The Permanent Portfolio

Today’s Markets and Money begins with an outsider’s look at the Australian banking sector. Then we’ll take a Prime Ministerial look. And finally, a Gallic technical trader’s look. All three perspectives suggest that Australia’s banking sector is a lot less insulated from the global crisis than its advocates have suggested. But don’t take our word for it…

First up is Christopher Wood, regular analyst at CLSA Asia-Pacific and writer of handy newsletter called GREED and Fear. “The ban on shorting Australian financial stocks is due to expire on 27 January,” he writes. “If it is not extended, this presents a clear opportunity for absolute-return investors. GREED and Fear continues to take the view that Australian financials will be the last area of Anglo-Saxon consumer financing excess to bottom with, as in Britain and America, the seemingly inevitable involvement of taxpayer money before the end of the cycle.”

“GREED and Fear also continues to recommend, as has been recommended since March 2008, that Asia-Pacific relative-return investors maintain a zero weighting in Australian financials. Australian banks, including their New Zealand subsidiaries, are characterised by high loan-deposit ratios and low loan loss provisions.”

“Meanwhile, the household sector is extremely leveraged while the former high flying residential property market is weakening fast. Household debt to disposable income is still running at 156%, compared with 130% in America. While Australian residential building approvals fell by 32% year-over-year in November, with new home sales down 15% year-over-year.”

“GREED and Fear hears from recent visitors to the ‘Lucky Country’ that there is still a state of denial, which is certainly not the case in Australia or Britain. If so, this mentality will not last. But the good news is that reluctant Australian taxpayers will be able to afford to pick up the tab. Public sector debt is only 15% of GDP.”

So there you have it. From the outside looking in, Aussie banks and investors are in denial about the housing market and the impact of the asset deflation and the credit crunch on bank bottom lines. Does that sound about right to you? Or is Australia’s residential property market truly immune from the Credit Depression? Discuss. Or write to us at

Meanwhile, allow us to turn the podium over to Australia’s Prime Minister, the Honourable Kevin Rudd. Rudd was in Adelaide, trying to bask in some of Lance Armstrong’s cancer-fighting limelight. But he was preoccupied with the emerging fact that foreign lenders are turning off the supply of credit to Australia as the world banking crisis accelerates.

“When markets fail, governments must act,” the Prime Minister said, apparently with a straight face. What he was referring to, according to today’s Age, is the $75 billion in foreign loans owed by Aussie firms that must be rolled over in the next two years. Trouble is, foreign lenders-and really lenders everywhere-appear to be in nearly full-scale retreat from lending.

This is the trouble with having only four big banks and being a net importer of capital. You can finance your lending out of domestic savings, of course. But Aussie banks-mostly to finance the housing boom of the last ten years-borrowed overseas to lend at home. And if you can’t borrow overseas? Hmm. Maybe government lending, or a government guarantee on borrowing, will work instead. We’ll see. Meanwhile, back over to Rudd…

“It would be difficult for Australia’s four major banks to fill the gap [between borrowing needs and foreign willingness to fund] on their own,” Mr. Rudd he said. “When businesses cannot get loans and are not confident about the future, they can’t or won’t invest, meaning they can’t create jobs and they can’t grow. The Government stands ready to take whatever further action is necessary to stabilise financial markets.”

Mr. Rudd could be getting a lot of action pretty soon. Between the $10 billion stimulus, bond guarantees, the expanded first home buyers grant, and various infrastructure plans, Bloomberg reckons the Rudd government has committed or spent $45 billion so far. It’s probably going to take a lot more than that, especially if the government has to guarantee (or the RBA provide outright) credit to local borrowers who can’t borrow internationally.

Not that the Aussie banks are being singled out. Heck, Australia’s four big banks may outnumber solvent banks in the U.K. and America combined by the end of the week, if things keep going they way they’re going. Bank stocks in America were absolutely hammered in Tuesday trading. Citigroup (NYSE:C) was down 20%. Bank of America (NYSE:BAC) was off 29%. And Wells Fargo (NYSE:WFC) was off 24%.

What gives? It’s the sinking feeling that the world’s banks still don’t have enough capital and will need much, much more to offset coming losses and begin lending again in normal way. But the equity capital just keeps melting away. For example, the Royal Bank of Scotland had a market cap of £75 billion two years ago. As of yesterday, it was only 4£.5 billion pounds. And that’s AFTER a taxpayer injection £32 billion!

More on what this means for Australia in just a second. And later this week, we’ll get into the real heart of the problem in the banking sector, dwindling capital and mismatched liabilities and assets.

But for now, let’s be clear: the banking crisis has entered a new stage in the equity markets. It has real world consequences for commodity demand and resource shares. We’ll get to that in a second. But what about Australian financial shares?

