At the end of major economic cycles, shortages develop in all areas of the economy. 

And this is what the world is experiencing today on a global basis. 

There is a general lack of labour, whether it is restaurant staff, truck drivers or medical personnel.

There are also shortages of raw materials, lithium (electric car batteries), semi-conductors, food,  a great deal of consumer products, cardboard boxes, energy and etc, etc. The list is endless.


Everything is of course blamed on Covid but most of these shortages are due to structural problems. 

We have today a global system which cannot cope with the tiniest imbalances in the supply chain.

Just one small component missing could change history as the nursery rhyme below explains:

For want of a nail, the shoe was lost.
For want of a shoe, the horse was lost.
For want of a horse, the rider was lost.
For want of a rider, the battle was lost.
For want of a battle, the kingdom was lost.
And all for the want of a 
horseshoe nail

Cavalry battles are lost if there is a shortage of horseshoe nails.

The world is not just vulnerable to shortages of goods and services.


Bombshells could appear from anywhere. 

Let’s just list a few like:

  • Dollar collapse (and other currencies)
  • Stock market crash
  • Debt defaults, bond collapse (e.g. Evergrande)
  • Liquidity crisis  (if  money printing stops or has no effect)
  • Inflation leading to hyperinflation

There is a high likelihood that not just one of the above will happen in the next few years but all of them.

Because this is how empires and economic bubbles end.

The Roman Empire needed 500,000 troops to control its vast empire.

Map of the Roman Empire.

Emperor Septimius Severus (200 AD) advised his sons to “Enrich the troops with gold but no one else”.

As costs and taxes soared,  Rome resorted to the same trick that every single government resorts to when they overextend and money runs out – Currency Debasement.

So between 180 and 280 AD the Roman coin, the Denarius, went form 100% silver content to ZERO.

And in those days, the soldiers were shrewd and demanded payment in gold coins and not debased silver coins.

Although the US is not officially in military conflict with any country, there are still 173,000 US troops in 159 countries with 750 bases in 80 countries. 

The US spends 11% of the budget or $730 billion on military costs.

US military presence

Since the start of the US involvement in Afghanistan, Pentagon has spent a total of $14 trillion, 35-50% of which going to defence contractors.

Throughout history, wars have mostly started out as profitable ventures, “stealing” natural resources (like gold or grains) and other goods–often due to shortages. 

But the Afghan war can hardly be regarded as economically successful and the US would have needed a more profitable venture than the Afghan war to balance its budget.


The US annual Federal Spending is $7 trillion and the revenues are $3.8 trillion.

So the US spends $3.2 trillion more every year than it earns in tax revenues. 

Thus, in order to “balance” the budget, the declining US empire must borrow or print 46% of its total spending.

Not even the Roman Empire, with its military might, would have got away with borrowing or printing half of its expenditure.


As Mr Micawber in Charles Dickens’ David Copperfield said:

‘Annual income 20 pounds, annual expenditure 19 [pounds] 19 [shillings] and six [pence], result happiness. Annual income 20 pounds, annual expenditure 20 pounds ought and six, result misery.’

And when, like in the case of the US, you spend almost twice as much as you earn that is TOTAL MISERY.

Neither an individual, nor a country can spend 100% more than their earnings without serious consequences. 

I have written many articles about these consequences and how to survive the Everything Bubble


The most obvious course of events is continuous shortages combined with prices of goods and services going up rapidly. 

I remember it well in the 1970s how for example oil prices trebled between 1974 and 1975 from $3 to $10 and by 1980 had gone up 10x to $40.

The same is happening now all over the world.

That puts Central banks between a Rock and a Hard place as inflation is coming from all parts of the economy and is NOT TRANSITORY!

Real inflation is today 13.5% as the chart below shows, based on how inflation was calculated in the 1980s

Consumer inflation is much higher than reported.


The central bankers can either squash the chronic inflation by tapering and at the same time create a liquidity squeeze that will totally kill an economy in constant need of stimulus. 

Or they can continue to print unlimited amounts of worthless fiat money whether it is paper or digital dollars.

If central banks starve the economy of liquidity or flood it, the result will be disastrous. 

Whether the financial system dies from an implosion or an explosion is really irrelevant. 

Both will lead to total misery.

