There's No Escaping An AI Bubble

GMO had an interesting paper about what is "probably" an AI bubble with a comparison of how they managed through previous bubbles and what to do about the AI situation. 

Getting right to the title of this post, what I mean is that whatever your equity allocation is, that sleeve won't be able to avoid an AI bubble. Here's an extreme example to make the point.

NVDX and NVDS are different inverse Nvidia ETFs. If there is an AI bubble and it pops, there's no escape for NVDA common stock. But a portfolio that was half the common stock and half an inverse fund would realistically be spared the full brunt of whatever might befall NVDA. Depending on the compounding maybe the blend would even go up a little. No one should put 50% into a stock and then 50% into an inverse variation of that stock.

This is the effect that GMO is getting to in their paper. What can be added to a portfolio, in our words, to help avoid the full brunt of a large decline? GMO refers to 2022 as the Duration Bubble. They say that during the Duration Bubble they were able to sidestep the worst of the fallout with equity long/short, merger arbitrage and global macro.

This is pretty much the exact conversation we've been having here for many years. Client/personal holding BTAL is of course long/short with a short bias, clients have owned the Merger Fund since the financial crisis and maybe a weaker association but in some circles, managed futures gets labeled as systematic macro so it might be in the same neighborhood as global macro even if not exact. 

The paper seemed to be in support of the GMO Benchmark Free Allocation Fund (GBMBX) which as of its most recent reporting allocates 48.5% to equities, 23.6% to fixed income and 27.9% to alternatives which are listed as equity "dislocation" and "alternative allocation." So that's pretty vague but gives an idea of how they size into alternatives in 60/40 terms, they take a little from equities and a lot from fixed income to build out the alternative sleeve. 

GMO also talks about deemphasizing predictions in favor of what I'd describe as making observations which is an ongoing conversation here as well. They talk about the Internet bubble not in terms of crashing but some sort of mean reversion. We talked about the "Duration bubble" not in terms that rates must go up (which of course they did) but in terms of inadequate compensation for the risk taken. 

Both instances are about making an observation and then avoiding or underweighting the risk posed by that observation. With the way the S&P 500 has evolved to be so heavy in a handful of stocks, many of which are part of the AI theme, there's probably no realistic expectation of avoiding any AI bubble fallout that might come along. If you have 10% in domestic equities, that 10% would get hit hard. If you have 90% in domestic equities, that 90% would get hit hard. What could spare the bottom line of your portfolio is what you do with whatever percentage is not in domestic equities. 

Since there's no way to know if or when there will be any consequence for the current AI market excess, it would be a bad idea to put 40% into an inverse S&P 500 fund against 60% in the S&P 500. If there's never a decline, that 40% will eventually evaporate. What if stocks go down and interest rates go up due to concerns about inflation? That was part of the story in 2022 and currently reported price inflation is simmering persistently above the 2% target. Many would argue that reported price inflation greatly understates what's really going on so some sort of stocks down, yields up scenario would not be a black swan from here. 

I concede that most people won't go to the extreme avoidance of duration as I do but underweighting it seems like a pretty good idea based on current observations. 

One way we've positioned certain alternatives is to say they do what people think/hope fixed income will do which is have very little volatility and trend gently higher.

The outcome of the Merger Fund is what I believe people want their bonds to do and in line with what people should expect from this fund. Other alts seek different outcomes of course. BTAL is essentially an inverse fund, managed futures seeks to be closer to all weather but doesn't always live up to that. Managed futures was great in 2022, a tough hold in 2023 and 2024 and doing pretty well (not great) this year. 

With each successive adverse market event there have been more tools available to help avoid the full brunt and that trend will likely continue. The importance here, said more directly, is that bonds with duration are no longer in the 40 year one way trade they were in, that's over. If bonds can now trade in both directions that makes them less reliable as diversifiers as we saw in 2022 and repeating for emphasis, some sort of run where stocks go down and interest rates go up is far from an impossibility. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. 

Nouriel Roubini's ETF Is Doing Well

There was a quick mention of the Atlas America ETF (USAF) in Barron's. USAF is comanaged by Nouriel Roubini, we dug in when it first listed. For that post last year I constructed a backtest and concluded that it seeks an absolute return or maybe market neutral type of result. There's a lot of short term treasuries and gold, it has a little bit in an inverse long term treasury ETF, there's REIT exposure, a long put spread (bearish position or a hedge) on the S&P 500 and it is short put spreads (a bullish position) on gold. There's also defense industry/cyber security exposure too. 

Sure enough, it has been very steady.

Now subbing in for AGG in a 60/40 portfolio.