Well, we won’t get into any analysis of loan books or balance sheets. It is true that Australian banks did not get into the subprime mortgage game. But it is also true they did make a lot of loans to margin lending firms in the stock market and still have significant exposure to residential real estate. We asked SWARM Trader Gabriel Andre to put that all aside and tell us what was the worst looking Aussie bank stock on a technical basis.

Here’s what he told his readers yesterday in a SWARM alert. His analysis included a forecast for the ASX/200. “Among the losers,” Gabriel wrote, “there may have one famous banking institution. Besides the balance sheet and the macro news, we had a look today at the Aussie banks. Just on the chartist side. Only with technical indicators. And there is one chart that does not look really good. It’s ANZ. Take a look at the chart below.

“The key level is at $15.5. It has been the main support of the price action during several months (points A, B, C and D) but has been cleared in November (point E) when the price went further down to a low of $12.30. The key level of $15.5 mechanically became the new resistance. Hit a few times since the beginning of the year (points F and G), the resistance has been holding firmly. The long-term resistance (red line) is also just above. The price action is therefore well capped.”

“Two different momentum indicators have already turned bearish: the MACD and the Klinger oscillator, which is sensitive enough to signal short-term tops and bottoms, yet accurate enough to reflect the long-term flow of money into and out of a security. This afternoon ANZ is quoting $13.7. It should go clearly further below, especially if the ASX ban on shorting the financials will expire next week.”

Maybe ASIC and the ASX will reconsider the ban on shorting financials. And maybe it will not matter anyway. Either way, stay tuned.

We wrote above that the renewed banking crisis is bad news for commodity demand and resource shares. But how so? The problem is asset deflation.

Yesterday we speculated that there could be trillion dollars more in credit-market losses related to commercial real estate, residential real estate, and corporate bonds. If that is the case, it means much lower share prices. It also means finance is going to be extremely tough to come by for mining companies, who are facing falling real demand to begin with.

Today Nouriel Roubini checked in on the issue of how much more asset deflation we face. At a conference in Dubai he said, “I’ve found that credit losses could peak at a level of US$3.6 trillion for U.S. institutions, half of them by banks and broker dealers…If that’s true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis.”

Now you can see why it was such a bad day for the banks. The scary fact is that Roubini’s estimate could still be conservative. You still have the corporate bond market, securitised consumer loans (credit cards and loans), and GSE and Agency-backed bonds (both of which are tied to U.S. residential real estate.)

But quibbling over trillions is not the point. The point is that if there is more asset deflation to come, it is extremely hard to find any positive argument for continuing to own, much less buying, all but very specific types of commodity-related investments. And just what would those investments be?

We turn to the late Harry Browne for the answer. In the early 1970s, Harry wrote a book called “How to Prepare for the Coming Devaluation.” Harry’s book was an investment primer on how to live in a world with massive, deliberate debasement of national currencies. Naturally, the strategy favoured “stuff” over “paper.” But not just any stuff.

It was-and still is-a radically simple asset allocation model. Harry said that roughly 25% of your assets should be in gold (combination of bullion, coins, and equities), 25% in foreign bonds, 25% in U.S. Treasury bonds, and 25% in growth stocks.

Investing: once complicated, now simple!

Would that model hold up well today? Well, we’d be wary of having money in the bond market. That’s one thing that’s changed since Harry wrote his book in the 1970s. And we’d probably add more energy investments, given our subscription to the Peak Oil theory of declining global oil production. But his observation that simpler is better when preparing for inflation is spot on.

An actively managed portfolio with a weighting of 60% to 70% of your assets in stocks does not look like a financial survival strategy for the next five or ten years. You want a more permanent portfolio that takes into account the macroeconomic and monetary events that influence share prices.

Harry’s big call was to buy gold and silver. And as you know, that worked pretty well. Buying gold has also been Bill Bonner’s trade of the decade since 2000. It’s working out pretty well too.

But did you know that there’s a fund that’s traded since 1996 which essentially imitates Harry Browne’s investment strategy? It’s called the Permanent Portfolio and trades under the symbol PRPFX. Note that we are not recommending you buy the fund.

What we are recommending is that you pay close attention to its strategy. “Designed to provide growth at low risk,” the home page says, “the primary goal of Permanent Portfolio is to preserve and increase the real long-term purchasing power of each shareholder’s investment, regardless of economic climate. ”

It does this with a portfolio consisting of gold, silver, Swiss Francs, real estate, U.S. Treasury bonds, and aggressive growth stocks. Take a look at how the fund has done since its inception versus the S&P.

As you can see, the Permanent Portfolio got clobbered during the tech boom. It’s relatively low allocation to growth stocks had it underperforming. Then, starting with the great Greenspan reflation of 2003, it roughly tracked the S&P 500, while still slightly underperforming. However, since late last year, it’s held up much better than the S&P 500 as the financial crisis decimated stocks.

