FSO Editorials: Surviving The Enormous Storms Ahead by Robert B. Gordon 06/24/2004

Surviving the Enormous Storms Ahead
With a Tested Portfolio Concept
by Robert B. Gordon, Sc. D.
June 24 2004

Nothing very exciting or troubling is happening in the markets right now. It’s sort of like a calm before a storm - a big storm. The leaves are rustling and the clouds are darkening. To some it may seem to be a good time to bring in the lawn furniture and check to see if any windows are open. Unfortunately, I must disagree. A few others and I agree we are due for a once in a century storm of great magnitude. It will require at least the equivalent of putting on strong storm windows and even they may not be enough. The approaching storm may be greater in some respects than any other to hit our nation because it is going to hit in so many ways and locations.

Of course the storm I am predicting is not a weather storm but an unbelievably complex financial storm that is going to hit so many parts of our economy all at once. Since many aspects of this storm are either unpredictable or unknowable, like the derivatives situation, there is really no precedent for knowing what safety steps are needed or desirable. Please read Jim Puplava’s great recent article "The Unraveling" for a brilliant coverage of the coming financial storm. As one thing I can do, I have decided to review the lessons we have been teaching over the past twelve months.

I want to start by using the words of a very adept reader who said it so well in a recent thank you note that I could not do it better myself:

"- Informing us that diversification is not enough.
- You must be in the right asset classes.
- Introducing the concept of blending stable and volatile funds to maximize gains and manage risk.
- Emphasizing the need for periodic rebalancing to lock in gains.
- Doing the enormous job of research to find such gems as the Hussman Funds.
- Performing the analysis and presenting us with your findings."

Let’s assume you are a new investor starting with a portfolio built in according with our suggestions. Remember first that your portfolio is intended to be permanent in its ratio of the various components. You may change the amount of assets at any time so long as you retain the desired ratios of asset classes. Choosing a good time to rebalance will be learned by studying the varying price changes of your different asset classes. Rebalancing should normally involve adding or subtracting assets to each fund but this can be done in small portfolios by simply adding new money to the under funded classes. After ten or more years, rebalancing will have an important effect on the overall returns of any portfolio designed according to our suggestions.

I see the market continuing to fool all but the minority following the Elliott Waves. The major averages will be dropping during waves 1, 3 and 5 and recovering during waves 2 and 4. There will be little value in following the news as it could be quite misleading. So, follow your own portfolio weekly and learn the normal habits of each asset class in your portfolio. The better you understand their reaction to the market moves, the better your understanding of the time to do a rebalancing.

Remember that the all-important function of the stable assets is to keep a sufficient safe reserve so that assets can be transferred to other classes: long term stable, volatile and short. These transfers should occur just as more volatile asset classes are coming up from a price bottom. Then, and most important, when the volatile asset classes are at the top of their price range, their profits should then be transferred by rebalancing to the stable reserve. This system of taking profits is the principal reason for rebalancing. If the rebalancing is not done or not done at the right time, then profits will be lost.

So, the big job of the investor during the first few years is to become an expert in determining when to make a profitable rebalancing. As the years go by you will become very expert since your portfolio composition will not change unless you want it to. The whole idea of having a permanent portfolio is quite new and you have a great opportunity to make it a success. You start out with my very best wishes and the knowledge that I will help as long as physically able.

There will be days when everyone of your asset classes drops in price. Presumably these days, the headlines will be quite scary. There will be other days when everything drops in price except your short fund. The most important thing to watch is the relative prices of your different asset classes. The volatile assets should rise and fall more than others. The stable assets should rise and fall the least with the long term stable assets in the middle.

When the volatile assets drop more than the stable over a period of months, this difference will eventually lead to profits during rebalancing. It will take a while for new investors to get the hang of this. Let’s choose a portfolio that has assets with different volatilities. Market action provides two kinds of opportunities:

1. Let’s say that the stable assets decline slightly and the volatile assets decline much more.

2. If a market bottom has been reached (some prices rising) a rebalancing operation would transfer assets from stable to volatile components. This will then increase the gains of the volatile asset during the rising market. Then at the market top, another rebalancing will transfer greater amounts of gain from volatile to stable assets than would have happened if the first rebalancing had been omitted. This is very important. Rebalancing is done at market bottoms to add assets to volatile assets before a rise and also to take profits at the higher prices at market tops.

3. In all rising markets, most volatile components will grow at faster rates and profits should be taken at the top thru rebalancing. Normally, rebalancing will involve returning all asset classes to their original percentage but, in small portfolios, one could just make the major changes.

In summary, the basic strategy is to take profits from the differing volatilities of the asset classes. Of course, we always hope to take profits from long term gains of all asset classes. This will be difficult in a severe down market. So, remember to rebalance with out gains at market lows to increase gains in the volatile assets in the next market rally. Please read this section again and If you have questions, please send me an e-mail.

