The absence of deflation inputs in MPT asset allocation models and our generation's inexperience with panic-led liquidations skewed quantitative models into optimizing portfolios for inflation risk. The endowment model is a prime example of negative reflexivity. Void of deflation inputs, endowments have been primarily optimized to hedge inflation risk. These models see bonds and more liquid assets as a bad bet.

The Yale model is very popular in our investment world. It holds a long-term 90% equity to 10% fixed-income allocation.[v] Generally, this model has an illiquidity bias. The Yale endowment believes that the more liquid an asset class or security category, the fewer opportunities there are for active management to generate alpha.

Yale entered 2008 with only 5% in bonds. They do not see diversifying value from corporate/foreign bonds. They usually hold about 5% in Treasury bills for operation needs, which completes the fixed-income allocation.

Yale ignored a deflationary bust risk right as we began to slide into the abyss. Asset deflation and default risk were evident when they established their asset allocations for 2008. Investors who follow their model lost more than 30% of their portfolio values in 2008. Figures 1 and 2 improve upon the Yale endowment model.

Booms, Busts & Other (More Normal) Times

Figure 1 displays the percent of time that we have spent in booms, busts and other times (somewhere in between) over the past 90 years. Since 1920, we have been in a bust 25% of the time. Hard times decline to 23% and 15% when the starting times begin in 1946 and 1984. Other times rise from 36% to 47% of all occurrences when observations begin in 1984 rather than 1920. Boom times consistently account for 38% to 40% of all periods, which have enabled financial asset returns to exceed Treasury bills since 1920.

Figure 1 supports the reflexivity theory. The Yale endowment is an example of observers lacking independence from their dependent variable (market prices). Observer bias keeps us from widening our data universe. Poor input quality limits our ability to hedge portfolios for all economic climates prevalent since 1920, especially the period from 1920 to 1946.

Since 1990, the U.S. has displayed economic/market cycles similar to those in the 1920 to 1946 period. Default risk dominated the former and latter periods. Great deflations and re-inflations ruled asset prices.

Figure 2 incorporates the historic economic drivers of asset allocation since 1920 shown in Figure 2. We borrow from GaveKal Research, a Hong Kong-based research firm. They identify extreme scenarios that investors need to prepare for, namely, inflationary busts/booms and deflationary busts/booms. Figures 1 and 2 expand upon their insights.

Here are our enhancements. First, we defined the conditions for each boom and bust scenario. Inflationary booms display moderate inflation ranging from 2% to 5% yearly with real gross domestic product (RGDP) growth greater than 3.5% annualized. Inflationary busts are periods with annual inflation above 3.5% with RGDP below 2.5%. Deflationary booms experience CPIs above -1% but below 2% with RGDP above 2.5%. Deflationary busts are hell. The CPI goes below -1% with growth below 1% yearly (T-bills rule).

In summary, since 1920, assets have sourced returns through factors driven by an inflationary boom 19% of the time. Inflationary busts rule is 16% of the time. Twenty percent of all observations were a deflationary boom. A deflationary bust prevails only 9% of the time. These percentages are in the table at the bottom of Figure 1 and at the top of the boxes found in the middle two columns in Figure 2. Extreme booms and busts comprise 64% of all experiences. Does it not make sense to balance portfolio assets to hedge booms/busts?

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