“We have the best government that money can buy.” – Mark Twain.
It says a lot about the financial establishment that the most revelatory coverage of the worst financial crisis in living memory has appeared, not in the pages of ‘The Financial Times’ or ‘The Wall Street Journal’, but in those of ‘Vanity Fair’ and ‘Rolling Stone’. In the first example, former bond salesman Michael Lewis displayed the finest characteristics of investigative journalism whilst exploring the more ridiculous examples of modern greed and credit-based insanity in forensic detail. In the second, Matt Taibbi broke new ground in gonzo journalism as he tilted against the previously impregnable windmills of Wall Street, giving us in the process the immortal description of the taxpayer-rescued brokerage firm Goldman Sachs as “a giant vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”. In the latest iteration of serious economic and cultural analysis arising from a non-mainstream source, we now have ‘Life After The State’ – a critique of government written by a stand-up comedian.
In Dominic Frisby’s defence, he wears multiple hats. As his Twitter profile puts it, he is an “Accidental financial bod, MoneyWeek writer, comedian, actor of unrecognized genius, voice of many things, & presenter.” And now an author. Published by the crowd-funding website Unbound, ‘Life After The State’ follows hot on the heels of Douglas Carswell’s ‘The End Of Politics’ and Guy Fraser-Sampson’s ‘The Mess We’re In’, and each attempts to address a nagging feeling from a slightly different perspective. That feeling was well expressed recently by the outspoken investor Paul Singer of Elliott Management when he remarked, almost in passing, that
America is deeply insolvent, and for that matter, so are most of continental Europe, the UK and Japan.
Or to put it another way, what the hell just happened, and why ?
The answer, and the beast that has to be slaughtered for any hope of progress and recovery, is Big Government. Many readers will doubtless respond that any retrenchment by an over-mighty State is simply wishful thinking. Some of us might respond in turn that it is actually a mathematical certainty. But Dominic, early on, spikes the guns of scepticism by citing the anonymous internet poster known as ‘Injin’:
Find the right answer, realise you’ll never see it in your lifetime, and then advocate it anyway, because it’s the right answer.
Frédéric Bastiat’s broken window fallacy also gets an early airing, which is entirely justifiable – it’s one of the most powerful ideas in the history of economics. We can ‘see’ what in the economy gets spent (by Big Government, having raided our wallets first, or worse, the wallets of those as yet unborn), but we cannot ‘see’ how that money might have been spent in the absence of Big Government. And there are only four ways of spending money. We can spend our money on ourselves. Which is nice. Or we can spend it on other people. Which is quite nice. We can spend other people’s money on ourselves (generally illegal). Or we can spend other people’s money on other people, which is what government actually does, and which tends to lead to malinvestment, waste, zombie banking, and so on. Happily, although there’s no shortage of economics in ‘Life After The State’, it’s all painlessly incorporated into the general argument, which makes for a highly readable and engaging book.
Another powerful idea arises in Chapter 8, and it’s a killer – quite literally. If governments had been separated from their monopoly control to print money, World War I would have been over by Christmas 1914.
Neither the British nor the German governments had the money, or gold, to pay for it. Both came off the gold standard and printed the money they needed. Had either government not had the power to print money or create debt – i.e. if they did not have control of money – the war would have had to stop.. Think about the implications.. German reparations.. Weimar hyperinflation.. the rise of Hitler..
And the same holds for almost all wars.
No war has ever been fought on a cash basis. Costs are concealed by deficit spending. If taxes had to rise concomitantly in the same year that wars were being fought, people would not pay. Instead, the cost is added to the national debt. People don’t have to pay £10 billion this year; instead they pay an extra £500 million every single year for eternity in interest on the national debt. Take away this power to create money and run deficits, and you suddenly limit the scope of the war to the amount of money the government has. In other words you limit government power – and you limit the damage that they can do. That alone is reason enough to separate money and state.
‘Life After The State’ is particularly good as a primer on gold, sound money and inflation. The anecdotal always helps, for context.
But the price of oil in US dollars has gone from $3.50 a barrel in 1972 to around $100 now. That’s something like a.. 96% loss in purchasing power. The same goes for all modern government currencies, which buy you less and less each year: less house, less chocolate bar, less anything. In 1971 I could have taken my son to the FA Cup Final for £2 (now over £100). The Mars bar I bought him at half-time would have been 2p (now 60p). The beer I bought myself would have been 11p (now £5 a pint at Wembley). The gallon of petrol I needed to get me there and back would have been 33p (now £7). And the house we went home to would have been something like 40 times cheaper.
