Most Americans are familiar with “Black Friday,” the day after Thanksgiving that marks the beginning of the Christmas shopping season. Hoping to get a jump on holiday sales, many retailers drastically slash prices and offer extended hours, with stores opening in the wee hours of the morning. The opportunity for deep discounts, often for a variety of the most popular wares and sought-after gifts (not the typical clearance of last season’s leftovers), creates massive interest with bargain conscious shoppers lining up around the block. By the time doors open, shoppers overwhelm the store, its employees, and often each other. The first day of the shopping season sadly brings out little spirit of sharing. Pushing, shoving, fighting, and trampling are commonplace. Such is the effect of dramatically lower prices; they create an almost frenzy-like rush to buy.
The capital markets are very different from Best Buy. The investment business is one of the few businesses in which deep discounts drive away customers. Falling prices are met with a mass appetite to return, not buy, merchandise and get the heck out of the store. Such is the effect of dramatically lower prices in investments; they create an almost frenzy-like rush to sell. Some of the biggest “sales” in the investment world have occurred on another black day of the week, Black Monday, most famously in October 1929 and October 1987, with some admittedly smaller examples recently (such as August 8, 2011, after the U.S. debt downgrade). While certainly no Black Monday, the second quarter of 2013 was filled with relatively sharp drawdowns for just about every asset class outside of U.S. equities. In this issue, we’ll explore recent events across the asset allocation spectrum.
Recent “Pillar” Performance
Most long-time readers of this publication know Research Affiliates’ views on projected long-term inflation, economic growth, and capital market returns. The CliffsNotes version is that over the next couple of decades the “3-Ds”—deficits, debt, and demographics—will produce a very different backdrop than the one to which most of us are accustomed. The developed world will have to monetize its burgeoning and eventually unsustainable debt burden via reflation and financial repression. Further, economic growth is likely to disappoint because of demographics alone. Baby boomers, already at peak productivity, will begin to leave the workforce without a large roster of young adults—those ready to make rapid incremental productivity gains—available to replace them. Sadly, the two main pillars of portfolio construction over the past 30 years—mainstream stocks and mainstream bonds—now offer very little in the way of yield (and therefore future returns) to compensate for these risks.
For these reasons, we have suggested investors build a sizable “Third Pillar” of assets that diversify equity risk and can perform better in a reflationary regime. The size and scope of this Third Pillar hinges on multiple issues. How willing are investors to shift from traditional portfolio approaches (and incur the inevitable maverick risk that comes with such a decision)? How much do they believe in the thesis of lower economic growth and higher inflation over the long-term that we and others assert?1 The ultimate scope of such a Third Pillar is open for debate, but it’s fairly obvious most investors are woefully short on inflation protection and equity diversification. Look no further than the 401(k) marketplace. The second largest provider of target date funds, Vanguard, has its 2020 target maturity fund invest exactly 0% in Third Pillar assets and contains over 90% of its risk budget in stocks!
Since about 2010, we’ve been urging investors to remain alert to buying opportunities for building a more robust Third Pillar. When will this opportunity arise? These alternative markets become cheap when investors are more concerned about deflation than inflation (deleveraging and demographics are often used to argue that deflation is the main risk). Building an inflation hedge is far less expensive when people are not concerned about the risk of inflation than when inflation is already self-evident. These markets become cheap when there’s a “flight to safety,” out of the unfamiliar “Third Pillar” assets and into the familiar first and second pillars. What a wonderful opportunity!!
Table 1 outlines a sampling of asset classes with Third Pillar strategies highlighted in blue and an equally weighted blend labeled “Third Pillar” near the top of the table. Note how these categories provide some diversification benefits relative to equities (all have correlations below 0.8 to the S&P 500 Index) as well as a measure of inflation protection (all are more positively correlated to inflation than mainstream stocks and bonds). Nearly all Third Pillar assets suffered mightily in the second quarter of 2013. We can see these strategies declined by –4.7% for the quarter, worse than the bludgeoning that Second Pillar assets (mainstream investment grade bonds) received at the hand of rising rates.