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The Permanent Portfolio Fund Looks Weak Long-Term

Summary Harry Browne’s simple concept of the permanent portfolio is still valid and is a low volatility method of passive investing. PRPFX does not closely follow the original concept of the PP and the current allocation is closer to stock picking than passive investing. PRPFX has become too volatile to be considered as a safe, long-term investment. Constructing your own PP with ETFs is cheaper than the mutual fund fees and allows you to stick with the original concept. While the concept is still valid today, it needs to be modernized in terms of internationalizing the asset classes and not putting all of the PP into one country. The Permanent Portfolio Concept In the early 80s, the idea of the permanent portfolio was created by Harry Browne and Terry Coxon and was laid out in a series of books written by the two. The whole concept is based upon the idea that nobody knows exactly what will happen in the future, and your investments should reflect this fact. The permanent portfolio calls for splitting the assets equally into 4 parts: 25% stocks, 25% bonds, 25% cash, and 25% gold. The portfolio would be rebalanced once a year, or if any one asset rises too much during the year. The purpose of this allocation is to have at least one portion of your portfolio doing well, regardless of the economic environment at the time. Harry Browne referred to 4 different general economic scenarios that the portfolio would address: inflation, deflation, prosperity, and depression/recession. The world around us is not quite that simple however, and today we see a hodgepodge of these 4 scenarios. There is deflation in things like oil, gold, silver, and smartphone technology, at the same time as inflation in medical care, college tuition, and certain food items. You cannot label today’s economy with only one term such as inflationary or deflationary. As Jim Rickards says , inflation and deflation are now locked into a very equally matched game of tug-of-war, since high amounts of force and tension on both sides will result in the rope being tugged nowhere despite all of the forces at play. Because of this, the permanent portfolio concept is even more relevant today than in the past. The 25% allocation to gold is enough to give most financial advisors the shivers, but when you look at the results of the PP compared to each of its components individually, it makes a lot more sense. (click to enlarge) Basically you end up with conservative gains and a lot less volatility overall. I would compare the PP strategy to riding a bicycle with training wheels on a flat path while wearing a helmet, elbow pads, and knee pads. You could certainly still crash, but you won’t be as scraped and banged-up as if you had gone all in with the stock market, for example, and it won’t be too terribly difficult to pick yourself up and be headed back down the path. So with this in mind, let’s look at the mutual fund that was based on Browne’s concepts and the flaws that it currently has. Permanent Portfolio Fund – PRPFX This is the flagship fund from the Permanent Portfolio Family of Funds. The fund was founded in 1982 by Terry Coxon and John Chandler. The allocation is quite a bit different than the original PP concept. It is only loosely based around the 25% x 4 allocation, as it has 6 asset classes made up of 36% US dollar assets, 20% gold, 15% aggressive growth stocks, 15% real estate and natural resource stocks, and 10% Swiss franc assets and 5% silver. The biggest problem with this allocation is the great over-emphasis on commodities. The purpose of having 1/4 gold in the PP concept is to act as something that will go up in periods of severe inflation and/or economic turmoil. Adding natural resource stocks and physical silver just adds more volatility that isn’t even necessary. Extra volatility is exactly what you don’t want for a long-term, wealth compounding fund. Take a look at the level of volatility since 2011. (click to enlarge) Does this look like a steady, conservative fund that you can dollar-cost average into every month and compound your wealth with? No investor should accept this level of volatility on something that