The State is so entrenched in our lives it is sometimes difficult to imagine life without it. It “looks after the birth of the baby, educates the child, employs the man, cares for the aged, and buries the dead.” But in doing so it also spends £700 insuring each birth against negligence claims; while it educates the child, there can be no guarantee that it does so well – no matter, the examination pass rates, like the currency, can easily be inflated; the man may be employed, but not gainfully so..
On Thursday last week, the newspaper of the neo-Keynesian financial establishment, ‘The Financial Times’ had room for three stories on its front page. One of them covered the resignation of Barclays’ head of compliance, Sir Hector Sants, on the grounds of stress and exhaustion (cue mass playing by an orchestra of the world’s smallest violins). Sir Hector was previously chief executive of the Financial Services Authority, an arm of Big Government – in other words, not a particularly successful one, if current financial scandals and the health of the banking system are any guide. Another detailed how a Prime Minister evidently deeply committed to free markets was pressing mobile phone companies to cut their bills to customers. If David Cameron were really serious about inflation, though, he would be advised to pay closer attention to what Mark Carney has been up to at the Bank of England. The FT’s main story, ‘Rate rise signalled for 2014 as UK recovery takes hold’, was accompanied by a photograph of Mr. Carney looking for all the world like an evil little elf (for all we know, perhaps he is one).
Apparently the Bank of England is now considering a UK rate hike as soon as next year, and 18 months sooner than previously expected by the market. One wonders what all those first-time buyers lured into buying property by the government, the Bank of England and their easy money policies, might make of that.
This article was previously published at The price of everything.
“No warning can save people determined to grow suddenly rich.” – Lord Overstone.
We have seen a confluence of events that suggests we may be reaching the terminal point of the financial markets merry-go-round – that point just before the ride stops suddenly and unexpectedly and the passengers are thrown from their seats. Having waited with increasing concern to see what might transpire from the gridlocked US political system, the market was rewarded with a few more months’ grace before the next agonising debate about raising the US debt ceiling. There was widespread relief, if not outright jubilation. Stock markets rose, in some cases to all-time highs. But let there be no misunderstanding on this point: the US administration is hopelessly bankrupt. (As are those of the UK, most of western Europe, and Japan.)
The market preferred to sit tight on the ride, for the time being. Three professors were awarded what was widely misreported as ‘the Nobel prize in economics’ for mutually contradictory research. What they actually received was the ‘Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel’, which is not quite the same thing. But then economics is not a science, and Eugene Fama’s ‘efficient market hypothesis’ is not just empirically wrong, but dangerously so. History, it would seem, is clearing the decks. Perhaps the most intriguing development of the week was the news that Neil Woodford would soon be retiring from his role managing £33 billion of other people’s money at Invesco Perpetual to start up his own business. It was widely reported that Mr. Woodford nursed growing frustration at the short-termism of the financial services industry. We will return to this theme.
One of the sadder stories in the history of investment management is that of Mr. Tony Dye. The following extract is taken from his obituary in The Independent:
Tony Dye was one of Britain’s best known fund managers, becoming a household name in the late 1990s due to his controversial opinions about the outlook for global stock markets. At a time when markets were soaring, Dye insisted they were overvalued and on the verge of a crash – a view which put him at odds with most other investors at the time and earned him the nickname “Dr Doom”.
As early as 1995, as the FTSE 100 was approaching 4,000 points, Dye began to make the case that markets were too expensive. At the time, he was the chief investment officer for Phillips & Drew, one of Britain’s biggest asset management firms, and by 1996 he had begun to move large sums of clients’ money out of equities and into cash.
In the years that followed, however, stock markets continued to soar, driven by the technology boom. But Dye stuck to his guns, avoiding the high-growth, high-risk internet stocks, maintaining large positions in cash, and consequently ensuring that Phillips & Drew’s funds significantly underperformed their rivals. By 1999, the firm was ranked 66th out of 67 for performance amongst Britain’s institutional fund managers, and was haemorrhaging clients – and in February the following year, just weeks after the FTSE had broken through 7,000 points for the first time, Dye was sacked.
Days later, his prophesy finally came true. Markets collapsed, and settled into a three year slump, which saw more than 50 per cent wiped off the value of global stock markets.
