Taxes

Tax‑Deferred Accounts (Traditional)

• Income: Untaxed on Traditional 401(k)s and untaxed on Traditional IRAs depending on coverage and gross income

• Short-Term Capital Gains: Untaxed

• Long-Term Capital Gains: Untaxed

• Distributions: Ordinary Income Rate

Tax‑Free Accounts (Roth)

• Income: Ordinary Income Rate

• Short-Term Capital Gains: Untaxed

• Long-Term Capital Gains: Untaxed

• Distributions: Untaxed

Taxable Accounts

• Income: Ordinary Income Rate

• Short-Term Capital Gains: Ordinary Income Rate

• Long-Term Capital Gains: Long-Term Capital Gains Rate

• Distributions: N/A

A Brief Note on Conversions…

401(k)s have high contribution limits and powerful tax deductions, but investments and platforms are often limited by the plan provider and mutual fund fees can be much higher than ETF fees.

Consider rolling 401(k)s into a matching IRA after a qualifying event (like leaving an employer) for investment, advisor, and fee flexibility. A Traditional 401(k) can be rolled into a Traditional IRA and a Roth 401(k) can be rolled into a Roth IRA.

Further, because intra-IRA sales are untaxed, IRA assets are most suitable for active strategies like Artificial Alpha’s Large-Cap Value Portfolio.

Distributions

Tax‑Deferred Accounts (Traditional)

• Unpenalized Early Distributions: Substantially Equal Periodic Payment plans or a Roth Conversion Ladder

• Unrestricted Distribution Age: 59.5

• Required Minimum Distributions: 73

Tax‑Free Accounts (Roth)

• Unpenalized Early Distributions: Roth IRA Contributions, among other circumstances

• Unrestricted Distribution Age: 59.5

• Required Minimum Distributions: N/A

Taxable Accounts

• Unpenalized Early Distributions: N/A

• Unrestricted Distribution Age: N/A

• Required Minimum Distributions: N/A

Optimal Applications

I would color the strengths/weaknesses heat map for each account type like this.

Traditional Retirement Accounts cover early retirement and base-level spending.

Ideally, you should contribute to a Traditional Retirement Account when you’re middle-aged and contributions are deducted from a high tax bracket. It is not desirable to over-contribute to a Traditional Retirement Account because required minimum distributions in retirement could subject your income to a higher tax bracket.

The superpower of a Traditional Retirement Account is that it combines tax savings and early distribution. An early retirement can be funded by setting up a SEPP plan (or a Roth Conversion Ladder) and primarily living off Traditional Retirement Account distributions. Technically you can withdraw Roth IRA contributions early without penalty, but those sums are not great enough for an extended early retirement.

Roth Retirement Accounts cover one-offs, gaps, and late retirement.

Ideally, you should contribute to a Roth Retirement Account when you’re young so that distributions can go untaxed later in life while in a higher tax bracket. It is somewhat desirable to over-contribute to a Roth Retirement Account because there are no required minimum distributions in retirement and distributions by heirs remain untaxed.

The superpower of a Roth Retirement Account is that all taxes are out of the way after contribution and Roth IRA contributions can be distributed early without penalty. This makes Roth distributions perfect for emergency expenses during early retirement, excess spending during retirement, and base-level spending when Traditional distributions run dry in late retirement.

Taxable Brokerage Accounts cover big purchases and miscalculations at any time.

Taxable Brokerage Accounts are where excess savings go. It is desirable to over-contribute to a Taxable Brokerage Account because the money inherits no limitations.

The superpower of a Taxable Brokerage Account is that it maintains maximum flexibility. Technically, you could perfectly fund a tax-efficient early retirement with some combination of Traditional and Roth Retirement Accounts. But any error in planning or surplus contributions imposes limitations on those contributions that might dwarf the impact of any tax savings. Contributing to a Taxable Brokerage Account lets you figure out the details later.

Conclusion

I especially wanted to write this letter because SEPP plans (or Roth Conversion Ladders) are not widely utilized. It is exceedingly popular to forgo Tax-Deferred Accounts entirely, but I think that is a mistake if early distributions are even remotely in the cards. Tax-Deferred Accounts are the only ones that combine tax savings and considerable early distributions.

On top of application differences, I also find value in tax diversification and tax smoothing. These benefits are improved by contributing to both Traditional and Roth accounts.

Each account type has its own unique timing, application, and tax implications. Very generally, I might argue that each application requires similarly sized funds. Clearly there is more precise, client-specific planning to do, but one rule of thumb might be to end up with 1/3 of assets in each account.

The Setup

The biggest economic risk caused by the war is the closing of the Strait of Hormuz and its effect on oil prices. Here are oil tanker crossings through the strait, courtesy of Joe Weisenthal.

And here is Oil’s reaction to these Middle East developments.

Since oil remains a key input to many economic activities, its price also remains a key driver of inflation.

Known Unknowns

Before I dive into some historical comparisons, I do have a few key considerations that remain unknowns.

First, the U.S. is a net exporter of oil. This was not the case during past inflationary shocks. The U.S. has historically been a net importer of oil and price spikes exacerbated inflationary shocks as opposed to damping them. We don’t know how oil prices will impact the U.S. economy this time.

Second, we know that geopolitical events average out to having almost no signal on market prices. What matters are outcomes and not the conflict itself. We do not know the outcome of this war yet.

A Sample of Inflationary Shocks

To study how investors can plan with these unknowns in mind, I put together a sample of inflationary shocks. These are months where y/y inflation had risen more than 3% off its lows and to a level over 4%. These are confirmed moments of significant price acceleration.

The market does not react in advance to inflationary catalysts. Below are the market returns for a few asset classes in the year prior to inflation bottoming and the moment of the catalyst. These periods of disinflation are amazing environments for financial assets.

Then, an inflationary catalyst appears and inflation rises to an uncomfortable level above 4%. We can tell that these were strong inflationary events because inflation didn’t retreat for a single month in this whole sample. On average, it took 7 months to go from catalyst at inflation bottom to sample trigger above 4%. This is a long process!

During these runs in inflation, average returns were still great (outside of bonds) but now with a ton of variance and bimodal outcomes.

It is only in the year after complete confirmation by government data that the market shows signs of stress. And the stress is real. This is about as bad a sample for stocks as I can find.

Staying Patient

These data are kind of insane. Huge returns followed by big drawdowns. However, keep in mind that these comparisons are still just a risk of this war and not a sure outcome. Additionally, it actually isn’t apparent that investors should panic quite yet. Maybe quite the opposite actually.

I don’t know your personality as an investor, so I can’t give you specific advice. But here are two lines of thought for the given moment that might suit two generic types of investors.