is supposed to be safe and conservative. But let’s not get too caught up in the short-term price, let’s look at how PRPFX did since 2000 compared to the Dow and the S&P 500. (click to enlarge) As you can see, PRPFX beat the two indexes over the long run, so if you bought this fund in the year 2000 then you deserve a pat on the back. However, if you are looking to start a position or continue an existing position in this fund, you are in for a bumpy ride. Instead of safely biking down a straight path with training wheels and pads on, you will be wearing no safety equipment and speeding further across a very hilly/curvy terrain. The distinction always needs to be made between investing and speculating when it comes any particular security, and in the case of PRPFX the inherent problem with the allocation is that commodities and particularly natural resource stocks are speculative in nature. So mixing these things in with bonds and bank deposits creates a problem. Take some of the mining stocks the fund holds for example, BHP , Vale S.A. (NYSE: VALE ) and Peabody Energy (NYSE: BTU ). BHP is the biggest mining company in the world, but even this fact does not stop it from being volatile and thus speculative in nature. It does not belong in a portfolio of money that you can’t afford to lose. In the cases of Vale S.A. and Peabody, the first company went down 40% over the year 2014 and the second went down 62%. (click to enlarge) Again, these are not the kind of companies you want to have in a portfolio that you expect to draw from in retirement or further down the road. The heavy weighting towards commodities does the fund well when the commodities themselves are in the midst of a bull market, but when the commodities are in a long period of decline it’s very detrimental to the long term investing approach. If you want to implement the original concept, you can do so using ETFs that will result in lower expense ratios compared to the expense ratio of .75% for PRPFX. Below is an example of a cheaper method of using the original 4 x 4 concept with ETFs: 25% Vanguard S&P 500 ETF- VOO -Expense ratio .05% 25% Vanguard Long-Term Bonds ETF- BLV -Expense ratio .10% 25% Vanguard Short-Term Bonds ETF- BSV -Expense ratio .10% 25% iShares Gold Trust ETF- IAU -Expense ratio .25% Or simply keep this component in physical gold held directly. Even with low expense ETFs, there is still a problem with this allocation. The problem is that all 4 areas are U.S. based which means you are putting all of your eggs into the American basket. Most people would see no problem with that today, since America is where the action is at. But the point of diversifying is to spread your risk out by not having it all in one place. Never forget the untimely proclamation made by Yale economist Irving Fisher, “Stock prices have reached what looks like a permanent high plateau… I expect to see the stock market a good deal higher than it is today within a few months.” This statement was made on October 19th, 1929, which was a mere 10 days before the infamous Black Friday. Just because things look promising today doesn’t mean that they will stay that way tomorrow. A lot can happen in a short time, and if a crash happens you wouldn’t want all of your portfolio exposed to the country where the crash takes place. The ETF choices for foreign diversification are not as vast as they are for domestic ETFs, but even with limited choices it could be easier than owning something like international bonds directly. Below is an example of such a portfolio: 25% iShares MSCI China ETF- MCHI 25% WisdomTree Asia Local Debt ETF- ALD 25% Australian Dollar Trust ETF- FAX 25% iShares Gold Trust ETF-IAU or physical gold You don’t want to just randomly pick a mix of countries, obviously Greek bonds and Russian rubles are not smart choices right now. Go for countries that have the least amount of economic/political chaos and that have decent reputations for economic freedom. Also, don’t spend the time back testing different ETFs in order to find the optimal allocation for the future. This defeats the whole purpose of admitting that you don’t know exactly how the future will play out. If you are ready to admit this, then the PP concept might be just for you.

