Bedtime for Bondo

 “By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”

  • Ben Graham, ‘The Intelligent Investor’.

They call them ‘junk bonds’ for a reason. They now constitute an offence against linguistic decency: ‘high yield’ no longer even is. Consider the chart below:

BofA Merrill Lynch High Yield Master II Index (spread vs US Treasuries)

High Yield Master II Index

(Source: BofA Merrill Lynch, St. Louis Federal Reserve)

(The index in question is a benchmark for the broad high yield bond market.) Not for nothing did the Financial Times report at the weekend that “Retail investors are getting increasingly nervous about high-yield bonds”.

They should also be getting increasingly nervous about government bonds. Consider, first, this chart:

                                                                                                                                                                             UK long bond yield

(Source: Thomson Reuters, Credit Suisse)

In the entire history of the UK Gilt market, yields have never been as low. This suggests that Gilt buyers at current levels are unlikely to enjoy an entirely blissful investment experience.

Just to round up this analysis of bond investor hyper-exuberance, consider this last chart, which puts interest rates (in this case, the UK base rate) in their historical context:

UK base rates, 1700 to 2014

UK Base Rates

(Source: The Bank of England, Church House)

(*The Bank Rate has comprised variously the Bank Rate, Minimum Lending Rate, Minimum Band 1 Dealing Rate, Repo Rate and Official Bank Rate.)

There is one (inverse) correlation in investment markets that is pretty much iron-clad. If interest rates go up, bond prices go down. This is entirely logical, since the coupon payments on bonds are typically fixed. If interest rates rise, that stream of fixed coupon payments loses its relative attractiveness. The bond price must therefore fall to compensate fixed coupon investors. So now ask yourself a question: in what direction are interest rates likely to go next ? Your answer may have some bearing on your preferred asset allocation.

Bond investors may be acting rationally inasmuch as they believe that central banks will keep interest rates “lower for longer”. But even more rational investors are now starting, loudly, to question the wisdom of central banks’ maintenance of emergency monetary stimulus measures, at least five years after the Global Financial Crisis flared up. Speaking at the ‘Delivering Alpha’ conference covered by CNBC, respected hedge fund manager Stanley Druckenmiller commented as follows:

“As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others – and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks. Since most investors like betting with the central bank, these occasions provided our most outsized returns – and the subsequent price adjustments were quite extreme. Today’s Fed policy is as puzzling to me as during any of those periods and, frankly, rivals 2003 in the late-stages to early-2004, as the most baffling of a number of instances I have in mind. We at Duquesne [Capital Management] were mystified back at that time why the funds rate was one percent with the ‘considerable period’ attached to it, given the vigorous economic growth statistics available at the time. I recall walking in one day and showing my partners a bunch of charts of economics statistics of that day and asking them to take the following quiz: Suppose you had been on Mars the last five years and had just come back to planet Earth. I showed them five charts and I said, ‘If you had to guess, where would you guess the Federal funds rate was?’ Without exception, everyone guessed way north of one percent, as opposed to the policy at the time which was a verbal guarantee that they would stay at one percent for a ‘considerable period of time.’ So we were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded. Maybe we got lucky. But the leadership of the Federal Reserve did not foresee the coming consequences as late as mid-2007. And, surprisingly, many Fed officials still do not acknowledge any connection between loose monetary policy and subsequent events..”

“I hope we can all agree that these once-in-a-century emergency measures are no longer necessary five years into an economic and balance sheet recovery. There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate. If for no other reason, so the Fed will have additional weapons available if the outlook darkens again. Many Fed officials and other economists defend their current policies by claiming the economy is better than it would have been without their ongoing stimulus. No one knows for sure, but I believe that is logical and correct. However, I also believe if you’d asked the same question in 2006 – that the economy was better in 2004 to 2006 than it would have been without the monetary stimulus that preceded it. But was the economy better in total from 2003 to 2010 – without the monetary stimulus that preceded it? The same applies today. To economists and Fed officials who continually cite that we are better off than we would have been without zero rate policies for long, I ask ‘Why is that the relevant policy time frame?’ Five years after the crisis, and with growing signs of economic normalization, it seems time to let go of myopic goals. Given the charts I just showed and looking at economic history, today’s Fed policy seems not only unnecessary but fraught with unappreciated risk. When Ben Bernanke and his colleagues instituted QE1 in 2009, financial conditions in the real economy were in a dysfunctional meltdown. The policy was brilliantly conceived and a no-brainer from a risk/reward perspective. But the current policy makes no sense from a risk/reward perspective. Five years into an economic and balance sheet recovery, extraordinary money measures are likely running into sharply diminishing returns. On the other hand, history shows potential long-term costs can be quite severe. I don’t know whether we’re going to end with a mal-investment bust due to a misallocation of resources; whether it’s inflation; or whether the outcome will actually be benign. I really don’t. Neither does the Fed.”

No more charts. If these three don’t get the message across, nothing will.

The bond environment, ranging from high yield nonsense to government nonsense, is now fraught, littered with uncertainty and unexploded ammunition, and waiting nervously for the inevitable rate hike to come (or bracing for a perhaps messy inflationary outbreak if it doesn’t). There are clearly superior choices on a risk-reward basis; we think Ben Graham-style value stocks are the logical and compelling alternative.


Wood will burn

 “I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”

  • Professor Robert Shiller, 25th June 2014, quoted in John Hussman’s weekly market comment.

“Paid promoters have helped push CYNK [CYNK Technology Corp] market cap to $655 million after a 3,650% increase in the share price on Tuesday.

“CYNK had assets of just $39 (no zeroes omitted) as of March 31, 2014 and a cumulative net loss of $1.5 million. The “company” has no revenue.

“CYNK claims that it is “a development stage company focused on social media.” However, the “company” does not even have a website and has just one employee [who acts as President, Chief Executive Officer, Chief Financial Officer, Treasurer and Company Secretary].

“With no assets, no revenue and no product, CYNK has no value. Author expects that CYNK shares are worthless.”

  • Article on CYNK Technology (which is based in Las Vegas) from Seeking Alpha.


Lord Overstone said it best. “No warning can save people determined to grow suddenly rich.” But there is clearly a yawning chasm between the likes of those folk cheerfully bidding up the share price of CYNK, and prudent investors simply trying to keep their heads above water. What has effectively united these two otherwise disparate communities is today’s central banker. Andy Haldane, the chief economist for the Bank of England, speaking at an FT conference last week, conceded that ultra-accommodative monetary policy had “aided and abetted risk-taking” by investors and that policy makers had wanted to use higher asset prices to try and stimulate the wider economy (that is to say, the economy) into a more robust recovery: “That is how [monetary policy] is meant to work. That’s why we did it.” If the Bank of England had not slashed interest rates and created £375 billion out of thin air, “the UK economy would have been at least 6 per cent smaller than it is today.” A curiously precise figure, given the absence of any counterfactual. But regardless of the economic “benefits” of quantitative easing, Haldane did have the grace to admit that

“That will mean, on average, that financial market volatility will be somewhat greater than in the past. I think it will mean, on average, that those greed and fear cycles in financial markets will be somewhat more exaggerated than in the past. That, for me, is the corollary of the risk migration.”