By the way, here’s how the fund’s assets were allocated at the end of last year:

Gold: 20%

Silver” 5%

Swiss Franc Assets: 10%

U.S. and Foreign Real Estate and Natural Resource Stocks: 15%

Aggressive Growth Stocks: 15%

U.S. Treasury Bills, Bonds and Other Dollar Assets: 35%

We might have fewer U.S. dollar bonds and more growth stocks in there too, but what’s killed the Permanent Portfolio in the last six months is its exposure to commercial real estate through its REITs. We mentioned last week that we thought arable farm land would be an increasingly valuable asset in the coming years. So if we were going to make this union of asset classes even more perfect, we would strip out the REITs and backfill some agriculture and land investments.

But the rest? It looks pretty sound for a world where you face more asset deflation prior to rampant, government-backed inflation. The 80% up figure translates to about six percent a year since its inception, which is just about the historic return for common stocks (if you include reinvested dividends).

One other item to note about this. The Austrian School’s analysis of the credit cycle is what informed Harry’s strategy. Like today, he understood that changes in the money supply would affect the real economy and the stock market. The credit cycle and the business cycle are inextricably bound together.

But that didn’t mean there isn’t a prime place in Austrian theory for the role of the entrepreneur. In fact, the great Austrian economist Joseph Schumpeter pointed this out in his early work, The Theory of Economic Development. Schumpeter pointed out that the aim of all economic production is to satisfy human wants.

In Schumpeter’s world, the entrepreneur is more important than the capitalist because it’s the entrepreneur who has the vision to challenge conventional ways of doing business and take risks (albeit with someone else’s money.) In Schumpeter’s vision of capitalism, “the gales of creative destruction” are unleashed by single-minded entrepreneurs who bring change. And not just change you can believe in, but profitable change!

Or as Schumpeter writes in The Theory of Economic Development, “Entrepreneurial profit … is the expression of the value of what the entrepreneur contributes to production.” This is why Schumpeter’s kind of capitalism is inherently moral and ethical. It is based on production which consumers find valuable and exchange which they enter into voluntarily.

There is no compulsion or arbitrary setting of prices or government-mandated production or lending. If the idea of the entrepreneur contributes to the production of some good or service people want more of than what’s already available (or if it’s entirely new) he profits. And sometimes enormously so.

That is one good thing we can say about the world we live in and one big reason why growth stocks should remain part of your asset allocation strategy. In medicine and energy, the world faces huge challenges and enormous entrepreneurial opportunities. It’s going to present investors with great chances to share profits from innovative firms.

With great volatility you also get a lot of innovation. As much as we focus on value destruction here in the Markets and Money, there are a lot of wealth creation stores to be pursued too!

But we’ll have to save the story of creative destruction for tomorrow! In tomorrow’s edition, we tackle the issue of fair value versus market value in the U.S. mortgage market. And we’ll have more on AGMOIL, the next trade of the decade involving a portfolio of agriculture, precious metals, and oil. Until then!

Dan Denning

for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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17 Comments on "The Permanent Portfolio"

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DR reader

“When businesses cannot get loans and are not confident about the future, they can’t or won’t invest, meaning they can’t create jobs and they can’t grow. The Government stands ready to take whatever further action is necessary to stabilise financial markets.”

The key in Australia is to keep the level of unemployment as low as possible. Houseowners in Australia will not (and cannot easily) walk away from a home loan even in a negitive equity situation. They will hold on as long as employed (or with understanding lenders) with a firm historical belief that houses in Australia’s capital cities will eventually be a good investment.History correctly tells them that. Even in the absence of any real knowledge of investments or market cycles they have a homeowning mentality which will go a long way in not adding fuel to the depreciating market.The… Read more »
Gerry – how do banks know that “pay what you can” will pay off for them? Banks aren’t completely stupid, they see a risk like that and they sort it out before it costs them heaps. In a falling market the bank will see how much of the loan will get paid off in a foreclosure…they surely won’t wait as prices drop further and further, they’ll cut their losses asap. I, like some others, get a bit tired of hearing about how Australians are so doggedly determined to keep their houses, etc. As against Americans right? Or New Zealanders? Or… Read more »
I’m having a mugambo guru moment. In the mid 80’s I hung out around too many politicians and public servants, and with the fecklessness of youth got a bit morally charged about the keating real estate miracle economy; and the disdain for anything that looked like productive industry unless it could be dug up, and then again only if you could prove you couldn’t eat it. So I buggered off to germany to work and learn and eventually came back when I figured that keating and his wonk and banker mates had met their waterloo; but they had quarantined the… Read more »

Pete…I was not comparing countries or their love of their own homes. The fundamental point was that in Australia when you get in a negitive equity situation you can’t simply hand the keys back and walk away as easily from contracted committments.They will chase you for the balance after conducting a fire sale on your house. It does not change the fundamentals but is a valid point in not adding to the acceleration of foreclosures,thats all.

