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Updated February 2021

ASSET ALLOCATION FOR BEARS

Abstract:   Passive and index investors, like active investors, are confronted with the challenge of managing money in bear markets for equities or fixed income.  Passive and index investors can control risk by averaging in when committing new cash to investments, setting appropriate equity/fixed income levels to control risk long term and allocating portfolios based upon estimates of worst case declines from current prices.  They can also hold alternative assets like gold and commodities which have low or no correlation with equity and fixed income returns.  Variations in returns in equities, fixed income, commodities, gold and home ownership are examined during bear markets in this article.


We cannot know the future with much certainty and this is particularly true when it comes to financial market returns, the economy, interest rates and other matters of concern to investors.  We have a large and persuasive body of research showing that markets cannot be consistently timed for profit, that  picking stocks or individual securities is unlikely to outperform passive asset class strategies, and that eminent economists cannot predict future moves in the economy any more accurately than chance guessing.  Everyone is equally handicapped when it comes to knowing the future.

A pure passive and index strategy therefore focuses on probable long-term risks and returns derived from past financial market data, typically 80 years or longer.  It looks backwards.  These risk/return predictions invariably embed certain statistical distortions and limitations.  Amongst these are the wholly unpredictable economic, social, political, and military events which in turn unpredictably affect investment market returns at unpredictable times.  Unpredictable factors that influence financial markets are always changing.  We examine this elsewhere on our website in "Financial Superstructures".  US markets today are sustantially different than those in 1985 and have given rise to a $300 trillion plus derivative market with complex financial derivatives, credit default swaps to insure prices, computer driven high frequency trading, market deregulation, loosening of corporate bookkeeping and continuous stimulus (i.e. rising debt) issued by the Federal Reserve.  An investor looking at retrospective risk/return data in 1950 would have drawn very different conclusions about asset class risks and returns than one looking at past data in the year 2000.  In the first half of last century the S&P 500 returned around 3.5% annually while in the second half it returned 9%.  Passive and index strategies typically focus on long-term statistical data and probabilities divorced from non-market events.  But, no matter how thorough academics might be in their analyses of past investment market data they too cannot know what events will affect markets in the future.  There are simply too many unpredictable and ever changing variables.

An exclusive focus on past long-term market returns data may disappoint investors putting money into equity markets.  This issue is explored in detail in "Stocks for the Long Run" elsewhere on our website.  From 1982 through early 2000 investors were rewarded with the biggest stock and bond bull markets in U.S. history.  After a relatively brief but nasty sell-off from Spring of 2000 through the end of 2002 equity markets headed upwards to an all-time high in October 2007, then crashed  and lost around 60% of their value by March 2009, then roughly quadupled  through 2020.  From January 2000 through December 2009, US markets gave no returns or negative returns.  In a WSJ article (9-2-2009), Rob Arnott, a money manager and quantitative analyst, noted that from February 1969 through February 2009 investors in 20 year Treasuries who rolled them at maturity into new issues of 20 year Treasuries and reinvested the interest would have received higher returns than investors in the S&P 500, a surprising 40-year period where 20 year Treasury bonds outperformed US stocks.  Last century, bull and bear equity markets alternated roughly in 20-year cycles and bull and bear fixed income markets alternated roughly in 10 to 25 year cycles.  It is easy to understand why investors might be concerned about bear markets.  They are far more frequent and destructive to capital than the financial industry wants to emphasize.

A few simple strategies can be employed by passive and index investors to reduce risk in bear markets.  Investors can estimate worst case declines for a given equity/fixed mix from today's prices based upon past data.  We examine this in detail in an article elsewhere on our website, "Portfolio Design".  The 2008 financial crisis resulted in globally diversified 100% equity portfolios declining 50% or more.  A DFA style portfolio with 50% to 60% equities declined around 25%.  The most critical determinant of forward returns, volatility about those returns, and worst case drawdowns in account value is the equity/fixed ratio and setting and maintaining that is under an investor's control.

Investors can average into markets.  The last long bear market lasted fifteen years, 1968 through 1982.  Investors received no net return after inflation in equities and had to endure a 50% inflation adjusted decline in equity values at various times during that period.  In 1983 they were understandably skeptical that the bear market had ended though stocks began to rise.  How did an investor fare if they waited until 1989, several years after the bull market began?  Quite well, they captured over 80% of the new bull market gains if they stayed in the market from 1989 through 2000.  There is little reason to rush new money into new bull markets in equities and in any case we can't be certain that a new bull market is underway.  Already existing equity positions should be held since we know we are unlikely to profitably time markets and when to exit and when to reenter.  But, new money allocated to equities can be added gradually over time with little likelihood that most of the gains in a new secular bull market will be missed.