Which is a bit like an arsonist torching a wooden building and then shrugging his shoulders and saying,

“Well, wood will burn.”

Our central bankers, of course, will not be held accountable when the crash finally hits, even if the accumulated dry tinder of the boom was almost entirely of their own creation. Last week the Bank for International Settlements, the central banker’s central bank, issued an altogether more circumspect analysis of the world’s current financial situation, in their annual report. It concluded, with an entirely welcome sense of caution, that

“The [monetary] policy response needs to carefully consider the nature and persistence of the forces at work as well as policy’s diminished effectiveness and side effects. Finally, looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated.” (Emphasis ours.)

Translation: ZIRP (Zero Interest Rate Policy – and in the case of the ECB, which has taken rates negative, NIRP) is no longer working – if it ever did. Hyper-aggressive monetary policy has side effects. Getting out of this mess is not going to be easy, and it’s going to be messy. Forward guidance, which was meant to simplify the message, has instead hopelessly confused it. And there are big risks that central banks will lose the requisite confidence to tighten policy when it is most urgently needed, and allow an inflationary genie entirely out of the bottle.

The impact of central banks’ unprecedented monetary stimulus on financial markets is so overwhelming that it utterly negates any sensible analysis of likely macro-economic developments. On the basis that sometimes it’s simply best not to play some games, we no longer try. What should inform investors’ preferences, however, is bottom-up asset allocation and stock selection. The US equity market is clearly poor value at present. That doesn’t mean that it can’t get even more expensive, and the rally might yet have some serious legs. But overvaluation at an index level doesn’t preclude the existence of undervalued stocks well away from the braying herd. (We think the most compelling macro value is in Asia and, if we had to single out any one country, Japan.)

Hussman, again:

“The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades..”

“Investment decisions driven primarily by the question “What other choice do I have ?” are likely to prove regrettable. What we now have is a market that has been driven to one of the four most extreme points of overvaluation in history. We know how three of them ended.”

The conclusion seems clear to us. If one chooses to invest at all, invest on the basis of valuation and not on indexation (the world’s largest stock market, that of the US, is one of the most seemingly conspicuously overvalued). As an example of the sort of valuations currently available away from the herd, consider the following. You can buy the US S&P 500 index today with the following metrics:

Price / earnings: 18.2

Price / book: 2.76

Dividend yield: 1.89%

Meanwhile, Greg Fisher in his Halley Asian Prosperity Fund (albeit currently closed) is buying quality businesses throughout Asia on somewhat more attractive valuations. (By geography, the fund’s largest allocations are to Japan, Vietnam and Malaysia.) The fund’s current metrics are as follows:

Average price / earnings: 7

Average price / book: 0.8

Average dividend yield: 4.5%.

But the realistic prospect of growth is also on the table. The fund’s average historic return on equity stands at 15%.

Pay money. Take choice.


A time of universal deceit


“Individuals who cannot master their emotions are ill-suited to profit from the investment process.”
- Ben Graham.

“What really broke Germany was the constant taking of the soft political option in respect of money..
“Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be so used. The more general the acknowledgement, the more useful it is. Once no one acknowledged it, the Germans learnt, their paper money had no value or use – save for papering walls or making darts. The discovery which shattered their society was that the traditional repository of purchasing power had disappeared, and that there was no means left of measuring the worth of anything. For many, life became an obsessional search for Sachverte, things of ‘real’, constant value: Stinnes bought his factories, mines, newspapers. The meanest railway worker bought gewgaws. For most, degree of necessity became the sole criterion of value, the basis of everything from barter to behaviour. Man’s values became animal values. Contrary to any philosophical assumption, it was not a salutary experience.
“What is precious is that which sustains life. When life is secure, society acknowledges the value of luxuries, those objects, materials, services or enjoyments, civilised or merely extravagant, without which life can proceed perfectly well but which make it much pleasanter notwithstanding. When life is insecure, or conditions are harsh, values change. Without warmth, without a roof, without adequate clothes, it may be difficult to sustain life for more than a few weeks. Without food, life can be shorter still. At the top of the scale, the most valuable commodities are perhaps water and, most precious of all, air, in whose absence life will last only a matter of minutes. For the destitute in Germany and Austria whose money had no exchange value left existence came very near these metaphysical conceptions. It had been so in the war. In ‘All Quiet on the Western Front’, Müller died “and bequeathed me his boots – the same that he once inherited from Kemmerick. I wear them, for they fit me quite well. After me Tjaden will get them: I have promised them to him.”
“In war, boots; in flight, a place in a boat or a seat on a lorry may be the most vital thing in the world, more desirable than untold millions. In hyperinflation, a kilo of potatoes was worth, to some, more than the family silver; a side of pork more than the grand piano. A prostitute in the family was better than an infant corpse; theft was preferable to starvation; warmth was finer than honour; clothing more essential than democracy; food more needed than freedom.”
- Adam Fergusson, ‘When Money Dies: the nightmare of the Weimar hyperinflation’.

“We are currently on a journey to the outer reaches of the monetary universe,” write Ronni Stoeferle and Mark Valek in their latest, magisterial ‘In Gold we Trust’. Their outstanding work is doubly valuable because, as George Orwell once wrote,

“In a time of universal deceit, telling the truth is a revolutionary act.”

Orwellian dystopia; Alice-Through-The-Looking-Glass World; state-sanctioned inflationist (deflationist?) nightmare; choose your preferred simile for these dismal times. The reality bears restating: as the good folk of Incrementum rightly point out,

“..the monetary experiments currently underway will have numerous unintended consequences, the extent of which is difficult to gauge today. Gold, as the antagonist of unbacked paper currencies, remains an excellent hedge against rising price inflation and worst case scenarios.”

For several years we have advocated gold as a (necessarily only partial) solution to an unprecedented, global experiment with money that can only end badly for money. The problem with money is that comparatively few people understand it, including, somewhat ironically, many who work in financial services. Rather than debate the merits of gold (we think we have done these to death, and we acknowledge the patience of those clients who have stayed the course with us) we merely allude to the perennial difficulty of investing, namely the psychology of the investor. In addition to being the godfather of value investing, Ben Graham was arguably one of the first behavioural economists. He wisely suggested that investors should

“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

Graham also observed,

“In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”

Judgment has clearly been tested for anyone who has elected to hold gold during its recent savage sell-off. The beauty of gold, much as with a classic Ben Graham value stock, is that as it gets cheaper, it gets even more attractive. This should be self-evident, in that an ounce of gold remains an ounce of gold irrespective of its price. This puts gold (and value stocks) markedly at odds with momentum investing (which currently holds sway over most markets), where once a price uptrend in a given security breaks to the downside, it’s time to head for the hills.
A few highlights from the Incrementum research:
 Since 1971, when President Nixon untethered the dollar from its last moorings to gold, “total credit market debt owed” in the US has risen by 35 times. GDP has risen by just 14 times. The monetary base, on the other hand, has risen by, drum roll please.. some 54 times.
 If, like Incrementum and ourselves, you view gold primarily as a monetary asset and not as an industrial commodity, it has clearly made sense to have some exposure to gold during these past four decades of monetary debauchery.
 They say a picture paints a thousand words. Consider the following chart of total US credit market debt and ask yourself: is this sustainable?


