On Portfolio Allocation, Gold, QE and the Mediterranean Diet!

From: aditya rana
Date: Sat, Mar 2, 2013 at 1:45 PM
Subject: On Portfolio Allocation, Gold, QE and the Mediterranean Diet!


Portfolio allocation between bonds and stocks is one of the most important aspects of the investment process, and as we reach the end of an era of declining bond yields, it is helpful to think about what might be an appropriate mix in an era of rising interest rates. James Paulsen, chief strategist at Wells Capital Management, provides an interesting historical perspective on this issue and what might we expect going forward. To summarise:

-The post-war investment environment has been significantly impacted by the two long-term secular phases of the bond market – with bond yields beginning (post WWII) a 35-year steady rise in yields, climaxing in a surge during the 1970s as never seen before in U.S. history, followed by a 35-year secular decline in yields to the current post-war record low yields.

-What is clear now is that the bond market is likely to enter into a third post-war phase, significantly altering its relationship with the stock market and therefore expected return on investment portfolios.

-The two 35-year phases of the bond market have exhibited a remarkable symmetry (see chart below) – with bond yields doubling about every 10-years from 2% in 1950, to 4% in 1960, 8% in the 1970 and finally peaking at 16% in 1981, followed subsequently by “a halving” about every 10-years – to 8% in 1991, 4% in the early 2000s and finally to 2% currently.

-The dramatic change in nature of the bond market in the post-war era produced two totally different investment environments – and with current yields at 2% it would be impossible to continue their secular decline – implying either the commencement of a secular rise in yields or a scenario lying somewhere in between the two previous eras.

-The two post-war periods altered the investment environment in three important ways: 1) average annualised bond returns varied significantly between the two eras, 2) the diversification benefit of bond ownership was much stronger during the era of falling yields than it was during the phase of rising yields, and, 3) the risk-reward frontier has been essentially flat since 1980 whereas it was quite steep during the previous era. Examining the three more closely:

1)Bond returns to be lower?:

-During the first post-war phase, 10-year bonds returns averaged -0.95% annually, while they averaged 15.0% during the second phase. However, surprisingly, stocks averaged 12.49% annually during the first phase and 12.37% during the second phase (see chart below). While bond yields may move sideways over the next several years, or (more probably) move higher, it is likely that they provide returns much lower than that provided by the stock market.

2)Bonds to provide less diversification?:

-During most of the post-war era, the returns of stocks and bonds have been positively correlated (i.e. they moved in the same direction), but with a correlation coefficient of less than 1.0 (i.e. is was less than perfect), implying that there were benefits to be had from diversification.

-However, there were two periods (1955 to 1965 and since 2000) when this correlation turned negative, significantly improving the diversification benefits of bonds (see chart below). In particular, the negative correlation since 2000 has led to the currently prevalent thinking that bonds will help stabilize income streams from a portfolio.

-It is likely that the correlation between bond and stock returns will revert to normal over the next several years, thereby significantly reducing the diversification benefits of bonds.

3) Risk-return frontier to steepen?:

-The risk-return frontier between bonds and stocks during the two eras have been dramatically different as illustrated in the chart below. Normally, the risk-reward frontier slopes upwards and to the right with stocks adding more to return as well as risk. An all bond portfolio returned 2.4% with 7% of risk, while an all stock portfolio returned 12.5% with about 14% of risk.

-However, since 1981 the trade-off between bonds and stocks altered considerably with stocks and bonds providing a similar return – an all bond portfolio returned 11.1% versus 11.9% for an all stock portfolio – so adding stocks only marginally improved returns while increasing risk substantially.

-During the next several years, the risk-reward frontier is likely to steepen and expose portfolios which have been constructed based on the experience over the last 30-years. In the coming years, additional risk is likely to better rewarded than has been the case over the last 30-years.

Interesting work which helps to clarify a quandary faced by investors over the last eighteen months (subsequent to 10-year yields reaching 2%) – whether to include a reasonable allocation to government bonds in an asset portfolio for diversification benefits. While government bonds did provide some diversification benefits during the risk-off periods in 2011 and 2012, these were only temporary in nature and investors would have been better off by avoiding them. Looking ahead, it would be sensible to construct a diversified portfolio using attractively valued stocks, commodities, high-yield bonds (developed markets and EM), emerging market local currency bonds, cash and gold to achieve an appropriate risk-reward trade-off.