In one sense, investors who are periodically adding money to bear markets are benefitted by them.  As the market declines they buy shares at ever cheaper prices.  If a new bull market arrives a bell is not rung announcing its arrival.  Wall Street is often wrong about markets and always optimistic about markets.  Even during the middle of 2008 Wall Street and the Fed saw no serious chance of a bear market.  Taking time to commit money, averaging into markets, is a form of insurance though it will decrease returns for the period it is employed if a new bull market has really begun.  Until we're looking backwards, we cannot know with certainty whether a bear market has ended or a bull market has begun.  Roughly half of our clients decide to average into equities, typically taking six months to two years to do so.  The other half enter in one plunge.  We haven't seen that either approach always works better.

Researchers have examined whether averaging into markets or lump sum investing works best.  Since over very long time frames equity markets more or less go sideways and up about two-thirds of the time and decline about one-third of the time, lump sum investing shows a long-term statistical advantage.  However, over some time frames averaging into markets works better.  One study presented on Bill Bernstein's Efficient Frontier site in the late 1990's examined lump sum versus averaging in for various time frames covering the 1953 through 1996 period.  The author concluded that dollar cost averaging into equities over six to twelve months is a form of insurance.

Vanguard (July 2012) published an article entitled, "Dollar-cost averaging just means taking risk later".  Vanguard compared lump sum versus dollar cost averaging for various portfolio weightings of stocks and bonds covering the US for 1926 through 2011, the UK for 1976 through 2011, and Australia for 1984 through 2011.  They  looked at how asset class mixes performed for each independent 10-year period within those time frames.  For all three countries the probability that lump sum investing would outperform 12 month dollar cost averaging was about 2:1, about two-thirds of the time they did.  Over rolling 10-year investment periods lump sum investing led to an average value 2.3% greater than dollar cost averaging.  Lump sum investing, however, resulted in somewhat more frequent portfolio declines and substantially larger average losses.  The timing of entry into markets does matter to returns, see "Tactical Asset Allocation" elsewhere on our website, yet we have no way of knowing with certainty when the optimal or worst points of entry might be.

A third strategy passive and index investors can use is to make sure that they have maximum global and asset class diversification in their equity holdings.  Very different returns from varied georgraphies and investments for varying time frames continuously occur.  A globally diversified DFA strategy, described elsewhere on this site in "Portfolio Design", includes value, small, and international equity asset classes.  How did it do during the bear market from April 2000 through December 2002?  The benchmark CRSP 1-10 total stock market index lost 40.3% while a 100% equity globally diversified DFA "balanced" portfolio lost only 10.98%.  Asset classes go in and out of favor.  The easiest protection against the pain of bear markets is for investors to add fixed income as a stabilizer for equities.  During the 2000 to 2002 bear market, a DFA balanced portfolio with 60% equity and 40% fixed returned 1.50% versus -40.3% for the CRSP 1-10 total stock market index.  It should be noted, however, that in 2008 globally diversified portfolios did significantly worse, declining over 50% compared to about 40% for US only equity portfolios and up through 2020 US equity markets have done substantially better than global markets.

The future cannot be predicted and data and factors affecting the markets are always changing.  Valuations based on p/e's, p/b's, p/revenues, dividend payouts and other historically reliable valuation metrics are often used to analyze whether markets are overpriced or underpriced.  Yet, the value of such measures is questionable because metrics today aren't the same as they were 20 years ago and aren't 100% accurate.  For example, when P/E's are reported for indexes today companies with no or negative earnings are removed from the aggregate data.  This results in higher "E's" and lower P/E's than would have been the case in the past and that makes the equity market look less pricey.  The strong bull market from 2009 through 2020in US equities was aided by record margin debt and leverage since margin requirements were lowered, interest rates were at record lows, and a 10% margin was deemed sufficient "based upon overall portfolio risk."  Market structures influencing market prices are always changing.

