|  | | | | Dollar-Proofing Your Portfolio |
| Inflation rates finally appear to be moderating. A few weeks ago, the Bureau of Labor Statistics reported a 2.5% annualized increase in the Consumer Price Index (CPI) for August 2024. Inflation is now approaching the Fed’s long-term inflation target of 2%.
Along with weak employment data, the lower CPI reading helped pave the way for a half-point cut in the Fed funds rate that went into effect on September 18.
Inflation may be subsiding—for now—but investors should not become complacent about managing long-term inflation risk.
To this end, investors should seriously consider meaningful portfolio allocations to gold as well as cryptocurrencies like Bitcoin (to the extent an investor can obtain comfort with digital assets).
Gold and crypto are non-dollar financial assets that offer valuable diversification benefits. They also have long-term return potential that may significantly exceed that of U.S. dollar-denominated assets like cash, government bonds and other forms of fixed income.
Alongside diversified exposure to stocks, gold and crypto can help investors protect themselves, if not benefit, from long-term inflationary drift. Gold and crypto can also position investors to benefit from potential shifts in the global monetary system that are currently underway and may even accelerate.
The backdrop
Consumers and investors still bear the scars of the Biden-era inflation tsunami. The Consumer Price Index surged approximately 20% from year-end 2020 through the end of August 2024. If inflation had been running at 2% target levels, cumulative CPI would have only increased 7.5% over this same time frame.
For the first time in decades, American households have experienced a severe hit to the purchasing power of their savings in a relatively short time frame. Money that may have been “safely” stored in bank accounts has been simply eroded in real terms (mitigated somewhat by any taxable interest earned).
Investors in long-term government bonds suffered a double hit, as higher interest rates brought down the nominal market value of their investments, on top of real purchasing power erosion. We can see this in the total return of the iShares 20+ Year Treasury ETF (TLT), which tracks the performance of U.S. Treasuries that mature in 20 years or later. Investors in this security have lost more than 30% since year-end 2020—and in real terms, closer to 50%. |
|  | Ironically, the portion of household savings that suffered most during the recent inflation wave were funds stowed away in what are typically regarded as low risk cash and government bond investments. Meanwhile, investments that are often described as risk assets have done quite well.
The S&P 500 has returned approximately 50% since year-end 2000. Gold is not far behind and has delivered an approximately 40% return. Bitcoin has followed a much more volatile path but has produced an approximately 220% total return. |
|  | Homeowners also benefited from the inflation wave, even though mortgage rates went up as a result of higher interest rates. Residential real estate soared as rising land and construction costs translated into higher replacement costs, which drove up home values.
While high mortgage rates have made purchasing a home more difficult and likely hurt demand, they also deterred sellers from moving. Many homeowners did not want to relinquish low rate mortgages that were already in place, which reduced the supply of homes for sale. According to the Fed, the Home Price Index has appreciated more than 40% since year-end 2000, similar to stocks and gold. |
|  | Mission accomplished?
An inflation optimist may be tempted to think that the recent inflation wave was a function of extraordinary circumstances related to pandemic stimulus, supply chain disruptions and other one-off events, like the Ukraine conflict. Prices went way up, but the Fed jacked up interest rates, which cooled the economy, and now we are headed back to 2%.
Taking a more historical perspective, one may not feel so confident that the problem has been solved. In fact, in the late 1960s, 1970s and most of the 1980s, we experienced elevated levels of inflation that passed through the economy in a series of waves.
Inflation was under 2% in 1965 but would not fall below the Fed’s current 2% target level again until 1986. After inflation approached 6% in 1970, a recession (perhaps similar to the potential contraction we could be experiencing now) helped bring inflation closer to the 3% level by 1972. But just two years later, by 1974, inflation was back to 11% as the economy recovered. |
|  | Another recession in the mid-70s brought prices down again. But by the late 1970s, as economic growth resumed, inflation rates got even higher. In 1980, CPI exceeded 13%.
