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Excerpt:
Returning to Fortune’s Formula, many pages were devoted to the pros and cons of geometric averaging (vs. arithmetic) and to the Kelly Criterion. While we all understand the power of compounding, a geometric refresher course never hurts. A fifty percent drop in wealth requires a one hundred percent rebound just to break even. A hundred percent decline is a complete wipeout from which there is no return. The Fed, over the past several years, has taken the nominal return on cash to zero and the real (inflation-adjusted) return to minus two percent or perhaps as bad as negative ten percent, depending upon whom you believe regarding the true rate of currency debasement. It has succeeded in pushing up the price of stocks, bonds, commodities and other assets. As a result, these assets are much more risky than they were several years ago. Certainly stocks aren’t intrinsically worth twice what they were two years ago (pre-doubling). Two years ago investors had to ponder the merit of holding cash, and thus losing two to ten percent of their purchasing power versus the prospect of making in the range of negative 25 to positive 250 percent in the stock market. The choice was easy. Now the prospects appear more daunting; a reasonable expectation may be in the ball park of minus 50% to plus 50% in stocks versus the same 0% expectation for cash (negative two to ten percent after inflation). The choice is less clear.
Cash is risky because the Fed is playing a dangerous game.
Hard Assets are increasingly risky because the Fed’s zero rate policy has “succeeded” in running the prices to higher levels than they would otherwise be.
Equities are risky for the same reasons that hard assets are, compounded by the fact that investors are inputting aggressive assumptions into their pricing models.
At the same time, cash offers short-term stability should downside volatility return to assets (real or financial) while hard assets offer scarcity value and equities offer growth and/or ownership of wealth-holding franchises. More than ever, diversification is in order.
While we, at Tradewinds, are still no fan of cash, as just discussed, it may deserve a place in investors’ portfolios. (Investors’ decisions must be made in accordance with their own needs and tolerance for risk.) Some allocation to cash, in addition to meaningful positions in global stocks and hard assets (real estate and metals), seems reasonable. Should inflation soar, as can reasonably be expected given the current gross mismanagement of fiscal and monetary policy worldwide, much of the portfolio is protected. However, if there is a long-overdue correction or bear market, the cash will provide some downside protection and purchasing power as bargains appear. Following two great years, in a geometric world, the third year still matters immensely.