There are tons of great books available on the subject of portfolio allocation, but I wanted something easy to understand (and thus, remember). One of the better models I can across was Harry Browne’s Permanent Portfolio.

The basic premise is to cover all possible scenarios in your porfolio:

25% of portfolio to protect against Inflation (eg. Gold)
25% of portfolio to protect against Deflation (Cash)
25% of portfolio to do well in a Bull Market (equities)
25% of portfolio to do well in a Bear Market (bonds)

Taking it a step further you can add in protection against Devaluation (eg. invest in foreign currencies and foreign bonds).  You can also add in real estate or REITs as an inflation hedge, and foreign equities. The the basic premise is simple. You try and benefit from any sort of market. 

This is pretty simple to implement. All you need is to do is buy low-cost ETFs and check your portfolio once a quarter to rebalance to the appropriate percentages.

If you like this philosophy but don’t want to implement it, you might want to take a look at the Permanent Portfolio Fund (PRPFX) which is modeled and named after Harry Browne’s  Permanent Portfolio. Over the past 27 years, it’s been down only 4 years. Maximum annual loss was 12% in 1984. In 2008, it lost less than 9%! It’s expense ratio is also reasonable at 0.82%. It’s 5-year average return is a respectable 10.3% vs say an S&P 500 index fund like (SWPPX) which had a 5-year average return of 0.99%.

 It’s portfolio consists of gold, silver, Swiss franc assets such as Swiss franc denominated deposits and bonds of the federal government of Switzerland, stocks of U.S. and foreign real estate and natural resource companies, aggressive growth stocks and dollar assets such as U.S. Treasury securities and short-term corporate bonds.

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And despite the decent performance of gold over the past 10 years, they’re correct. Gold is a lousy investment. It creates no income and just barely keeps up with inflation.

But do you know what the best performing asset class was during the past 10 years? No, it wasn’t your stock portfolio or your real estate. It was gold, and it returned a decent 270% over that period.

Despite its out-performance of all major asset classes, gold still gets no respect from the investment community. That’s because it is only a store of value and typically only does well in periods of currency crisis, or times of poor monetary policy.

For example, during post-WW2 Germany and in post-Mugabe-school-of-economic-policy Zimbabwe, their currencies have faced severe devaluation and gold prices sky-rocketed against those currencies. Faced with hyperinflation and an inability to buy basic necessities, people flock to gold causing the price to soar.

But that wouldn’t happen in the US right?

Economic research has shown that consumer psychology is affected by the amount of wealth people feel they have. If they’re broke and living pay-check to pay-check, but have tons of equity in their homes, they still feel wealthy. But even if they still have a job, but are upside down on the mortgage and have negative equity in their home, they feel poor and their spending decreases. Since the US is a consumer spending driven society, with spending constituting 70% of our GDP, the Federal Reserve has been trying desperately to get the consumer to start spending again.  Part of this entails propping up housing prices by keeping mortgage rates low, and another part is keeping interest rates low on non-collateralized consumer debt (that’s credit cards and student loans).

In an effort to stem the free-fall in the housing market, the Federal Reserve has been trying to keep the interest rates for mortgages as low as possible. Historically, the Fed has tried to manipulate the short-end of the yield curve by adjusting the shortest of short-term rates – the Inter Bank Overnight Rate (also called the Federal funds rate in the US. The UK has something similar called the LIBOR). This is supposed to have a trickle down affect the interest rates of long-term interest rates (such as the 10 year and 30 year Treasuries).  The rates for 3o year fixed rate mortgages are impacted by the rates on the 10 year Treasuries. So by keeping the federal funds rate at zero (or 0.2% which is close to 0%), mortgages rates should stay quite low. However, given the fact that this is not a typical economic scenario, the fed isn’t quite sure that mortgage rates would stay below 5%. So it has been buying billions of long-term Treasury bonds as well as mortgages, which is a quite a bold move away from its historic stance. When the 800 pound gorilla starts buying bonds, the prices rise and the yields go down.  When the Federal Reserve decides to buy $300 Billion dollars worth of mortgages and government bonds, something is definitely wrong with the economy.

I’m  interested to see the effect on mortgage rates once the Fed stops buying Treasuries and mortgages.

The government is increasing its deficit spending at a steady clip. If this continues, eventually we will be unable to repay the debt and barely just able to service the debt. Obviously this is not a viable long-term strategy, but it doesn’t look like there is any other back-up just in case helicopter Ben’s strategy of throwing money at the problem doesn’t pan out.

Clearly, we are currently in a crisis period in regards to fiscal policy and gold prices are likely to keep going up. During times of good fiscal policy, gold does nothing. This does not seem to be one those times.

A well-known hedge fund manager (and world poker champion) David Einhorn shares the sentiment.  And someone else who agrees with him is Liu Mingkang, chairman of the China Banking Regulatory Commission. He recently said, “Low U.S. interest rates and a weaker greenback have “seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.”

Someone I know who works at a very well-known bond fund company recently advised me to sell my gold holdings. He advised me the same thing last year when gold was only $800/ounce. And I told him the same thing I said last year – Not yet.

Disclaimer: I’m long gold/silver bullion, gold mining stocks and short long term treasuries.