We are going to run a seven year demonstration program including 3 years before the bear market and 4 years in the bear market and including a long bear market rally. We, of course, were limited to using funds and stocks which were in existence seven years ago. The results represent the best and truest test we have yet made of our permanent portfolio concept with intermediate rebalancing. We will discuss the portfolio first and then give the details of the performance. We used 7 funds and 3 stocks in all 4 asset classes as below:

     Stable Assets
          U.S. Treasury Target 2005                   10%
          Leading Foreign Govt. Bond Fund         10
          Major Intermediate Treas. Bond Fund    10
                                              Total Stable 30%

     Long Term Stable Assets
          Top Performing Bond/Stock Fund         10%
          Permanent Portfolio Fund                      10%
          Diversified Major Energy Fund                10%
          Leading Water Stock -NYSE                  10%
                              Total Long Term Stable      40%

     Volatile Assets
           ASA Gold Stock - NYSE                         10%
           CEF Gold/Silver Bullion Fund - ASE         10%
                                                Total Volatile      20%

     Short Assets
           BEARX -Prudent Bear Fund                   10%
                                                  Total Short    10%

                                       Grand Total               100%

I picked this portfolio from my knowledge of funds and stocks that had an established record in June 1997 when prices of BEARX first became available in my Fast Track (tm) data base. When you see the results below, I am sure you will agree that we chose a very interesting portfolio. We would recommend all of the constituents today for a new portfolio except the 2 treasury bond funds whose recent performance has faded.

We were quite limited in choosing stable assets due to the absence of the unique Hussman funds, so we decided to make up for them by using 4 attractive long term stable assets. When we score the long term stable class as half stable and half volatile, the portfolio then ends up as 50% stable and 50% volatile - a good mix for the rather critical test. Because, let me assure you, I did not run any other portfolio test for this essay. I do not have a software program for the arithmetic and the calculations are quite boring, especially at my ripe old age. But readers, please remember your calculations can be much simpler. In fact you would not have any at all with ten equal constituents. You would simply divide your existing portfolio total by ten and reallocate your assets accordingly. The arithmetic steps involved were given in an essay a few months back and can be found in my archive.

This experiment has many interesting lessons and deserves close study by all investors.

Asset Class	Start	Rebalancing Totals			No Rebalancing
Asset Class	6/18/1997	6/18/2001*	7/22/2002**	6/18/2004	6/18/2004
Target 2005 Bond	$1,000	$1,149	$1,149	$1,976	$1,594
Foreign Bond	$1,000	$1,114	$1,500	$2,235	$1,733
Inter. US Bond	$1,000	$1,161	$1,679	$1,754	$1,632
Bond Stock Fund	$1,000	$1,023	$1,743	$2,759	$2,111
Permanent Portf.	$1,000	$2,457	$1,216	$2,294	$3,297
Large Energy Fund	$1,000	$1,035	$1,518	$2,814	$2,093
Water Stk. NYSE	$1,000	$1,436	$2,254	$2,191	$3,407
ASA Gold NYSE	$1,000	$ 632	$2,329	$1,988	$1,387
CEF G/S ASE	$1,000	$ 945	$1,497	$2,194	$1,472
BEARX Mgd Short	$1,000	$ 555	$3,005	$1,260	$1,000
GRAND TOTAL	$10,000	$11,507	$18,231	$21,468	$19,726
* All asset classes were rebalanced to $1,151 as of 6/18/01 ** All asset classes were rebalanced to $1,823 as of 7/22/02

Please take some time to compare all these numbers as they are very informative. As a starter, look at BEARX. The low price occurred on 6/18/01. In the first rebalancing, its value was raised to $1,151. All other assets were increased at that time except the Water Stock and Permanent Portfolio which were reduced to $1,151.

The increase in BEARX assets then enabled it to reach a peak value of $3,005 on 7/22/02. The BEARX assets were then reduced to $1,823 at the 7/22/02 rebalancing, thereby providing realized long term capital gains of about $1200. Long term gains were also taken on that date from ASA Gold and the Water stock.

After two rebalances, BEARX ended the 7 year period at $1,260 for a small second gain. While, with no rebalancing, it ended at its $1,000 starting price with no capital gains. Imagine those seven years ending with no gain after once showing a large profit that simply disappeared.

Now, please look at the price spread among the 10 asset classes after two rebalances and with no rebalances - about $1,600 vs. $2,400, which indicates to me that there should have been 4 or 5 rebalances over the 7 years. Maybe someone will volunteer to do the arithmetic so I can publish it is in a future issue.

The annual rates of return over the 7 year period were: 11.5% for rebalanced and 10.2% for no rebalances. However the best reason for rebalancing is to increase the building and capturing of capital gains and to keep your portfolio from running away from its starting proportions.

Any reader who has questions on the example given above should send them to me for answers.

John L. Dickerson has written a very fine article in the FSO web page, detailing his ideas about a switch coming about from investing in financial assets to real assets. Here is his list of real assets. See how many of them I included in my 10 asset portfolio above. And my recent list of asset classes includes several more. We expect them to do quite well. His full article is very much worth reading.

Water
Base Metals
Precious Metals
Oil & Gas
Energy Services and Pipelines
Hydro-Electric Power
Basic Materials
Raw Land, Timber, Paper and Pulp
Farming and Agricultural Commodities
Select Foreign Value Equities
Select Foreign Bonds in Commodity-Based Currencies

If any reader, new or old has any problem with, or questions about, the basics of portfolio design of multi-asset, permanent portfolios intended for periodic rebalancing, please send me your questions so I can clarify them. We have demonstrated their flexibility and ability to withstand both bull and bear market climates using a group of carefully selected assets working together.

The time is quite short to get your investment assets ready for the next down leg in this bear market. Today the EW waves show we are near the end of wave 5 of wave 2 up. The next step is wave 1 of wave 3 down. So please be sure that your close family circle understands what lies ahead. Remember we are not in a new bull market as many think but in the fifth year of what will be a very deep and long bear market. Read my many previous essays in my archive.