You’re an active investor and you want to hedge inflation risks. History says that a melt-up in stocks is just as common as a crash until inflation gets baked into the data. If your goal of active investing is to reduce portfolio volatility, gold has been a much better hedge than bonds outside of gold standard environments.

You’re a passive investor and you never want to alter your stock portfolio but you’re uncomfortable by these risks posed by the war. Consider that we tend to leave gains on the table during these moments of uncertainty, not losses. Volatility during these moments is huge but overall outcomes are average to above average. As passive investors should ideally set out to do, stay the course!

Conclusion

I’ve been writing a lot in the past few years about taking more stock diversification than the S&P 500 and when to use gold and other commodities as a hedge against risk. I don’t think these geopolitical developments diminish those ideas, in fact I believe they reinforce them.

In part because value investing recently endured its worst decade in history, value investors have nearly gone extinct.

This new year is recycling old styles however, and value stocks are back on the menu. The Value ETF $VTV is up 8.2% year to date while the S&P 500 is only up 0.3%. The original P/B value factor is now outperforming the S&P 500 over the past 10 years.

Value investing is the tip of a much larger and more visceral AI story. AI represents innovation, it represents growth, and it represents disruption.

Economic growth is a threat to incumbents. AI threatens to topple longstanding near-monopolies. One industry at the front lines of intensifying innovation is the software sector, which is down -23.1% year to date. Incumbents do not find growth friendly and the S&P 500 is chalked full of tech incumbents with a lot to lose.

Even the hyperscalers, the companies commanding AI investment, are bleeding from the battle. The Mag 7 returned $396B of free cash flows to shareholders in 2024 but projections have those free cash flows reduced to $197B in 2026. Some companies have reduced their free cash flows to zero and are starting to take out debt. The battle for AI is increasingly forcing hyperscalers to sacrifice shareholder payments and equity for datacenter Capex. The Mag 7 is down -6.7% year to date.

The picture under the surface in 2026 is of all out battle. Many stocks have been hit hard and many others have made great progress. The S&P 500 fails to tell the whole story as it remains unbothered near all time highs.

Value stocks face an entirely different reality than tech stocks, and stand among the early victors. Many sell tangible goods. Very few are threatened by innovative growth. Most feel so unthreatened that they can entirely resist the slippery Capex slope. And they have cheaper multiples?

We can see these tailwinds from a macroeconomic lens too.

Many of these value stocks fall into the “cyclical” variety, meaning they are much more sensitive to financial conditions. I wrote this piece last September about how financial conditions are easing after a few restrictive years. Cyclical stocks now have more tailwinds from friendly financing.

Value stocks also outperform during periods of higher growth.

Growth drives yields higher and prices lower. Yes, that seems like a paradox, but Growth = Disruption and Disruption = Lost Market Share. Value stocks already have attractive yields so they experience less price damage during these moments of economic acceleration.

And so suddenly the ugly sweater has a feeling of safety to it. The skirmish in tech is heating up right as the macroeconomic environment eases for cyclical value stocks.

I still expect a business friendly environment in 2026, but there are both more winners and more losers so far than in recent years. Index funds are at risk of underperformance, for the first time in many years, because of how little non-tech diversification the most popular options offer.

There will come a time when active investing far outpaces passive investing for five or more years, and I wonder if we’re experiencing such a pivotal moment. I believe Artificial Alpha’s Large-Cap Value Portfolio is well-positioned to make these adjustments if they prove valuable, as they have so far this year.

Buy vs Rent

201KB ∙ XLSX file

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The “Inputs” tab has 14 variables that need to be filled in to estimate the cost/profit of each choice.

• B3:B5 are the growth rates of the home and an alternate investment portfolio. I would recommend using the long-term growth rates provided.

• B6:B12 are the costs associated with owning the home. I entered nationwide averages for these fields but they vary wildly by state. I would recommend editing these inputs for a more accurate calculation.

• B13:B16 are inputs for the home and mortgage. I found a home here in Colorado for this example.

The “Monthly Balance Sheet” tab calculates the net worth for the owner and the renter across all 360 months of a 30 year mortgage, assuming the renter invests their excess savings into a diverse portfolio of stocks, bonds, and gold.

Buy to Stay, Rent to Move

The owner loses fees on their transaction(s), but then generally sees their net worth grow faster over time after that. This means they always start lower and usually end higher in the race for wealth.

The break-even point, at which both owner and renter have the same net worth, and where these lines cross, is calculated in B18. Sometimes a poorly priced market will not see these lines cross at all. That a breakeven point exists at all is dependent on a fairly priced rental market.

The example I have pre-populated illustrates the general calculus, simplified into a one-variable rule. Buy a house if you plan on staying in one place for longer than 5-7 years. Rent if you don’t. The default values are from the first rental example I found on Zillow in Denver. Most middle-class housing markets are priced for a similar tradeoff!

Homeownership Is a Savings Account

Next turn to F2:F4, where I subtract the home owner’s total payments from their final net worth. I am going to round the Profit calculation up to $0 to simplify my claim, which is that the average home owner comes out even in the end. Their savings do not depreciate. Neither do their savings compound. Putting money into your house resembles depositing money into a savings account (with much more variance).

This means that buying a bigger house is just like putting more money into a savings account. The opportunity cost of buying a bigger house is making actual investments with the difference in cost.

Conclusion

Wealth isn’t made by consuming housing, especially as a renter.

Please use this tool to do napkin math on houses in your area. I have friends whose rent is so cheap that it makes very little financial sense for them to buy!

And of course, there are far more variables than the financial ones that go into any home buying decision.

I wrote about treasuries and gold and debasement last year. That piece outlines the measurable value of commodities and bonds. The following analysis is something I’m always performing to estimate if those pressures are building or waning.

The Debt Backdrop

The federal debt might be driving more policy than you’d realize. If the entire federal debt were to mature tomorrow, and the government financed it at prevailing 10 year treasury rates, those interest payments would total 28% of federal tax receipts.

This situation would not be concerning if it didn’t set such a limiting ceiling for growth. Nominal growth is currently only 5.4% y/y and so long-term rates are only at 4.2%. Growing our economy at the same rate as the 1960’s, 70’s, and 80’s might imply a doubling of interest rates (or more) to 8.4%. Our debt, financed at 8.4%, would then total 56% of federal tax receipts. Not enough revenues would be left over to operate the government.

This is obviously a gross oversimplification of the federal debt burden. All I want to illustrate is that any desire for higher growth is at odds with the government’s ability to finance existing debt, especially now.

The Government Reaction Function

One approach to burdensome government debts, which has been executed many times before, is to artificially lower interest rates such that the economy (and thus, tax receipts) can grow faster than the debt. Overnight rates at the Federal Reserve are the best (and only?) place to finance the government at artificially low rates.