On September 18, after cutting rates 50 basis points, Fed Chair Powell referred to the inflation of the last few years as a “burst,” which seems to be an evolution of its prior description as “transitory” (which did not age particularly well). The burst metaphor suggests that the inflation surge is now perhaps permanently behind us, a one-time thing.
Powell may ultimately be justified in his cautious optimism, but the experience of the 1970s and 1980s involved not one but three distinct inflationary bursts. And each was more severe than the next.
Inflation was only finally tamed during the Reagan Administration, through a combination of aggressive monetary policy by Fed Chair Paul Volcker and a disinflationary economic boom spurred by technological innovation and deregulation. Yet inflation would still not come down to levels we now consider low until midway through Reagan’s second term.
The inflation outlook
Market expectations for future inflation rates do remain “well-anchored,” as Federal Reserve officials like to say. The Treasury Inflation-Protected Securities (TIPs) market currently implies average inflation rates over the next 10 years of approximately 2.2%.
Perhaps the best argument for a low inflation future is based on the idea that Artificial Intelligence (AI) is about to unleash a tremendous productivity boost across the economy and create enormous slack in labor markets.
Consider the customer service call center industry. Estimates suggest there are potentially more than 3 million people in the United States who work in call centers, which represents almost 2% of the entire work force. One of the earliest large scale implementations of AI technology is to replace call center representatives, especially at the first layer of interaction.
The U.S. economy may get bailed out by innovation, like it did to a large extent in the 1980s, but many structural drivers of inflation remain in place, not least of which is runaway federal spending, especially on entitlements.
As we have written previously, deficit spending is inherently inflationary. Meanwhile, a high debt burden can create a scenario that economists refer to as fiscal dominance.
Fiscal dominance is an economic scenario in which the central bank has to keep interest rates lower than they should be (which is inflationary) just to prevent the government from drowning in interest payments. Put differently, entitlement spending left unaddressed could put the U.S. in a situation where it has no path other than to inflate its way out of its debt problem. |
|  | Congressional Budget Office forecasts |
| America’s long-term fiscal problem tends to come and go from the headlines, but the problem just gets worse as time passes. Earlier this week, ratings agency Moody’s, the last of the major ratings agencies to rate U.S. debt AAA or equivalent, warned bond investors of a deteriorating fiscal outlook. |
| | U.S. fiscal strength will materially weaken in the absence of meaningful policy steps to reduce the fiscal deficit, rein in new borrowing to fund those deficits and slow the rise in interest expense that consumes an increasingly large share of government revenues. - Moody’s (9/24/2024) |
| | The end of 60/40?
Traditional asset allocation approaches often rely on the concept of a 60/40 allocation to stocks and bonds. The principal idea here is that a 40% allocation to bonds will reduce overall portfolio volatility, while creating an opportunity for investors to rebalance into stocks in market downturns, when interest rates normally decline and bond valuations rise.
In recent years, the 60/40 model has been seriously challenged. In 2022, as interest rates rose, stocks fell, but long-term bonds generally performed even worse. Importantly, since 2022, the S&P 500 has recovered dramatically, with a total return of more than 50% from year-end 2022 levels. However, long-term government bond returns are only slightly positive over the same time frame. |
|  | Long-term Bonds Underperformed Stocks in 2022 |
| A 60/40 approach should be generally fine if we are returning to another multi-decade period of low and stable inflation and steady growth, which could perhaps materialize as a result of technological progress. That being said, a heavier allocation to stocks would likely outperform a 60/40 portfolio significantly, if such a favorable scenario were to play out.
Given doubts about a low inflation future, many investors are now, understandably, reassessing traditional approaches to portfolio construction. Rather than making a heavy allocation to low-return dollar-denominated assets like cash and bonds, they are looking to supply-constrained, non-dollar assets like gold and cryptocurrency (especially Bitcoin) as a diversification tool for stock portfolios.
The key idea is that, unlike cash and bonds, these non-dollar alternatives would hold their value, or substantially grow in value, if the dollar continues to erode in real terms. |
| | The case for gold
Within the financial advisor community, it is far from uncommon to encounter negative attitudes toward gold as an asset class. Investing in gold is relatively simple and straightforward, while stocks, bonds and real estate investments can involve more complexity (and therefore more opportunities to extract fees).