Their choice is obvious since they would never dare to starve an economy craving for poisonous potions of stimulus.

History tells us that central banks will do the only thing they know in these circumstances which is to push the inflation accelerator pedal to the bottom.

Based of the Austrian economics definition, we have had chronic inflation for years as increases in money supply is what creates inflation. 

Still, it has not been the normal consumer inflation but asset inflation which has benefitted a small elite greatly and starved the masses of an increase standard of living.

As the elite amassed incredible wealth, the masses just had more debts.

So what we are now seeing is the beginning of a chronic consumer inflation that most of the world hasn’t experienced  for decades.


This is the inevitable consequence of the destruction of money through unlimited printing until it reaches its the intrinsic value of Zero. 

Since the dollar has already lost 98% of its purchasing power since 1971, there is a mere 2% fall before it reaches zero. 

But we must remember that the fall will be 100% from the current level.

As the value of money is likely to be destroyed in the next 5-10 years, wealth preservation is critical.  

For individuals who want to protect themselves from total loss as fiat money dies, one or several gold coins are needed.

So back to the nursery rhyme:

For want of a nail gold coin, the shoe was lost.
For want of a shoe, the horse was lost.
For want of a horse, the rider was lost.
For want of a rider, the battle was lost.
For want of a battle, the kingdom was lost.
And all for the want of a horseshoe nail gold coin.

Gold is not the only solution to the coming problems in the world economy. 

Still, it will protect you from the coming economic crisis like it has done every time in history

And remember that if you don’t hold properly stored gold you don’t understand:

  • What happens when bubbles burst
  • You are living in a fake world with fake money and fake valuations
  • Your fake money will be revalued to its intrinsic value of ZERO
  • Assets that were bought with this fake money will lose over 90% of their value
  • Stocks will go down by over 90% in real terms
  • Bonds will go down by 90% to 100% as borrowers default
  • You lack regard for your stakeholders whether they are family or investors
  • You don’t understand history
  • You don’t understand risk

The 1980  gold price high of $850 would today be $21,900,  adjusted for real inflation

Gold has not yet adjusted to real inflation. Shortages of gold will soon come.

So gold at $1,800 today is grossly undervalued and unloved and likely to soon reflect the true value of the dollar. 

jueves, octubre 21, 2021



It's Show Time for the Fed


Despite lackluster third quarter and year-to-date performance for gold, the fundamental backdrop for precious metals and related mining share prices continues to strengthen in our opinion. 

Here's why we believe this: 

- Inflation has become increasingly problematic and more persistent than previous sanguine assessments by Federal Reserve Board (Fed) Chairman Jay Powell and other Fed officials.1

- Real interest rates remain deeply negative, a positive for gold. 

The average annual return on gold during periods of negative real interest rates has been a stellar 21.12%.2

- Monetary policy continues to be highly accommodative. 

The bearish case for gold rests on the deteriorating probability of the Fed tapering asset purchases in November.3

- The global economy is beginning to sputter. 

Spreading economic weakness will make any tightening moves by central banks difficult to implement without broader repercussions.

- Physical gold buying centered in India and China has risen dramatically. Indian demand alone is 500 tonnes greater than it was in 2020, more than enough to absorb current mine supply.4

- Net buying of gold bullion by central banks is likely to continue and may possibly increase.5

- Positioning by commodity traders is at negative extremes and is usually followed by short-covering rallies. The selling of paper gold on the thesis of Fed tightening is already priced into the market.6

- Gold mining equities are trading at deep value while generating record cash flow.

“Overconfidence, complacency, recklessness and intoxication come to mind when characterizing the current financial market zeitgeist.”

Loss of Faith in the Fed Could Benefit Gold

Notwithstanding the wide array of bullish considerations (all of which deserve paragraphs of exposition that have been written elsewhere and are omitted here for the sake of brevity), the number one game changer for gold could be a loss of faith in the U.S. Federal Reserve Board. 

Unshakeable confidence in the Fed's stewardship of the financial system and the economy has been the anchor for the bull market in financial assets. 

That trust is at great risk, in our opinion, when (and if) tapering begins. 

In our Q2 Gold Strategy Letter ("You Gotta Have Faith"), we concluded:

"Faith in the Fed's omniscience is convenient to the investment consensus because it underpins the extraordinary overvaluation of financial assets. 

