General Theory of Portfolio Construction by Charles Gave

2025-04-16

Chapter 1

Equities, gold, real estate, art and vintage Ferraris are “real assets”. Government bonds, insurance policies, bank deposits and cash are “contracts”.
“real assets” have value either because they will generate future cash flows (at Gavekal, we call such assets “tools”) or because they are rare (we call such assets “jewels”). Valuing “tools” is a lot easier (discount future cash flows by a risk-free rate) than valuing “jewels” (what is the right price for a bottle of Pétrus or a Vincent van Gogh painting?). In this booklet, I will use equity markets as a proxy for “tools” and gold as a proxy for “jewels”.
For me, a bear market is a period in which equities underperform gold.

The deflationary boom: This is the natural state of capitalism. After all, most entrepreneurs and chief executives wake up every day wondering how to produce more with less. When entrepreneurs solve that equation, an economy experiences “creative destruction” and what we call in our research “Schumpeterian growth”. At such times, the asset of choice is long-duration equities, i.e. growth stocks. Value managers underperform. Government and corporate bonds do well, as does real estate. Basically, any “long-duration” asset thrives.
The inflationary boom: This occurs during wars, or in any other period when the weight of government within an economy expands rapidly. A telltale sign is thus a rapid rise in government spending as a share of GDP. In such periods, investors should seek out scarcity assets, with the most obvious being gold, although commodities more broadly usually outperform. Bonds typically struggle.
The inflationary bust: (stagflation) It is a miserable period for investors, as very few assets do well. Long-duration assets do especially poorly. Even bonds collapse. At such times, one should own cash, and usually energy since the way the broader economy is often pushed into stagflation is through a spike in energy prices.
The deflationary bust: Both prices and sales volumes fall. Repaying the principal of the debt becomes impossible. The only assets that rise are long-dated government bonds.

The economy is nothing but energy transformed. This means that energy is the input, while the output is goods and services sporting a higher value than the input. Price of WTI Oil in gold makes a decent proxy for energy costs.
I assume that as long as stock market valuations rise faster than the WTI price, energy is being transformed productively and, thus, economic growth should naturally follow. On the flip side, if the WTI price goes up faster than the S&P 500, there is a high chance that the economy will stop growing and stock market returns will be miserable.
We are on the tight side of Four Quadrants if the ratio of the S&P 500 against the WTI oil price is above its seven-year moving average

What mattered was whether the bond market was protecting me against rising prices. Specifically, were long-dated US treasuries a proper store of value?
Four Quadrants horizontal axis will now measure if the economy is, at the time, energy efficient or energy inefficient. The vertical axis shows if the currency is acting as a store of value and is thus labeled as being either a “good currency” or a “bad currency”.

%25 Cash %25 Bonds %25 Gold %25 Equities
Periodic rebalancing to maintain 25% weightings
deflationary boom: volumes rise and prices fall
inflationary boom: the prices and volume of production rise together
inflationary bust: (stagflation) Prices rise while volumes fall
deflationary bust: volumes and prices go down at the same time
Harry Browne’s Permanent Portfolio have a decent real return of around 4.1% a year. (S&P 500 %6.8) It promises low volatility using an efficient diversification between asset classes and without having to move outside of one’s country.

While knowing which assets to own is a challenge, knowing which not to own is perhaps easier.
If the ratio between the total return of a constant-duration 10-year US Treasury bond and the price of gold is above its seven-year moving average, I stay in US government bonds. Otherwise I move into gold.
Bonds and gold are mutually exclusive. Own bonds in deflation, own gold in inflation.
Gavekal Three Asset Porfolio: %33 Cash %33 Equities %33 Gold or Bonds. Real return: 5.5%

Today, roughly 4% of the S&P 500 is made up of energy names compared to 30% in 1980. Thus, if oil prices were to rise suddenly, the stock market would go down and the rebalancing would lead to more Nvidia, Microsoft or Amazon being bought, all big consumers of energy. Very little would go to ExxonMobil, BP or Petrobras.
I propose to create a fifth “bucket” made up of the index of energy producers (XLE.US). In so doing, I will guarantee that I always have at least 20% of the equity part of the portfolio in energy, plus whatever energy shares represent in the S&P 500.
Energy enhanced Browne returns 5% a year.
When moving from five to four assets by excluding gold or bond, real returns are %6 a year.