In March 2000 FASB accounting rule 157 was suspended, allowing banks and financial institutions to mark their assets, that is loans, to whatever price they wished them to be rather than much lower prices that might be available in free market quotes.  Huge profits ensued.  Since 2009 the majority of cash flow for corporations has gone to share buybacks, driving up stock prices and earnings along with management compensation.  Money that could have been spent on research and capital expenditures and hiring went to driving up stock prices through stock buybacks.  These few examples illustrate a basic fact all investors should keep in mind.  Unexpected events and changes in market prices are the result of many factors and financial statement analysis can be misleading.

Another means passive and index investors can use to cope with equity bear markets is to invest in non-equity asset classes which might offset or counterbalance equities and fixed income and have low or no correlation with equity returns.  The remainder of this article examines how each major investment category, equities, bonds, gold, commodities, and housing, might be affected in an equity bear market.  We cannot know for certain how different asset classes will perform in a bear market and very broad asset class diversification, a sober assessment of risk, and an appropriate overall equity/fixed ratio are always the keys to asset preservation and growth.  I'd also like to emphasize that a substantial body of research indicates that while asset class allocations are the prime determinant of overall portfolio returns, we can't predict with certainty which asset classes will perform best for periods of up to 30 years or longer.  This is examined elsewhere on our website in "Risk and Return".

It seems reasonable to assume that if on average bulls actively managing portfolios can't, after fees and trading expenses, beat passive and index portfolios, then bears actively managing portfolios probably aren't likely to do so either.  Predicting asset class performance is a loser's game.  Again, maximum diversification and prudent overall equity/fixed ratios are the keys to asset preservation and growth.  And, we should probably all adhere to Warren Buffet's two rules of investing, (1) Don't lose money, and (2) refer to Rule 1.

EQUITIES:

On first take it might appear that being long any equities in a bear market is, by definition, a losing proposition.  However, within bear markets equities can do well for several years.  The data are very clear, time of entry into any asset class is the primary determinant of forward returns in that asset class and we've no certain way to determine an opportune entry point.  Investors starting out at the equity peak in 1929 received an inflation and deflation adjusted return through 1942 of -0.9% per year, excluding dividends, from the S & P 500.  Investors putting money in the S&P in 1968 had to wait until 1983 fourteen years later just to break even after inflation.  Yet, an investor in the S&P from 1981 through 2000 received a whopping after inflation return of 13.1% annually from the S & P, not including dividends.  Investing at the beginning of bull markets as opposed to the end of bull markets can make a huge difference in returns yet a substantial body of research indicates that markets and asset classes cannot be accurately and profitably timed.  The problem is partly that it is never clear if we are in long-term secular bull market, a bull market correction, or a bear market or bear market correction unless we are looking backwards in time.  This is explored in more detail in "Stocks for the Long Run?" and "Tactical Asset Allocation" elsewhere on our website.  Surprisingly, it turns out that holding equities during the 1930's bear markets and Great Depression produced historically average positive real returns in the 7% range due to deflation.

The data above pertains to just one segment of the market, the S & P 500, so let's look at more fully diversified equity portfolios, what many consider to be the most sophisticated equity and bond portfolio models available at this time, those of Fama and French and DFA (Dimensional Fund Advisors, Austin, Texas).  For equities, DFA employs highly diversified passive equity portfolios which emphasize value and small equity premiums in the U.S. and overseas markets and other factors.  These models are derived from factor analyses and multiple regressions on very long-term equity data, most going back to 1927. 

Using DFA data we find that portfolios holding 25% each of US large cap stocks, microcap stocks, one-month T-bills and five year T-notes returned 6.81% from October 1929, the market top, until ten years later, September, 1938.  Deflation averaged -2.25% yearly, so the real return on this portfolio during the worst bear market of last century was 9.05%, substantially higher than the historical average real inflation adjusted equity return around 6% for the US.  Volatility was high, of course, with a 23.4% standard deviation.  If we look the inflationary bear market covering January 1968 through December 1981 the results are also surprising.  Stocks were widely regarded as having been a loser's investment in the 1970's.  Yet, for this period, a portfolio holding 25% each of U.S. large and small growth stocks and large and small value stocks returned 10.24% per year nominally and, adjusted for inflation, about 2.7% per year.