The relationship between overvalued financial assets and belief in an all-knowing Fed is symbiotic. Loss of that faith for heavily sedated markets would lead to losses of trillions of dollars in the world of financial assets."

The fourth quarter of 2021 poses a moment of truth for the Fed. 

If the Fed reacts to persistently hot inflation readings with tough talk but no action, its credibility may wither. 

If the tapering promised for November triggers falling stock and bond prices, a very likely event in our opinion, the Fed will take the blame, also damaging its credibility. 

Moreover, will persistent tapering be enough to tamp down intransigent inflation? Any of these possibilities would diminish investor trust.

The Fed's Game of Chicken

Chairman Powell also knows that the Fed cannot afford to reverse course as quickly as in 2018 — when it attempted balance sheet normalization and rate hikes — without again embarrassing the institution. 

Therefore, the Fed may this time stick to its guns and attempt to ride out market adversity, an unpopular decision, especially if the already weakening economy slows further. 

The Fed can only lose the upcoming game of chicken and it will be interesting to see how it narrates its way out of this predicament. 

The question is, how much market and economic damage precedes the inevitable pivot?

Overconfidence, complacency, recklessness and intoxication come to mind when characterizing the current financial market zeitgeist. 

Market positioning for an abrupt loss of confidence in the mechanism inflating the bubble is almost non-existent, in our opinion. 

Sobriety is scarce and denial of risk is commonplace. 

As noted by Michael Solomon in a recent investor letter:

"A survey reported by Bloomberg [see Appendix A] confirms the absurdity and lack of rationality that we perceive in much of the market's behavior. In that survey, 59% of members of Gen Z (defined as 9 to 24-year-olds) confessed to being drunk when they trade. Of all investors surveyed, 32% admit to having traded when intoxicated." (Source: Marlin Sams Fund, LP 10/1/2021)

We believe gold mining stocks represent huge upside leverage to a potential loss of confidence. 

Downside risk is low because of their deeply discounted valuations. 

Figures 1-3 demonstrate the compelling absolute and relative value offered by gold mining shares as well as the asymmetric risk/reward proposition they represent: 

Figure 1. EV/EBITDA: Gold Mining Equities vs. S&P 500 (2011-2021)

Figure 2. Gold Miners Showing Superior Metrics to S&P 500

Valuations and Fundamentals: Gold Mining Equities vs. S&P 500 as of 9/30/2021

Figure 3. Gold Miners Offer Higher Dividend Yields than the S&P 500

Dividend Yield: Gold Mining Equities vs. S&P 500 (2011-2021)

A Near Perfect Environment for Gold and Gold Miners?

Since mid-June, gold and related mining stocks have been over-sold, shorted or ignored. 

The bearish thesis for gold and gold mining stocks has been that the Fed will slay inflation by "tapering" asset purchases, in stark contrast to their general dovishness over the past several economic cycles.

Now the rubber hits the road; the bear case for gold depends on the following fantasies:

Tapering is different than raising interest rates.

Our Counter: They're the same thing — both restrictive monetary policies are designed to accomplish similar outcomes.

The global economy can withstand a small increase in borrowing costs.

Our Counter: It can't. Excessive leverage will result in spreading defaults of marginal borrowers.

A 2022 slowdown is not in the cards.

Our Counter: It is. Multiple signs of weakness are already showing up, including weak employment reports, poor consumer sentiment and negative China Caixin Manufacturing PMI (purchasing manager’s index).

Nosebleed financial asset valuations are impervious to rising interest rates.

Our Counter: They're not. There are plenty of signs of market averages topping.

Inflation is transitory.

Our Counter: Evidence is increasing that it is intransigent and unlikely to be stemmed by tapering.

In our opinion, the number one reason for disinterest in gold has been the seemingly endless equity bull market. 

However, it would seem that things can hardly get better for equity bulls. 

The rosy economic outlook, super easy monetary policy and bullish crowd psychology are not immutable. 

Odds suggest that future changes are more likely to be negative at the margin than positive.

As noted by Bob Farrell, "Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways." 

Risks unperceived at market peaks can begin to multiply faster than investors can react. 

