Asset Allocation and the Nuclear Threat

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If you take a look at the front page of SA, it’s like nothing happened – Apple (AAPL), Tesla (TSLA) and other high-tech darlings, REITS plus a few articles on the question of whether a return of 7% of source A is better than an 8% return from source B. But today’s situation is very far from ordinary.

In my latest Bullish Enterprise Commodities (EPD) article, I inserted an additional disclosure at the end: “Possible escalation of war in Ukraine makes stocks riskier than usual”. During the publication, the discussion was quite active and long. These were fossil fuels and their current scarcity, electric vehicles and green initiatives, hydrogen and carbon dioxide sequestration, return on investment and distributions, insider and terminal ownership. export, etc. The only thing nobody mentioned is my little revelation. True, due to the small font imposed by SA, it was not very noticeable. And even…

While writing this post, I was wondering if now is a good time for bullish messages. One can apply different probabilities to the materialization of the nuclear threat, but nobody can deny that this risk is an order of magnitude higher than, say, at the beginning of 2022.

What follows is an attempt to rationalize my thinking about this grim possibility in unemotional terms. Needless to say, it is provisional and subject to discussion and dispute. But that’s not the reason to avoid the subject.

Policy Summary

Last week, Russia annexed four Ukrainian provinces even though it does not fully control any of them. This act deprived the Russian leadership of any political flexibility and became a voluntary commitment to fight to the end. This decision may seem irrational but makes more sense in the tense context in Russia that English sources fail to capture. Combined with recent Russian military failures, it has made the nuclear threat more real than ever since the Caribbean crisis.

There are two extreme ways to assess this situation for investors. First, you can completely ignore it and hope that the tension will dissolve on its own over time. It’s similar to how investors generally treat almost all political developments. But the current situation may be too dire to qualify for such a laissez-faire approach.

The only option to end the confrontation seems to be the fall of the current regime in Russia AND its replacement with some kind of moderate government. This option is extremely unlikely in the short term. Other scenarios are unlikely to eliminate the nuclear threat.

On the other hand, some investors may believe that any nuclear conflict will become catastrophic for all assets (as well as humanity), and so there is no reason to consider this possibility. It’s well put by Warren Buffett: “If you’re worried about the effect of nuclear attacks, you have other things to worry about than the value of Berkshire.”

The two extreme positions do not require much from investors. However, the current situation may evolve as something in between.

There are many scenarios in which nuclear weapons will be used locally and/or in a limited way and will not lead to a direct nuclear confrontation between Russia and NATO (or the United States). For example, it is conceivable that Russia’s tactical nuclear first strike would be met with a conventional NATO response as a sufficient countermeasure. A possible non-strategic development is a crucial difference between the current situation and the Caribbean crisis.

It is in the interests of the Russian leadership to keep the nuclear threat unfulfilled for as long as possible and to use it only when military misfortunes risk leading to the downfall of the leadership. As we don’t know when and if this will happen, investors should be prepared for a long and difficult race with an unknown outcome.

Possible answers

Investors may respond with drastic solutions such as replacing stocks entirely with cash and/or treasury bills and/or gold. But these measures are only satisfactory when little attention is paid to yields.

For the same reason, I am skeptical of strategic hedging. The current cost of buying a one-year put to fully hedge SPY is around 8.5%. There are plenty of other ways to hedge, none of them particularly cheap in the current circumstances. Between expensive long-term full coverage and switching to Treasuries yielding almost 4%, the latter seems preferable.

Another option is some sort of market-neutral strategy. It can be implemented by balancing long and short positions or by arbitrage. It is certainly feasible and quite practical, but investors are unequally qualified to implement this approach. From my communications with SA readers, only a few of them are proficient in short selling or arbitrage. Due to their niche status, the capability of both methods is also limited. But that seems like the right approach, at least for part of his portfolio.

For most investors, there are two traditional and easy-to-implement ways of solving the problem: asset allocation and asset selection. We will focus on the first because it seems more important.