Many investors, such as Warren Buffett, happen to dislike gold as well, because they view it as an unproductive asset. An inert metal that never loses its luster, gold basically just sits there.
For the most part, gold bugs are laughing at gold’s critics these days. Setting aside gold’s attractiveness as a diversifier for stock market risk, gold has simply performed extremely well. |
|  | Over the past 20 years, an investor in one of the most prominent gold ETFs, the SPDR Gold Trust (GLD), has compounded at approximately 8.6% annually, relative to the SPDR S&P 500 ETF (SPY) at 10.3%. It should be mentioned, the return on the S&P 500 is also an impressive result and probably higher than what most financial professionals generally regard as reasonable in terms of long-term expectations for stock market returns.
While an investment in gold has marginally underperformed an investment in U.S. stocks over the past 20 years, several points are worth noting.
First, the actual after-tax return of an investor in the S&P 500 ETF could be lower, as the calculation does not consider any tax impacts on dividends, which for purposes of return calculations are immediately reinvested in full.
Gold generates no taxable income; its total return is purely capital appreciation. For a taxable investor, the actual after-tax 20-year return in SPY would likely fall below 10%, depending on applicable tax rates.
Second, the 20-year time frame captures the big run-up and subsequent decline in gold prices during the Global Financial Crisis era. So it arguably fairly captures the gold price across the cycle. Meanwhile, on a relative basis, 2004 represents a fairly favorable starting point for stocks, which were still substantially below year 2000 peak levels.
Third, the marginally higher returns on stocks were to a large extent the result of great technological achievements and extraordinary value creation stories, including all of the Magnificent Seven tech stocks. The 10.3% pre-tax return in the S&P 500 was basically made possible through scientific miracles as humanity established the internet age.
By contrast, how did investors in gold generate the slightly lower but still quite impressive 8.6% return over the 20-year period? Simply by purchasing some shiny metal bars and leaving them alone in a vault! This is an investment strategy that has basically been around since the first Egyptian empire in 3100 BC.
Diversification benefits
Conversations about gold as an investment generally focus on its low correlation and frequently negative correlation with equities, which make it a highly attractive hedge asset. Gold tends to perform relatively well in periods of financial stress.
There are plenty of (generally incomprehensible) academic studies on gold’s performance relative to equity market risk. A better way to analyze gold’s value as a hedge against a stock market sell-off may be simply to zero in on how gold has performed in these moments.
Academic studies are great, but from a practical standpoint, an investor wants to understand how gold will behave when it comes time to make use of the hedge—and sell gold to buy stocks when they are “on sale.”
In the first half of 2020, investors were treated to a very severe stock market sell-off as the pandemic threatened to bring the global economy to a halt. Although the S&P 500 would remarkably be flat on the year by early June, the index fell some 34% from its February peak to the market bottom on March 23, 2020. Over the same time frame, gold declined just under 4%. |
|  | A few things are notable about how gold performed during the March 2020 Covid crisis. The initial reaction of gold was up. Investors were likely buying gold as a “risk-off” asset and in anticipation of monetary easing to address a potential economic crisis.
Gold did slip a little bit as stock markets reached their lowest levels, likely because of liquidity (investors selling gold in order to buy other assets at much lower prices). Gold then recovered, however, and resumed an upward trajectory as loose monetary and fiscal policy became apparent (which propelled stocks as well).
It could be argued that cash would have experienced zero volatility during the March 2020 crisis, while long-term Treasuries did rally somewhat as interest rates immediately fell. But the key relative advantage of gold is that it has historically generated much stronger returns through the cycle than long-term Treasuries (less than 4% over the past 20 years) and certainly cash.
Investors can debate which asset class—cash, long-term bonds, or gold—holds up best in moments of extreme market stress. But investors should not lose sight of which asset class has the potential to deliver the best long-term performance as one waits years if not decades for those moments to occur.