Neil Woodford’s apparent concerns are well placed. There is a grotesque mismatch between the set-up of institutional asset managers and what is in the best interests of their end clients, the individual members of the public who pay their fees. The investment fund marketplace is grotesquely oversupplied. There is far too much, to use the dismal phrase, product. The problem is exacerbated by perhaps inevitable weaknesses in psychology – both on the part of the manager, and on the part of the investor. Stress points abound throughout the chain. The investment fund world is hopelessly balkanised, and brimming over with a degree of product specialisation utterly unwarranted by investors’ real needs. The fund management industry is a perpetual production line of novelty, or rather an endless rehash of the same old ideas. The point of absurdity was reached and surpassed when there were more mutual funds listed on the New York Stock Exchange than there were common stocks with which to populate them. The industry is a monstrous hydra, busily consuming its own, and its investors’, capital. New funds are launched daily. Failing older funds are quietly tidied away, merged, or destroyed. They are ‘uninvented’.
Alison Smith and Stephen Foley covered the news of Neil Woodford’s resignation for the Financial Times. They cited the FT’s own John Kay, who carried out a review of UK equity markets last year, and who said,
The short-term horizon is basically introduced by the intermediary sector.. Pension trustees [for example] are told they should keep reviewing managers, while retail investors get constant invitations to trade from independent financial advisers [for example] and the platforms set up to enable them to do so.
As they suggest, Neil Woodford’s past success means that raising money for his new business is unlikely to be much of a struggle. “But imagine the hurdles in the way of a manager who would like to purse long-term strategies but is just starting out.” In the words of Professor Kay,
How easy would Warren Buffett find it to set up now?
We have not been immune to the demands of clients frustrated at the performance of diversified portfolios lagging the broader equity markets (although this explicit benchmarking against stocks was never a mandate to which we subscribed). We struggle, in some cases, to make sufficiently clear our concerns about broader market valuation, or just as importantly the gravity of the global financial situation (including a potential QE-driven currency crisis), which makes a wholehearted commitment to the stock market in late 2013 seem to us a risky strategy. So where, if anywhere, does the fault lie? Sometimes it is not just asset managers who should be accused of being short-termist, or of missing the big picture.
Our thesis has been consistent for five years now. We believe we are at the tail end of a 40-years’ and counting experiment in money and the constant expansion of credit. This experiment is not ending well. Because government money, unbacked and unchecked as it now is by anything of tangible value, can be created at will, it has been. What is extraordinary is that despite trillions of dollars / pounds / yen of stimulus, there are few visible signs of what we would call inflation, in anything other than the prices of financial assets themselves.
We are living through a historic period of global currency debasement. The neo-Keynesian money-printers who dominate the world’s central banks have ‘won’ the debate, but are now scratching their heads, looking in vain for the economic recovery that they were expecting all those trillions to have bought. They will continue to look in vain, because money creation and true wealth creation are polar opposites. As portfolio manager Tony Deden has asked,
If cheaper currency is the source of wealth, where has Bangladesh gone wrong? If cheaper money means economic prosperity, why not just print as much as we can and give it out to everyone? We have become fools. The customers know nothing and the advisers know even less. And then we have the idiot economists – the neo-classical Keynesian variety with solutions to problems they did not even anticipate; solutions that have, in fact, been long discredited. And so we lurch from crisis to crisis, eating our meagre capital in the hopes of becoming rich in money. It is a pity.
Those words were written four years ago. The printing presses have been run to exhaustion ever since. So far they have bought us an inflationary rally in the prices of financial assets, and not much else. It has been a lousy time for anyone focused on the disciplined and genuinely diversified pursuit of capital preservation in real terms (more recently, for anyone seeking to escape the inflationary insanity via the honest money that is gold). We have not, to any significant extent, participated in the ‘phony rally’. But then we are playing a longer game than most of our peers. Round and round and round she goes; where she stops, nobody knows. Fund manager Sebastian Lyon recently quoted another celebrated fund manager, Jean-Marie Eveillard:
I would rather lose half of my shareholders than half of my shareholders’ money.
This article was previously published at The price of everything.
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼Its philosophical underpinnings, however, were not solely a desire to get rich quick but, according to the FBI complaint published on Wednesday after the site was shut down, “Austrian economic theory” and the works of Ludwig von Mises and Murray Rothbard, economists closely associated with the Mises Institute, in the US state of Alabama.”
- More obnoxious anti-Austrian School slurs from the Financial Times, on this occasion by John Aglionby and Tracy Alloway.