A time of universal deceit (1)

(Click image to view larger version)


To repeat, there are only three ways of trying to handle a mountain of unsustainable debt. The options are:
1) Maintain economic growth at a sufficient rate to service the debt. We believe this is grossly unlikely.
2) Repudiate the debt. Since we also operate within a debt-based monetary system (in which money is lent into being by banks), default broadly equates to Armageddon.
3) Inflate the debt away.

At the risk of pointing out the obvious, which path do we consider the most likely? Which path does it suit grotesquely over-indebted governments and their client central banks to pursue?
But it does not suit central banks to be caught with their fingers in the inflationary cookie jar, so they now have to pretend that deflation is Public Enemy Number One. Well, deflation is certainly a problem if you have to service unserviceable debts. So it should come as no surprise if this predicament is ultimately resolved through an uncontrollable and perhaps inevitable inflationary or stagflationary mess.

So we have the courage of our knowledge and experience. (In fact, of other people’s experience, too. As the title of Robert Schuettinger and Eamonn Butler’s book puts it, we have ‘Forty Centuries of Wage and Price Controls’ and their inevitable failure to draw upon. We know how this game ends, we just don’t know precisely when.) We have formed a conclusion based on facts and we know our judgment is sound. For the last two years, the crowd has disagreed with us on gold. We think we are right because we think our data and reasoning are right. Not that we don’t see value in other things, too: bonds of unimpeachable quality offering a positive real return; uncorrelated assets; value and ‘deep value’ stocks. And we ask a final question: if not gold, then what? Are we deceiving ourselves – or are our central bankers in the process of deceiving everyone?



“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”

- James Rickards, ‘The death of money: the coming collapse of the international monetary system’, 2014. [Book review here]

“Sir, On the face of it stating that increasing the inheritance tax allowance to £1m would abolish the tax for “all except a very small number of very rich families” (April 5) sounds a very reasonable statement for the Institute for Fiscal Studies to make, but is £1m nowadays really what it used to be, bearing in mind that £10,000 was its equivalent 100 years ago ?

“A hypothetical “very rich” person today could have, for example, a house worth £600,000 and investments of £400,000. If living in London or the South East, the house would be relatively modest and the income from the investments, assuming a generous 4 per cent return, would give a gross income of £16,000 a year, significantly less than the average national wage.

“So whence comes the idea that nowadays such relatively modest wealth should be classified as making you “very rich” ? The middle-aged should perhaps wake up to the fact that our currency has been systematically debased, though it may be considered impolite to say so as it challenges the conventional political and economic wisdom. To be very rich today surely should mean you have assets that give you an income significantly higher than the national average wage ?”

- Letter to the editor of the Financial Times from Mr John Read, London NW11, 12 April 2014

“The former coach house in Camberwell, which has housed the local mayor’s car, was put on the market by Southwark council as a “redevelopment opportunity”. At nearly £1,000 per square foot, its sale value is comparable to that of some expensive London homes.”

- ‘London garage sells for £550,000’ by Kate Allen, The Financial Times, 12 April 2014.

“Just Eat, online takeaway service, slumped below its float price for the first time on Tuesday as investors dumped shares in a raft of recently floated web-based companies amid mounting concern about their high valuations..

“Just Eat stunned commentators last week when it achieved an eye-watering valuation of £1.47 billion, more than 100 times its underlying earnings of £14.1 million..

““They have fallen because the company was overvalued. Just Eat was priced at a premium to Dominos, an established franchise that delivers and makes the pizzas and has revenues of £269 million. Just Eat by comparison is a yellow pages for local takeaways where there is no quality control and no intellectual property and made significantly less revenues of £96.8 million. A quality restaurant does not need to pay 10 per cent commission to Just Eat to drive customers through the door,” Michael Hewson, chief market analyst at CMC Markets said.”

- ‘Investors lose taste for Just Eat as tech stocks slide’ by Ashley Armstrong and Ben Martin,

The Daily Telegraph, 8 April 2014.

Keep interest rates at zero, whilst printing trillions of dollars, pounds and yen out of thin air, and you can make investors do some pretty extraordinary things. Like buying shares in Just Eat, for example. But arguably more egregious was last week’s launch of a €3 billion five-year Eurobond for Greece, at a yield of just 4.95%. UK “investors” accounted for 47% of the deal, Greek domestic “investors” just 7%. Just in case anybody hasn’t been keeping up with current events, Greece, which is rated Caa3 by Moody’s, defaulted two years ago. In the words of the credit managers at Stratton Street Capital,

“The only way for private investors to justify continuing to throw money at Greece is if you believe that the €222 billion the EU has lent to Greece is entirely fictional, and will effectively be converted to 0% perpetual debt, or will be written off, or Greece will default on official debt while leaving private creditors untouched.”

In a characteristically hubris-rich article last week (‘Only the ignorant live in fear of hyperinflation’), Martin Wolf issued one of his tiresomely regular defences of quantitative easing and arguing for the direct state control of money. One respondent on the FT website made the following comments:

“The headline should read, ‘Only the EXPERIENCED fear hyperinflation’. Unlike Martin Wolf’s theorising, the Germans – and others – know only too well from first-hand experience exactly what hyperinflation is and how it can be triggered by a combination of unforeseen circumstances. The reality, not a hypothesis, almost destroyed Germany. The Bank of England and clever economists can say what they like from their ivory towers, but meanwhile down here in the real world, as anyone who has to live on a budget can tell you, every visit to the supermarket is more expensive than it was even a few weeks ago, gas and electricity prices have risen, transport costs have risen, rents have risen while at the same time incomes remain static and the little amounts put aside for a rainy day in the bank are losing value daily. Purchasing power is demonstrably being eroded and yet clever – well paid – people would have us believe that there is no inflation to speak of. It was following theories and forgetting reality that got us into this appalling financial mess in the first place. Somewhere, no doubt, there’s even an excel spreadsheet and a powerpoint presentation with umpteen graphs by economists proving how markets regulate themselves which was very convincing up to the point where the markets departed from the theory and reality took over. I’d rather trust the Germans with their firm grip on reality any day.”

As for what “inflation” means, the question hinges on semantics. As James Turk and John Rubino point out in the context of official US data, the inflation rate is massaged through hedonic quality modelling, substitution, geometric weighting and something called the Homeowners’ equivalent rent. “If new cars have airbags and new computers are faster, statisticians shave a bit from their actual prices to reflect the perception that they offer more for the money than previous versions.. If [the price of ] steak is rising, government statisticians replace it with chicken, on the assumption that this is how consumers operate in the real world.. rising price components are given less relative weight.. homeowners’ equivalent rent replaces what it actually costs to buy a house with an estimate of what homeowners would have to pay to rent their homes – adjusted hedonically for quality improvements.” In short, the official inflation rate – in the US, and elsewhere – can be manipulated to look like whatever the authorities want it to seem.