USAF is only one year old so the sample size is small but the result is a little better than plain vanilla AGG-like bond exposure. Getting a similar result as AGG without the interest rate risk posed by AGG is a good outcome. 

Maybe intermediate and longer term rates will never go up again, I don't know but if they do go up then we know that AGG would get hit. A fund that avoids intermediate and longer term rates, like USAF, would avoid that potential hit. 

The point is not to be in the business of trying to predict anything but if we can get an AGG like result (from when AGG is doing well) without taking on AGG's biggest risk, that seems like a good trade.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.

Scottish Portfolio Management

Barry Ritholtz had a great post about Sturgeon's Law. As Barry explains it, Theodore Sturgeon was a science fiction writer who when asked why so much science fiction is bad he said "90% of everything is crap." Barry pivoted that quote to what he called Sturgeon's Corollary, "90% of all investment products are crap."

This works on a couple of levels for what we do here. The most important one for what you actually do in your portfolio or for clients if you're an advisor is to avoid most of the new stuff, most of the complex stuff and most of the expensive stuff. We talk about private equity and credit in this context but there are others. The odds are high that expensive, complex products will not be worth the extra fees. Some will be but most will not whether Barry's 90/10 idea is the right number or not, most should be avoided. 

That doesn't mean it's not worth sifting through what is likely to be crap for that 10% that won't be crap. I've never thought about this sort of pareto principle aspect to it but this is why we spend time revisiting things like derivative income funds (mostly crap), some of the levered products (mostly crap), managed futures (mixed bag) or catastrophe bonds (pretty good for the most part). 

By sifting through, occasionally I find something I believe will be additive to the portfolio

There is a different layer for advisors, maybe, for me anyway. I've said this before but I don't want to get asked questions by clients for which I have absolutely no answer. It could happen that I have no answer for something of course but I am very motivated to try.

That gets us to this chart. I saw a Tweet promoting the ETF version of RDMIX, the ETF trades in Canada, RDMIX trades in the US. RDMIX has changed its strategy at least twice and is currently 100% equity and 100% global macro. The fund did great in early 2022 and has struggled since. This year it corrected hard in April and is up a lot since, netting out to a 6.3% gain per Yahoo Finance.

RDMIX is in blue, HEQT is hedged equity, LCR is multi asset core and of course VBAIX is plain vanilla 60/40. Since the April low, RDMIX is up 18% which is in line with the other three funds. Far more often than not, when we look at these funds, I struggle to see what benefit the complexity (leverage) gives you.

I will always be willing to sift and revisit but also very selective to use.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. 

Sleepability Versus Optimality

First up is a conversation started by Cullen Roche about defined outcome/buffer funds.

Part of our regular discussion here includes referring to funds or strategies as being valid even if not optimal. Using buffer funds as equity proxies is far from optimal but it can be valid. You've probably heard and read people talk about having a portfolio that you can live with or will let you sleep at night which is probably why buffer funds have become so popular. 

The math supports the AQR notion that you'd be better off owning less in equities and more cash to capture the buffer effect. I don't think I've seen AQR allege that any of the buffer funds have malfunctioned, just that they are inferior which they probably are. Smart people mock line item risk but from the end user's viewpoint it might be easier to stay invested when instead of a 30% decline like the Covid panic in 2020, their buffer fund only drops 15% (just making up an example) irrespective of the portfolio weighting. 

Cullen obviously makes the point about sleeping in his comment. For the last 15 years, the S&P 500 has compounded at 14.79% and 60/40 as measured by VBAIX has compounded at 9.92% with 10 drawdowns of at least 10% for the S&P 500. The corresponding drawdowns for VBAIX were usually less but not always. Maybe someone can get what they need compounding at only half that rate for being a little ahead of where they need to be with their account balance and feeling they cannot tolerate huge declines very well. 

Look back at the same 15 year period and the drawdowns and realize that in every single one, people panicked out believing whatever the event, it was somehow different. Of course none of the were different and market kept working higher even if in fits and starts occasionally. 

Tony Isola wrote about what he called the first decade retirement plan which focused on health adjusted life expectancy, the years where people are still able bodied before getting "old." The amount of time that we are living after being able bodied is increasing which is negative in terms going many years without being able to do what you want to do. 

I didn't see a source cited for the chart but if I'm reading that correctly it's saying beyond 64, we collectively deteriorate quickly. In many (I think most) cases this is very preventable. We learn as children to exercise and not eat too much sugar and of course the vast majority of people do not exercise and do eat too much sugar. 

There are of course financial implications for retirees either spending a lot on medication or not if healthy and fit and quality of life issues with how they feel and what they are able to do with their time versus spending time in endless doctors' waiting rooms waiting for appointments. 