The Daily Mail no longer has a monopoly on libelling the dead: the Financial Times is also doing a pretty good job. John Aglionby’s story this week (‘Libertarian economics underpinned Silk Road Bitcoin drug website’) was, even by the standards of a paper coloured pink that should really be coloured yellow, an extraordinary piece of character assassination. You do not have to be a believer in Austrian business cycle theory to find the linkage between an apparently criminal website and two widely respected economic theorists to be utterly objectionable. Those FT readers who were moved to respond on the paper’s website tended to think similarly:
“the lowest of lows..”
“FT trying to discredit Ludwig von Mises, the Austrian business cycle theory and Bitcoins all in one go.. for god’s sake, you do not have any decency left..”
“childish, glib and misleading.. a new low for the FT.. Disgusting, to say the least”
“Another shining example of the death of journalism”
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼￼“Sorry to say, but you all seem to fail to understand that the FT is making a heroic attempt to switch from factual financial reporting to a top position in entertainment of the masses. Don’t you think they are doing well? I most certainly do.”
That the Austrian business cycle theory should be held in such low esteem by such a prominent financial journal might be taken as an admission of guilt for not having noticed the credit bubble while it was inflating, and for then having continually defended the (neo-Keynesian) establishment line rather than debate the practical value of any alternative policy course.
In Austrian business cycle theory, the central bank is the culprit responsible for every boom and bust, firstly in fuelling excessive bank credit growth and maintaining interest rates at overly stimulative lows; then in prolonging the inevitable recession by propping up asset prices, bailing out insolvent banks, and attempting to stimulate the economy via the mechanism of deficit spending. It is difficult to see why the theory is so problematic given that the US Federal Reserve, for example, is not an agency of the US government per se but rather a private banking cartel. When push comes to shove, whose interests will the Fed ultimately protect – those of the banks, or those of the rest of the productive population?
But in any discussion of the ‘long emergency’ enduring throughout the insolvent West, the role of politicians should not be ignored. If politicians had moderated their tendencies to make unaffordable promises to their electorates, western fiscal disasters and the attendant debt mountains would now be less dramatic. And if politicians were not slaves to the electoral calendar, it is fair to assume that difficult choices might even have been taken in the long term interests of their respective economies.
The current gridlock in the US political system (first over the shutdown and latterly over the debt ceiling) is a perfect example of grandstanding politicians abdicating all responsibility for the electorate they claim to serve. And as a glaring example of cognitive dissonance, Treasury bond investors’ responses to fears over a looming default really do take some beating. That beating should, of course, be reserved for investors stupid enough to believe that debt issued by the world’s largest debtor country should be somehow treated as risk-free, especially when the possibility of formal default is only a matter of days away.
Treasury bond defenders will no doubt point out that in a fiat currency world where the central bank has the freedom to print ex nihilo money to its heart’s content, the very idea of default is absurd. But that is to confuse nominal returns with real ones. Yes, the Fed can expand its balance sheet indefinitely beyond the $3 trillion they have already conjured out of nowhere. The world need not fear a shortage of dollars. But in real terms, that’s precisely the point. The Fed can control the supply of dollars, but it cannot control their value on the foreign exchanges. The only reason that US QE hasn’t led to a dramatic erosion in the value of the dollar is that every other major economic bloc is up to the same tricks. This makes the rational analysis of international investments virtually impossible. It is also why we own gold – because it is a currency that cannot be printed by the Fed or anybody else.
On the topic of gold, the indefatigable Ronni Stoeferle of Incrementum in Liechtenstein has published his latest magisterial gold chartbook. (FT: if you’re reading, Ronni is an Austrian, so you’ll probably want to start the character assassinating now.) Set against the correction in the gold price 1974-1976, the current sell-off (September 2011 – ?) is nothing new. The question is really whether our financial (and in particular debt) circumstances today are better than they were in the 1970s. We would merely suggest that they are objectively worse.
Trying to establish a fair price for gold is obviously difficult, but treating it as a commodity like any other suggests that the current sell-off is not markedly different from any previous correction during its bull run:
To cut to the chase, it makes sense to own gold because currencies are being printed to destruction; the long term downtrend in paper money (as expressed in terms of gold) remains absolutely intact:
And we cannot discuss the merits of gold as money insurance over the medium term without acknowledging the scale of the problem in (US) government debt:
Whatever happens in the absurd and increasingly dangerous debate over raising the US debt ceiling, the fundamental problem remains throughout the western economic system. Governments have lived beyond their means for decades and must tighten their belts. Taxes are certain to rise, and welfare systems certain to contract. Even if western governments manage to rein in their morbidly obese consumption patterns without a disorderly market crisis, their legacy will be felt by generations yet to come. The debt mountain cannot and will not resolve itself. (Why, again, we own gold; because we think there is a non-trivial chance of a gigantic financial system reset.) The piper must, at some point, be paid. Western economic policy can be distilled down into just four words: the unborn cannot vote.