In this context, it is worth noting that gold’s return is completely based on capital appreciation, whereas the entire return on cash investments, such as money market funds, is taxable income. The vast majority of the return of long-term bonds is also taxable income.
Store of wealth
Gold has proven to be not only a reliable hedge against a downturn in stocks but a reliable store of wealth that indirectly participates in the upward drift of other asset classes, such as stocks. Gold does not just hold its value as the global base of fiat money grows, but it tends to keep pace with value creation in other classes.
The supply of gold is constrained (approximately 2% growth through mining annually). Gold, as priced in units of fiat currency such as the U.S. dollar, benefits not only from increases in the money supply but increases in other asset values as investors recycle upside from those assets into gold.
Because the physical supply of gold does not keep pace with the nominal growth in global equity and real estate markets, the price of a unit of gold is pushed upward as investors rebalance upside from other assets into gold. Wealth creation elsewhere essentially gets recycled into gold, where it is stored.
The evolving monetary system
Gold’s importance as a tool to store wealth may only be increasing, with recent strength in the gold price signaling such changes. Over the past several years, central banks around the world have been accumulating gold reserves. They are favoring gold over U.S. Treasuries.
This pattern is especially noticeable among emerging market countries that are aligned with the BRICS movement. Especially since the United States began freezing Russian assets within the global banking system that are held abroad, central banks around the world have been attuned to a new set of geopolitical risks.
The advantage of gold as a reserve asset is that it is no other nation’s liability. Any country can store gold within its own borders inside a vault. With the U.S. having weaponized the global banking system in an attempt to achieve its military objectives in Ukraine, many countries, including some of the world’s most populous, have chosen to add to their gold reserves.
Gold’s independence from the political system drives its appeal among private sector investors as well. This is a global phenomenon but especially pronounced in China, where savings rates are high and households are purchasing gold directly in small form factors (like gold beads).
China’s recently announced stimulus efforts may only increase liquidity within the Chinese economy and create more gold buying power among Chinese consumers.
How much gold should one buy?
Investors who have come to the conclusion that a long-term allocation to gold makes sense must then think through how much they should own in the context of their broader investment portfolio.
Asset allocation decisions are highly personalized, based on the individual circumstances of the investor and many other factors. We do not provide individual financial advice. That being said, we view ourselves as an information resource for individuals to make their own decisions, possibly in consultation with financial advisors or tax accountants.
A potentially useful starting point for thinking about a gold allocation in relation to a diversified stock portfolio is the total market value of above-ground gold in the world in relation to the total market value of stocks.
Recent estimates suggest there are approximately 212,000 metric tons of gold in the world today, which at recent market prices of gold implies a total valuation around $18 trillion. Recent estimates of global stock markets are approximately $115 trillion, with this year’s growth in stock market valuations suggesting a higher figure.
Combining the two asset classes, we estimate gold represents 10% to 15% of the total value of gold and stocks worldwide. Approximately half the above-ground supply of gold is in the form of jewelry. One might then argue that the market value of investment-related gold is 5% to 7.5.% of the total value of stocks and gold combined.
Investors should consider a wide range of factors if they are interested in allocating to gold. For gold to play a meaningful role in one’s portfolio, the investment needs to be material. A low-single digit allocation (1% to 3%) would be a common sense starting point.
Another variable to consider is how much an investor would realistically expect to deploy into stocks in a crisis environment that led to a sharp market downturn, similar to March 2020. A larger allocation to gold may be required to provide an investor with sufficient buying power under such circumstances.
Asset allocation is a highly individualized decision, but we would propose a moderate range of gold exposure within a portfolio between low-single digits and 10%.
Some investors with high conviction in the future of gold as an asset class have allocations significantly above this range, which we find defensible. We would suggest, however, to the extent one’s gold allocation moves beyond single digits, gold becomes less of a portfolio diversifier and more of a directional bet.
How should an investor own gold?