It is quite simple to blame the Fed’s decisions for the current market turmoil. But I believe geopolitical concerns (i.e. a nuclear threat) are already taking their toll. I see common stock bargains today, but I’m reluctant to commit money. It’s very different from what I usually do. Considering myself a typical retail investor, I would expect similar behavior from my peers. Institutional investors may behave differently. For example, many equity fund managers will remain fully invested because they are not risking their own money and significant underperformance against indexes is suicidal.

The quantitative framework

Even under normal conditions, there is no universal asset allocation rule.

Benjamin Graham in “The Intelligent Investor” advocated an equity allocation of 25-75% depending on the situation, individual circumstances and risk tolerance. William P. Bengen, in his article on the popular 4% rule, stated the following based on careful analysis of historical data: “I think it is appropriate to advise the client to accept an allocation as close to 75% as possible and in no case less than 50%”. The famous investor Peter Lynch in his book “Beating The Street” suggested allocating to stocks as close to 100% as possible. I don’t remember that Warren Buffett clearly formulated an attribution rule, but from his writings, he seems rather close to Peter Lynch.

I will now follow my original work reproduced in one of my old articles. Imagine we only have two assets available – an index (SPY) that offers annual returns spread around the mean µ with standard deviation σ (also called volatility) and a risk-free fixed income investment with a known return r . We want to determine the optimal allocation at index f, with 0

Under certain assumptions, this optimal allocation can be expressed by a simple formula:

optimal capital allocation formula

Author

Under normal conditions, µ ~ 0.1 (10%), σ ~ 0.2 (20%) and current r ~ 0.04 (4%). If we follow the formula to calculate f, it will be greater than 1. This means that the formula suggests that we should borrow on margin (provided we can do so at the same 4%) to achieve the optimal allocation.

Based on this formula, an investor should only allocate at least something to the risk-free asset when r>6%! This directly supports Peter Lynch’s approach.

However, human investors prefer suboptimal allocations as long as the risk of losing money is significantly reduced. The above formula promises the highest return at the cost of rather high risk (please check my older post referenced earlier regarding shortcomings and interpretations of the formula).

What matters to us now is that the allocation f to stocks is inversely proportional to the squared volatility. Uncertainty due to the nuclear threat may primarily manifest itself in persistent higher than normal volatility.

Volatility (VIX) is currently around 30 but it is influenced by both Fed actions and the nuclear threat and we don’t know how to measure these influences separately. And VIX itself at some point is too volatile to be based on.

I haven’t found a way to estimate this volatility or extract it from historical examples. But assuming a modest 10-20% increase in it (well below the current value of the VIX), this produces a decrease in equity allocation by a factor of about 1.2 to 1, 4.

If we agree with William Bengen’s suggestion that the optimal allocation should be around 75% under normal conditions, then the nuclear threat should move that allocation to 52-62%.

It is impossible to prescribe a basic income for everyone. Individuals vary in their situations and their aversion to risk. But at least for aggressive investors who follow Bengen or Lynch earnings according to our formula, it seems rather prudent to divide their normal allocation by 1.2-1.4 to account for the nuclear threat until this threat is no longer.

Those who allocate following Benjamin Graham may invest in stocks close to or below 50% of their investment assets.

Some Practical Considerations

The decrease in f was partially achieved naturally due to the market decline in 2022. However, f is not very sensitive to market fluctuations.

Let’s ask ourselves a simple question: how will f change after a 1% drop in the market? Here is the answer: the change will be a decrease of f*(1-f). This function has a maximum of 1/4 at f=1/2. This means that a drop of 1% will decrease f by 1/4% or less. For a fall of ~20% in 2022, the allocation should evolve to ~5%. This is probably not enough and further stock sales are needed if not already done.

Conclusion

Going back to the question I posed at the very beginning: is this a good time for bullish stock stories? In my opinion, the answer is yes as long as a reader/writer tries to optimize their stock portfolio without expanding it.

This may seem too strict for many of you and I totally understand that. I divide my time between the USA and Europe. When I land in JFK or Miami, I feel rather isolated from the war far away. But when I’m in Europe, my feeling becomes very different.

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