On the subject of high-yield bonds, Howard Marks, the CEO of Oaktree and one of the most experienced managers of high-yield bonds, put out a short note emphasising that high-yield bonds are less vulnerable to rising interest rates than other type of bonds, as they have lower duration and also benefit from an improving economy. In addition, while yields are at historical lows, credit spreads of 490 basis points are at the high end of the historical range over the last 30-years. While a rise in interest rates will have a negative impact on their prices, it should prove to be only temporary, and high-yield bonds are likely to outperform treasuries and high-grade credit in the years ahead.

Gold has had a poor start for the year – driven by selling by hedge funds, differing views in the FED about the duration of its QE programme, and a better outlook for the U.S. economy – however, as Bernanke indicated in his recent testimony, the QE programme is likely to continue as it has had clear benefits on asset prices and the economy without increasing inflation. With the $85 billion per month buying programme very likely to continue, gold prices should be well supported in the coming months as the correlation between the Fed’s balance sheet and the price of gold has historically been very high, at 0.93, according to Macquarie Research (via Frank Holmes of U.S. Global Investors). “The firm found that for every $300 billion expansion in the balance sheet of the U.S. government, there was a $100 an ounce increase in the price of gold. When you factor in the Fed’s current bond purchases totalling $85 billion per month for the next nine months, the central bank will be adding $765 billion in new assets. “Using the previous ratio, this would compute to a $255 an ounce increase in the gold price,” says Macquarie. By this measure alone, gold would rise approximately 16 percent over the next several months.” Stay with gold as part of a diversified asset portfolio!

-In the event you are not persuaded by the positive impact of QE on the stock market, please peruse the chart below (via Morgan Stanley) which illustrates the relationship quite clearly!

-And while it is true that macro-economic surprises (on the upside and downside) have an impact on stock prices, the effect is only temporary as a downturn in the economy (and lower stock prices) is likely to be followed eventually by further QE (and higher stock prices).

Study Promotes Olive Oil and Dismisses Low-fat Diet?

A recent publication of a study in the New England Journal of Medicine(NEJM) received a high level of publicity in the media, as it advocated having a mediterranean diet with lots of olive oil and nuts (plus moderate wine and meat consumption) to reduce the risk of heart disease. While the relative benefits of a Mediterranean diet are well established, a closer look at the study implies a somewhat different message than that implied by the popular media (as is usually the case-both in the areas of health and economics!). I present a riposte from the noted diet and health practitioner/advocate Dr. John McDougall, MD (apologise for the length but this is important!):

The article about how adding olive oil and nuts to their usual diet will reduce their risk of heart attacks by 30 percent. This article has also told them that a low-fat diet fails to help. Stroke was the only problem where the tested Mediterranean diet made a real difference. The diet had no effect on heart attacks or death rates overall. The popularity of this message proves once again that “people love to hear good news about their bad habits.” They are reassured that simply by adding more olive oil and nuts you will improve your health…cutting out the brie and beef stroganoff are secondary thoughts.

The article begins by saying, “The traditional Mediterranean diet is characterized by a high intake of olive oil, fruit, nuts, vegetables, and cereals; a moderate intake of fish and poultry; a low intake of dairy products, red meat, processed meats, and sweets; and wine in moderation, consumed with meals.” Of course, this diet is an improvement over the usual fare consumed in the US and Europe, and that is why benefits were seen. The study lasted five years and involved about 7,447 people, ages 55 to 80, in Spain.

There was no reason to say the low-fat diet is a failure based on this research, because participants in the “low-fat” group made no real change in their diets. In the “low-fat” group, total fat consumption decreased insignificantly from 39 to 37 percent. Why was so little effort placed on teaching and then testing a really healthy low-fat diet like mine (the McDougall Diet is 7 percent fat), and then comparing it with the Mediterranean diet? There was no financial interest in pursuing this end. The vested interest was in selling olive oil and nuts. Two companies supplied the olive oil (Hojiblanca and Patrimonio Comunal Olivarero), and the nuts came from a nut producer in Spain (La Morella Nuts) and the California Walnut Commission. Plus many of the authors have extensive financial ties to food, wine, and other industry groups.

One major disadvantage of replacing saturated fats (meats and dairy) with olive oil and nuts is that there is no weight loss from exchanging one type of fat for another: “The fat you eat is the fat you wear.” When this same group of researchers published their earlier findings in 2006 they found that their “olive oil" group lost less weight than did the “low-fat” group (0.19 Kg) and the “nut” group lost about the same (0.26 Kg) as the “low-fat” group in 3 months.1 (Remember they were not really following a low fat diet.) With the McDougall diet we have found an average weight loss of five times as much, 1.6 Kg (3.5 pounds), in a week and participants are encouraged to eat as much as they want, buffet style.

