumes B & C, saves A throughout next steps
4 A AAA BBB CCC Production
5 A ABC ABC ABC Exchange
6 AA P1 only consumes B & C, saves another unit of A throughout next steps
7 AA AAA BBB CCC Production
8 AA ABC ABC ABC Exchange
9 AAA P1 only consumes B & C, saves another unit of A
10 M AAA BBB CCC Production, P1 this time produces M instead of 3xA
11 M ABC ABC ABC Exchange
12 M Consumption
13 M AAAAAA BBB CCC Production, P1 uses M which doubles production output
14 M AAA ABC ABC ABC Exchange
15 M AAA Consumption, P1’s output per time has increased

Instead of producing M himself, P1 could also have provided the goods to P2 or P3 in a credit transaction if one of those had had a better investment idea, have one of them build a machine that increases their output, and then get his goods back plus interest which could be financed out of higher production output. However this is arranged, the concept of savings and investment is not changed in the slightest.

If P2 and P3 do the same thing, their real income rises as well and as a result the society’s standard of living rises as a whole.

This is the essence of all wealth generation. If some countries enjoy a higher standard of living than others it is precisely due to the fact that the amount of capital per individual is higher than in others and as a result the output per unit of labor is higher. Thus savings are indispensable to an increase in everyone’s standard of living. Without savings, there would be no investment and hence no capital accumulation. Without capital accumulation the output per unit of labor remains the same.

But all capital that has been accumulated requires maintenance. The machinery, tools, computers, and other productive factors require repair, replacements of parts, and routine checkups, lest their output per unit of labor shrink. Hence, even in order to just maintain an existing stock of capital, continuous savings on the part of individuals on the market are necessary. If the government discourages people from saving, the necessary uphold of existing capital will fall short, what ensues is called capital consumption. The productivity of existing capital will diminish rapidly and the workers’ real income will drop. Thus capital consumption is the inevitable result of policies such as credit expansion or taxation of incomes derived from interest, dividends, and capital gains. The business cycle irrefutably shows how credit expansion precipitates capital consumption.

History has shown that no one single country is ever safeguarded against the blunder of capital consumption. It has lead to the decay and demise of the most powerful and wealthiest empires, and plunged their inhabitants into decades if not centuries of pauperism. On the flip side, rapid capital accumulation has helped the poorest and most underdeveloped nations rise to the ranks of industrialized nations within a matter of years.

Hence there is only one way to continuously and progressively raise the standard of living for the common man. If politicians are truly interested in attaining this objective, they need to encourage savings, capital accumulation, and investments inside the country. The best means to this end are an unconditional abandonment of the policy of credit expansion, a sound monetary policy, and a significant lowering if not an outright abolition of the taxes levied on incomes derived from interest, dividends, and capital gains. Any policy that aims at the opposite, is bound to progressively lower the standards of living of working men and women.

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