But people are not so easily fooled. Another angry respondent to Martin Wolf’s article cited the “young buck” earning £30K who wanted to buy a house in Barnet last year. Having saved for 12 months to amass a deposit for a studio flat priced at £140K, he goes into the estate agency and finds that the type of flat he wanted now costs £182K – a 30% price increase in a year. Now he needs to save for another 9 years, just to make up for last year’s gain in property prices.

So inflation is quiescent, other than in the prices of houses, shares, bonds, food, energy and a variety of other financial assets.

The business of rational investment and capital preservation becomes unimaginably difficult when central banks overextend their reach in financial markets and become captive to those same animal spirits. Just as economies and markets are playing a gigantic tug of war between the forces of debt deflation and monetary inflation, they are being pulled in opposite directions as they try desperately to anticipate whether and when central bank monetary stimulus will subside, stop or increase. Central bank ‘forward guidance’ has made the outlook less clear, not more. Doug Noland cites a recent paper by former IMF economist and Reserve Bank of India Governor Raghuram Rajan titled ‘Competitive Monetary Easing: Is It Yesterday Once More ?’ The paper addresses the threat of what looks disturbingly like a modern retread of the trade tariffs and import wars that worsened the 1930s Great Depression – only this time round, as exercised by competitive currency devaluations by the larger trading economies.

Conclusion: The current non-system [a polite term for non-consensual, non-cooperative chaos] in international monetary policy [competitive currency devaluation] is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing. If I use terminology reminiscent of the Depression era non-system, it is because I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it. In the process, unlike Depression- era policies, we are also creating financial sector and cross-border risks that exhibit themselves when unconventional policies come to an end. There is no use saying that everyone should have anticipated the consequences. As the former BIS General Manager Andrew Crockett put it, ‘financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle.’ A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.

The Fed repeats its 2% inflation target mantra as if it were some kind of holy writ. 2% is an entirely arbitrary figure, subject to state distortion in any event, that merely allows the US government to live beyond its means for a little longer and meanwhile to depreciate the currency and the debt load in real terms. The same problem in essence holds for the UK, the euro zone and Japan. Savers are being boiled alive in the liquid hubris of neo-Keynesian economists explicitly in the service of the State.

Doug Noland again:

“While I don’t expect market volatility is going away anytime soon, I do see an unfolding backdrop conducive to one tough bear market. Everyone got silly bullish in the face of very serious domestic and global issues. Global securities markets are a problematic “crowded trade.” Marc Faber commented that a 2014 crash could be even worse than 1987. To be sure, today’s incredible backdrop with Trillions upon Trillions of hedge funds, ETFs, derivatives and the like make 1987 portfolio insurance look like itsy bitsy little peanuts. So there are at this point rather conspicuous reasons why Financial Stability has always been and must remain a central bank’s number one priority. Just how in the devil was this ever lost on contemporary central bankers?”


“Everything we are told about deflation is a lie”

“The European Central Bank has given its strongest signal yet that it is prepared to embrace quantitative easing to prevent the euro zone from sliding into deflation or even a prolonged period of low inflation.”
- ‘Draghi strengthens QE signal’, Financial Times, April 4, 2014.

Yes, heaven protect Europe’s embattled citizens and savers from a prolonged period of low inflation. How could they possibly survive it ?

If history is any guide, probably quite well. As Chris Casey points out in his essay ‘Deflating the deflation myth’, the American economy during the 19th Century twice experienced deflationary periods of roughly 50 percent:
price level
Source: McCusker, John J. “How Much Is That in Real Money?: A Historical Price Index for Use as a Deflator of Money Values in the Economy of the United States.” Proceedings of the American Antiquarian Society, Volume 101, Part 2, October 1991, pp. 297-373.

This during a period of “sustained and significant economic growth”. But just think of all those poor consumers, having to make the best of constantly falling everyday low prices.

In their research article ‘Deflation and Depression: Is There an Empirical Link?’ of January 2004, Federal Reserve economists Andrew Atkeson and Patrick Kehoe found that “..the only episode in which we find evidence of a link between deflation and depression is the Great Depression (1929-1934). We find virtually no evidence of such a link in any other period.. What is striking is that nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.”

In his 2008 essay ‘Deflation and Liberty’, Jörg Guido Hülsmann writes as follows:

“In the present crisis, the citizens of the United States [he could have added: and of the UK, and Europe] have to make an important choice. They can support a policy designed to perpetuate our current fiat money system and the sorry state of banking and of financial markets that it logically entails. Or they can support a policy designed to reintroduce a free market in money and finance. This latter policy requires the government to keep its hands off. It should not produce money, nor should it appoint a special agency to produce money. It should not force the citizens to use fiat money by imposing legal tender laws. It should not regulate banking and should not regulate the financial markets. It should not try to fix the interest rate, the prices of financial titles, or commodity prices.

“Clearly, these measures are radical by present-day standards, and they are not likely to find sufficient support. But they lack support out of ignorance and fear.

“We are told by virtually all the experts on money and finance – the central bankers and most university professors – that the crisis hit us despite the best efforts of the Fed [..and the Bank of England, and the ECB..]; that money, banking and financial markets are not meant to be free, because they end up in disarray despite the massive presence of the government as a financial agent, as a regulator, and as money producer; that our monetary system provides us with great benefits that we would be foolish not to preserve. Those same experts therefore urge us to give the government an even greater presence in the financial markets, to increase its regulatory powers, and to encourage even more money production to be used for bailouts.”

But as Hülsmann goes on to argue, all of these contentions are wrong, and have been proven to be wrong since the times of Adam Smith and David Ricardo. A paper money system is not beneficial “from an overall point of view”. (Nor has any unbacked paper money system ever lasted.) A paper money system does not create real resources on which our welfare depends. “It merely distributes the existing resources in a different manner; some people gain, others lose. It is a system that that makes banks and financial markets vulnerable, because it induces them to economize on the essential safety valves of business: cash and equity.”

The conventional view of deflation is that if it sets in, “the banking industry, the financial markets, and much of the rest of the economy will be wiped out in a bottomless deflationary spiral.” But as Hülsmann goes on to argue, such a spiral would not prove fatal to the lives and welfare of the general population. Rather, it would destroy “essentially those companies and industries that live a parasitical existence at the expense of the rest of the economy, and which owe their existence to our present money system.”

Let us be more explicit. Severe deflation threatens at an existential level bankrupt banks and the bankrupt governments that perpetuate their existence. Deflation is a mortal enemy to the heavily indebted state and its embedded parasites, but it is a friend to the saver and to anyone with a positive net worth. Because it is so dangerous to the debtor, (unelected) central bankers clearly feel they have no option but to incinerate savers at the altar of perpetuating an unsustainably indebted banking and political elite.

So it would seem that the euro zone, under Mario Draghi, is on the verge of outright quantitative easing, and that the ECB is also committed to using “unconventional instruments” in an increasingly desperate attempt to revive the corpse through explicit inflationism, not least by actually buying sovereign debt of dubious underlying value, rather than merely pledging to. The financial markets certainly appear to think so: the yields on Spanish 5-year government paper fell below those of their US equivalents last week. Spanish bonds yielded more than 7% above US paper as recently as 2012. And as Bloomberg pointed out, the yields on Spanish and Italian five year paper, and the yield on 10 year Irish government debt, all fell to record lows last Friday.