As far back as 1791, when Revolutionary War debts crippled the government, the First Bank of the United States was ordered by Congress to finance federal debt at a rate no higher than 6%.

And the Federal Reserve has received as little protection as the First Bank. Much like Jerome Powell today, the Federal Reserve Chair has a history of being pressured to lower rates. The Federal Reserve artificially lowered rates to fund WWI. The Fed again coordinated with FDR to suppress interest rates during WWII. LBJ pressured the Fed to lower rates as he ramped up spending on the Great Society and the Vietnam War. Nixon took the same baton from LBJ.

This is not to argue that the government has no other options for dealing with the debt. Instead, this is to identify a government policy that is prone to implementation. We can be more confident in our read of the situation because yield suppression is a well-trodden path during periods of high debt.

Losers and Winners

The losers of this policy and/or power struggle are the bondholders whose yields would fail to keep pace with nominal growth, debasement, and/or inflation. The government does not want to pay bondholders a market yield, in which case their bonds would underperform!

The winners of this policy are all assets that are protected against nominal debasement and/or inflation. Gold, houses, and commodities are obvious winners vs bonds because of their direct competition for diversification allocations and assumed protection against debasement. Stocks likely view these developments through a neutral lens because their earnings generally grow with inflation but their multiples can be damaged by weak bank leadership and inflation volatility.

Takeaways

The core audience of this letter might not own bonds or gold because diversification assets aren’t suitable for their investment strategy. These developments might have very little impact on those investors or their strategies.

Another audience might be meaningfully diversified because they find diversification more suitable for their retirement needs. Those investors should use this analysis to understand the dominos that cause a 60/40 portfolio to supply insufficient diversification. There is plenty of precedent for yield suppression at the expense of bondholders. This is why portfolios backtested with 20% Treasuries and 20% Gold perform better than a 60/40 portfolio on a risk-adjusted basis.

Despite leading other stock indices in risk-adjusted returns, the S&P 500 isn’t the best at anything specific.

Small-Cap, Mid-Cap, and Value stocks have had higher overall returns than the S&P 500. These economically sensitive stocks have beat the S&P 500 on every 30 year rolling period since 1926. Might these indices be more suitable for growth-oriented investors?

You’d think the S&P 500’s superior risk-adjusted returns would make it the best investment for long retirements, but riskier stocks have better supported long retirements due to their superior average returns. Might these indices be more suitable for newly retired investors?

Short-dated Treasuries (bills) have lower volatility than the S&P 500. Safety assets like these are better for protecting capital and have performed better on a standalone basis for short retirements. Might Treasuries be more suitable for extremely risk-averse investors?

I could expand on this theme by showing the S&P 500’s 2nd place finish in different macro regimes. Like its 2nd place finish vs. gold during inflationary growth. Or its 2nd place finish vs. the Nasdaq during innovative periods of deflationary growth. For active traders, the S&P 500 is usually a close second too.

I will concede on one 1st place finish for the S&P 500. The S&P 500’s top place finish in risk adjusted returns makes it most suitable for leveraged trading, especially in secular bull markets.

Whether an investor is looking for more suitable investments or active strategies, the S&P 500 almost always falls short by itself. These differences are never large though, which is why the S&P 500 has remained so trustworthy and popular.

The S&P 500 is a jack of all trades, master of none. If I had to pick a single investment to grow with an investor throughout their entire life, I would pick the S&P 500. I would start every diversified portfolio with a healthy allocation to the S&P 500. But at no given moment is the S&P 500 the best choice by itself.

For example, I previously wrote about diversification concepts for risk-averse investors. This is when I reveal that those index-based strategies are very blunt and inefficient solutions to achieving a low volatility portfolio, even though they are technically sound. The S&P 500 is only somewhat appropriate for those investors.

Consider, for contrast, an aggressive investor who is willing to look past short-term volatility and focus on maximizing long-term returns. This investor very likely owns the same S&P 500 index fund as the diversified, risk-averse investor. Are those same 500 investments actually suitable for both portfolios?

Truthfully, the risk-averse investor would benefit from carving out a small subset of stocks from the S&P 500 and holding only those stocks. I would estimate that ~80% of the stocks in the S&P 500 are, to some degree, working against that investor’s low volatility preferences! And the same goes for the aggressive investor, who might carve out a completely different subset of the index for maximizing growth.

Unfortunately, ETFs that satisfy diverging risk/reward preferences are not widely available and that is why there is so little incentive for investors to stray from the boilerplate S&P 500 crowd.

Below are some specific shortcomings of available ETF products. I will emphasize these shortcomings from the perspective of an aggressive investor, but the risk-averse investor is presented with the same challenges.

Issue #1: Unavailable Products

If you want to lever your exposure to your favorite meme stock then you might be able to find an ETF for that (this is unadvisable for most investors, and very lucrative for the ETF provider). But if you want to passively invest in some of the factors outlined in Nobel Prize winning research by Eugene Fama and Kenneth French, you’re out of luck!

Most of the “factors” that Fama-French identified are fundamental measurements used to identify stocks with a higher risk/reward profile. These are the type of stocks that the aggressive investor might find more interesting.

One factor identified by Fama-French is asset growth, or what Fama-French refer to as the Investment factor. The lowest 20% of companies by asset growth have had a 13.2% total return per year since 1963, vs. 10.6% for the S&P 500.

Despite having access to over 4,000 listed ETFs, 61 of which are levered single-stock ETFs, there is no way to passively invest in this basic subset of equities. Investors must invest in individual stocks to incorporate this investment style.

Issue #2: Excessively Broad Products

Some investment styles do exist via available products but their precision leaves much to be desired.

Take, for example, the Vanguard Mid-Cap Value ETF ($VOE). This ETF implements aspects of the Size and Value factors from Fama-French research, all with a low fee. Investors theoretically have access to higher risk/reward investments via this ETF.

There are a few problems with this implementation, however, primary of which is how broad they’ve left the filter on this portfolio. There are 180 stocks left in this portfolio and I suspect the 180th stock is barely contributing extra risk/reward exposure.

To illustrate this point, I built a Mid-Cap Value portfolio that invests in the top 25 Value stocks from the S&P Mid-Cap 400 index based on a single measurement of Value. This should concentrate risk/reward by reducing the size of the portfolio from 180 to 25.

Sure enough, the backtested portfolio would have had a 14.0% total return per year since 2015, vs. 8.8% for the $VOE ETF.

Almost all ETFs are quite broad and carry 100 or more stocks. Investors should invest in individual stocks if they want to sufficiently concentrate their investment preferences.

Issue #3: One-Dimensional Products

The last shortcoming of available products is that they are painfully one-dimensional, meaning that most filter on a single metric.

There is no be-all and end-all measurement of risk, safety, etc. Multiple filters are needed to intensify whatever characteristics are desired from an equity portfolio. Fama-French, for example, identified four factors in their aforementioned research.