An unraveling of the current speculative euphoria, at a time when precious metals fundamentals have rarely been more solid, would constitute a near perfect environment for gold and gold miners.

Expectations for rising interest rates seem to be moving into high gear (see Cornerstone Macro). 

Somehow, these expectations are deemed to be harmful to gold but no threat to financial asset valuations in general. 

Perhaps this inconsistency can be explained (1) by the consensus belief that economic growth and strong earnings will be sufficient to offset the damage from rising rates and (2) that interest rates will rise just enough to put a lid on inflation but not economic growth and thereby render more draconian monetary tightening unnecessary.  

To us, this view ignores the yawning mismatch between the incremental supply of deficit-driven Treasuries and the lack of demand at ultra-low interest rates. 

As recently noted by Macromavens (10/12/2021):

"The point being that, as troubling as the recent backup in rates has been, it is FAR worse than surface-scanning investors dare imagine. 

The fact that $20 billion in foreign purchases, $38B in bank purchases, $8B in spec buying (and $40B in purchases by the Fed!) — which annualize to roughly $2.8 trillion in Treasury demand — failed to arrest the backup in rates (much less send them tumbling downward) SHOULD send ice cold shivers down the market's spine. 

For, unless one imagines that the pace of Treasury issuance is about to slow big time, (and that requires one hell of an imagination!) the recent action in the Treasury market reveals how impossible our financing situation has become."


The financial markets have not taken into account the magnitude of supply or the distortion of interest rate price discovery caused by quantitative easing. 

The impending attempt at balance sheet normalization could prove far more disturbing to financial markets than the failed 2018 episode. 

Appendix A

Amid "Gamification” Concerns, Nearly 6 in 10 Gen Z Investors Admit to Trading While Drunk

By Weston Blasi, (MarketWatch) Bloomberg 8.27.2021

Overview: According to a new survey, 59% of Gen Z traders claim to have bought or sold an investment while inebriated. Should you have to pass a breathalyzer to make trades on Robinhood (HOOD) or Charles Schwab (SCHW)? According to a new survey from consumer finance website MagnifyMoney, 32% of U.S. investors say they have made trades while drunk. Gen Zers fell into the trap most of any generation with 59% confessing to drunk trading — just 9% of baby boomers admitted to drunk trading.

Cornerstone Macro

Rate Hike Expectations are Rising

Quote from: Roberto Perli, Partner, Head of Global Policy, Cornerstone Macro 

"This view is getting more and more traction in the market, and unfortunately is getting more and more likely. A big reason is that it's hard for Powell to manage the hawks in the FOMC when he is in limbo. By delaying his renomination, the Admin is also making a big policy error.”

Figure 2 Definitions

EV/EBITDA: Enterprise Value (Market Capitalization plus Total Debt less Cash) to estimates of forward EBITDA compiled by Bloomberg. Higher figures reflect companies are trading at a higher valuation premium relative to their earnings. Free Cash Flow Yield: Operating Cash Flow less Capital Expenditure less Net Working Capital divided by the current stock price. Higher free cash flow yields reflect companies are generating greater amounts of cash flow relative to their share price. Return on Capital: measured by adjusted net income divided by total capital (total investment of shareholders and debt holders). Higher return on capital reflects that companies are better at turning outside investment into profits. Net Debt/EBITDA reflects total debt less cash divided by estimates of forward EBITDA compiled by Bloomberg. Companies with lower figures reflect lower leverage and debt as a percent of earnings. Profit Margin reflects forward estimates of net income divided by forward estimates of revenue, compiled by Bloomberg. Higher figures reflect companies are able to generate more earnings as a percent of top line sales, an indication of operating efficiency and expense management.

1 Source: WSJ, by the Editorial Board. The Inflation Tax Rises; 10/13/2021

2 Source: Bloomberg. Data for the period 12/31/1984 to 12/31/2020. Gold bullion is measured by the Bloomberg GOLDS Comdty Spot Price.

3 Source: “Monetary policy is the wrong tool”: Why economist El-Erian thinks the Fed is making a mistake.

4 Source: LAWRIE WILLIAMS: China’s 2021 gold demand already exceeds full year 2020.

5 Source: BNN Bloomberg. Gold regains shine after central bank buying drops to decade low.

6 Source: Meridian Macro Gold and Silver Report 10/16/2021.

Reflation or stagflation

Rising rates don’t have to crush stocks, but they can

Robert Armstrong 

© Financial Times

Reflation redux, hopefully

What has put the scare into stocks? 