Whether in terms of goosed bond markets or inflated stock markets, inflated higher not necessarily by any improvement in corporate prospects but primarily by expectations of more ex nihilo money courtesy of the world’s major central banks, these are false markets. They cannot entirely be trusted – assuming that markets ever can. Fund manager Seth Klarman has written well on the artificiality of today’s markets:

“The Fed and the Treasury openly discuss the aims of their policies: to manipulate financial markets higher and to generate reported economic “growth” and a “wealth effect”. Inside the giant Plexiglas dome of modern capital markets, just about everyone is happy, the few doubters are mocked and jeered, bad news is increasingly ignored… The artificiality of today’s markets is pure Truman Show. According to the Wall Street Journal, the Federal Reserve purchased about 90% of all the eligible mortgage bonds issued in November.”

John Phelan of the Cobden Centre writes well that “the Federal Reserve has become an enabler of the financial havoc it was designed (a century ago) to prevent.”

Messrs Yellen, Draghi et al should be careful what they wish for. Inflation targeting is hardly a precise science. Achieving an entirely arbitrary 2% inflation level is bad enough for savers on fixed incomes when deposit rates are close enough to zero as to make no difference, but markets have a tendency to overshoot. Most government bond markets are clearly overbought – but in a QE world given fresh impetus by the looming arrival of the ECB, overbought markets can become even more overbought. When we don’t claim to understand the underlying dynamics (political) or the final destination (though we have our own fears), it’s much better simply not to play. From an asset allocation perspective, classic, benchmark-unconstrained Benjamin Graham-style ‘deep value’ equity is, we now believe, pretty much the only game in town – and that is where we now focus our attention, almost exclusively.

Meanwhile, we watch in disbelief as market distortions become even more untenable.


Lured by plausible nonsense

“One of the peculiar sins of the twentieth century which we’ve developed to a very high level is the sin of credulity. It has been said that when human beings stop believing in God they believe in nothing. The truth is much worse: they believe in anything.”
- Malcolm Muggeridge.

Finding a cure for cancer always makes for a good story. So the New York Times runs it:

“Within a year, if all goes well, the first cancer patient will be injected with two new drugs that can eradicate any type of cancer, with no obvious side effects and no drug resistance..”

Cancer experts, including a Nobel Laureate, are reported to be “electrified” by the results. While existing treatments can only slow the disease, the new trials are said to eradicate tumours completely. The company that holds the licence for the treatments is mentioned as well. Its name is Entremed. The stock price responds immediately, and rises by 600%. The news is extraordinary, and extremely exciting.

It just isn’t new. As Thomas Schuster points out in his study of financial markets and their relationships with mass media (you can read it here), the New York Times had itself reported the same story in an article half a year earlier. The original copy contained all the ‘active ingredients’ repeated in the more recent cover story: the amazing research results; the breathless enthusiasm of experts; the name of the licensee, Entremed. CNN and CNBC also happened to report the story. Economically speaking, the cover story is news without any information content: the market already knew the pertinent facts six months ago. If the efficient market hypothesis were valid, the republication of the story should have had little or no effect on Entremed’s share price. But it did.

“Isn’t it funny,” said a senior portfolio manager once, “when you walk into an investment firm and you see all of the financial advisers watching CNBC. That gives me the same feeling of confidence I would have if I walked into the Mayo clinic or Sloan Kettering and all the medical staff were watching General Hospital.”

The media structure content by selection and evaluation. But the weighting of information in the media, suggests Schuster, never corresponds to the distribution of information in reality:

“The media produce explanations by establishing logical links and causal relations; these interpretations, though, are only more or less adequate to reality. The media enrich information by adding new elements such as “emotion” or “suspense”; through this process, however, the character of the information is altered. The media can even create their own events where nothing would happen otherwise – or they can encourage others to do so. In short: the media select, they interpret, they emotionalize and they create facts.”

Pity the poor journalist who must make a daily market report trying to explain price movements with (necessarily) imperfect knowledge of what really triggered them.

“A typical stock market report looks like this: Stock X increased because.. Index Y crashed due to.. Prices Z continue to rise after.. Most of these explanations are post-hoc rationalizations. Correlations which do not really exist are established. Reasons are constructed which can be interchanged arbitrarily. The explanations, as it seems, are quite obvious, even if they are far- fetched. In a nutshell: an artificial logic is created, based on a simplistic understanding of the markets, which implies that there are simple explanations for most price movements; that price movements follow rules which then lead to systematic patterns; and of course that the news disseminated by the media decisively contribute to the emergence of price movements.”

Just as nature abhors a vacuum, so humanity abhors uncertainty. The tragedy of flight MH370 shows this human characteristic in spades. The families of the passengers are wholly justified in wanting to know the truth. But for the rest of us, we find it extraordinarily difficult to live with the uncertainty of a missing plane. We demand answers. And human beings are suckers for narrative. We would rather grasp onto the most fanciful theorizing than accept that some things may never be known to us. In a world of uncertainty, we crave concrete certitude. So we are inevitably setting ourselves up for disappointment; we are invariably going to be fooled, at least some of the time, lured by plausible nonsense.

Speaking of plausible nonsense, there must have been some reason for investors to have been buying shares of newly listed King Digital (makers of the online game Candy Crush) in the secondary market this week, but we’re not aware of any compelling ones. Certainly not on valuation grounds. But then valuations in the US equity market as a whole seem to have got somewhat ahead of themselves. Value investor Tobias Carlisle (along with Tocqueville Funds’ François Sicart, and Farnam Street Investments) points out that the distribution of price / earnings multiples within the S&P 500 index is at its tightest level for 25 years. Or to put it in plainer English, this is the worst value opportunity set within the US stock market for a quarter of a century. James Montier of GMO agrees, calling it a “hideous opportunity set” for investors.

“…a reflection of the central bank policies around the world. They drive the returns on all assets down to zero, pushing everybody out on the risk curve. So today, nothing is cheap anymore in absolute terms. There are pockets of relative attractiveness, but nothing is cheap or even at fair value. Everything is expensive. As an investor, you have to stick with the best of a bad bunch.”

We’re not quite as downbeat as Montier, but perhaps only because, since we manage less money than GMO, we’re completely unconstrained as to benchmarks, markets and indices, and have no pressure whatever to own US stocks when they don’t offer compelling value – which they don’t appear to, today. Such is the curse of indexation and benchmarking – when you have to own a market irrespective of whether you like it. (This is also the curse of the asset gatherer versus the asset manager.) Since we’re not obligated to fish for stocks in US waters, we can take advantage of deep value opportunities in smaller and mid-cap markets throughout Asia (and notably Japan), where Ben Graham-style deep value opportunities still exist offering some semblance of a margin of safety.

The 1,000 lb gorilla in the room remains the Fed. Can the US central bank really end QE without material consequences across asset markets ? Place your bets. There is not much evidence of the ‘worry gene’ prevalent in financial media, which have a vested interest in delivering positive, reassuring news. Robert Shiller in his celebrated ‘Irrational Exuberance’ noted that:
“Many news stories.. seem to have been written under a deadline to produce something – anything – to go along with the numbers from the market.. Sometimes the article is so completely devoid of genuine thought about the reasons for the bull market and the context for considering its outlook that it is hard to believe that the writer was other than cynical in his or her approach.”