In much the same way that available ETFs are diluted by their size, they are also diluted by their extreme simplicity.

The Artificial Alpha Edge

Artificial Alpha Investments has provided clients with active portfolio management to address these ETF shortcomings since October 18, 2021. Its flagship portfolio, designed for outperformance, has been continuously traded since January 22, 2020.

A wonderful side-effect of buying individual stocks with purpose is that undesirable investments tend to fall away. In theory and in practice, this selective work yields additional outperformance even beyond risk related effects. The portfolio’s risk-adjusted outperformance is expressed through its Sharpe Ratio and Alpha measurements.

Working With Me

I’ve been building this Large Cap Value portfolio since 2017 and trading it since 2020. I incorporated in 2021 because I sensed I was on to something. Today, after years of tweaking its logic and studying every aspect of its landscape, I believe in the portfolio’s unique value more than ever.

I hope to justify the fees I charge by delivering unique products and superior outcomes, on top of great advice and services. The number of products I offer and preferences I can service will be expanding in 2026. Please reach out with interest!

Gold’s price is quite correlated with the money supply. The faster the money supply increases, the faster Gold’s price goes up. More money chases the same amount of Gold as the currency gets debased. Gold investors are betting on more debasement.

Treasury investors are similarly hoping to outpace debasement, but the game is very different.

Whereas the future return on Gold is unknown, and likely dependent on the future rate of currency debasement, the yield on a Treasury is promised up front. The yield on a 10 year Treasury will not change over the course of those 10 years, no matter how much the currency gets debased along the way.

Thus, the only way for a Treasury to outpace debasement is for less money to get printed over the life of the Treasury than the investment’s agreed-upon yield. Treasury holders are betting on less debasement.

Below are some historical examples of this dynamic using this chart of y/y government expenditures (one measure of debasement) and 10 year Treasury yields for reference.

The government printed money at about the same pace as Treasury yields between 1954 and 1965, such that Treasuries represented a solid investment.

Then, the Vietnam War and rapidly expanding federal social welfare programs ballooned debasement past Treasury yields in the late 1960s. This imbalance led to the end of the Gold standard, drastic outperformance of Gold over Treasuries, and rampant inflation in the 1970s. Markets finally balanced again in 1980 when Paul Volcker raised interest rates to where they could adequately compete with debasement.

The 1980s and 1990s were great decades for investors. Yields on all investments, and in particular Treasuries, outpaced debasement for a long time.

Debasement picked up again in the 2000s as an exorbitant amount of debt was created on household balance sheets in the housing sector. Yields, especially in the mortgage industry, were far too low in comparison to all this debasement. Gold enjoyed a decade of outperformance as most debt underperformed and then some debt defaulted in the 2008 recession.

The 2010s were weird. Debasement was so low that growth suffered. Yields were properly priced, however.

The 2020 pandemic jumpstarted today’s market forces. Government spending went through the roof as we protected families against a partially shuttered economy. Yields went to zero out of fear. We are still experiencing an imbalance between high government spending (debasement has only accelerated since the pandemic) and low yields. Government spending increased by 7.8% y/y in Q2 2025 and 10 year Treasuries only yield 4.1%.

I took the chart above and calculated the annualized real rate of return for 10 year Treasuries and Gold when government expenditures were growing faster or slower than Treasury yields. The ability for each investment to protect purchasing power was highly dependent on whether yields were reasonably priced vs. trailing debasement.

Even for investors who don’t wish to trade this valuation technique, such a simple model should inspire confidence in each asset’s unique diversification benefits.

Today’s 10 year Treasury yield at 4.1% will not protect against 7.8% y/y growth in government spending. This is why active traders and retired/diversified investors are turning to Gold to protect their portfolios against debasement.

Economic policy has been restrictive for a few years now, and the economy has slowly weakened but did not altogether break. The result has been similar returns for the S&P 500 and a more defensive, diversified portfolio (“diversified” in this case is an equal weighted GLD, IEF, VTV, VO, and SPY portfolio).

The conversation should be shifting, however. Leading economic indicators have been easing and stock market risks are now abating.

Take inflation, which began easing in early 2023.

The Federal Reserve first cut rates in late 2023 and continued cutting earlier this month.

The labor market also started easing in late 2023.

The yield curve un-inverted earlier this year.

And just today, we got data that suggest the housing market eased considerably in August.

While powerful on their own, I like to combine all of these signals into a single indicator of macroeconomic tightness. This aggregate indicator has now declined by 0.4 standard deviations from its peak a few years ago, signaling an easier economic environment going forward.

Stocks tend to thrive in the year after a 0.4 standard deviation drawdown in this indicator. Because smaller companies are more sensitive to financial conditions, they have had the most extraordinary results.

I think risk is turning to the upside again.

Young investors might rest easier because this macroeconomic environment aligns with a higher risk tolerance. Retired investors could struggle with FOMO because this macroeconomic environment encourages more risk than their boilerplate diversified portfolio.

Passive investors should use this letter to adjust their expectations. Active investors should consider this changing macroeconomic landscape.

But why are gold’s returns so high recently? Let me use this moment to illustrate gold’s character as a financial asset.

One major source of “money printing” is the federal government, which over time has expanded the money supply with higher and higher spending. This isn’t the only form of “money printing” but it is the largest and most relevant to the 2020s.

I prefer to look at the long-term growth rate of the government’s spending, with this chart showing the annual growth rate over the previous 10 years.

Government spending results in higher nominal GDP, with which there is a strong correlation.

But government spending is largely uncorrelated with real economic growth.

This lack of any real economic stimulus means that most government spending results in higher prices instead of economic benefits. Inflation is much more correlated with government spending than is real growth.

Prices rise on general consumer goods, like those represented in CPI, but they also rise for more traditional assets like homes.

Gold prices also correlate with government spending, although with much more volatility due to gold’s financial nature. Remember that gold was pegged to the dollar prior to 1971, so prices were flat for much of this history.

Silver prices were not pegged to the dollar and we can see a longer history of correlation.

Accelerating Government Expenditures are the simplest explanation for accelerating gold prices. Covid caused an acceleration of government spending that we are having trouble stopping and, as expected, precious metals are protecting against this currency debasement.

You will notice that gold even reacts in this way to deficit related headlines. When the Federal Circuit struck down President Trump's tariffs imposed under the International Emergency Economic Powers Act on August 29, gold rose 2.4% on the next trading day in anticipation of higher government deficits.

Hopefully this adds some color to gold’s role in a diversified portfolio. As an added bonus, I touched on some economics with interesting political implications. Gold is a very politicized asset after all!