The prime suspects are the good-sized moves up at the long end of the yield curve. 

The meandering rise in interest rates that has been with us since early August has accelerated to a brisk jog (all chart data from Bloomberg):

Here are the changes across the curve just since the Federal Reserve meeting on Wednesday last week:

That is a reasonably stiff and quite uniform increase across the middle and the long end. 

Are we headed back to the levels hit this spring, when the reflation trade dominated markets, to Wall Street’s delight? 

What has changed since the markets’ placid initial response to the Fed’s announcement last week?

Hawkish noises from the Bank of England, plus ebbing panic over Evergrande’s balance sheet, might have made a world of higher rates and inflation suddenly seem more likely. 

The price of Brent crude briefly passing $80 may have played a part, too. 

Or it could be none of that. 

Sometimes, even the bond market simply takes some time to see what is in front of its nose.

As I intimated on Thursday last week, the market’s initial placidity seemed odd. 

Above-trend economic growth for the next year at least is still the consensus expectation, house prices are on fire and wages are bubbling up. 

The Fed has told us it is about to slow the pace of its bond purchases. 

And yet here are real rates, rising but still well below zero:

What this chart says to me is that rates have room to rise. 

There should be a rising inflation risk premium in there, given how inflation data has evolved during the past few months. 

Real yields should also be anticipating the exit of a huge buyer from bond markets over the next year or so. 

So why should real yields still be negative?

I spoke with Bob Michele, the chief investment officer and head of fixed income at JPMorgan Asset Management, and he summed up my feelings exactly:

“I think that three things have been going on over the last 10 days. 

The central banks in aggregate — not just the Fed but the Bank of England, the Reserve Bank of Australia and others — are approaching a shift in policy and a start to tapering. 

We see a total of $300bn of [monthly] bond buying from all the central banks, so you should expect as they exit that things are going to change. 

A real yield of minus 1 per cent is not normal. 

It is an artificial construct of the central banks.

“[Then there is a] recognition that reopening [price] pressures are not going away any time soon — bottlenecks, energy prices, container ships stacked up, the labour market. 

It’s going to take years, not months, and in the meantime to get stuff done is going to cost more.

“The third thing is the debt ceiling. 

Does anyone step back and realise you are having a debate on the debt ceiling because a lot of debt is being issued, and a lot more will be issued? 

It’s a wake-up call . . . who is going to buy this [debt] if the central banks pull back? 

People like me, and I’m not going to buy government debt at a negative real yield.”

Here is how I would sum up. 

The only way to think that real yields can stay negative is if you think growth is going to disappoint, or the Fed is going to flinch and delay tapering and tightening, or both. 

Otherwise it seems to me that there is only one way for rates to go — up — and the important question is whether they drift up or spike up. 

If they drift, that may well be fine for risk assets. 

Spikes tend to cause messy repricings as investors deleverage.

Certainly, stocks have not responded well to the recent move up in rates. 

Many market observers make the point that stock valuations “rest on a foundation of low rates”. 

That is, low interest rates must drive stock prices up, mathematically, because they are the rates at which future cash flows are discounted. 

This is true as far as it goes. 

But much depends on what drives the rates higher — a strong economy or just inflation. 

In the former case, and not the latter, higher future cash flows help offset higher discount rates. 

Another reflation trade might be just fine for stocks. 

Not so stagflation.

So watch the performance of economically sensitive value stocks. 

If we are getting the benign rate increases, driven in large part by economic growth, one would expect value to do well relative to tech and other growth stocks, and at least hold their own absolute terms, as they did this spring. 

Here the Russell 1000 value and its growth counterpart, plotted against the 10-year yield:

So far, while value has outperformed growth in relative terms as yields have accelerated upwards, it has moved sideways at best in absolute terms. 

That looks more like stagflation than reflation, but it is early days.

Recovering Prosperity

The foundation of American economic prosperity is being undermined by increasingly dominant firms and outdated corporate-governance practices. Fortunately, there are simple steps that regulators can take immediately to put the economy – and American society – on a sounder footing.