Switzerland’s Monetary Policy Change – GLD Rallies

The Swiss National Bank’s decision to end its policy to peg the Swiss franc to the euro stirred up the financial markets. The decision seems to have also pulled up the price of GLD. How SNB’s decisions relates to the recent rally of GLD. The big news from the Swiss National Bank to stop pegging its currency to the euro has shocked the foreign exchange markets. Some analysts have also linked this move to the recent recovery of gold, including the SPDR Gold Trust ETF (NYSEARCA: GLD ). This relation, however, isn’t straightforward – let’s examine the recent rally of GLD . After over three years, the SNB announced an end to its policy to peg the currency at a minimum exchange rate of 1.20 euro to the Swiss franc. The ongoing devaluation of the euro has, according to the bank, triggered it to make this move. As Thomas Jordan, chairman of the SNB, stated : “Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated substantially against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB has concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.” This decision has stirred up the financial markets – mainly devaluing the euro against leading currencies, including the U.S. dollar. Normally, an appreciation of the U.S. dollar would tend to coincide with a decline in the price of GLD. But the price of GLD kept going up. The SNB’s recent move actually raises the uncertainty in the financial markets, which plays in favor of gold investments such as GLD. Paul Krugman suggested that the implication of the recent regime change in Switzerland is that the markets will become more skeptical about other central banks, speculating whether these banks will follow through on their dovish policies. I think this is a bit of stretch, but some traders will make this connection – albeit one central bank’s policy change won’t necessarily impact the reliability of other banks. The latest news from SNB suggests the ECB’s next policy change could surprise the markets with a bigger than currently expected QE program. When it comes to GLD, however, the main issues relate to the changes in the U.S. dollar, the uncertainty in the markets and long-term treasuries yields. In the past week, the U.S. dollar devalued against the Swiss franc, which is now likely to keep recovering. U.S. long-term treasuries’ yields kept falling down, which tend to have a negative relation with the price of GLD. An economic slowdown does play in favor of GLD, because it tends to cut down U.S. treasuries’ yields. Moreover, the World Bank recently released its updated economic outlook for the next few years. The bank projects the global economy will grow by 3%, and not 3.4% as it previously estimated. It also revised down its outlook for China, EU and Japan. Albeit the U.S. GDP is expected to actually grow faster than previously estimated, the fear factor of global economic slowdown is keeping GLD up at least in the short term. This is another indication why the demand for gold on paper leads the way for physical demand for gold; if it were the other way around, an expected lower growth rate in China’s economy – the leading importer of gold – would have resulted in a drop in the price of gold. In any case, it seems that the physical demand for gold in the short term hasn’t picked up: The Gold Forward Offered Rate, or GOFO, has risen in recent weeks, after they were negative during part of December of 2014 (and several other times during last year). A rise in GOFO rates is another indication for a fall in the short-term physical demand for gold. The next big news item will be the upcoming ECB monetary policy meeting next week. This time, all eyes will be towards ECB president Draghi to see if he states the amount of the ECB’s QE program. Current market expectations are around 500-700 billion euros, albeit some have also suggested this figure could, in theory, even reach 2 trillion euros. So any number higher than this could drive further down the euro, which could push more investors towards precious metals, including GLD. Again, the appreciation of the U.S. dollar isn’t helping GLD, but a fear of ECB pumping cash into EU’s banks to buy sovereign debt could drive higher the demand for the yellow metal. The Swiss National Bank’s move shook up the foreign exchange market and apparently also, in the process, pulled up GLD. The next ECB monetary policy meeting could also be the next big event to stir up the foreign exchange markets and GLD – in times of uncertainty, GLD strives. (For more please see: ” On Demand for Gold and GOFO rates “)

The SNB Catalyst For GLD

Summary SNB surprised the market by its sudden decision to abandon the EURCHF floor and reduce its deposit rate further to -0.75%. Existing push factor of GLD such as current deflation, strong USD and holding cost is being pushed aside by negative interest rates and market concern about market stability. Global negative interest interest rates is attracting bids for GLD especially when conservative investors cannot hold their funds in safe deposit and bonds without attracting a penalty. Deeper market concerns over the ability to grow the economies of Europe and Japan without destabilizing the economic system. SNB Surprise served as a catalyst to bring these concerns to the front of investors mind and is responsible for the gap up of GLD. The Swiss National Bank (SNB) surprised the market on 15 January 2015 by announcing the abandonment of the floor of the Swiss Franc (CHF) 1.20 to the euro. In addition, the SNB announced that it has reduced its sight deposit rate from -0.25% to -0.75%, effective 22 January 2015. The rationale that the SNB imposed this floor in 2012 is to prevent importing deflation from Europe but it has done it at the cost of a ballooning balance