Saturday, November 1, 2008

Battle Royale

Everybody was kung fu fighting
Those cats were fast as lightning
In fact it was a little bit frightening
But they fought with expert timing
--Carl Douglas

A titanic square off is underway between hyperinflationary and deflationary proponents. Hyperinflationists believe that the massive world wide intervention, measured in the $trillions, to recent market crises will paper the globe in fiat confetti--and governments will do whatever it takes to stave off price declines.

Deflationists argue that the gigantic amount of global leverage built up over years (decades) is beginning to unwind and is unstoppable--regardless of bureaucratic meddling.

Often the answer to binary scenarios lies somewhere in between. In this case, however, I'm not so sure. An extreme amount of monetary and fiscal stimulus is being thrown at an extreme debt buildup. That these two extremes somehow average together to produce a 'normal' situation seems doubtful to me.

The problem for investors is that the appropriate responses to these binary scenarios diametrically oppose each other. Hyperinflation calls for staying away from cash, borrowing funds (since you pay back in currency that depreciates during inflationary price increases), and investing in risky assets that keep up with or exceed the price increases spawned by hyperinflation. In hyperinflationary periods, cash is trash because money is everywhere and there's too much supply.

Deflation calls for building cash, paying down debt (since you pay back in currency that gains in value during price deflationary price declines), and shedding risky assets that fall in value during deflationary deleveraging. In deflationary periods, cash is king since few people have it.

Rather than pick one scenario and bet all chips on it, I've found it more reasonable to design a portfolio around probabilitistic assessment of the future. For example, I currently estimate the following probabilities for general macroeconomic scenarios over the next few years:

hyperinflation - 30%
'normal' inflation - 20%
deflation - 50%

Correspondingly, I've been trying to blend my asset allocation to reflect these views. Here's a rough sketch of where I currently stand:

-->20% commodities (via ETFs such as GLD, JJE, RJA). Applies primarily to hyperinflationary scenario but should also 'work' under normal times.
-->45% cash and short term fixed income (money market funds, short term CDs). Applies to 'cash is king' deflationary scenario.
-->35% stocks (primarily high dividend paying pharma names Merck (MRK) and Pfizer (PFE)). Decent value and high yield applies across scenarios. Stock price appreciation for the hyper and normal scenarios. Dividend yield (MRK and PFE currently yield 5-7%) for the normal and deflationary scenarios.

These probabilities and allocations are, of course, not etched in stone; they're subject to change as things unfold. While favoring the deflationary argument, I've recently warmed more to the inflationary possibility given mamouth interventions still to follow from administrations that possess central planning mindsets. Thus, I've upticked my commodity exposure in kind.

Have you noticed the irony of this approach? Even though there's a good chance that these various scenarios don't average themselves together in reality, I'm blending my decisions as if they will.

There's plenty of risk to this approach, of course. For example, my assigned probabilities could be off, or my choice of investment vehicles may be wrong.

But my humble view is that such an approach may help navigate a period where preserving, let alone building, wealth promises to be extremely challenging.

positions in GLD, JJE, MRK, PFE, RJA

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