This article was previously published at The price of everything.
“This took guts.”
- Comment by Steven Ricchiuto of Mizuho Securities in response to the Federal Reserve’s surprise decision to refrain from “tapering” its $85 billion monthly bond purchase programme, as reported by the Financial Times, 19 September.
Human beings are suckers for a story. The story peddled by mainstream economic commentators goes that the US Federal Reserve and its international cousins have acted boldly to prevent a second Great Depression by stepping in to support the banks (and not coincidentally the government bond markets) by printing trillions of dollars of ex nihilo money which, through the mechanism of quantitative easing, will mysteriously reflate the economy. It’s a story alright, but more akin to a fairy story. We favour an alternative narrative, namely that with politicians abdicating all real responsibility in addressing the financial and economic crisis (see this article), the heavy lifting has been left to central bankers, who have run out of conventional policy options and are now stoking the fire for the next financial crisis by attempting to rig prices throughout the financial system, notably in property markets, but having a grave impact on volatility across credit markets, government bond markets, equities, commodities.. As politicians might have told either them, or Steven Ricchiuto of Mizuho Securities, it’s quite easy to be brave when you’re spending other people’s money.
Before we get back to the Fed, it’s worth a minute recapping why it was created, namely as a private banking cartel with a monopoly over the country’s financial resources and the facility to shift losses when they occur to the taxpayers. Satire goes a long way here (not least because the reality is so depressing) – here is Punch’s take on the banks from April 1957*:
Q: What are banks for?
A: To make money.
Q: For the customers?
A: For the banks.
Q: Why doesn’t bank advertising mention this ?
A: It wouldn’t be in good taste. But it is mentioned by implication in references to reserves of $249,000,000 or thereabouts. That is the money they have made.
Q: Out of the customers?
A: I suppose so.
Q: They also mention Assets of $500,000,000 or thereabouts. Have they made that too ? A: Not exactly. That is the money they use to make money.
Q: I see. And they keep it in a safe somewhere?
A: Not at all. They lend it to customers.
Q: Then they haven’t got it?
Q: Then how is it Assets?
A: They maintain that it would be if they got it back.
Q: But they must have some money in a safe somewhere?
A: Yes, usually $500,000,000 or thereabouts. This is called Liabilities.
Q: But if they’ve got it, how can they be liable for it?
A: Because it isn’t theirs.
Q: Then why do they have it?
A: It has been lent to them by customers.
Q: You mean customers lend banks money?
A: In effect. They put money into their accounts, so it is really lent to the banks.
Q: And what do the banks do with it?
A: Lend it to other customers.
Q: But you said that money they lent to other people was Assets?
Q: Then Assets and Liabilities must be the same thing.
A: You can’t really say that.
Q: But you’ve just said it. If I put $100 into my account the bank is liable to have to pay it back, so it’s Liabilities. But they go and lend it to someone else, and he is liable to pay it back, so it’s Assets. It’s the same $100, isn’t it?
A: Yes, but..
Q: Then it cancels out. It means, doesn’t it, that banks don’t really have any money at all?
Q: Never mind theoretically. And if they haven’t any money, where do they get their Reserves of $249,000,000 or thereabouts?
A: I told you. That is the money they’ve made.
A: Well, when they lend your $100 to someone they charge him interest.
Q: How much?
A: It depends on the Bank rate. Say five and a half percent. That’s their profit.
Q: Why isn’t it my profit ? Isn’t it my money ?
A: It’s the theory of banking practice that..
Q: When I lend them my $100 why don’t I charge them interest?
A: You do.
Q: You don’t say. How much?
A: It depends on the Bank rate. Say half a percent.
Q: Grasping of me, rather?
A: But that’s only if you’re not going to draw the money out again.
Q: But of course I’m going to draw it out again. If I hadn’t wanted to draw it out again I could have buried it in the garden, couldn’t I ?
A: They wouldn’t like you to draw it out again.
Q: Why not? If I keep it there you say it’s a Liability. Wouldn’t they be glad if I reduced their Liabilities by removing it?
A: No. Because if you remove it they can’t lend it to anyone else.
Q: But if I wanted to remove it they’d have to let me?
Q: But suppose they’ve already lent it to another customer?
A: Then they’ll let you have someone else’s money.
Q: But suppose he wants his too.. and they’ve let me have it?