sheet to GDP from at least 60% to 85%. The SNB has finally accepted that deflation of -0.1% for this year and have made it clear that even if they do prevent deflation from Europe, they can’t prevent deflation from the U.S. through a strengthening USD. In this article, we will look at how the conflicting pull and push factors which affect the attractiveness of gold. In my previous articles, I have been bearish on gold as I consider opportunity cost of holding gold when the U.S. economy is rising and the fact that the strengthening USD will weaken gold. In addition, I have considered the fact that there is very little inflation worldwide given the low energy price. Hence gold would lose its allure as an inflation hedge, especially when it is increasingly clear that major economies like Japan and Europe is nearer to deflation than inflation. Negative Interest Rates Even as I consider these factors to be relevant, it would appear that other factors are now raising to the forefront to challenge these push factors of gold. The most prominent factor would have to be the negative interest rates. We are seeing a number of major countries imposing negative interest rates. The latest and deepest negative interest rates come from the SNB at -0.75% of deposit rates. The European Central Bank (ECB) has set its deposit rate to -0.1% and there are Japanese Treasury Bills that are having negative interest rates . This is because investors prefer these treasury bills even when key interest rates are zero and they are willing to pay a premium for it. Negative interest rate means that investors have to pay the banks to keep their money and this has offset the cost of gold purchase. For investors who are conservative, they are not likely to invest into equities which they perceive to be of high risk. Given that they can’t deposit their money safely in banks or bonds without attracting a penalty, they are more likely to be attracted to gold as a store of value. Market Concern about Economic Stability Then there is the risk of unintended consequences. With the ECB and Bank of Japan (BoJ) determined to ease monetary conditions further, they are increasing the risk that these actions will cause a bubble in the future. The issue is that inflation might surface in other form with all these QE efforts. These QE measures are described as emergency measures by the Fed and this is why they are being rolled back by the Fed right now. The question remains unanswered in the market as to whether a prolonged dosage of QE will actually help or harm the economy. We have to remember that the Fed used QE to purchase banks asset to restore confidence in the system and this is done with a bank stress test. The banks subsequently healed as investor confidence were restored and were able to lend as they have a clean balance sheet. They also have incentive to lend as the economy recovers amid a low interest rates environment. As the economy recovers, people consumes and we naturally see inflation which stands at 1.3% in December 2014. This will have been higher if not for low energy prices. There might be a question as to whether the banks started to lend first or the economy recovered and people consumed first before the banks were willing to lend. My opinion is that QE and the bank stress test cause the recovery in confidence first and the bank lending and consumption happened in tandem. The big question for Europe and Japan is that despite all these efforts in QE, we do not see a recovery in their economy. Europe is still having sub 1% growth and Japan has slipped into recession again with the second and third quarter of contraction in 2014. This might point to a bigger problem to their economies than what QE can solve. SNB Catalyst on GLD The SNB move to abandon the peg and lessen the deposit rate serves as a catalyst which brought the issue of negative interest rates to the forefront of investor’s mind. This is a signal to investors that there might be a paradigm shift in how major economies will operate from now on. The fact that the SNB has to surprise the market instead of following the usual central bank communications strategy which has been the norm for the past 10 years also hints at future uncertainty. In this environment, we are likely to see more demand from gold. We can see this from the SPDR Gold Trust ETF (NYSEARCA: GLD ) chart below. GLD tracks the performance of gold bullion after expenses and it is listed on the New York Stock Exchange. It is liquid with $27.54 billion of market capitalization and 17 million of last known daily transactions. (click to enlarge) Despite this liquidity, we see that GLD gap up on the SNB surprise. This is a clear sign that there are issues in the Europe and Japan which the market is concerned about. The market’s concern seems to be that despite the QEs, Japan and Europe would not be able to solve their issues. The side effect of these QE besides the massive purchase of securities, is to resort to negative interest rates which is forcing conservative investors out of safe deposit. These issues have always come along with QE and the market assumption has been that the recovery prospect will outweigh the risk involved as mentioned above. However the SNB surprise suggest otherwise and this is serving as a catalyst for these issues to surface and for GLD to gap up. Of course, the market has been wrong before and GLD was up from 2009 when the Fed started its first QE to 2011 when it was clear that the U.S. economy has recovered before GLD became bearish again. There is a possibility that this will be the start of a new bullish trend for the medium term if Europe and Japan is not able to get their act together. It would appear that even the strong USD cannot hold down GLD and this shows the depth of the market concerns.