There are multiple ways for investors to obtain exposure to gold. There are numerous private companies that help investors purchase and store gold directly. There are also numerous mutual funds and Exchange Traded Funds (ETFs) that give investors direct exposure to gold, although in some cases these involve the use of derivative instruments.
There are also many stocks that provide investors with exposure to gold through exposure to gold mining operations, royalties and streaming assets. Within our Inflation Protection Model Portfolio, there are a number of gold-related equities that we prefer.
Some investors favor direct physical ownership of gold (potentially even in the form of jewelry) whereas others appreciate the convenience of owning gold through publicly traded securities. How one owns gold is another a highly personalized decision, and nothing prevents an investor from having diversified exposure within the asset class. |
| | The case for crypto
Bitcoin and other cryptocurrencies are an emerging asset class that represent another way to diversify away from dollar-based assets like cash and bonds. Bitcoin has emerged as the leading cryptocurrency. With a total capitalization around $1.3 trillion, Bitcoin now represents more than half the total market value of all cryptocurrencies.
While there are other cryptocurrencies, including Ethereum, which has the second largest market capitalization at around $300 billion, Bitcoin is the one that is most widely regarded as a financial asset, akin to “digital gold,” and that has gained the most institutional acceptance.
Other digital assets, including Ethereum, can be owned and viewed as a form of money but are perhaps better understood as tokens whose value is based on access to the networks they represent. Their value is more based on their practical utility, perhaps akin to an industrial metal as opposed to a precious metal like gold.
For reasons we have previously discussed, we think Bitcoin should be taken seriously as a potential investment. Bitcoin involves many risks but also offers an unusually high degree of long-term upside potential as the financial world rapidly moves towards decentralized (non-sovereign) instruments and deploys blockchain technology.
How much Bitcoin should one buy?
For many reasons, our views on position sizing for Bitcoin are quite different from gold. Bitcoin shares many qualities of gold as a supply-constrained asset that can efficiently store value and is unaffiliated with any particular government entity. Bitcoin, however, has many attributes that suggest a more cautious approach to allocation is warranted.
Gold is an established commodity/financial asset that has been used as such for thousand of years and continues to be used as such in every country in the world. Gold has over time even been used as the foundation of currency systems and according to many reports could potentially even re-emerge as the basis for a new BRICS currency.
Gold is also a physical asset that, for all intents and purposes, is not only indestructible but cannot be reproduced (despite the best efforts of alchemists over the millennia).
Bitcoin, by contrast, was invented in 2008. Bitcoin has succeeded largely because the underlying system has proven highly resistant to hacking and other threats. Yet, not to diminish Bitcoin’s success over the past 15 years, as a technological network, it could in various ways fail.
As a general matter, one of the best ways to get your mind around the potential risks of any investment is to read the Risk Factors section of a prospectus that has been prepared by securities lawyers, who are paid to cover all bases so their clients don’t get sued. We learned a great deal about the potential vulnerabilities of the Bitcoin network in the Grayscale Bitcoin Mini-Trust ETF (BTC) prospectus.
Investors in Bitcoin should recognize that realistic downside risk is potentially 100%, which among other things could happen as a result of a technological failure or disruption.
While it is hypothetically imaginable that gold could become worthless, a more plausible downside scenario is a severe contraction in value. It is worth mentioning in this context, gold essentially tripled in value from 2006 to 2011 but then fell nearly 40% until it bottomed out in 2016.
Whereas gold can experience periods of price weakness, it is highly unlikely to be eliminated entirely and, to the extent that is true, will always have the opportunity to recover. Without being too alarmist, it is conceivable that Bitcoin at some point could become completely and permanently worthless, like the shares of a bankrupt company.
When it comes to Bitcoin, our preference is to think of it more as a highly promising technology stock, perhaps not unlike the mega-cap technology platform stocks which are similarly highly valued. At $1.3 trillion, Bitcoin has a valuation comparable to Facebook’s parent company Meta (META).
Like a tech stock, any number of things could lead Bitcoin to a complete meltdown and total or near total impairment of capital. On the other hand, like a tech stock, Bitcoin could continue to see tremendous value creation.
