Diversification Against Bubbles

When I say diversification against bubbles, I would argue the current state of the markets makes now the most difficult time to invest in many decades. I get asked what to invest in constantly by friends and family. While this would appear normal, the reason why I get asked this question is not. I make the claim that everything is in a bubble. This means real estate, bonds, and stocks are all over valued because of this unprecedented $4.5 trillion expansion of the Fed’s balance sheet which represents 24% of the U.S. economy. You can see the bubble in the chart below which has household assets relative to disposable income. It is at the highest ratio in over 50 years.

There is bizarre logic that comes from those who critique this perspective. If I hesitate on a recommendation of where to put your money, critics say if I don’t know where to allocate assets then I must be wrong. This is wrong because knowing where to put your money is completely different than knowing we’re in a bubble. I consider the bubble valuations to be very easy to spot. The tough part is where to put your money after you recognize the situation.

The first option is shorting assets. You can short junk bonds, momentum stocks, dividend stocks, and bet against specific areas where real estate is overheating. These would all be smart ideas if you knew when the market would turn. I personally am picking my spots with this strategy, but would never recommend it to be a large allocation position in your portfolio. The biggest risk with this strategy is your own personal ability to take losses. If there are talks of the central banks potentially buying more stocks, there is risk to the upside. It is hard to stay short in that situation because you don’t know when their firepower will end.

In a situation where risk is as prevalent as it is, the most important goal is capital preservation. Considering the low yields of bonds and the low returns of stocks, preserving capital has the least opportunity cost it has had in a long time. The analogy of picking of pennies in front of a truck is accurate as this you may make money on a few stocks, but the risk you take doesn’t account for the returns you may get. As you can see in the chart below, according to GMO most asset classes are expected to have negative returns over the next 7 years because of valuations. U.S. Large caps will underperform the long term average by 9.6%.

The potential places to allocate you money to preserve capital are paper currencies, digital currencies, and precious metals. There are advantages and disadvantages to each which is why I think diversifying is the best bet. The chart below from a gold IRA resource shows some of the pros and cons of investing in gold, bitcoin, and the U.S. Dollar. This is an overview which is valuable because most assets in the same category have the same characterizations. An example of what I mean is dogecoin is in the cryptocurrency category with bitcoin and both have high portability.

Warren Buffett claims diversification is to protect yourself from ignorance. Personally I have researched cryptocurrencies extensively. Most coins are based off the same blockchain technology, but the differences between them can become larger overtime making some coins become more valuable in the future than others. Small problems with coins now can become big ones in the future. One example of this is the differentiation between proof of work and proof of stake. The proof of work protocol is used on bitcoin. The problem with this concept is it requires a high amount of computing to verify transactions. With transaction fees decreasing over time as the number of bitcoins added decreases to zero, the computing power to support the blockchain will become too expensive to maintain. This could leave bitcoin open to a 51% attack. A proof of stake concept allows simpler calculations and less expensive machines as the amount of the cryptocurrency you own is the amount of mining power you have. There are also issues with this because it encourages large holders to sit on their positions and collect interest which could then inhibit liquidity.

My understanding of cryptocurrencies is that they will all face individual hurdles that the initial creators did not foresee when they created the protocol. The ability for a cryptocurrency to evolve is based on the dedication of the developer team. I cannot foresee out in the future which cryptocurrency will get the most developer support, so I think diversifying by the market cap of the currency is a wise decision. Equal weighting would bring risk of putting too much money into an unknown entity with few backers.

Paper currencies issued by governments should also have a place to mitigate risk. The chart below shows the IMF’s Special Drawing Rights breakdown. This is recalculated often because of changes in economies. This is a good place to start with your diversification. The problem is all of the countries in this group have massive debts. This would cause you to move to emerging market currencies. Emerging markets currencies may be able to withstand some of the impact of a dollar crash, but the U.S. economy is so massive any weakness will hurt every currency, meaning the risk of debt cannot be eliminated.

Precious metals are another area to consider. Gold and silver have been used as currency throughout history. For this area of your portfolio I would only own these two precious metals. Owning a commodity like oil is risky because it may fall when demand falls during the next recession. Owning gold and silver protects you from the losses you may see in the currency part of your portfolio.

Conclusion

If you want to speculate in a trading account, shorting some overvalued securities would be a good idea. For your retirement portfolio having a mixture of stocks, bonds, and real estate is not diversification. They are all negatively impacted by a major recession. The better way to diversify would be to hold a diversified portfolio of various precious metals, various paper currencies, and various cryptocurrencies.