We all know or have known people in their 70's capable great things physically, maybe running or ability to climb mountains or whatever. Some slice of the population will simply be lucky on this front but most, me included, just need to put in the work. Not even a lot of work. 

@Mangan150 on Twitter talks constantly about just needing an hour/wk of intense exercise and then being somewhat active during the week. I would encourage a little more than that but people just trying to be lean and fit do not need to be in the gym everyday and don't need to spend many hours every week. A moderate amount goes a long way.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.

Turning 60/40 Upside Down

I wanted to do a quick experiment with a 60/40 portfolio. Can we get a similar result allocating 60% to some sort of fixed income sector and 40% to some sort of muted equity exposure. The first thing that came to mind was 60% into a convertible bond fund and 40% into a defined outcome "equity" ETF. For the period I studied, convert plus defined outcome was about 300 basis points short which surprised me, I thought it would be closer. I tried asking Copilot which fund or ETF is most correlated to the S&P 500 and it said CWB which is the first convertible fund I tried. I thought that was funny. 

Portfolio 2 is interesting. It's had the same growth rate as plain vanilla 60/40 but with only 2/3 the volatility. 

The first question might be whether Portfolio 2 just captures a low volatility effect. Short answer is no.

The point of this is just to underscore the importance of understanding not only what a fund owns but what the strategy, if there is one, is trying to achieve. We've used the example of long/short many times in this context. Some long/short funds are trying to offer equity beta, trying to outperform, some are absolute return/market neutral and a couple are essentially inverse funds. 

Short post tonight.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.

The Internet Hates Michael Green

Michael Green was out with Part 2 of his much discussed and somewhat controversial look at the poverty line in the US. We looked at the post here and then discussed some of the reaction here. Here's Part 1 from Green. 

Most of Part 2 turned out to be point/counterpointing with some of the critics, most notably, Scott Winship whose article we also dissected. From there, Green pretty much said home ownership is a scam, 401ks are a scam and so is higher education. There's more nuance which we'll get to but my reaction was pretty much... 

With owning a house, he said price appreciation is actually just inflation. If you buy a house for $200,000 and it goes to $1 million, what then? If you sell it, you'd just be trading into another $1 million house. Home value appreciation is just an illusion that is encouraged to make people feel wealthier without any actual wealth he said. 

He touches on trading down but seems to dismiss the possibility. If someone needs to access the equity in their house for retirement, having the house gives them optionality to downsize, assuming it's paid for. It will take some work to find the right downsize situation but it is possible. 

Green refers to the 401k mirage, noting that only the wealthiest benefit, the wealthiest own the majority of the stocks (true) and that typical 401k participants own target date funds. I am certainly not a fan of target date funds but they can work.

That goes back ten years. It assumes starting with $1000 and putting in $1000 every month (so no raises along the way) and both funds have created a decent retirement balance, not enormously wealthy but pretty good for ten years. Testfol.io had clearly incorrect data but Copilot said that starting with $1000 in 2007 when the funds launched, adding $1000 every month the balance now would be;

Again, I don't think target date funds are optimal but they are valid. This doesn't seem like an illusion to me. 

Green correctly sounds a cautionary tone about private equity eventually making its way into 401k plans. He said what we've said, they need more suckers. 

The last thing I will mention is his taking down of the "great wealth transfer." I've been hearing about this since the late 80's with money going to boomers back then from their parents. Did it happen? Hard to quantify but Green says the money that millennials and Gen-Z expects to get will instead pay long term care bills. If you google it, you might find that the health department says 70% of older American will need long term care. 

Anecdotally, that seems absurdly high. I asked Copilot to dig deeper. The 70% includes family helping their parents and grandparents. Copilot says 35-40% will need to go into a nursing home with only 10-15% staying more than two years. Ok but copilot says there are now 1.3 million Americans in nursing homes but the population of people 70 or older is 37 million. Yes there will probably be growth in the number of people who need nursing home care but 35-40% is still way too high. 

I think counting on an inheritance makes for a terrible retirement plan for several reasons but the healthcare angle the Green takes is far more pessimistic than the reality. 

Green in both essays (a Part 3 is coming) paints a bleak picture. The internet is falling all over itself trying to debunk and bash what Green has written thus far. It's kind of odd actually. If you want to delve into the details of Green's numbers, go for it but it is hard to look at the big picture of the questions Green is asking and feel optimistic. 

I'm always going to bang the drum of taking matters into our own hands to minimize reliance on other people figuring it out for us. If "they" (the government) figure it out great but that is clearly not their top priority and in meantime we're living our lives now while "they" spend time not solving any problems.

Live below your means, take care of yourself physically and stay curious/engaged.

