Asset Allocation And Nuclear Threat

If one takes a look at the front page of SA it is business as usual – Apple (AAPL), Tesla (TSLA), and other hi-tech darlings, REITS plus some posts about whether a 7% yield from source A is better than an 8% yield from source B. But today’s situation is very far from ordinary.

In my last bullish post about Enterprise Products (EPD), I inserted an additional disclosure at the end: “The possible escalation of the war in Ukraine makes stocks riskier than usual”. Upon publishing, the discussion was quite active and long. It was about fossil fuels and their current shortage, EVs and green initiatives, hydrogen and carbon dioxide sequestration, ROIC and distributions, insider ownership and export terminals, and so on. The only thing that nobody mentioned is my little disclosure. Granted, due to the petit font imposed by SA, it was not very noticeable. And still…

Writing that post I was concerned whether it was the right time for bullish posts at all. One can apply different probabilities to the nuclear threat getting materialized but nobody can deny that this risk is orders of magnitude higher than, say, at the beginning of 2022.

What will follow is an attempt to rationalize my thinking about this grim possibility in unemotional terms. Needless to say, it is tentative and subject to discussion and challenge. But this is not the reason to avoid the topic.

Political summary

Last week, Russia annexed four Ukrainian provinces even though it does not control any of them in full. This act has deprived the Russian leadership of any political flexibility and become a self-imposed commitment to fight until the end. This decision may seem irrational but makes more sense against the tense backdrop in Russia that sources in English fail to render. Combined with the 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, one can completely ignore it hoping the tension will dissolve somehow by itself with time. It is similar to how investors typically treat almost any political development. But the current situation may be too grave to qualify for a such laissez-faire approach.

The only option for ending the confrontation seems the fall of the current regime in Russia AND replacing it 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 think that any nuclear conflict will become catastrophic for all assets (together with humankind), and hence there is no reason to consider this possibility. This is well formulated by Warren Buffett: “If you’re worried about the effect of nuclear attacks, you’ve got other things to worry about than the value of Berkshire”.

Both extreme positions do not require investors to do much. However, the current situation may evolve as something in-between.

There are plenty of scenarios in which nuclear weapons will be used locally and/or in a limited way and not lead to a direct nuclear confrontation between Russia and NATO (or the US). For example, it is conceivable that the first tactical nuclear strike by Russia will be met with a NATO conventional 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 Russian leadership’s interests to maintain the unexecuted nuclear threat as long as possible and use it only when military misfortunes may lead to the leadership’s downfall. Since we do not know when and if it happens, investors should be prepared for a long, rough ride with an unknown outcome.

Possible responses

Investors can respond with radical solutions like the complete replacement of equities with cash and/or Treasuries and/or gold. But these measures are satisfactory only when one does not care much about returns.

For the same reason, I am skeptical of strategic hedging. The current cost of buying a one-year put to fully hedge SPY is about 8.5%. There are many other ways to hedge with none of them being particularly cheap under the current circumstances. Between costly full long-term hedging and switching to Treasuries yielding close to 4%, the latter seems preferable.

Another option is some kind of market-neutral strategy. It can be implemented by balancing long and short positions or by arbitrage. This is certainly doable 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 either short-selling or arbitrage. Due to their niche status, the capacity of both methods is also limited. But it seems the right approach at least for a part of one’s portfolio.

For most investors, there are two traditional and easy-to-implement ways to address the issue – asset allocation and asset selection. We will focus on the former as it seems more important.

It is rather straightforward to make Fed decisions responsible for the current market turmoil. But I believe geopolitical concerns (i.e. a nuclear threat) are already taking a toll. I see bargains in common equities today but find myself reluctant to commit cash. This is very different from what I normally do. Considering myself a typical retail investor, I would expect similar behavior from peers. Institutional investors may behave differently. For example, many stock fund managers will remain fully invested as they are not risking their own money and significant underperformance versus indexes is suicidal.

The quantitative framework

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

Benjamin Graham in “The Intelligent Investor” advocated 25-75% stock allocation depending on the situation and individual circumstances and risk tolerance. William P. Bengen, in his article about the popular 4% rule, formulated the following based on the careful analysis of historic data: “I think it is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible and in no case less than 50 percent”. Famous investor Peter Lynch in his book “Beating The Street” suggested allocating to stocks as close to 100% as one can stomach. I do not remember Warren Buffett formulating any allocation rule clearly but based on his writings, he seems rather close to Peter Lynch.

I will follow now my original work reproduced in one of my old articles. Let us imagine we have only two assets available – an index (SPY) that delivers annual returns spread about average µ with standard deviation σ (also called volatility) and risk-free fixed income investment with a known return r. We want to figure out the optimal allocation to index f, with 0<f<1. Here “optimal” means allocation that is expected to deliver the highest return over the long term.

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

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

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

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

What matters for us now is that equities allocation f is inversely proportional to the squared volatility. The uncertainty due to the nuclear threat may manifest itself primarily through persistent higher-than-normal volatility.

Volatility (VIX) currently is around 30 but it is influenced by both Fed’s actions and nuclear threat and we do not know how to measure these influences separately. And VIX itself at any particular moment is too volatile to be based upon.

I have not found a way to estimate this volatility or extract it from historical examples. But assuming a modest 10-20% increase in it (way below the current value of VIX) produces a decrease of equities allocation by a factor of ~1.2-1.4.

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

It is impossible to prescribe some universal allocation to everybody. Individuals vary in their situations and risk aversion. But at least for aggressive investors who follow Bengen or Lynch recipes in line with 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 equities close to or below 50% of their investment assets.

Some practical considerations

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

Let us ask a simple question: how will f change after a 1% market drop? 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. It means that a 1% drop will decrease f by 1/4% or less. For a ~20% drop in 2022, the allocation should change at ~5%. This is probably not sufficient and additional selling of equities is due if not already done.

Conclusion

Getting back to the question I posed at the very beginning: is it the right time for bullish articles about equities? In my opinion, the answer is yes as long as a reader/writer is trying to optimize her equity portfolio without expanding it.

This may sound too strict for many of you and I fully understand it. I am splitting my time between the US and Europe. When I land in JFK or Miami, I feel rather insulated from the war far away. But when in Europe my feeling becomes very different.