Coffee Addict
I don’t disagree with anything in Dan’s post or the following comments by Gerry., Pete and Ross. The Australian economy and the AUD is in for a hell of a hit. People in countries like Russia, China and India have known hardship and are well practiced in adapting to changed economic circumstances. By contrast, workers and welfare recipients in the urban areas of Australia, the US and the UK will be stuffed. Many of these people don’t have practical skills to fall back on and don’t have an interest in developing new skills. Many expect, as their God given right,… Read more »
Greg Atkinson
I have been bearish on the Australian economy since early late 2007. It was quite clear to me then as an Australian living overseas that the Australian economy was way ahead of itself…when you start hearing about visa’s being issued to people to work at MacDonalds (because the mines had sucked in all available labour in some areas) then you know you are in a bubble. As I mentioned in my blog last year, if commodities rolled over Australia would be in serious trouble and we find ourselves in that situation now. Of course the government spent a large part… Read more »
Gerry: We can still go bankrupt here. Sure it hurts, but if you have no money now, and no windfalls likely in the future, it starts to make sense regardless of what it does to your credit rating. Once the herd starts moving, the banks won’t be able to keep up with the ‘chasing’ very well. Maybe they can try getting money from homeless people. Coffee Addict: If Kev prints money to save our big four, and if that includes sending money overseas to lenders, then our economy is surely doomed. Who would want newly minted AUD? Whilst some countries… Read more »
Greg: “…all the talk last year about Australia being better positioned to withstand the financial crisis was complete rubbish..and for this the RBA and government should be held accountable.” Really? Like the bank CEO’s? How could they ‘foresee’ a China slowdown or Australian economy slowdown, especially if they are not allowed to talk about it? It seems to them that just mentioning the R word brings on a recession. Besides, how do they know whats going on with our banks if the banks don’t even know, or won’t tell anyone the truth? Good point about the McDonalds visas too. I… Read more »
Greg Atkinson
Pete, I am not sure how the banks got into a tangle..they seem good at doing that though. (think NAB and their venture into the U.K some years ago). As for the government and RBA I do not know what data they were looking at but I think the main blunder was that officials (and banks and mining execs) started to think that China could somehow run on auto and would not be affected by a slump in Japan, Europe and the U.S. I think Rudd’s pre-occupation with China also “blinkered” the thinking of the government to some extent. As… Read more »

I agree Greg, I was certainly getting sick of the government, and almost everyone else touting China as Australia’s saviour. Or there was the suggestion that Australia would be okay without China anyway. Craziness! We cannot rely on ‘hope’ to guide us financially, egads (daloob?).

And yes, Australia sure did have big problems, but as someone else mentioned here (maybe you?), the ‘resources boom’ temporarily paved over those cracks, so they were ignored by all.

Greg Atkinson
Guest thing I am curious about is how so many people got it so wrong with China. Companies like BHP, most analysts/economists, the IMF and the government all seemed to have overstated the robustness of the Chinese economy. (even China based analysts were bullish on the Chinese economy just weeks ago) I never quite signed up to the endless Chinese growth story but sadly I did pay attention to what the experts were saying and kept hold of some shares in BHP and few other companies with exposure to China. (ouch) I think I will explore this issue more in… Read more »
Groupthink would be probably pretty close. I think a few factors: – China is not particularly transparent, most of us really don’t know what the whole country is like and what they are doing exactly – China is quite corrupt, figures get distorted (as above) – ‘Too big to fail’: the same idea for those financial institutions really, how could something so big fail like that? Impossible! – Perceptions of China immune to the problems of the US (like the crazy credit driven export model couldn’t fail?). Whilst its not only the US that imports from China, the ‘global’ financial… Read more »

How right you are. Most Australians are in serious denial that there is any problem. Denial is a very dangerous thing, beccause it doesn’t make you immune from harm. Its better to spend the same time preparing a plan.

rick e

Christina you bought that 5 acre block out at Bowral yet?

Nowadays these sort of discussions almost exclusively focus on economic theories, political judgement, bankers incompetence etc. All important in themselves, but not the essential problem which can be summed up in the saying moral failure has practical consequences. The root cause of our problem is moral. Money is no different to anything else. It is a commodity to be used and when people or almost whole societies become obsessively focused on it for its own sake, irrespective of the consequences to others, we are in deep trouble. Morality is not just a private matter between consenting adults. It is the… Read more »
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