Not just Value stocks though. This chart uses Value stocks for its visualization but all economically sensitive equities fall into this bucket, including Small-caps and Mid-caps. Many companies have different economic drivers than Large-caps and their stocks benefit from inflationary environments.

We will again substantiate added diversification, this time amongst stocks, via the same backtests as before.

Reducing Volatility

The following statistics suggest that investors benefit from further equity diversification. The 30/30/20/20 portfolio includes 30% S&P 500, 15% Value stocks, 7.5% Small-caps, 7.5% Mid-caps, 20% Treasuries, and 20% Gold.

Volatility-adjusted returns were improved over all previous portfolios and large drawdowns were again less frequent.

The real performance of this final diversified portfolio is visualized vs. the initial S&P 500 portfolio below.

There is a small total return drag on the diversified portfolio, but it exhibits far less volatility than the S&P 500. I would like to note that the volatility reduction acts over both short and long time-frames. The diversified portfolio has smaller recessionary drawdowns and no lost decades in this sample.

Stretching Savings

One side effect of lower volatility is to support higher withdrawal rates and extended retirements. I previously introduced The 4% Rule because it provides a framework for testing these goals.

The chart below allows readers to observe combinations of withdrawal rates and retirement lengths that similarly resulted in a 1% failure rate. Four different portfolios are represented by the four curves.

Investors could have increased withdrawal rates or extended retirements using each iteration of diversification.

Active Strategies

Buying an index of value and small stocks has passive value in a portfolio but active investors will find even more value in trading individual stocks in this space. This is the product that Artificial Alpha Investments uniquely offers clients. I will provide more information on this in a later letter!

Portfolio Construction

These findings use academic data to backtest results. In practice, we must find ETFs that deliver similar results.

One example of a portfolio that delivered similar results held 30% $VOO, 15% $VTV, 7.5% $VO, 7.5% $VB, 20% $SHY, and 20% $IAU.

In Summary

Now we have a completely passive portfolio that is reasonably diversified for investors with short/moderate time-frames, less risk appetite, and moderate/high withdrawal rates. This portfolio likely isn’t suitable for any individual, but I use it to illustrate the general goals of diversification as well as one possible conclusion.

Going Further

I develop quantitative models to service clients beyond these recommendations. These active products attempt to improve the performance of each sleeve in this portfolio. My next letter will summarize the product I provide suitable clients to outperform passive equity returns.

Here is the average S&P 500 price return following these events. Very typical.

Gold prices, which would normally benefit from high military spend and economic headwinds, also experienced typical results.

The stock market surprises me all the time. When it does, I’m almost always surprised by its apathy. The world’s economy and its markets are incredibly resilient.

In theory, the gold standard was to incentivize a balanced money supply such that gold prices could be held constant. In practice, the federal government often ran deficits, “printed money”, and put pressure on the peg.

Periods of “money printing” were historically met with bank runs to convert increasingly worthless dollars into trustworthy gold and these money supply imbalances eventually caused strains on the peg. Debt accumulation during WW1 forced many governments to temporarily suspend the gold standard. Debt accumulation during the Great Depression forced Britain to completely abandon the gold standard in 1931 and the US to temporarily suspend the gold standard in 1933.

Despite eventual capitulation, artificial price dampening by governments dedicated to the gold standard made sure that gold was not useful as a financial instrument. It is not surprising to me that Gold was excluded from the 60/40 portfolio in 1952.

In a world without the gold standard, gold is a very unique financial asset.

1. Gold supply is largely fixed because it is so hard to find or produce.

2. Gold’s intrinsic value is unaffected by a recession.

3. Gold does not degrade.

Bonds fail #1 because the government has the power to print more bonds, stocks fail #2 because earnings fall during a recession, and other commodities fail #1 and #3 because of their inferior chemistry. Stagflation, an environment with high money growth and low real growth, would theoretically favor gold’s unique combination of financial qualities.

Backtesting confirms this theory. During stagflationary periods since 1971, when Real GDP was low and Nominal GDP remained high, Gold was the best performing asset. This is evidence that Gold’s price follows its fundamentals.

The environment in which Gold excels also happens to be an environment in which the S&P 500 tends to struggle. The S&P 500 returned -2.4% per year during stagflationary periods.

Charting the 10 year annualized return of Gold and Stocks again confirms a clear preference for opposite economic environments, this time on a longer timeframe. You can even see that challenges to the gold standard after WW1 and The Great Depression were accompanied by negative pressure on the stock market. These are illustrations of Gold’s hedging value against the S&P 500.

Bonds are also useful for hedging Stocks, but Gold and Bonds hedge completely different types of recession. Bonds are an attractive hedge when Real GDP and Nominal GDP slow, but struggle when Nominal GDP growth remains high. This is evidence that Gold and Bonds provide different types of S&P 500 insurance.

By balancing hedges across Bonds and Gold, investors are hedging against a wider range of economic outcomes. I will substantiate this added diversification by revisiting the same applications from The 60/40 Portfolio.

Reducing Volatility

The following statistics suggest that investors with less risk appetite can use diversification to lower their portfolio’s volatility without severely handicapping returns.

The 60/20/20 portfolio includes 20% Treasuries and 20% Gold and volatility-adjusted returns were further improved over the 60/40 portfolio.

Stretching Savings

One side effect of lower volatility is to support higher withdrawal rates and extended retirements. I previously introduced The 4% Rule because it provides a framework for testing these goals.

The chart below allows readers to observe combinations of withdrawal rates and retirement lengths that similarly resulted in a 1% failure rate. Three different portfolios are represented by the three curves.

Investors could have increased withdrawal rates or extended retirements using 60/40 diversification, but this was doubly true using 60/20/20 diversification.

Hedging Recession

Active investors will find that challenging environments favor diversifying assets to risk assets. Since 1971, Gold has returned 13.0% per year during recessions whereas the S&P 500 has returned 1.2% per year during recessions.

In Summary

Again: Diversification is most relevant to active investors with short/moderate time-frames, less risk appetite, and moderate/high withdrawal rates. Diversification is least relevant to passive investors with long time-frames, more risk appetite, and low withdrawal rates.

Not all are convinced of Gold’s role in a diversified portfolio. I am comforted by gold’s independence from a gold standard, consistent supply and demand across millennia, connection between price and fundamentals, proven history of hedging Stocks when Bonds cannot, and performance improvements in a diversified portfolio.

My portfolio has been especially concentrated in recent years. Up to 88% has been allocated to the S&P 500, with only 12% in mid-caps and small-caps. Sometimes I make active bets like this, but I never deviate too far from my baseline plan.

I started writing in March of last year about why I think concentration is now the wrong tilt for my stock holdings. I’ve since shifted my portfolio to 10% non-Mag 7 large-caps, 12% mid-caps, and 11% small-caps. This 33% total means I have a small tilt towards stock diversification, and I’m open to more.