Edmund S. Phelps, Mohammad A. Salhut

NEW YORK – As public discontent forces a political reckoning in most developed economies, the social contract binding together markets, states, and citizens is being reimagined. 

Indeed, today’s anger and alienation present an opportunity to address cracks in our societies’ economic foundations, starting in the United States.

Commercial activity is being rapidly digitized at scale, suggesting that the largest and most successful companies in the technology sector – from Amazon to Zoom – will continue to be dominant market forces for the foreseeable future. 

Yet while investors in these fast-growing enterprises have enjoyed significant financial gains, most others have not. 

The leading tech companies have fallen short not only in creating value for many of their stakeholders but also in contributing to US economic growth overall.

Indeed, now that everyone has adapted to the effects of the COVID-19 pandemic, many business leaders have shifted their focus back to quarterly profits and share prices. 

Just this month, Microsoft, the world’s second-most valuable publicly traded company, announced a $60 billion share buyback plan and dividend increase. 

Meanwhile, there has been very little talk of what management teams could do to create long-term value for shareholders and stakeholders alike.

Mounting evidence, presented by the International Monetary Fund and many others, suggests that Big Tech companies are stifling innovation through their acquisition strategies and competitive practices. 

If one believes, as we do, that economic growth is predicated on innovation, then one must support urgent action to address this problem.

Beyond the various legislative proposals to break up Big Tech firms, there are some simple steps that the newly confirmed chairman of the US Securities and Exchange Commission, Gary Gensler, can take immediately to ensure corporate accountability among technology firms, and to encourage sustained commitments to innovation for America’s shared benefit.

First, the SEC can and should require all publicly traded companies in the US to disclose clearly how much they spend on research and development. 

Under decades-old accounting standards, this category includes only activities aimed specifically at developing new products, services, or processes, or at major improvements to existing products, services, or processes. 

Small, incremental “routine or periodic alterations” are expressly prohibited from being qualified as R&D.

Yet, much to the country’s social and economic detriment, several of today’s Silicon Valley giants have lumped together such minor alterations under their R&D expense-line items. 

Given that the biggest technology companies command a large and increasing share of the economic pie, transparency about how much they are investing in genuine innovation is fully warranted.

Second, the SEC should make the long-overdue switch back to semi-annual reporting. 

Research suggests that there are high costs associated with the quarterly disclosures that every public firm currently undertakes. 

The formation of a capital market in which management teams must constantly issue profitability guidance has fostered a short-term mentality with far-reaching adverse economic consequences.

Short-termism has hampered managers’ ability to make substantive long-term investments, shortened the average tenure of CEOs, and diminished managers’ capacity to make decisions that may be crucial to US competitiveness in the global economy. 

Likewise, burdening small publicly traded firms – the foundation on which the economy is constructed – with repetitive and substantial reporting costs impedes growth-oriented investment by diverting resources.

Beyond these reforms to encourage change from the top, the pandemic has created an opportunity to reinvigorate grassroots innovation. 

This fall, millions of US students have returned to the classroom, some for the first time in more than a year. 

Because state governments are relying on federal funding to continue to educate the country’s youth, we have a once-in-a-generation chance to bring about fundamental change in the delivery of education at the local level.

Economists, intellectuals, entrepreneurs, and politicians share a general dissatisfaction with America’s educational performance relative to its peers. 

In particular, US schools have evidently failed to nurture creativity, risk-taking, and challenge-seeking in today’s young people. 

These values played a seminal role in US national development and should be inculcated in students as they return to the classroom.

The last 18 months have brought disruptions but also opportunities for positive change. America’s capitalist system will need to adapt to the new world. 

That means, for starters, re-centering the economic conversation around stakeholders and our shared future. 

The return to schools and campuses should occasion a return to education that celebrates the core, essential American values that helped the country become such an unprecedented success.

As we look to the future after the pandemic, we must focus on strengthening our institutions and reinvigorating our culture. 

To that end, shoring up the next generation’s intellectual foundation and providing corporations with the flexibility to innovate are just two steps we can take today. 

Many more can follow from those. 

Although America’s social, financial, and political challenges remain as stark as they have ever been, we can strive for a rebirth of the values and institutions we need.

