Uncle Sam Wants YOU... To Hold His Bag
The role of gold and bitcoin in modern portfolios
Summary
Money supply growth is likely to outpace bond yields for the foreseeable future
Bonds are unlikely to maintain purchasing power in an era of financial repression
I examine the role of gold and bitcoin in a traditional 60/40 portfolio
The ongoing selloff in bitcoin may offer an attractive entry point
[six minute read]
bag·hold·er /ˈbag-hōl-dər/ n.
One who, through misfortune, poor timing, or misplaced optimism, is left owning a financial asset after its value has sharply declined and others have exited their position.
Introduction
If you speak to a financial advisor today, they are likely to recommend a variation of the traditional 60/40 portfolio:
60% in equities (i.e. the S&P 500)
40% in fixed income (i.e. U.S. government bonds)
What’s the history of this portfolio and why has it become so common?
Modern portfolio theory, developed by Harry Markowitz in the 1950s, demonstrated that mixing risky and safe assets can improve risk‑adjusted returns relative to holding either alone.
The core idea is that equities provide growth and bonds provide income while dampening volatility. Seems logical.
Over the last several decades, this strategy has worked well.
Over the next several decades, a new approach is worth considering.
Interest Rates
U.S. interest rates peaked in the early 1980s and declined steadily through 2021:
For 60/40 portfolios, the declining trend in rates was an added tailwind.
Each time the economy slowed or equity markets sold off, the federal reserve stepped in to lower interest rates. Lower rates encouraged borrowing which drove economic activity and asset prices.
With short term rates near 20% in the early 1980s, the federal reserve deployed this strategy consistently, and to great effect, for over four decades.
Active managers took notice and opportunistically rotated portfolio allocations between bonds and equities in response to fluctuations in relative value.
Hedge fund managers took it a step further, borrowing against fixed income positions to lever the volatility dampening bonds in a highly effective strategy that became known as risk parity.
During the 2008 financial crisis, the federal reserve lowered interest rates to zero and so began a new era.
“What the wise man does in the beginning, the fool does in the end.” —Howard Marks
U.S. Federal Debt/GDP
When interest rates peaked in the early 1980s, federal debt/GDP was ~30%.
Today, federal debt/GDP has ballooned to nearly 120%, a level last seen following deficit spending that financed the second world war:
Following the end of WWII, the U.S. debt/GDP ratio collapsed rapidly. U.S. soldiers transitioned from non-productive activities (i.e. fighting and blowing things up) to productive activities.
Working age men returned to the U.S. to deepen their education, work in factories, and start new businesses. Demographic trends encouraged household formation. Productivity and GDP grew, collapsing the relative value of debt by expanding the denominator in the debt/GDP equation.
Today, no such inflection point in productivity exists.
The Congressional Budget Office (CBO) projects that federal debt/GDP will balloon to 156% by 2055, assuming no future recessions and with no end in sight.
Off-Balance Sheet Liabilities
Off-balance-sheet liabilities represent financial obligations not captured in official debt figures because they are unfunded:
Social Security, Medicare, and other entitlement commitments
Loan guarantees (e.g., FHA, student loans, Fannie Mae/Freddie Mac)
Pension and retiree-health liabilities
The CBO estimates the present value of the U.S. federal government fiscal gap—the difference between projected future spending and tax revenues—is approx. $70 trillion, discounted to 2025 dollars.
If we include unfunded liabilities (and we should), total federal debt/GDP is more accurately stated as a staggering 357%.
Financial Repression
Another tailwind from the multi-decade decline in interest rates that began in the 1980s was the reduction in federal interest expense. As interest rates came down over time, the federal government could borrow more while the cost of servicing that debt declined. With rates now close to the zero lower bound, this has largely played out.
Over the last 12 months, the U.S. federal government spent roughly $2.0 trillion more than it took in as tax receipts.
In other words, taxes are already insufficient to service the current debt.
Without major reforms, tax receipts will be insufficient to service the growing debt load for the foreseeable future.
When countries become overindebted, there are three options to address the problem:
Default—highly unlikely as this would undermine credibility of the dollar system
Reform (raise taxes and cut spending)—not going to happen
Inflate—expand the supply of dollars to service the debt and drive GDP growth
There is only one realistic path forward. Inflate.
The U.S. can create dollars in any quantity it needs to address this issue.
There will be no default, no crisis, and no collapse of the U.S. dollar.
But there are other consequences.
Over the last two decades, broad money supply in the U.S. as measured by M2 has grown by roughly 6% annually.
Today, if you lend your money to the government through 10-yr. treasury bonds, you will earn roughly 4.0%.
In exchange for lending your hard earned savings, you will earn a negative real return of -2.0%, as measured against the increase in money supply. Your account balance grows over time, but your purchasing power declines.
This is wealth confiscation, also known as financial repression.
With the U.S. debt imbalance set to worsen, financial repression is here to stay.
Alternatives
Let’s briefly examine the alternatives for re-allocating the 40% bond position within a traditional 60/40 portfolio:
Foreign bonds—most countries have worse debt/GDP ratios than the U.S.
Commodities—should lose value over time as extraction technologies improve
Real estate—cyclical, illiquid, correlated to equities, requires active management
Gold & Bitcoin—largely uncorrelated to equities over extended time horizons and have delivered positive real returns above growth in the money supply
While treasury bonds offer you a -2.0% real yield, gold and bitcoin have delivered real annual returns of 3.1% and 65% respectively over 10 years.
Conclusion
The analysis above is not novel. This is becoming well understood.
In game theory, common knowledge refers to a fact that every player knows, knows that every other player knows, knows that every other player knows that they know, and so on ad infinitum—an infinite chain of mutual awareness.
As financial repression escapes from obscure corners of Substack to the sphere of common knowledge, portfolios will shift.
The chart below was produced by VanEck, one of the largest global investment management firms and ETF issuers. Their analysis suggests that just a 6.7% allocation to Bitcoin and Ethereum within a traditional 60/40 portfolio would have improved annual returns from 8.7% to 17% over a 10-yr. look back.
Expect more analysis like this in the years ahead.
A Final Note
One key drawback of both gold and bitcoin is volatility. Both assets have substantially higher volatility than U.S. government bonds.
These are not short term trading vehicles, they are long term portfolio allocations.
I would warn against getting seduced by these assets when they are trading at or near all time highs.
Investors will need to tolerate higher volatility in the years ahead if they aim to achieve positive real returns and grow their purchasing power.
Bonds were excellent portfolio diversifiers for over four decades. In the era of financial repression, buying dips in gold and bitcoin may be a superior strategy.
In my recent post The Bear Case, I laid out a cautious view and defensive positioning on bitcoin in the near term.
From the October high, BTC has experienced a peak to trough decline of 36%. Historical bear markets have produced deeper selloffs.
If you don’t own bitcoin today or hold only a small position, the ongoing selloff may offer an attractive entry point worth considering.