In October, I wrote about the increased dangers that stock investors are facing in the event of a recession. These extreme valuations have had me uncomfortable with a 100% allocation to stocks.

I again attempted my hand at illustrating an environment that will favor diversification in February. This time, however, I wrote more broadly about diversification. Asset-class diversification.

Now that additional information has been revealed about our economic situation and the dangers of high valuations suddenly seem relevant, I’ve started to act on that broader idea of diversification.

I am slightly deviating from my 100% baseline stock allocation. I have already allocated 7% in recent months to some combination of cash, bonds, gold, and mortgage payments. I’m allowing myself to go as far as 20% by the end of Q2. Not too far, but not insignificant.

For those of you who just want to stick to your baseline, trust your plan. Retirees should trust that a plan of broad diversification will get them through good times and bad. Young investors should trust that lower stock prices are good for them and their future ability to accumulate equity.

At the very least, I wanted to write somewhat explicitly that I think the next 12-24 months will be difficult for investors. I’m not convinced of this fact, which is why my actions have been small so far. But I do think the odds are decently high and increasing.

A 60/40 portfolio, one which holds 60% stocks and 40% bonds, is the most simple and common rule of thumb for asset class diversification. The idea was born from wonky, Nobel Prize winning work by Harry Markowitz and William Sharpe (Markowitz, 1952).

Although Modern Portfolio Theory is complicated, its prescription is quite simple; the portfolio with the optimal risk/reward profile is one that mirrors the total market universe. The market consisted of $60 of stocks for every $40 of bonds when “Portfolio Selection” was published in 1952, and thus the 60/40 rule of thumb was born.

I will substantiate this 60/40 portfolio by illustrating common applications of diversification.

Reducing Volatility

The following statistics suggest that investors with less risk appetite can use diversification to lower their portfolio’s volatility without severely handicapping returns.

Historically, diversified investors only had to sacrifice 24% of their real returns for 39% less volatility. A 60/40 portfolio spent 44% less time in a 15% inflation-adjusted drawdown and 65% less time in a 25% inflation-adjusted drawdown.

Stretching Savings

One side effect of lower volatility is to support higher withdrawal rates and extended retirements. I previously introduced The 4% Rule because it provides a framework for testing these goals.

We found in that letter that retirees who only held stocks had a 1% chance of running out of money within 25 years of retirement if they followed the 4% rule. Do these statistics improve if those retirees diversified instead?

The chart below puts different variables on the two axes, allowing readers to observe combinations of withdrawal rates and retirement lengths that similarly resulted in a 1% failure rate. Two different portfolios are represented by the two curves.

Investors following the 4% rule could have used 60/40 diversification to increase their withdrawal rate to 4.6% or lengthen their retirement from 25 years to 35 years without increasing their risk. Moderate withdrawal rates and time-frames could have been extended using diversification.

Hidden in this chart are the investors who did not necessarily benefit from diversification. Young investors have a timeframe longer than 45 years, where diversification hindered success just as much as it helped. Wealthy investors have a withdrawal rate less than 3.5%, where risks did not necessarily require diversification.

Hedging Recession

Active investors will find that challenging environments favor diversifying assets to risk assets. Since 1945, a 60/40 portfolio has returned 7.3% per year during recessions whereas the S&P 500 has returned 1.2% per year during recessions.

In Summary

Diversification is most relevant to active investors with short/moderate time-frames, less risk appetite, and moderate/high withdrawal rates. Diversification is least relevant to passive investors with long time-frames, more risk appetite, and low withdrawal rates.

For whatever reason someone seeks diversification, I think the 60/40 portfolio is attractive in its simplicity. My work extends beyond that solution however. The next letter in this series will introduce gold and/or commodities as complementary diversification assets.

First, because by all indications we have a robust economic environment coming into 2025. This analysis does not outmuscle a strong economy. Please read Short-Term Drivers and When Valuations Matter for a dissection of economic growth and valuations.

And second, because I’ve shared these thoughts with friends and colleagues and been met with an incredibly wide array of responses. I think each response was appropriate, considering each person’s unique preferences and timeframes.

With that said, today’s financial environment is too much of an outlier to not share my interpretation on where we stand. Here’s a synthesis of some obsessive research on technology cycles, financial manias, and mispriced monopolies.

America’s Technological Eras

The following eras all exhibited the same financial, economic, and social characteristics. I might suggest slightly different dates than social historians because of my added attention to financial conditions. The first resemblance among these eras are their technology origins.

1. The Railway Mania (1840-1860) began in the U.K. in the 1840s and quickly spread to America. Before the railways, non-bank businesses were not widely financed in public U.S. markets. After the railways, technological innovation flourished and new sectors of the economy were born.

2. The Gilded Age (1873-1906) was a period of great economic innovation, spurred by the railroads and resulting in factories, mining, energy, and finance. More than half the population was freed from agrarian lifestyles for the first time in history.

3. The Roaring Twenties (1920-1929) are best known for their societal change, but supporting all that social integration were major technological breakthroughs in automobiles, electricity, radio, and telephones.

4. The New Deal Era (1932-1940) might seem unique on this list but I would argue that these government transformations should be remembered as giant innovations. Federal taxation and spending increased dramatically.

5. The Cold War Era (1949-1973) saw immense progress among technologies that serve the government. U.S. atomic bomb production peaked in 1965 and we landed on the moon in 1969. I might point towards dollarization and the Federal Reserve’s rise to power first, but that’s an esoteric choice.

6. The Dot-com Era (1983-2000) began with the invention of the internet in 1983, which proceeded to connect everything and everyone like never before.

7. The iPhone Era (2009-???), as I’ll call it for now, began at the conclusion of the Great Financial Crisis when handheld devices augmented our consumption of almost all information.

Tech-Fueled Monopolies

Monopolies, oftentimes earned through technological innovation, came to dominate the financial landscape by the end of each era. Here are some limited examples.

1. Railway Mania (1840-1860): Railroads like Pennsylvania Railroad were merging all over the country. The government subsidized new construction and competition but did a poor job of suppressing monopolies in the 1860s.

2. Gilded Age (1873-1906): America’s monopoly problem once again came to a head in 1904 as Standard Oil controlled “91% of oil refinement and 85% of final sales in the United States.” This time, new antitrust laws finally split up the old railroads and broke Standard Oil into 39 companies.

3. Roaring Twenties (1920-1929): Ford and U.S. Steel had little threatening competition. And AT&T benefited from a government-enforced monopoly called the Bell System that let them capture “over 60% share of national users of phones.”

4. New Deal Era (1932-1940): The government did a poor job of suppressing monopolies during the Great Depression, so we replayed all the same hits from the Roaring Twenties.