If it’s any consolation (either to Shiller or to ourselves), those market updates are increasingly being written by machines. Stupid or cynical they are not, unless programmed to be so. But trustworthy?


More Bread and Circuses

Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.

“Lower borrowing and a smaller deficit mean less debt.”
- George Osborne, British Chancellor, in his 2014 Budget Speech.

“Bingo ! Cutting the bingo tax and beer duty – To help hardworking people do more of the things they enjoy.”
- Asinine Conservative post-budget advertisement.

“Bingo ! I say, you there ! How is your whippet ? Jolly good, jolly good. Carry on.”
- Inevitable twitter response via #torybingo.

“, and above all gambling, filled up the horizon of their minds. To keep them in control was not difficult.”
- George Orwell, ‘1984’.

“Mad piece of theatre over the petty cash”
- Headline to Matthew Engel’s budget review in the Financial Times.

Continue reading “More Bread and Circuses”



Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.

“10th March 2000: NASDAQ closes at a record 5048.62, up 24.1% for the year to date — after gaining 86.5% in 1999. A conference on optical fibre stocks sells out nearly every hotel room in Baltimore, the biggest stocks on NASDAQ trade at an average of 120 times earnings, and 15% of NASDAQ’s value is made up of companies less than two years old that have never earned a profit. James J. Cramer, author of the eponymous column “Wrong!” for, writes that a revival of value stocks “will only happen when the Brocades and Broadcoms blow up. And I don’t see that happening any time soon.” In fact, says Cramer, he’s tempted to short-sell Warren Buffett’s Berkshire Hathaway, betting that the great value investor’s shares are “ripe for the banging.” BancOne fund manager Chris Guinther sums it all up: “In today’s market, it pays to be aggressive.” Today is the absolute peak of the market bubble: In one of the worst crashes in history, NASDAQ plunges 60.6% over the next 12 months. And Cramer’s “Red Hots”? Brocade unravels by 67.1%, Broadcom collapses by 84.1%. Meanwhile, Berkshire Hathaway gains 72.2% over the year to come.” 

- ‘This day in financial history’ on

“The Fed and the other major central banks have been planting time bombs all over the global financial system for years, but especially since their post-crisis money printing spree incepted in the fall of 2008. Now comes a new leader to the Eccles Building who is not only bubble-blind like her two predecessors, but is also apparently bubble-mute. Janet Yellen is pleased to speak of financial bubbles as a “misalignment of asset prices,” and professes not to espy any on the horizon.

“Let’s see. The Russell 2000 is trading at 85X actual earnings and that’s apparently “within normal valuation parameters.” Likewise, the social media stocks are replicating the eyeballs and clicks based valuation madness of Greenspan’s dot-com bubble. But there is nothing to see there, either–not even Twitter at 35X its current run-rate of sales or the $19 billion WhatsApp deal. Given the latter’s lack of revenues, patents and entry barriers to the red hot business of free texting, its key valuation metric reduces to market cap per employee–which computes out to a cool $350 million for each of its 55 payrollers.” - ‘Yellenomics: the folly of free money’ by David Stockman.

Trying to time the markets is either next to impossible, or simply impossible. Either way, we think it’s impossible, so we don’t try. And since we don’t short stocks, the path of least resistance when it comes to equity market investing is

a) Avoid obvious overvaluation, and
b) Concentrate on apparently dramatic undervaluation.

If in doubt, the best policy is always to ask ‘What would Ben Graham have done ?’ and then just do that. (And conversely, if Ben Graham would never have done it, then don’t do it either.) And David Stockman isn’t the only person who detects evidence of a bubble in Big ‘Tech’. V. Prem Watsa of Fairfax Financial Holdings points to the highly speculative valuations currently on offer in the ‘social media’ and ‘other tech / web’ space. For example:

Data courtesy Fairfax Financial Holdings Ltd, March 7 2014.

It’s fairly safe to assume that Ben Graham would not have given ownership of these companies at current valuations his uninhibited endorsement. Indeed, as he once said,

“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes — in fact, very frequently — they make mistakes by buying good stocks in the upper reaches of bull markets.”

So in summary, here are the cardinal errors:

i) Buying rubbish (or speculative nonsense);
ii) Overpaying for quality.

Avoiding the first error is relatively easy, subject to the vagaries of subjective judgment. Avoiding the second, however, may be difficult, perhaps impossibly so, when our monetary overlords at the central banks are hopelessly distorting the price of money. The prudent response, we feel, is to lean that much more heavily on the side of caution by only even considering out-and-out deep value – at least within the context of the listed equity markets. And it is worth repeating Graham and Dodd’s 1934 definition from ‘Security Analysis’:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” [Emphasis ours.]

Quite which operations in today’s marketplace will turn out to be speculative is not yet known to anybody. But the law of gravitation, egged on by the madness of crowds, will doubtless reveal its secrets to us before too long. The ‘social media and other tech / web space’ seems as good a place as any to expect to see investment operations smashed against the rocks before the year is out.

But as we suggest, overpaying for quality may be an inevitable risk in a financial world in which hopes and fears over QE, Zero Interest Rate Policies and banking system solvency (and the threat of depositor bail-ins) dominate more objective fundamentals such as corporate profits growth (or lack thereof). Groupthink alone is sufficient to cause unhealthy dislocations when gravitational forces ensue. We suspect that global megacap consumer brands may now be an unhealthily crowded trade – the sort of investment that makes sense at first glance given the problems highlighted at the beginning of this paragraph, but unhealthily crowded nevertheless. They certainly have been before. Take the ‘nifty fifty’ growth stocks of the early 1970s. Coca-Cola was one such stock. When the forces of recession arrived on the back of the Russian gas embargo Arab oil embargo, Coke’s stock managed to lose over two thirds of its value.

The real thing: Coca-Cola share price, 1973-1974

The real thing: Coca-Cola share price, 1973-1974

Coke wasn’t alone. Over the same period, Disney also lost over two thirds of its value. Blue-chip IBM survived relatively unscathed: it only lost 57%. Note that this isn’t a prediction for the next bear phase – but we would suggest that the social media sector, being inherently more flimsy, has that much further to fall.

Where are we currently finding ‘deep value’ ? In pockets of the mid-cap market throughout Asia, notably in Japan, and also, ahem, in Russia, which we note has now replaced gold as the most reviled part of the global asset marketplace. But we also note that gold seems to have turned a corner after its annus horribilis in 2013. As does its kissing cousin, silver. Since we bought both for very specific reasons, and the underlying fundamentals for holding both have if anything only strengthened even as their prices melted last year, we’re unlikely to be selling either any time soon. And of course the miners of each have also seen their share prices recover some, though so far only some, of the ground they lost, but again we’re in the sector for the long haul. We think money printing is in and of itself inflationary. We also think that central banks may soon have to go ‘all-in’ in their fight against deflation. We think they are destined to lose control of the markets before they are ultimately proved wrong in any case, but who knows ? This is what happens when you allow economic policy wonks unfettered power to experiment on complex markets with unproven (and unprovable) models and make-it-up-as-you-go-along monetary policy on the hoof. Since this is destined to end badly, apart from diversifying sensibly into non-equity assets, it makes sense to seek shelter – in equity terms – in those things most worthy of Ben Graham’s affection. Or in the words of Ben Graham’s most celebrated acolyte, Warren Buffett,

“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.”


