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Talkin' Shop: Different Market Environments

Eric, CIO of Standpoint, talks about the four economic environments and how the investments that make up a portfolio will perform differently in each of the four ‘quadrants.’ A stock and bond portfolio may do well in a high growth and low inflation period like the 1990s and 2010s but can really struggle during other environments like the 1970s and 2000s. An all-weather approach is a solution to help round out a stock and bond portfolio.

Key Takeways

  • Long only commodities and currencies is not how Standpoint employs an All-Weather approach. There is a right and wrong way of combining multiple asset classes.
  • The proper use of commodities and currencies can help defend against a lost decade and inflation.
  • When the economy is doing well, and the stock market is going up, you need to be comfortable taking the risks necessary to make money during that environment.

Transcript

Eric Crittenden: When I look at all the different economic environments that I think are plausible and likely, it's the Bridgewater approach. You can bracket them up into four quadrants, you got growth, high or low, and you've got inflation, high or low, and it's like a 2x2. No matter what happens, you're going to be able to fit the market environment that you experienced somewhere in that 2x2. It could be the recent-- from 2009 to current, you've had really high growth and low inflation, and that's the best-case scenario for stocks and it's a pretty good scenario for bonds, which is why people are invested in stocks and bonds and not too happy with alternative investments and commodities and whatnot.

In a period like the 1980s, you had a little bit different, you had high growth but you also had high inflation. Stocks and bonds did okay, but other things like commodities and certain currencies did fantastically well. You could have had a different portfolio, a different portfolio would have been optimal during that period of time.

In a period of time like the '70s, it was radically different, stocks did very poorly in real terms with a couple of 50% declines, so you had a lost decade, more than a lost decade, and bonds did very poorly as well because interest rates went from 3% up to about 18%. In real terms, bonds did tragically bad and stocks did pretty bad at the same time.

That scares me and says, all right, well, if I'm managing money over that 14-year window, I've put my clients through a lost decade, I've charged fees, I've generated shit tons of taxes for people on the bond side because the yields were nominally high but the real returns were negative, and they actually went backwards in real terms. 14 years later, my clients actually have a lower net worth, a higher cost of living, they've paid me fees and they paid the government all these taxes and they've gone backwards. I look at it and say, "That's not for me."

Some people might look at it and say, "Hey, that's just a risk that we run, that’s the cost of doing business. If it happens it happens and that's okay.” Okay. I'm saying, "No, I would rather have a different portfolio that has a much lower likelihood of experiencing something like that."

We know you don't get something for nothing, so how would I build a portfolio that makes me comfortable? Well, it would need to minimize that lost decade risk, it would need to minimize the risk of dramatically underperforming equities in a bull market. I think it's bad to not make money when the GDP is growing, the economy is growing, and the stock market's doing well. I feel like that money is there for the making and you should have the courage and the fortitude to participate. How would you do that? How would you ensure that you would benefit from being an investor when investors are making money in stocks, but also protect yourself from a lost decade or hyperinflation or any of these other things? That's where using some of the other ingredients the right way comes into play.

If you just stick it in stocks and bonds, you do fine in most market environments but you do tragically bad in an environment like the 1970s, or an environment like the great depression. If you participate in commodities and currencies the way I think money is made in those particular sectors, it gives you something that I believe makes money over time, competitively, but is fundamentally different from the risk and reward of stocks, and it's fundamentally different from the risk and reward of bonds, so it's truly a diversifier.

Also, you get the benefit at least historically of actually thriving when stocks do poorly and thriving when bonds do poorly and in particular, thriving when both stocks and bonds do poorly at the same time.

Now, I can't guarantee that's how it'll play out always, no one can guarantee these things, but I think that's valuable information from the past to know that there is this other, I don't know if it's really an asset class, I think of it as one but this other thing that fills that pothole and doesn't drag the whole portfolio down. In a perfect world, I'd be able to demonstrate this to people, I'd be able to say, "All right, well, here's your 60/40 portfolio, you got a large cap US stocks total return, Barclays Aggregate Bond Index, slam them together, no fees, run the equity curve and you can see that most of the time it looks great, '70s looked horrible. In 2008 it was down, I don't know, 40% or something. During COVID it was down 20, but it's always bounced back and made new highs and, historically, it's made 10% annualized returns with, I don't know, 13% vol and 30% max drawdowns, not too bad. But there are environments where it is really poor, where you can lose money in real terms for up to 15 years.

Is there a way to smooth that out and make it better? Can you get rid of some of the risks it's taking without giving up the returns? Well, generally speaking, the answer is no, there's not a lot of other ingredients that actually when you add them in help, but this trend following approach on commodities and currencies which on a stand-alone basis looks really good to me, it actually, when you blend it in with stocks and bonds, helps quite a bit.

It helps by filling in those potholes like a period like the 1970s you could have done just fine. In a period like the credit crisis in 2008, you could have done just fine. During a period like COVID, where the market went down 34%, you could have done just fine. I look at it and say, "I like this thing, I think it adds a lot of value, and it gives me what I'm looking for." Which is I have the portfolio has the reasonable rate of return, but I'm also, it appears, getting rid of, to a large degree, the potential for a lost decade and the potential to get totally left behind in inflation. By adding it in, it really just solves those two problems that I worry about, that other people are going to worry about but they're not worrying about right now.

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