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.

What Do You Mean FIRE Is Obsolete?

Sam Dogen, aka the Financial Samurai and an early proponent of the FIRE movement had an intriguing post saying that Early Retirement/FIRE is becoming obsolete. The TLDR is that having more opportunity to work from home (a Covid byproduct) has created more of a sense of independence from better time ownership and the lack of a commute makes work more enjoyable. 

FIRE is an fun topic to write about and explore but the focus here has always been on the financial independence aspect, the FI in the acronym. The commute comments really resonated with me, that was a big driver for me trying to get to the point of working from home which I did, starting in 2003. Anytime I tell someone I've been working at home for that long I always throw in "thank God for the internet" which always gets a nod and a chuckle. 

A little while back I commented that I thought I've been in coast FIRE mode for awhile which means not necessarily having to save more for retirement but still needing to let the money grow without living off of it yet. Sam crapped on that one pretty good but didn't elaborate, simply saying it's an illusion and a participation trophy. I wish he would have dug in a little deeper on that because below is a chart he shared that I take to support the concept coast fire.

It doesn't matter whether you agree with the expected amount needed column or not, you're in one of those demographics, you have some sort of framework of what you think you need and you have some amount already accumulated. I take coast fire to be about optionality. If you're 50 and you have 85% of what you think you need, it seems to me like you can coast with some optionality. That might mean gearing down into a lower paying job that you enjoy more or if you enjoy what you do, maybe you can allocate more of your income to whatever your idea of fun or discretionary spending might be.   

We all have our own opinions and beliefs about every aspect of retirement from whether to even do it, when to do it and how our finances should work which gets us to one article from Barron's and one from Yahoo, both about when to take Social Security. 

The comments, especially on the Yahoo article were worth reading. One common theme to comments on these posts is the belief that people can do better themselves by taking the money early and investing it in the stock market. Speaking to beliefs, ok, maybe you can do better yourself than the 8% annual step up in Social Security payouts but there's more than that, there's also the COLA adjustment. Here's the last ten years of COLA adjustments from Copilot.

Year	COLA (%)
2016	0.3
2017	2.0
2018	2.8
2019	1.6
2020	1.3
2021	5.9
2022	8.7
2023	3.2
2024	2.5
2025	2.8

If the average year in the stock market is 8-9% and average COLA is 3.11% or 2.65% for the median if you prefer, then the hurdle rate becomes quite a bit higher. Now add the complexity that there are very few years that the stock market hits the average return (usually more or less than the average) and this becomes even more complicated. If Social Security is like the fixed income portion of an investor's portfolio (Jack Bogle said that) then trying to capture the stock market effect with that money increases the exposure to volatility. 

It's not for me to say what someone else should ultimately do but it's important to make all of these decisions based on an accurate framing. This point is similar to whether to take Social Security early or not, irrespective of investing it in the stock market. Take the time to understand the differences between taking it early and waiting (meaning how the numbers and math works) and then once the math is dialed in, applying that math to your particulars. 

Uninformed people are going to make poor decisions. JP below is destined to make a bad decision if he doesn't take a little time to understand the problem

Social security payments aren't going away. Occasionally people will comment about taking it before the cuts potentially take effect. Making the decision based on thinking you won't endure a benefit cut is a bad decision. There will not be a cliff like that. Maybe people above a certain age won't be impacted (this is my belief) or maybe not but taking it early will not by itself spare you from a benefit reduction. 

If your age 62 payout is $2000 and there is a 25% haircut you'll get $1500, if your age 70 number is $4000 and there is a cut, you will get $3000. When you start won't change that. 

If you want to take it 62 but plan to keep working, they withhold $1 for every $2 earned above $23,400 and they do that until you it your full retirement age (FRA). You get it back when you reach your FRA but in the interim the payout would be small. Maybe that is still worth it, not for me to say but the point of digging into these things before you pull trigger is something everyone should do. 

I'm seeing more acknowledgment of what I think is an important determinant which is waiting until 70 so that the lower earning spouse has a higher survivor benefit. That's not to say it resonates with too many people, it doesn't seem like it does but that's ok, we each have our own beliefs. Part of the pushback on this point seems to be a notion of winning versus losing against Social Security. Like my breakeven for waiting until 70 versus taking it at 62 is 79 and three months. If I die at 77, then I will have "lost" even though I would have provided for my wife. I might be in the minority on this but if I get what I want out of it while I am alive, I don't understand caring about after I'm dead. 

Whatever your beliefs about any and all aspects of retirement and Social Security, invest the time needed to make the right decisions for what it is you actually want. The whole system is overly complicated and it easy to get important details wrong. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.