“We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”


Forty centuries of learning nothing

“The co-authors began working on this book in 1974, just after the termination of President Nixon’s controls in the United States. Since that time, we have examined over one hundred cases of wage and price controls in thirty different nations from 2000 BC to AD 1978..

“We have concluded that, while there have been some cases in which controls have at least apparently curtailed the effects of inflation for a short time, they have always failed in the long run. The basic reason for this is that they have not addressed the real cause of inflation which is an increase in the money supply over and above the increase in productivity. Rulers from the earliest times sought to solve their financial problems by debasing the coinage or issuing almost worthless coins at high face values; through modern technology the governments of recent centuries have had printing presses at their disposal. When these measures resulted in inflation, the same rulers then turned to wage and price controls.”

- Robert L Schuettinger and Eamonn F Butler, ‘Forty centuries of wage and price controls: how not to fight inflation’ (The Heritage Foundation, 1979).

It emerged last week that the average asking price for a property in the UK had risen above £250,000. Superficially this sounds like good news for home-owners. In reality, the only benefit goes to government, which enjoys a higher tax take from stamp duty at 3% as opposed to the 1% rate that applies to property purchases below the £250K level – assuming people can be coerced into wanting to move. Unless home-owners are down-sizing, they merely have to pay more for the houses into which they move. And higher house prices make life just that little bit more miserable for a younger generation already plagued by the rising cost of education, the likely burden of student debt, and an increasingly competitive jobs market. And anyone trying to join the long-standing cult that is British property ownership has reason to be wary of the government’s latest attempt to inflate the property bubble by encouraging reckless credit provision via the 5% deposit ‘help to buy’ scheme. It’s almost as if the financial-crisis-triggered-by-a-bursting-property- bubble never happened.

As Schuettinger and Butler point out in their history of wage and price controls, government- provoked inflation is nothing new. The Roman Emperor Nero (AD 54-68) responded to growing economic problems by devaluing the currency. The devaluation started relatively modestly but accelerated under Marcus Aurelius (AD 161-180) when the weights of coins were reduced. “These manipulations were the probable cause of a rise in prices,” wrote Levy. The Emperor Commodus (AD 180-192) turned to price controls and decreed a series of maximum prices, but things deteriorated and the rise in prices became “headlong” under the Emperor Caracalla (AD 211-217).

Egypt was the imperial province most severely affected. During the fourth century, the value of the gold solidus changed from 4,000 to 180 million Egyptian drachmai. Levy also attributes the grotesque rise in prices which followed to the increase of the amount of money in circulation. The price of the same measure of wheat in Egypt rose from 6 drachmai in the first century to 200 in the third century; in AD 314, the price rose to 9,000 drachmai and in AD 334 to 78,000. Shortly after AD 344 the price had reached more than 2 million drachmai. Other provinces endured similar inflations. Levy wrote:

In monetary affairs, ineffectual regulations were decreed to combat Gresham’s Law [bad money drives out good] and domestic speculation in the different kinds of money. It was forbidden to buy or sell coins: they had to be used for payment only. It was even forbidden to hoard them ! It was forbidden to melt them down (to extract the small amount of silver alloyed with the bronze). The punishment for all these offences was death. Controls were set up along roads and at ports, where the police searched traders and travellers. Of course, all these efforts were to no purpose.

Perhaps the most notorious attempt to control wages and prices took place under the Emperor Diocletian. Commodity prices and wages reached “unprecedented heights” shortly after he assumed the throne in AD 284. The Empire’s economic troubles have been attributed to a vast increase in the armed forces (to repel invasions by barbarian tribes); to a huge building programme of questionable value; to the consequent raising of taxes and the employment of ever more government officials; and to the use of forced labour to accomplish much of Diocletian’s public works programme. (Thank goodness the current UK government isn’t intent on squandering over £40 billion it doesn’t actually have on a high speed rail link of dubious utility.)

Diocletian, on the other hand, attributed the inflation entirely to the “avarice” of merchants and speculators. Some things truly never change.

What is undeniable is that as taxes rose, the tax base shrank, and it became increasingly difficult to collect taxes, resulting in a vicious circle. (Happily, the Liberal Democrats in coalition with the current government have a progressive attitude towards soaking the rich.)

Probably the single biggest cause of Diocletian’s inflation was his debasement of the coinage. In the early Empire, the standard Roman coin was the silver denarius. Its value had gradually been reduced in the years leading up to his reign as emperors issued tin-plated copper coins which still kept the name “denarius”. Under Gresham’s Law, silver and gold coins were hoarded and left circulation.

During the 50 years ending in AD 268, the silver content of the denarius fell to one five- thousandth of its original level. Trade was reduced to barter and economic activity stagnated. The middle class was almost obliterated. To overcome the baleful influence of his bureaucracy, Diocletian introduced a system of taxes based on payments in kind, which had the effect of destroying the freedom of the lower classes and tying them to the land. Then came currency reform, and the Edict on prices and wages. Historian Roland Kent:

Diocletian took the bull by the horns and issued a new denarius which was frankly of copper and made no pretence of being anything else; in doing this he established a new standard of value. The effect of this on prices needs no explanation; there was a readjustment upward, and very much upward.

Diocletian had the option of either inflating – minting increasingly worthless denarii, or to deflate – in the form of cutting government expenditures. He chose to inflate. He also chose to fix the prices of goods and services and suspend the freedom of the people to decide what the currency was actually worth. He fixed the maximum prices at which beef, grain, eggs and clothing could be sold, and the wages that workers could receive, and prescribed the death penalty for anyone who disposed of his wares at a higher figure.

Less than four years after the currency reform associated with the Edict, the price of gold in terms of the denarius had risen by 250%. By AD 305 the process of currency debasement began again. Levy:

State intervention and a crushing fiscal policy made the whole empire groan under the yoke; more than once, both poor men and rich prayed that the barbarians would deliver them from it. In AD 378, the Balkan miners went over en masse to the Visigoth invaders, and just prior to AD 500 the priest Salvian expressed the universal resignation to barbarian domination.

David Meiselman, in a foreword to ‘Forty centuries..’ writes as follows:

What, then, have price controls achieved in the recurrent struggle to restrain inflation and overcome shortages ? The historical record is a grimly uniform sequence of repeated failure. Indeed, there is not a single episode where price controls have worked to stop inflation or cure shortages. Instead of curbing inflation, price controls add other complications to the inflation disease, such as black markets and shortages that reflect the waste and misallocation of resources caused by the price controls themselves. Instead of eliminating shortages, price controls cause or worsen shortages. By giving producers and consumers the wrong signals because “low” prices to producers limit supply and “low” prices to consumers stimulate demand, price controls widen the gap between supply and demand.