A: You’re being purposely obtuse.
Q: I think I’m being acute. What if everyone wanted their money at once?
A: It’s the theory of banking practice that they never would.
Q: So what banks bank on is not having to meet their commitments?
A: I wouldn’t say that.
Q: Naturally. Well, if there’s nothing else you think you can tell me..
A: Quite so. Now you can go off and open a banking account.
Q: Just one last question.
A: Of course.
Q: Wouldn’t I do better to go off and open up a bank?
*Cited in G. Edward Griffin’s history of the Fed, ‘The Creature From Jekyll Island’.
If only. In defending an insolvent banking system, central banks have now created a more absurd situation than Punch could ever have dreamed of. This commentator, for example, has a meaningful cash deposit with a UK commercial bank that is currently earning 0.0% interest (let’s say minus 3% in real terms). To put it another way, we have 100% counterparty and credit risk with a minus 3% annual return. Is it any wonder the UK savings rate is not higher ? Is it any wonder that savers are stampeding into risk assets ? But the likes of the Fed have muddied the pond further by attempting a policy of “forward guidance” that is little more than a sick joke, given the recent sell-off in government bond markets and the resultant rise in government bond yields, on fears of “tapering”. The Fed has lost control of the bond market. As Swiss investor Marc Faber puts it,
The question is when will it lose control of the stock market.
For several years we have been warning of the dangers of central banks becoming increasingly interventionist in the capital markets. We are old school free market libertarians: if bankers make bad decisions, let their banks fail. This is essentially the same perspective taken by Michael Lewis, recently interviewed in Bloomberg Businessweek. On the fifth anniversary of its bankruptcy, Lewis was asked whether he thought Lehman Brothers had been unfairly singled out when it was allowed to fail (given that every other investment bank was quickly rescued, courtesy of the US taxpayer). His response:
Lehman Brothers was the only one that experienced justice. They should’ve all been left to the mercy of the marketplace. I don’t feel, oh, how sad that Lehman went down. I feel, how sad that Goldman Sachs and Morgan Stanley didn’t follow. I would’ve liked to have seen the crisis play itself out more. The problem is, we would’ve all paid the price. It’s a close call, but I think the long-term effects would’ve been better.
But that is not what happened. We didn’t get runs on investment banks. We got bank bailouts, taxpayer rescues, QE1, QE2, QE3 and now QE-Infinity. The impact on the real economy has been questionable, to say the least:
But the impact on financial markets has been demonstrably beneficial to investment banks and their largest clients.
As Stanley Druckenmiller points out, the Fed didn’t act bravely, they bottled it. They had the opportunity to start, ever so gently, to reverse a policy of monstrous intervention in the capital markets, and they blew it. That makes it all the harder for them to “taper” next time round. When do capital markets free themselves from the baleful manipulation of the state? Marc Faber was similarly unimpressed:
The endgame is a total collapse, but from a higher diving board. The Fed will continue to print and if the stock market goes down 10% they will print even more. And they don’t know anything else to do. And quite frankly, they have boxed themselves into a corner where they are now kind of desperate.
The Fed may be desperate, but we’re not. We have our client assets carefully corralled into four separate asset classes. High quality debt (not US Treasuries or UK Gilts) offers income and a degree of capital protection given that the central banks have demolished deposit rates. Defensive equities give us some skin in the game given central bank bubble-blowing in the stock market – but this game ends in tears. Uncorrelated, systematic trend-followers give us a “market neutral” way of prospectively benefiting from any disorderly market panic. And real assets give us some major skin in the game in the event of an inflationary disaster. Since pretty much all of these assets can be marked to market on a daily basis, they are not free of volatility, but we are more concerned with avoiding the risk of permanent loss of capital, Cypriot bank-style. We have, in other words, Fed-proofed our portfolios to the best of our ability. And on the topic of gold alone, Marc Faber again:
I always buy gold and I own gold. I don’t even value it. I regard it as an insurance policy. I think responsible citizens should own gold, period.
Now that the Fed has blinked in the face of market resistance, it seems inevitable to us, as it does to people like Marc Faber, that at some point, possibly in the near future, traditional assets are at risk of loudly going bang. How close are you going to be to the explosion?
This article was previously published at The price of everything.
“Sir, Martin Sandbu writes: “We should not worry about inflation – if we strip out volatile or policy-driven elements, it stands at 1.5%, according to Citigroup”, (“Carney has not yet bent the markets to his will”, August 14.)