5. Cold War Era (1949-1973): The Cold War resulted in less outright monopolies (unless you account for the federal government’s new stranglehold on power), but that doesn’t mean the market wasn’t concentrated. The largest 50 companies became known as the Nifty Fifty and were lauded for their ability to capture and maintain market share.

6. Dot-com Era (1983-2000): Microsoft controlled 97% of the PC market. The Department of Justice filed an antitrust lawsuit against Microsoft and the FTC ruled against Intel.

7. iPhone Era (2009-Today): Apple has a 59% share of phone sales in America. Google has a 71% share of global phone operating systems and a 79% share of search. Facebook has 60% of all social media users. Tesla accounted for 80% of the EV market in 2019 and now accounts for 44% of the EV market. Amazon captures 38% of all online retail sales in America. Nvidia sells between 70% to 95% of all artificial intelligence chips.

The potency of these monopolies can be roughly measured by taking the market cap of the 10 largest stocks as a percentage of the total stock market. A “normal” concentration is 22% across America’s financial history. Manias drive concentrations much higher.

1. Railway Mania (1840-1860): 16% (1840) → 31% (1860)

2. Gilded Age (1873-1906): 19% (1892) → 26% (1904)

3. Roaring Twenties (1920-1929): 15% (1920) → 24% (1932)

4. New Deal Era (1932-1940): 22% (1932) → 25% (1939)

5. Cold War Era (1949-1973): 20% (1949) → 29% (1973)

6. Dot-com Era (1983-2000): 17% (1988) → 27% (2000)

7. iPhone Era (2009-???): 17% (2014) → 33% (Today)

Here is another measurement of market concentration.

Declining Stock Yields

New technologies are unproven in the beginning, and it is unclear which businesses will win. Shareholders initially demand a high yield to match excessive risk.

By the end of each era, new technologies are widespread and shareholder payments seem predictable. Shareholders are willing to accept lower yields due to a perception of stability.

A “normal” Shareholder Yield in post-war America is 4.1%. Manias drive yields much lower.

1. Railway Mania (1840-1860): No Data

2. Gilded Age (1873-1906): 9.0% (1877) → 3.1% (1899)

3. Roaring Twenties (1920-1929): 7.5% (1920) → 3.0% (1929)

4. New Deal Era (1932-1940): 13.8% (1932) → 4.0% (1938)

5. Cold War Era (1949-1973): 5.6% (1949) → 2.6% (1972)

6. Dot-com Era (1983-2000): 7.5% (1982) → 2.1% (2000)

7. iPhone Era (2009-???): 6.6% (2009) → 2.4% (Today)

Fraud

Of all the “behavioral” indicators of a mania, I believe fraud fits into this framework the best. Most of all, because many of these frauds are adjacent to the latest technologies.

1. Railway Mania (1840-1860): The Credit Mobilier Scandal

2. Gilded Age (1873-1906): Green Goods Scams

3. Roaring Twenties (1920-1929): Ponzi Schemes

4. New Deal Era (1932-1940): Gold brick scams

5. Cold War Era (1949-1973): Various federal government and military coverups

6. Dot-com Era (1983-2000): Fake antivirus scams

7. iPhone Era (2009-???): Cryptocurrency Pump and Dumps

Political Instability and War

What’s fascinating and horrifying about these periods of technological change is that they all seem to end with war. Wars that are often waged and won using the latest innovation. I’m not totally sure what to make of this correlation, but I think we see markers of it today.

Only one major U.S. war (the Korean War in 1950) escalated during more moderate stock market concentration and/or yields.

1. Railway Mania (1840-1860): Civil War (1861-1865)

2. Gilded Age (1873-1906): Philippine–American War (1899-1902) and WW1 (1914-1918)

3. Roaring Twenties (1920-1929): Smoot–Hawley Tariffs (1930-1934)

4. New Deal Era (1932-1940): WW2 (1939-1945)

5. Cold War Era (1949-1973): Vietnam War (1964-1973)

6. Dot-com Era (1983-2000): Wars in Iraq and Afghanistan (2001-2011)

7. iPhone Era (2009-???): Drone, AI, and Trade Wars

Reorganization of Capital

Back to finance. These manias also tend to end with increased competition for capital. Giants eventually fall. Capital flows to their competitors. Below are the annualized total returns for large-caps, mid-caps, and small-caps in the 5 years following each era.

1. Railway Mania (1840-1860): No Data

2. Gilded Age (1873-1906): No Data

3. Roaring Twenties (1920-1929):

   1. S&P 500 (1931-1936): 9.1%

   2. Mid-Caps (1931-1936): 19.9%

   3. Small-Caps (1931-1936): 27.1%

4. New Deal Era (1932-1940):

   1. S&P 500 (1939-1944): 9.3%

   2. Mid-Caps (1939-1944): 20.2%

   3. Small-Caps (1939-1944): 30.3%

5. Cold War Era (1949-1973):

   1. S&P 500 (1974-1979): 8.4%

   2. Mid-Caps (1974-1979): 21.3%

   3. Small-Caps (1974-1979): 27.8%

6. Dot-com Era (1983-2000):

   1. S&P 500 (1999-2004): -1.2%

   2. Mid-Caps (1999-2004): 10.6%

   3. Small-Caps (1999-2004): 19.7%

7. iPhone Era (2009-???): No Data

The S&P 500 averaged 6.4% across the small sample, which isn’t catastrophic but probably more trouble than the volatility of those periods was worth. Mid-caps and Small-caps averaged 18.0% and 26.2% respectively, as they finally enjoyed the benefits of the new technology.

Benefits of Diversification

Through both qualitative and quantitative comparisons, I might suggest we are experiencing a financial mania. It is unclear to me how long this environment will last, how low stock yields will fall, or how concentrated the market will grow. Conversely, I also can’t be sure that an especially painful period will follow close behind (although, all of these eras did end with painful market drawdowns).

Historically speaking, diversification has been directionally correct in this type of environment. I know stocks best, so I might suggest mid-caps and small-caps, but other investments are suddenly competitive too. Treasuries have yields again, TIPs have real yields, and gold has outpaced the S&P 500 since Q1 2021.

The right type of diversification is person-specific and situation-dependent. Please have a conversation with a professional first if you feel a need for diversification!

My Own Reaction

I manually rebalanced my investments recently so that my top 10 holdings make up 22% of my portfolio. Specifically, I sold S&P 500 ETFs in tax-deferred accounts and bought mid-caps and small-caps over the past 7 months. I hope to do more.

I don't trade factors for me or my clients in taxable accounts, because it's more trouble than it's worth, but I'm prepared to change my stance on that given the potential opportunity in front of us.

Paying down more mortgage principal with my savings is in the cards too.

All in all, let’s not treat “diversification” with disdain in 2025. It might be right for plenty of investors.