Despite the clear lessons of history, many governments and public officials still hold the erroneous belief that price controls can and do control inflation. They thereby pursue monetary and fiscal policies that cause inflation, convinced that the inevitable cannot happen. When the inevitable does happen, public policy fails and hopes are dashed. Blunders mount, and faith in governments and government officials whose policies caused the mess declines. Political and economic freedoms are impaired and general civility suffers.

The chart below, courtesy of Church House, shows the history of the most important price in the UK economy – the price of money, as set by the central bank (as opposed to the market):

Screen Shot 2014-02-25 at 09.21.31

The chart below, courtesy of the St Louis Federal Reserve and Incrementum AG, shows the expansion of the US monetary base since 1918; the three separate iterations of QE are marked:

Screen Shot 2014-02-25 at 09.22.40

Some thoughts:

  • The (government-sanctioned) price of money hasn’t been this low in 300 years.
  • The US monetary base has exploded. (We concede the role of private banks in money creation too, so we watch the velocity of money carefully.)
  • As Robert Louis Stevenson once said, “Sooner or later everyone sits down to a banquet of consequences.”
  • We hold gold.

This article was previously published at The price of everything.


Animal spirits deflating

“The Fed insists on saving us from ‘everyday low prices’ – they call it deflation. I submit that in a world of technological wonder, prices ought to be weakening: it costs less to buy things because it costs less to make them. This benign tendency the Fed resists at every turn. It wants the price level (as it defines it) to rise by two percent a year, plus or minus. In so doing, it creates redundant credit that finds its way into other things. These excess dollars do mischief. On Wall Street we call this mischief a bull market and we’re generally all in favour of it..

“The Fed, in substance if not in name, is [still] engaged in a massive experiment in price control. (They don’t call it that.) But they fix the Fed Funds rate, they manipulate the yield curve.. they talk up the stock market. They have their fingers and their thumbs on the scale of finance. To change the metaphor, we all live to a degree in a valuation ‘hall of mirrors’. Who knows what value is when the Fed fixes the determining interest rate at zero? So I said “experiment in price control” but there is no real suspense about how price control turns out. It turns out, invariably, badly.”

- James Grant, recently interviewed on CNBC.

Consider the following table. It comes by way of iShares by Blackrock (not a fragrance), via Barry Ritholtz and Absolute Return Partners. It shows the recommended positioning of Wall Street’s finest with regard to bond markets and equities. (This exercise may well show that when everyone is thinking the same, nobody is really thinking at all.)

Screen Shot 2014-02-11 at 09.26.27

As far as the sell side was concerned, brash individualism and bold contrarianism died some time during 2013. By the start of 2014, all that remained on Wall Street was the hive mind of the Borg – a rather bland consensus that bonds were bad and equities were good. Astonishing that stockbrokers might possibly nurse such bias. So January’s primary trends (bonds rallying, and equities tanking), if sustained, may serve to remind us all that unsolicited sell side research, being to all intents and purposes free, is worth precisely what folk pay for it.

If the last investor is already loaded up to the gills on stocks, where is the greater fool to whom those stocks can then be sold? January may have given us an answer. Pimco’s Bill Gross comes to a similar conclusion in his latest investment outlook, from which the following is taken: “careful.” Bull markets are either caused by or accompanied by credit expansion. With credit growth slowing due in part to lower government deficits, and QE now tapering which will slow velocity, the U.S. and other similarly credit-based economies may find that future growth is not as robust as the IMF and other model-driven forecasters might assume. Perhaps the whisper word of “deflation” at Davos these past few weeks was a reflection of that. If so, high quality bonds will continue to be well bid and risk assets may lose some lustre.

Astonishing, too, that the world’s largest bond manager might possibly nurse such bias in favour of “high quality bonds”. Especially when they’re not (high quality, that is) – there just happen to be oodles of them. But the fact remains that investors seem to have been spooked by the final arrival of Fed tapering, and those in emerging markets doubly so. But since we’re all trapped in what James Grant calls that valuation ‘hall of mirrors’, courtesy of central banks endlessly tinkering with asset prices via the most aggressive monetary stimulus in world history, it’s not remotely easy trying to foresee the outlook for either bonds, or stocks, or anything else. Rather than just abandon the field and sit disgruntled on the sidelines in cash, our response is to seek solace in the most compelling examples of deep value we can find, both in the credit market and in stocks.

Tim Lee of Pi Economics also sees evidence of a growing deflation shock. His chart below shows that a proxy for global broad money growth (a simple weighted average of money growth rates for the US, the Eurozone, the UK and Japan) peaked in 2011 and now appears to be rolling over.

Screen Shot 2014-02-11 at 09.26.43

Tim now expects major equity markets to continue to decline as the crisis in the ‘Fragile Five’ economies accelerates. “At some stage the dollar will then begin to appreciate more broadly and Eurozone yield spreads will begin to blow out. Treasury yields will, of course, continue to decline.” If this comes to pass, Wall Street will have managed to get its asset allocation advice for 2014 precisely wrong on both counts. Developed equities will fall, while fixed income (notably US Treasuries) will rally further.

Macro hypothesizing is all very well, but it at least partly assumes that the hypothesizer is benchmarked and in our case, we’re not. We don’t currently have significant exposure to developed world equities since we see much more compelling value (in classic Graham & Dodd terms) in certain pockets of the Asian markets. And we currently have no exposure to US Treasuries because we can access higher real yields with objectively superior credit quality elsewhere. That is, of course, a raging anomaly, but we never said markets were entirely or even necessarily remotely rational.

We always thought that markets (in both the debt and equity spheres) were overly complacent about the risks associated with Fed tapering. Last year, for example, the Fed printed and bought $500 billion-worth of US Treasuries – and the Treasury market still went down. The idea that the Treasury market would shrug off the determined departure of its biggest buyer in 2014 always seemed nonsensical. Now, however, there is increasing reason to fear deflationary forces at work throughout most of the developed markets other than Japan, so the price dynamic for Treasuries has changed markedly. Similarly for developed world equities, where the gyrations of January indicate – to us – a market that is coming to the slow realisation that it has already stepped over the cliff edge. Unfortunately many investors, with central banks having slashed deposit rates to de minimis levels, have gone ‘all-in’ with regard to risk assets in the desperate pursuit of yield. Be careful what you wish for. It is quite clear that central banks will do literally anything within their power to attempt to avert deflation – to ensure that “it cannot happen here”. That does not mean they will succeed – but they may end up destroying fiat currencies in the process (one of the reasons we have consistently held gold).

Tim Lee believes it is “quite obvious” what the Fed will ultimately do:

They will expand their balance sheet dramatically further by doing QE in outright risk assets – junk debt, equities, etc. They will swap money for risk assets, not money for safe assets.

The problem is that this would be a very big step; a further violation of the ‘rules’ of central banking. And we have a new Fed chairman, who has only just taken office. It is likely that things will have to get very bad before that very big step can be taken.

Six years into this crisis, and in the words of Lily Tomlin, things are going to get a lot worse before they get worse. From our perspective as asset managers, it comes down to a simple mantra: continually question precisely what you own, and why you own it.

This article was previously published at The price of everything.