These analyses are supported by John Merrill's studies of the Great Depression.  He found that a portfolio with 30% in U.S. equities, 50% in bonds, and 20% in cash gave a real return (after deflation in this case) of 7.3% from September of 1929 through February of 1937.  Changing the allocations to 47% equities, 47% bonds, and 6% cash yielded about the same real return of 7.4%.  This return is very close to the long-term real return on equities from 1929 through 1998 although it should be added that investors had to stay committed through a 4% decline on the first portfolio and 18% decline on the second portfolio.  It should also be noted that portfolios with 100% in fixed income or 100% in equities did far worse.  Thus, even in a nasty equity bear market and the Great Depression with deflation and 25% unemployment, a diversified equity, bond, and cash portfolio gave historically average positive returns though investors had to ride through an 89% decline in the Dow Industrials between 1929 and 1932.

FIXED INCOME:

Fixed income instruments are employed in passive and index portfolios to generate income and dampen volatility in equities.  They tend to do poorly during inflationary periods and do well when interest rates are declining or the economy is deflating.  The historical evidence is very clear.  Short-term fixed income securities of high quality, generally running from one to seven years in maturity, offer a superior balance of risk and return to longer term and lower quality fixed income securities and are far more stable in price than equities.  From 1802 through 1997 T-bills gave a real return of 2.9% and long Treasuries, 3.5%.  Long-bonds, on several occasions, left investors locked into lower interest rates as inflation rose.  Investors entering the long-term government bond market in 1941 received a real inflation-adjusted return of -0.1% annually from 1941 through 1990, 49 years.  Investors purchasing long bonds in the 1960's at 4% could only watch helplessly as short-term and money market rates climbed to 12% in 1980 and long bonds rose into the high teens.  Showing the unpredictability of fixed income returns; investors purchasing 30 year Treasuries in 1982 received the same return as investors buying the S&P 500 with dividends reinvested over the next three decades.

In both inflationary and deflationary equity bear markets liquidity is highly desirable.  Short-term cash and high quality short or intermediate bond portfolios, one to eight years out, provide liquidity with minimal price fluctuations while sacrificing little in total returns to longer-term and lower quality fixed income instruments.  If the source of a bear market in equities is rising inflation above 3% or so, both equities and longer-dated bonds can go down simultaneously.  Rising interest rates are inversely correlated with stock prices and bond prices although that varies.  In addition, equity bear markets accompanied by an economic contraction push down prices on lower rated debt, creating greater risks of default in anything but high quality debt.

COMMODITIES:

Commodities are a component of inflation or deflation because they are price inputs into what we all consume.  Energy, food, base metals, lumber, and other things that exist in the physical world are commodities.  When economies are weak or contracting prices tend to decline and when economies are inflating they tend to rise in price.  There are several commodity indexes including the Goldman Sachs Commodity Index, The Dow Jones Commodity Index, DJ-UBS, the Deutsche Bank index, and Roger's index.  Each has somewhat different strategies for weighting commodities and capturing and measuring returns with some heavier in oil and energy and others heavier in agricultural products or metals.  For 1972 through 1998, the GSCI returned 10.3% per year with a standard deviation of 24.25%.  The S & P 500 returned 13.8% per year with a standard deviation of 16.7%, a better return with less volatility.  However, a 50/50 combination with both the S & P and the GSCI produced a 13.4% return with a 12% standard deviation, indicating commodities somewhat lowered the volatility of an equity portfolio without substantially reducing its returns.  This period included a nasty bear market in the 1970's, inflation, very high interest rates, a weak economy, then robust equity, bond, and real estate markets in most of the period from 1982 through 1998.

One problem for commodities, however, is that a deflating global economy, which can also sink equity prices, might decrease global demand and commodity prices.  In 2001 for example, the GSCI declined 31%, undermining portfolio returns in a year in which almost all major U.S. and global equity indexes were also down substantially.  It failed in its role as a portfolio diversifier.  However, commodities did do well in the inflationary economy and equity bear market of 1972 and 1973, gaining 21.71% and 57.73%, respectively.  And, in 2002, commodities were up over 30% in a weak near-deflationary global economy.  So, for a bearish investor, commodities might be a diversifier in bear equity markets but their performance is volatile and wholly unpredictable.  That's why their correlation to equities is near zero.  Another problem is that prices in commodities shorter term are set in the US in futures markets which can move far from cash or real spot markets due to speculation and hoarding (corners).  In 2008 the price of oil more than doubled then lost over 75% of its value even though supply and demand in physical markets did not collapse.  Speculation in the Comex futures market was the cause.