The obesity-causing effects of all that olive oil are also seen in the countries in southern Europe. When 54 obese women in a Mediterranean country were studied, they were found to be following a diet low in carbohydrates (35% of the calories) and high in fats (43% of the calories)…and 55% of the total of these fats came from olive oil.2 Overweight and obesity lay the foundation for type-2 diabetes and degenerative arthritis of the lower extremities, as well as cancer, heart disease, and strokes.

Does Olive Oil and Eating Nuts Really Prevent Heart Disease?

Common knowledge is using olive oil (monounsaturated fat) and eating nuts (polyunsaturated fats) are protective against heart disease, but there is evidence that questions the real life benefits:

* Serial angiograms of people’s heart arteries show that all three types of fat—saturated (animal) fat, monounsaturated (olive oil), and polyunsaturated (omega-3 and -6 oils)—were associated with significant increases in new atherosclerotic lesions over one year of study.3 Only by decreasing the entire fat intake, including poly- and monounsaturated-oils, did the lesions stop growing.

* Dietary polyunsaturated oils, both the omega-3 and omega-6 types, are incorporated into human atherosclerotic plaques; thereby promoting damage to the arteries and the progression of atherosclerosis.4

* A study in African green monkeys found when saturated fat was replaced with monounsaturated fat (olive oil), the olive oil provided no protection from atherosclerosis.5

* One of the most important clotting factors predicting the risk of a heart attack is an elevated factor VII. All five fats tested—rapeseed oil (canola), olive oil, sunflower oil, palm oil, and butter—showed similar increases in triglycerides and clotting factor VII.6

Most likely, the heart benefits of a Mediterranean diet are due to it being a nearly vegetarian diet. The Mediterranean diet is a good diet in spite of the olive oil and added nuts.7

I believe the reason this New England Journal of Medicine study shows benefits is because the people in the Mediterranean diet group reduced their intake of meat and dairy foods and increased their intake of starches (cereals and legumes), vegetables, and fruits. The inclusion of olive oil and nuts was not a “magic pill” that spared their ailing arteries from forkfuls of bacon and eggs. However, the reader should consider these findings of this study important because they do show that people can change their diets when instructed to do so and that removing animal foods from the diet is beneficial. But recommending more olive oil, nuts, seeds, and fish is not the message people deserve to hear. They need to know that a truly healthy diet provides the bulk of the calories from traditional starches, like rice, corn, and potatoes. Commercialism needs to be eliminated when life and death issues for you and your family are at stake.”

1) Estruch R, Martinez-Gonzalez MA, Corella D, Salas-Salvado J, Ruiz-Gutierrez V, Covas MI, Fiol M, Gomez-Gracia E, Lopez-Sabater MC, Vinyoles E, Aros F, Conde M, Lahoz C, Lapetra J, Saez G, Ros E.Effects of a Mediterranean-Style Diet on Cardiovascular Risk Factors: A Randomized Trial. Ann Intern Med. 2006 Jul 4;145(1):1-11.

2) Calle-Pascual AL, Saavedra A, Benedi A, Martin-Alvarez PJ, Garcia-Honduvilla J, Calle JR, Marañes JP. Changes in nutritional pattern, insulin sensitivity and glucose tolerance during weight loss in obese patients from a Mediterranean area. Horm Metab Res. 1995 Nov;27(11):499-502.

3) Blankenhorn DH, Johnson RL, Mack WJ, el Zein HA, Vailas LI. The influence of diet on the appearance of new lesions in human coronary arteries. JAMA. 1990 Mar 23-30;263(12):1646-52.

4) Felton CV, Crook D, Davies MJ, Oliver MF. Dietary polyunsaturated fatty acids and composition of human aortic plaques. Lancet. 1994 Oct 29;344(8931):1195-6.

5) Rudel LL, Parks JS, Sawyer JK. Compared with dietary monounsaturated and saturated fat, polyunsaturated fat protects African green monkeys from coronary artery atherosclerosis. Arterioscler Thromb Vasc Biol. 1995 Dec;15(12):2101-10.

6) Larsen LF, Bladbjerg EM, Jespersen J, Marckmann P. Effects of dietary fat quality and quantity on postprandial activation of blood coagulation factor VII. Arterioscler Thromb Vasc Biol. 1997 Nov;17(11):2904-9.

7) Keys A. Mediterranean diet and public health: personal reflections. Am J Clin Nutr. 1995 Jun;61(6 Suppl):1321S-1323S.

Here is to treating popular reports in the media with a healthy dose of scepticism (particularly if they say what you would like to hear!).



2-2013-bonds vs stocks.pdf


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