Portfolio Allocation Alert

As I discussed in last week's post, inflation seems to be posing more of an issue in investors' minds over the past several weeks.  Inflation is manifesting itself in many ways, including a rather rapidly steepening yield curve (higher market-driven long term interest rates with short term rates pegged close to zero by the Fed), increases in commodity prices like copper and oil, and fears that continued fiscal stimulus coupled with huge pent-up demand for "the way things were" (travel and leisure will likely benefit the most from this trend) will ultimately lead to significant inflation in the coming years.  If unchecked by the Fed, high inflation could become a big problem for investors who aren't positioned properly.  

Not everyone agrees with what is happening - some are saying the steepening yield curve is merely "normalizing," while others are taking the relatively rapid rise as a sign of higher than expected inflation on the horizon.  That coupled with the Fed's limited ability to combat inflation by raising interest rates due to the huge amount of public (and private) debt is even more concerning.  There is also some disagreement about how higher interest rates and inflation will impact the attractiveness of stocks.  It seems to me that interest rates will have to rise a lot to where there is a sufficiently positive real return (and inflation expectations will also need to be confirmed with reality), before investors will be willing to move a significant amount of money out of stocks into bonds.  Many investors believe that stocks are a good place to be if there is inflation, especially companies that have pricing power and relatively fixed costs, those that benefit from low short term rates and high long term rates like banks, cyclical stocks and also those that are involved in the production of commodities.  High tech growth companies, however, may suffer significant value decline in a high interest rate environment due to the effect on discounted future cash flows (higher interest rates in the future mean lower value in today's dollars assuming the cash flows are held constant).  

If you step back and think about it, higher inflation does seem like a natural consequence of what is happening all around us.  Due to the pandemic and being stuck at home, for example, the demand for bicycles, appliances and furniture has increased significantly.  With supply chains disrupted, manufacturers are having a hard time filling orders, but ultimately prices will rise as rising raw materials and labor costs work their way through the system due to the significant demand.  A recent trip to the furniture store confirmed that for me - no negotiating prices / "big sales" and you might have to wait a couple of months to get what you want.  Copper has been particularly interesting to me since it is a key component in electric vehicles as well as house construction, both of which have seen unprecedented demand recently and which has likely been a big driver in the recent rise of copper prices.  

I have also learned that since copper prices have been so low for so long (about 10 years), there has been no incentive to develop new sources, so supply of copper is somewhat limited, while demand is increasing.  This is true of many other commodities, including the so called "rare earth metals" needed for electric vehicles and defense production, uranium, iron ore and many others.  Some observers believe we are at the beginning of a 10 year "commodity super cycle" due the confluence of limited supply and strong demand stoked by the "return to normal" post-pandemic phase and massive government fiscal stimulus.  

After reflecting on all this, I decided to restructure my portfolio to significantly reduce exposure to bonds and more broadly diversify across the remaining asset classes including adding exposure to commodities, increasing exposure to emerging market stocks, real estate and bitcoin, while keeping a good amount of short term TIPS for emergencies and opportunities.  I will wait to move back into longer term bonds until I can see there is a positive real yield that makes sense - otherwise the long term bond rally seems set to continue to unwind in the coming months and years as rates continue to rise and values fall.  

Here's the new portfolio allocation after last week's adjustments which still reflects broad diversification, but a move away from long term bonds:

Cash - 14% (mostly held in 4-week US treasury bills, but due to very low and declining yields, shifting over to Vanguard Treasury Inflation Protected Securities ETF (VTIP) for better yield at about 1.2% and low volatility; after that move cash will be about 1.5%)Stocks - 35% Mixed Portfolio of Long Stock Positions and Covered Calls - 11% (cash flow strategy)US Large Cap - 6% US Mid Cap - 6%US Small Cap - 6%Emerging Markets - 6%Commodities - 6%Bonds - 0% (will be 12.5% when the shift to VTIP (5 years or less duration) discussed above is complete; will review higher allocation to longer maturities after interest rates normalize in the future)Real Estate - 22% (rental property 75%; REIT portfolio 25%)Private Equity - 10% (angel investments - posted about this quite some time ago if you are interested - here's the link)Bitcoin - 10% (allocation has grown from 6%-8% target due to small additions and recent price appreciation, but goal is to continue to stay overweight and accumulate through dollar cost averaging over time); if you're interested in different ways to invest in Bitcoin check out my recent post here.Other Alternatives - 3% (mostly physical gold and silver held in a vault and some music royalties)

This is intended to be a buy and hold, multi-year strategy.  Before investing, make sure you do your own research, consider what others have to say and make your own decisions.  Also make sure to look at your overall portfolio diversification regularly.  

I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2021.  To see all my books on investing and leadership, click here. 
Stay safe, healthy and positive.