“Please arrange for Mr Sandbu to cancel the policies concerned and to prevent the volatile situations encountered. When was the last time inflation was 1.5% ? This comment is as meaningless as my saying: “If savings rates were 5%, then I could afford two more holidays a year.” They aren’t, and I can’t.”
- Letter to the editor of the Financial Times, from Mr Charles Kiddle, Gateshead, UK.
King Cnut The Great, more commonly known as Canute, was a king of Denmark, England, Norway and parts of Sweden (thanks Wikipedia !). He is likely to be known to any English schoolchildren still being educated for two specific things: extracting Danegeld – a form of protection racket – from the citizenry, and for the possibly apocryphal story that once, from the shoreline, he ordered back the sea. Over to Wikipedia:
Henry of Huntingdon, the 12th-century chronicler, tells how Cnut set his throne by the sea shore and commanded the tide to halt and not wet his feet and robes. Yet “continuing to rise as usual [the tide] dashed over his feet and legs without respect to his royal person. Then the king leapt backwards, saying: ‘Let all men know how empty and worthless is the power of kings, for there is none worthy of the name, but He whom heaven, earth, and sea obey by eternal laws.’ He then hung his gold crown on a crucifix and never wore it again “to the honour of God the almighty King”. This incident is usually misrepresented by popular commentators and politicians as an example of Cnut’s arrogance.
This story may be apocryphal. While the contemporary Encomium Emmae has no mention of it, it would seem that so pious a dedication might have been recorded there, since the same source gives an “eye-witness account of his lavish gifts to the monasteries and poor of St Omer when on the way to Rome, and of the tears and breast-beating which accompanied them”. Goscelin, writing later in the 11th century, instead has Cnut place his crown on a crucifix at Winchester one Easter, with no mention of the sea, and “with the explanation that the king of kings was more worthy of it than he”. Nevertheless, there may be a “basis of fact, in a planned act of piety” behind this story, and Henry of Huntingdon cites it as an example of the king’s “nobleness and greatness of mind.” Later historians repeated the story, most of them adjusting it to have Cnut more clearly aware that the tides would not obey him, and staging the scene to rebuke the flattery of his courtiers; and there are earlier Celtic parallels in stories of men who commanded the tides..
The encounter with the waves is said to have taken place at Thorn-eye (Thorn Island), or Southampton in Hampshire. There were and are numerous islands so named, including at Westminster and Bosham in West Sussex, both places closely associated with Cnut. According to the House of Commons Information Office, Cnut set up a royal palace during his reign on Thorney Island (later to become known as Westminster) as the area was sufficiently far away from the busy settlement to the east known as London. It is believed that, on this site, Cnut tried to command the tide of the river to prove to his courtiers that they were fools to think that he could command the waves. Conflictingly, a sign on Southampton city centre’s Canute Road reads, “Near this spot AD 1028 Canute reproved his courtiers”.
Cnut did exist, even if his mythologised battle with Nature was a fabrication. And for anyone who thinks that politicians are capable of learning from disastrous policy failures, the following lesson from history is also instructive. Explicitly linking economic policy and monetary policy rates to unemployment rates is not an innovation of either Ben Bernanke’s Fed or Mark Carney’s Bank of England. As Ferdinand Lips points out in his ‘Gold Wars’ (hat-tip to The Real Asset Company’s Will Bancroft):
With the passage of [the US Employment Act of 1946], the US government officially declared war on unemployment and promised to maintain full employment regardless of cost. Thus, it hoped to eliminate the business cycle and to prevent the country from ever sinking to the economic depths of the 1930s.
In the 1950s and the 1960s a weekly column in Barron’s called “The Trader” was written by a certain Mr. Nelson. Week after week, he untiringly drew readers’ attention to the consequences the Employment Act had on the purchasing power of the currency..
One would have thought that economic central planning would have been somewhat discredited after the Soviet empire collapsed in 1989, in favour of free markets. That message has yet to get to the US Federal Reserve or the Bank of England. But the Soviet experience is doubly instructive, in that it shows just how long a fatally dysfunctional system can last in the face of its obvious, existential, contradictions and absurdities.
Our thesis is that we are perilously close to the disorderly end-stage of a 40 year experiment in money and unfettered credit. That experiment started when US President Nixon took the US dollar off gold in 1971, and in the process created a global unbacked fiat currency system for the first time in world history. The history of paper currencies is instructive, too. Not one has ever lasted. Fast forward 40 years.. Texan fund manager Kyle Bass points out that total credit market debt now stands at some 360% of global GDP. For an individual country to maintain a debt to GDP ratio of 250% is consistent with that country deficit-spending its way through a war – such as was the position for the UK in 1945. For the entire world (read: notably the western world) to be loaded with such an untenable debt burden today suggests that something has gone catastrophically wrong with our banking and credit system.