As the title suggests, this letter will introduce the 4% rule first (Cooley et al., 1998). I think the 4% rule is most core to retirement planning because it acts as a prescription for both retirement saving and retirement spending.

The 4% rule proposes one withdraw 4% of their savings in year 1 of retirement and increase that withdrawal by the rate of inflation in subsequent years. This simple prescription intends to maximize withdrawals and provide lifestyle consistency, while keeping failure rates to a minimum.

The 4% rule relies on historical data and backtesting for substantiation. As far as I know, useful academic data on core asset prices begin in 1871 (Shiller, 2000). These data, which span more time than even the original study, allow us to test the success rate of 1,248 monthly retirees between 1871 and 1974.

Our dataset includes dozens of recessions with different peculiarities and pitfalls. How often did the 4% rule fail our ancestors?

My research found very similar results to the original study. Holding the S&P 500 and following the 4% rule failed our retirees 1% of the time within 25 years and 4% of the time within 35 years. These are decent results for a rule of thumb.

But I know there is more we can do to improve these outcomes. I will head down that path of optimization in the next letter by invoking the 60/40 rule and exploring the benefits of diversification.

The most cited yield curve plots Treasury yields on the y-axis vs. maturity dates on the x-axis. A normal yield curve is positively sloped, because bonds with longer maturities carry more risk (chief of which is inflationary risk) than a bond maturing tomorrow.

An inverted yield curve features higher yielding short-term bonds at present but expectations for lower short-term rates in the future. Normally, this type of pricing is due to expectations for a forthcoming recession, during which the Federal Reserve tends to dramatically lower short-term rates and make up for temporary money market outperformance.

Although yield curve inversions are almost always adjacent to recessions, they don’t necessarily represent a sell signal for the S&P 500. Remember my tongue-in-cheek mantra, “buy always, especially at the lows.”

Part of the reason this signal is so weak is because many companies, especially the large-cap companies in the S&P 500, borrow at long-term rates and are unaffected by the higher short-term rates of the inverted yield curve. Small-caps and mid-caps borrow at short-term rates more often and are disproportionally affected by an inverted yield curve.

An inverted yield curve is more indicative of a comparative advantage for large-caps than it is a sell signal for the entire market. In fact, the competitive relief of yield curve normalization is so great for small-caps and mid-caps that they have outperformed the S&P 500 by 13.5% and 21.4% on average in the year following uninversion.

Overall, small-caps and mid-caps are hurt most by higher short-term rates and yield curve inversion. Afterwards, they enjoy tailwinds of normalization.

I almost added this letter to my Misleading Data series because of how much pessimism an inverted yield curve produces. This analysis makes it clear, however, that most investors, specifically those allocated to the S&P 500, are not heavily exposed to the most rate-sensitive investments.

I also considered making this a continuation of my Stock Market Concentration series because this December’s yield curve normalization might very well catalyze the opportunity outlined in those letters. I will continue to diversify away from the S&P 500’s high concentration and expensive multiples with additional confidence.

And I also questioned whether this letter should be released at all because many investors should ignore 1-year implications on principle. But I am slowly coming to understand that even long-term investors have entry points for investments they’ve deemed suitable for their goals. It is reassuring for buyers and holders to identify when a long-term, fundamentals-driven investment like this one might feel tailwinds.

Hopefully this letter will impress all these ideas. That the S&P 500 doing fine while small-caps and mid-caps underperform is par for the course during a yield curve inversion. That I suspect active investors could finally see tailwinds in 2025 for beaten down small-caps and mid-caps. And that this 1-year analysis is aligned with a larger, long-term investment thesis as opposed to standing on its own as a trade.

Survey data very often fall short of the predictive requirements for useful data, especially surveys that deal with sentiment or projections.

One particularly nefarious use of surveys is to power headlines. News outlets prefer particularly outrageous survey results, whether they are conducted properly or not. Are respondents led to respond in a certain way due to social pressure or sloppy survey language?

Another more modern challenge to surveys is that sampling is getting more difficult. People are much less likely to answer the phone, and online surveys are more difficult to administer. Although still the gold standard of survey data, the BLS has seen falling survey response rates for some time now.

Other surveys have lost so much predictive power from response rate challenges that they’ve been supplanted by innovative solutions. Election surveys were far less useful than betting markets (like Polymarket) at predicting the 2024 election results. Nate Silver wrote about some of the artificial ways that pollsters tried to keep up, to no avail.

https://www.yahoo.com/news/nate-silver-cheating-pollsters-putting-163354984.html

And a final challenge comes in the form of sampling bias. We know that respondents will report wildly different economic expectations based on who is in the White House, despite a very small correlation between political parties and economic success.

These mood swings are okay when dampened via balanced sampling, but sometimes the sample is biased in one way or another. For example, the NFIB Small Business Association has a majority of Republican members. Their expressed sentiment can differ wildly from their reported activity during Democrat presidencies.

The logistical challenges to trusting any given survey data are insurmountable. Further, markets care very little about survey data. They care about policy and economic outcomes, both of which are invariably tied to hard economic data.

The pessimistic sentiment data from surveys between 2020-2024 were a trap for investors. I’ve seen a lot of investors remain too pessimistic because survey data indicated a poor economy. The hard economic data have shown otherwise. My suggestion, just try to ignore almost all surveys!

The framework I established in my June ’24 letter for picking short-term asset class winners is very helpful for decoding what the market thinks about a Trump victory. I would recommend that letter if you haven’t read it and want some more background on the data below.

https://www.artificialalphainvestments.com/p/short-term-drivers

The following chart summarizes the average annual return for different asset classes during different economic regimes. Each economic environment favors a different asset class, and each asset class prefers a different economic environment.

Casting the market reaction on top of this table (Value Stocks won, Treasuries and Gold lost) has the market expecting higher nominal growth and higher real growth under Trump.

I wasn’t surprised by the market’s expectation for higher nominal growth under Trump. Trump’s agenda is expected to lead to a higher net deficit than that of Harris’s agenda. All of this net spending should spur investment.

The first thing that caught my attention, however, is that the market expects higher nominal growth to largely translate into higher real growth, as opposed to inflation. This is the harder read. Are Trump’s proposals good or bad investments? The market says good.

Doubly interesting is how poorly Gold reacted to a Trump presidency. It is fair for Gold to have a tepid reaction to higher real growth, but I think there is an additional factor at play here. We’re already hearing chatter from the Trump team about Bitcoin’s role as a reserve asset, which would mean Gold suddenly has a direct competitor for demand from the central bank. I’ll again refrain from offering any predictions on Bitcoin adoption, but I do think Bitcoin is engineered as a commodity and reserve asset (as opposed to a currency).

We will see if the market is right! This is certainly one of the more optimistic reactions to a presidential election in some time.