Edmund S. Phelps, the 2006 Nobel laureate in economics and Director of the Center on Capitalism and Society at Columbia University, is author of Mass Flourishing and co-author of Dynamism.

Mohammad A. Salhut is a graduate student and research assistant at the Center on Capitalism and Society at Columbia University.


Why it is wise to add bitcoin to an investment portfolio

It is a Nobel prize-winning diversification strategy

“Diversification is both observed and sensible; a rule of behaviour which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim,” wrote Harry Markowitz, a prodigiously talented young economist, in the Journal of Finance in 1952. 

The paper, which helped him win the Nobel prize in 1990, laid the foundations for “modern portfolio theory”, a mathematical framework for choosing an optimal spread of assets.

The theory posits that a rational investor should maximise his or her returns relative to the risk (the volatility in returns) they are taking. 

It follows, naturally, that assets with high and dependable returns should feature heavily in a sensible portfolio. 

But Mr Markowitz’s genius was in showing that diversification can reduce volatility without sacrificing returns. 

Diversification is the financial version of the idiom “the whole is greater than the sum of its parts.”

An investor seeking high returns without volatility might not gravitate towards cryptocurrencies, like bitcoin, given that they often plunge and soar in value. 

(Indeed, while Buttonwood was penning this column, that is exactly what bitcoin did, falling 15% then bouncing back.) 

But the insight Mr Markowitz revealed was that it was not necessarily an asset’s own riskiness that is important to an investor, so much as the contribution it makes to the volatility of the overall portfolio—and that is primarily a question of the correlation between all of the assets within it. 

An investor holding two assets that are weakly correlated or uncorrelated can rest easier knowing that if one plunges in value the other might hold its ground.

Consider the mix of assets a sensible investor might hold: geographically diverse stock indexes; bonds; a listed real-estate fund; and perhaps a precious metal, like gold. 

The assets that yield the juiciest returns—stocks and real estate—also tend to move in the same direction at the same time. 

The correlation between stocks and bonds is weak (around 0.2-0.3 over the past ten years), yielding the potential to diversify, but bonds have also tended to lag behind when it comes to returns. 

Investors can reduce volatility by adding bonds but they tend to lead to lower returns as well.

This is where bitcoin has an edge. 

The cryptocurrency might be highly volatile, but during its short life it also has had high average returns. 

Importantly, it also tends to move independently of other assets: since 2018 the correlation between bitcoin and stocks of all geographies has been between 0.2-0.3. 

Over longer time horizons it is even weaker. 

Its correlation with real estate and bonds is similarly weak. 

This makes it an excellent potential source of diversification.

This might explain its appeal to some big investors. 

Paul Tudor Jones, a hedge-fund manager, has said he aims to hold about 5% of his portfolio in bitcoin. 

This allocation looks sensible as part of a highly diversified portfolio. 

Across the four time periods during the past decade that Buttonwood randomly selected to test, an optimal portfolio contained a bitcoin allocation of 1-5%. 

This is not just because cryptocurrencies rocketed: even if one cherry-picks a particularly volatile couple of years for bitcoin, say January 2018 to December 2019 (when it fell steeply), a portfolio with a 1% allocation to bitcoin still displayed better risk-reward characteristics than one without it.

Of course, not all calculations about which assets to choose are straightforward. 

Many investors seek not only to do well with their investments, but also to do good: bitcoin is not environmentally friendly. 

Moreover, to select a portfolio, an investor needs to amass relevant information about how the securities might behave. 

Expected returns and future volatility are usually gauged by observing how an asset has performed in the past. 

But this method has some obvious flaws. 

Past performance does not always indicate future returns. 

And the history of cryptocurrencies is short.

Though Mr Markowitz laid out how investors should optimise asset choices, he wrote that “we have not considered the first stage: the formation of the relevant beliefs.” 

The return from investing in equities is a share of firms’ profits; from bonds the risk-free rate plus credit risk. 

It is not clear what drives bitcoin’s returns other than speculation.

It would be reasonable to believe it might yield no returns in future. 

And many investors hold fierce philosophical beliefs about bitcoin—that it is either salvation or damnation. 

Neither side is likely to hold 1% of their assets in it.