In early 2006, Ibbotson, a well-respected vendor of historical financial data which DFA also uses, published an analysis of commodities as a portfolio diversifier for 1970 through 2004.  They focused on a fully collateralized total return commodity index with monthly rebalancing.  For that period, commodities produced a compound annual return of 12.38%, more than 1% above the S&P's return of 11.22%, with a higher standard deviation, 19.88% vs. the S&P's 17.23%.  According to Ibbotson, "Our historical analysis supports the claims that commodities have low correlations to traditional stocks and bonds, produce high returns, hedge against inflation, and provide diversification through superior returns when they are needed most....we found that including commodities in the opportunity set resulting in a superior historical efficient frontier, which included large allocations to commodities.  Over the common standard deviation range, the average improvement in historical return at each of the risk levels was approximately 133 basis points (as low as 36 basis points using a Black-Littermand model) and... improved the risk return characteristics of the efficient frontier...We believe commodities offer an inherent or natural return that is not conditional on skill".  Highly respected DFA advisor Bill Bernstein disagrees, argued that past returns are misleading and that commodities do not inherently produce interest, dividends, or capital gains and are not investments as such, and that backwardization and contango in the futures markets have distorted past returns and will be different in the future.  Ibbotson recommends between 9% and 29% in commodity allocations with 22% to 29% for a portfolio allocated 60% to equity and 40% to fixed income.  Debate and research on commodities as a portfolio diversifier is likely to continue.  DFA offers a commodity fund, DCMSX, based on the Dow Jones-UBS commodities index.

GOLD:

A small subset of investment professionals advocate gold and argue for a return to the gold standard.  The gold standard fixed the value of the US dollar against gold until 1933 and that means a nation's currency is backed fully by gold.  In 1971 President Nixon fully removed the US dollar from any remaining ties to gold.  The gold standard had its problems, namely variations in gold supply and demand and consequent inflationary and deflationary cycles in banking.  In 1913 the Fed was created in large part to avoid problems with the gold standard and bank safety.  The Fed has unfortunately engineered continuous inflation of the money and credit supply at a rate far exceeding economic growth and as a consequence the purchasing power of the dollar has fallen about 98% since 1913.  This is currency debasement.  Very long-term the price of gold has paced the rate of inflation closely while government currencies have always ended up worthless or close in 50 to 125 years.  From 1802 through 1997 gold returned 1.2% per year while the inflation rate was 1.3% per year so gold slightly underperformed inflation.  However this figure is misleading since gold's price was fixed against fiat currency by the US government during most of that time and gold priced in US dollars couldn't change in price.  Also, US citizens couldn't own gold from 1933 through 1973.

From 1963 through 1992, gold returned 7.80% per year, but that includes a very bullish period for gold from 1972 through 1980 when the U.S. went off the gold standard in 1971 and gold rose from $35 per ounce to over $860 an ounce in an obvious bubble by 1980.  From 1981 through 2000 gold went mostly sideways in price and offered no gains.  From January 2000 through June 2011 gold rose 450% nominally, far exceeding the returns from all other asset classes.  From its high at $1900 an ounce in 2011 through 2016 gold declined about 40% then rose again to an all-time high of $2069/oz. in August of 2020 and that high continues as of 2-2021.

The primary argument for gold in portfolio allocations is that it does well during or after periods of very high money and credit creation like we have seen since the 1990's and particularly during the 2014 through 2021 period.  It is interesting to note that US dollar money supply increased by about 24% in 2020 while the US economy grew by an inflation adjusted 2.3%.  This is simply currency debasement.  Many central banks and foreign investors hold gold since it has been a consistent store of value for over 5000 years while every fiat paper currency has eventually ended up worthless.  Gold is an uncorrelated asset with equities and can do exceptionally well in times of high inflation, currency declines or collapses, and political or economic instability.