META currently represents an approximately 2.5% allocation within the S&P 500. A potential portfolio allocation to Bitcoin in this general range makes sense to us as well.
A low single digital allocation to Bitcoin is sufficient for investors to benefit materially if any of the extreme upside scenarios were to unfold (such as Michael Saylor’s forecast of Bitcoin reaching $13 million in 20 years). At the same time, it is low enough an allocation that losses in a worst case scenario would be manageable.
While Bitcoin has similarities to technology stocks, one important difference is that if Bitcoin were to rise to even greater prominence as a form of global money, this could itself be destabilizing to the dollar-based financial system. In that sense, Bitcoin is more than a bet on an interesting technology platform.
If Bitcoin were to become a major global financial asset, this could be disruptive to other financial assets and the value of the dollar itself relative to commodities and real assets. So unlike a tech stock, there could be be negative portfolio implications to Bitcoin’s potential success that investors may want to hedge against by establishing at least a minimal exposure to Bitcoin.
To equal gold’s $18 trillion market capitalization, the total value of Bitcoin would need to increase approximately 14-fold from current levels. In this sense, Bitcoin may have open-ended appreciation potential that exceeds even the fastest growing companies.
We tend to believe gold is more likely to benefit from the success of Bitcoin than suffer from it (and gold has certainly performed well in recent years as Bitcoin has soared). Gold and Bitcoin are arguably competing with hundreds of trillions of dollars of fiat money and bonds, rather than each other. To the extent Bitcoin and cryptocurrency disrupt the fiat money system, gold should continue to benefit as a non-fiat asset.
Notwithstanding the argument above that gold and Bitcoin are teammates rather than competitors, investors in gold might want to consider an investment in Bitcoin as a hedge just in case the dynamic does become more competitive.
How should investors own Bitcoin?
As with gold, investors have multiple options when it comes to Bitcoin, which largely comes down to personal preference. Investors with an appetite for direct ownership (and confidence in their ability to remember passwords) can explore various opportunities to self-custody Bitcoin through a cold wallet. Alternatively, they can own Bitcoin and other cryptocurrencies through a custodian like Coinbase (COIN).
The SEC has recently approved ETFs for both Bitcoin and Ethereum. Several asset managers are offering Bitcoin and Ethereum ETFs at relatively low fees that are comparable to many stock index funds. While many investors want to own cryptocurrency directly, without the involvement of intermediaries (similar to holding gold bars or coins in your own safe), others may value the convenience and efficiency of the ETF vehicles.
In theory, ownership of crypto through publicly traded vehicles renders it more vulnerable to political or legal intervention and enforcement. In reality, investors should consider how willing they might be to transact in Bitcoin, even if they had direct access to it, in a scenario where it was legally prohibited. In this sense, the involvement of intermediaries in one’s Bitcoin investments may not be a meaningful drawback. |
| | Know thyself
A key variable, too often underemphasized, when sizing any investment is having a strong sense of one’s ability to withstand price movements. Gold and Bitcoin may generally be uncorrelated with stock market movements, which is perhaps the most compelling reason they deserve special attention within a portfolio. But they are indeed volatile, meaning they will fluctuate noticeably in price.
Gold’s volatility is generally comparable to the broader stock market, whereas Bitcoin is extremely volatile. An investment in either asset is likely to fail if an investor commits capital but then exits the investment because he experienced losses and did not have the stomach for it.
Given the volatility of gold and Bitcoin, investors should make investments in these assets with a strong understanding of what it is they are buying and why and with a long term-perspective. Investors should not only be prepared for downside but could also consider leaving room to add to positions if they do see lower valuations in the future.
As we have emphasized, asset allocation is a highly personalized decision that should take into account a wide range of factors, not least of which is a realistic appraisal of one’s ability to withstand ups and downs on what should be seen as a multi-year, if not multi-decade, journey.
There are many compelling reasons to consider investing in gold and crypto, but we urge investors not to bite off more than they can chew! |
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