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The IMF still has another 203 tons of gold to sell and the hot favorite to make the purchase has been China.  However, according to a report by Reuters, its a lot cheaper for China to buy domestically mined gold than purchase bullion from the IMF at the current spot price. According to Li Yang, a former adviser to the People’s Bank, “China’s gold is much cheaper than that.”

You may not realize it, but China is the world’s No. 1 gold producer, and its mine costs are much less than $1,100 per ounce. And given China’s propensity to put national well-being over any private individual or firm, they’re likely to just pay for the gold being mined at cost, which would be a lot lower than the spot price.

According to another Chinese Central Bank official,

China is the world’s biggest gold producer, so there’s no urgency for us, as there is for India, to snap up big volumes whenever they come onto the global market. It’s cheaper for us to buy gold from the Chinese market, but it doesn’t help diversify our huge foreign exchange reserves.

To diversify our portfolio, we should spend dollars on things like gold. But the catch is that even if China bought half the world’s annual gold supply, it would only cost a few tens of billions of dollars, which is tiny compared to China’s huge reserves.

China has 2.27 trillion dollars in reserves. Spending 25 Billion a year buying gold is chump change. The question that’s relevant is whether they will, because that will put upward pressure on gold prices.

While no one knows whether China will or will not buying gold on the open market, the one thing we do know is that the monetary base of the US Dollar is growing exponentially making each existing dollar less valuable. Check out this graph from the St. Louis Fed:

While its not obvious from the graph, the monetary base has in the past year. Its true that this money hasn’t worked its way in to the economy, but if and when it does we should expect higher inflation and a spike in prices of real assets like gold, silver and real estate.

If I had a few trillion dollars, I’d be buying a few hundred tons of gold every year!

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For those a little dusty on their history, the British pound sterling (so called because it’s value was backed by sterling silver) was the world reserve currency until the 1930’s. After that, the sun set on the British Empire and the sterling was replaced by the US dollar. Now it seems the dollars time in the sun has come to end as well. The Telegraph article states:

Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles. Asia’s “mercantilist mindset” of recent decades is about to be broken by the spectre of an inflation spiral.

A monetary policy of near zero rates – further juiced by quantitative easing – is completely incompatible with circumstances in most of Asia, the Middle East, Latin America, and Africa. Divorce is inevitable. The US is expected to hold rates near zero through 2010 to tackle its own crisis.

Mr Bloom said regional currencies would emerge as the anchor for their smaller trading partners, with China, Brazil, or South Africa substituting the role of the US. Australia is already linking its fortunes to China through commodity ties.

This is nothing new, but it is the first time a major bank has openly stated this. But the important question hasn’t been answered.

What does it mean to the average American?

In order to obtain the necessary financing to fund the multi-trillion dollar stimulus/bailout package the government needs to sell bonds. Traditionally, the Chinese and other foreign governments have used their excess reserves of US dollars to purchase these bonds. If we switch to some other currency (or mixture of different currencies), the amount of US dollars held by foreign governments will decrease and the demand for US treasuries that yield next to nothing will decrease substantially. In order to entice the buying of these treasuries, the interest rates will have to jump substantially higher. And when this happens, the cost of the US government’s debt will start to rise. As will the cost of borrowing for US citizens and businesses. The government already pays nearly a billion dollars a day in interest payments (hat tip: Silver Bars Direct: Why $1,000 gold is now significant). If this cost were to double, and we add in the additional $9 trillion in debt the white house has admitted it is likely to borrow, we’re looking at over a trillion dollars a year in debt payments.

In order to repay this interest (and maybe the original principle too), do you think the government is likely to raise taxes or just print more money? If it prints more more, its just fueling the debt spiral which will lead to Zimbabwe-type hyper-inflation.

So what should you do?

Invest in hard assets that have been proven to keep their buying power during inflationary times.  Along with gold and silver bullion, buy some cheap land to either farm, hunt or bury your precious metals! And if you’re one of those people who think buying gold and silver is useless then hold on to your dollars and watch them become even more worthless. Since 1900, when the dollar coin actually contained silver, the dollar’s purchasing power has dropped to only4 cents. This trend is only like to get worse.

Disclosure: I own gold & silver bullion, numismatic coins and mining stocks.

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However, this is only from a “technical perspective”, and unemployment for 15 million Americans (officially 9.7%) will continue, if not get worse. In fact, it may stay this way for nearly 4 more years according to other economists.

So what does this mean? The operation was a success but the patient still died!

Apparently pumping a trillion dollars in to the economy will create a technical expansion even if the net benefit to society is negative. What happens when the government pulls the plug on throwing money at the ecnomy? Won’t the GDP decline again, pushing us back in to a double dip recession?

And what happens if our lenders make this decision for us? Supposing China and Japan no longer want to buy our 30 years bonds at a measley 3 or 4%. What if the interest rates go up to 8%? Will we be able to afford $1 trillion dollars a year in interest payments? Will we start issuing notes for the interest payments? Nah, we’ll just devalue the currency and let inflation help us out of this mess. Either that or the government stimulus will continue indefinitely, aka monetary policy Zimbabwe-style! Oh wait, isn’t that the same thing?

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