The financial industry and financial press generally ignore or disparage gold as an investment.  As gold prices climbed rapidly in 2010 numerous articles appeared in the Wall Street Journal and elsewhere cautioning investors about the risks in gold, a bubble in gold, and the lack of intrinsic value in gold.  After further climbs in 2011 the financial press turned a little more positive on gold.  When gold's price was pushed down by massive short futures contracts in Q213 the financial press published an unending series of articles celebrating its demise and the danger in owning gold.  This continued through 2020.  Gold skeptics argue that gold is a metal and doesn't produce interest, dividends, or profit growth thus its value is subjective and its price is only that which people accord to it.  The weakness in this argument is that paper "fiat" currencies are also only worth what people accord to them if they are not linked to something of value that is scarce...like gold.  Paper currencies have always gone to zero value, something gold has never done.  Stock, bond, and real estate prices are denominated in fiat currency and thus their price is also linked to the creation of fiat paper.  Excess fiat currency creates higher asset prices and/or consumer price inflation.  Financial market prices are falsified when fiat currency is overproduced versus economic growth.  Gold is expensive to mine and produce.  Gold has no counterparty promising to pay and is not linked to any counterparties although its price is heavily manipulated in largely unbacked gold futures contracts on the US Comex and some other exchanges.

Common in anti-gold articles is a mention that gold traded over $860/ounce spot in early 1980 and only recovered that in 2008.  Not mentioned is that the $860 price occurred in a very brief and obvious bubble blow-off in early 1980 after gold moved up from $35 an ounce, about 7x, to the $250 range over the prior 9 years before the bubble top blow off over $600/oz. in three months in 1980.  If we compare the US government's CPI data with the price of gold for 1970 through 2009, gold rose at an inflation adjusted annual rate of 6.73%.  For 1980 through 2009 it rose 0.78% per year above the CPI inflation rate despite this data starting at the 1980 peak.  For 2000 through 2009 it returned 10.46% annually above the CPI.  Gold clearly outpaces inflation in certain financial environments although it's correlation with inflation is low but positive over the longest periods, in the 0.2 range (Dimson et al).

In a WSJ article (August 2010), Jeff Opdyke asked Ibbotson Associates to determine how closely inflation and gold-price movements' tracked each other during 1978 through 2009.  For that period the correlation was at most 0.08, essentially zero.  However, for 1973 through 2009 the US dollar and gold were inversely correlated at a very significant -0.65%.  Opdyke concludes that "gold is a currency" and not a conventional commodity, a protection against constant currency debasement created by governments and central banks.  A study by the World Gold Council published in Forbes in August 2010 found very low correlations between gold and other commodities, except silver at around 0.7.  They also found that for 2000 through 2009 gold was less volatile than other major asset classes with gold's standard deviation at 15.8%, the S&P at 18.4%, and the GSCI commodities index at 21.7%.  Another study found that from 1982 through 2010 the price of gold correlated a very high 0.93 with the rise in total US debt.  As of 2020 US debt is about 27 trillion and the annual deficit added about $4.5 trillion in 2020, not including promised future Social Security and Medicare benefits which run in the tens of trillions.  There are few signs that US politicians are willing to reduce spending or raise taxes and this provides a strong underpinning for gold's long term returns versus the US dollar.

Wall Street most likely doesn't promote gold because there is little money in it for Wall Street.  Gold custodians charge very low fees, new forms of gold can't be offered in initial public offerings since there aren't any new forms of gold, physical gold can't be subjected to levered buyouts and mergers and acquisitions since it's a metal and no hidden assets are there to be extracted, and high management fees can't be charged for trading gold since there is no evidence speculators can trade and time the gold market profitably.  In addition, central banks prefer fiat currency creation and dislike anything that would limit them from creating fiat currency, like a gold standard.  Governments generally spend more than they take in from taxes and prefer to avoid the fiscal discipline imposed by a gold standard, instead preferring an "inflation" tax and that tax is created by the excess creation of fiat currenty and borrowing from the future.

Ibbotson conducted a study of the benefits of precious metals in portfolio diversification covering February 1971 through December 2004.  Of particular note is their finding that precious metals tend to do best when traditional asset classes like equities and fixed income have negative returns, thus smoothing and contributing to returns in highly diversified portfolios.  Ibbotson found that the risk/return ratio in conservative, moderate, and aggressive equity/fixed portfolios was improved by allocations of 7.1%, 12.5%, and 15.7% to gold respectively.  EAM generally recommends a 5% to 15% allocation to gold along with a globally diversified equity and fixed income portfolio although many of our clients choose not to own gold.

HOME OWNERSHIP:

Although a home is the major portion of net worth for most Americans and home price increases from the mid-1990's through 2007 through 2020 were strong a home should probably be seen as a consumption and not as an investment.  That's because it is lived in, and once sold, a replacement will also reflect increased prices elsewhere unless one moves to a part of the country where real estate is less expensive.  And, if a new home is not purchased to replace one that has been sold, cap gains may need to be paid and rent must be paid.  Historically home prices have been strongly correlated with economic conditions, interest rates and bond prices, and, on several occasions, to equity prices.

From 1968 through 1992 (Department of Commerce data) the average one family house price index appreciated at the rate of 6.17% per year versus 10.44% per year for the S & P 500, trailing both equities and commodities but outperforming bonds.  Sketchier data from earlier in the century suggest that homes and rentals appreciated at about the rate of inflation and were very sensitive to equity market declines in the 1930's in a deflationary economy.  Robert Shiller of Yale, creator of the Case-Shiller housing indexes and widely recognized as the nation's leading authority on housing prices, has price data going back over 100 years.  Long-term, housing gave returns less than 1% above the rate of inflation.  Annual returns of 10% to 20% in much of the country in the 2003 through 2006 period reversed in 2007 and prices dropped about 35% nationwide in 2008 and early 2009.  Home prices continued rising to new highs in 2020.

Very low mortgage rates produced by Fed policies and government tax incentives which drove up home prices reduced the supply of new home buyers who could afford the down payment or monthly payment and kept them out of the hoursing market.  As of 2016 the majority of home purchases were driven by investors buying to flip, rent or syndicate homes in securities.  This has not been true historically.  In a normal market, investors account for around 20% to 25% of home purchases.  Shiller notes that ultra-long-term housing data is hard to come by but that careful records in one part of Amsterdam show an appreciation rate of 0.2% after inflation from 1628 through 1973 and a study of US home prices shows a real inflation adjusted appreciation rate of less than 1% per year from 1948 through 2004.  Recent strong gains in housing prices are unlikely to continue.

Other problems may present themselves when homes are viewed as investments or diversifications for equity portfolios.  Historical data show that real estate prices can decline about as much as stock prices in some circumstances though generally far less than the declines in equities.  Houses can also take a long time to sell in bear markets.  A Bank of International Settlements study constructed asset-priced indexes separate from prices for goods and services, and found that for 13 industrialized countries, equities and residential real estate generally tracked quite closely together.  In Japan, for example, Tokyo condos declined about 65% from 1990 through 2010, just about the same as the decline of the Nikkei stock index for the same period.  The average California home went from $1,600 in 1900 to $5,600 in 1929 then back to $1,600 in 1932, reversing 30 years of prior gains.  An article published by UC Davis in March 2011 found that Manhattan real estate prices correlated strongly with equity prices during 1929 through 1932, declining 56% in nominal terms.  Housing could fail to diversify equities in an equity bear market.  On the other hand, during the inflationary 1970's equities gave poor returns and residential real estate stayed a little ahead of high inflation in most parts of the US.  We think one's personal residence should not be regarded as an investment or as a sure protection of assets if financial markets are collapsing or the economy is deflating.  And, illiquidity can appear rapidly in housing markets as we saw in 2008 when equities, bonds and housing crashed simulataneously.

CONCLUSIONS:

They are no magic or optimal asset classes or allocations which do well in all economic conditions or can be counted on to do well during equity bear markets.  Least anyone thinks taking positions in equities can be timed based on fundamentals or that bear markets can be identified, consider the Nikkei.  It peaked at 38,916 on 12/25/1989.  In nine months it fell to 20,984, declining over 46%.  Quick and early players who timed it right and shorted the Nikkei could have done well.  But, extensive research suggests that consistent short-term timing of markets is rarely if ever possible.  Let's assume our investor held on to their equity positions and awaited a new bull market as the fundamentals worsened throughout the 1990's.  The Nikkei made several visits to the low teens only to end up ten years later at 20,434 on 4/10/2000.  It then dropped hard to under 8000 by March of 2003 and has been trading in the 14,000 to 40,000 range since then.  Identifying it was in a bear market would have been impossible due to price volatility.  As one writer quipped, "Its hard to imagine how any of that market action was based on economic fundamentals because the fundamentals were rotten all the time."

Chase, C. D.  Chase Investment Performance Digest.  Chase Publishing, 1993

Fischer, D. H.  The Great Wave:  Price Revolutions and the Rhythm of History.  Oxford University Press, 1996

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