We don’t know what the future holds but, crucially, our investment process does not explicitly require us to, and we have engineered it such that our process carries a degree of insurance against our own overconfidence as asset management fiduciaries. The market can be directed, coerced, bribed, manipulated, distorted and pummelled, but we don’t believe it can ever be completely destroyed – despite the best efforts of central bankers. There is early evidence that bond market vigilantes have had enough with QE and other desperate policy manoeuvrings, and are voting with their feet. If bond yields continue to rise, think very carefully about your exposure to market risk in all its other forms. We have, and are positioned accordingly.
In the current context, if Cnut did ever order back the tide, whether he did so to instruct his courtiers or to display his arrogance over the forces of nature is somewhat moot. The great physicist Richard Feynman made a similar admonition to NASA after the 1986 space shuttle disaster ending up killing seven crew members. In his infamous warning to a bureaucracy seemingly overtaken by ‘spin’, he said in his conclusion to the Challenger report,
For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.
For Feynman, and for Cnut, it was Nature. For us, it is the markets. Modern critics of the central banks, like ourselves, would suggest that we now have a modern equivalent of Cnut’s Danegeld, in the form of punitively low interest rates, rates which are being kept artificially low to try and resurrect a borderline insolvent banking system which is still content to pay significant executive bonuses and, in some instances, even dividends (to shareholders foolish enough to own common stock issued by banks whose fundamental value cannot be remotely assessed on any sensible economic basis). The economy, in other words, is being held hostage to cater to narrow and largely unreconstructed banking interests. At the same time, the farce of “forward guidance” – the pledge to keep interest rates unchanged until there is tangible evidence of economic recovery, almost irrespective of the latent inflationary pressure being stoked up – is being revealed as farce by Gilt yields that have risen by over 100 basis points since May (and the same holds for US Treasuries). Despite the king’s orders, in other words, the tide continues to come in.
A version of this article was previously published at The price of everything.
“This suspense is terrible. I hope it will last.”
- The Hon. Gwendolen Fairfax in ‘The Importance of Being Earnest’ by Oscar Wilde.
The failure of Lehman Brothers in September 2008 will forever be regarded by capital markets professionals as a JFK assassination-style moment, an occasion now set in amber that marked the moment when everything changed – or at least should have done. With the benefit of hindsight, it’s somewhat remarkable that the bankruptcy of a second tier investment bank better known for credit trading than for any facility with stock underwriting, for example, could trigger a global credit crunch. But it did. Andrew Ross Sorkin’s ‘Too Big To Fail’ – still probably the best example of financial crisis porn – masterfully explains why:
It was just past 7:00 a.m. on the morning of Saturday, September 13, 2008. Jamie Dimon, CEO of JP Morgan, went into his home library and dialled into a conference call with two dozen members of his management team.
“You are about to experience the most unbelievable week in America ever, and we have to prepare for the absolutely worst case,” Dimon told his staff.
“..Here’s the drill,” he continued. “We need to prepare right now for Lehman Brothers filing [for bankruptcy]. Then he paused. “And for Merrill Lynch filing.” He paused again. “And for AIG filing.” Another pause. “And for Morgan Stanley filing.” And after a final, even longer pause, he added: “And potentially for Goldman Sachs filing.”
There was a collective gasp on the phone.
As we now know, Lehman Brothers remained the only lamb to be sacrificed at the altar of the financial markets. The US administration quickly capitulated in the face of those markets. The other institutions were therefore rapidly forced into shotgun marriages, emergency capital- raisings, or bailed out by taxpayers, or mysteriously allowed to convert into commercial banks (a privilege never granted to Lehman Brothers, but somehow deemed appropriate for fellow brokerage firm Goldman Sachs). But in a parallel universe, with less supine taxpayers and altogether less biddable regulators, there would have been a domino-style failure by, and concomitant run on, the financial system.
A revisionist British political perspective now blames everything on pesky North American speculators. The chart below, for example, courtesy of Grant Williams, shows the extent to which a culture philosophically committed to living beyond its means has infected its host:
￼￼￼This conveniently ignores the run on Northern Rock from the previous year, or the bail-outs of the likes of Lloyds and RBS. That Barclays Bank, which only avoided taking the taxpayer’s shilling by resorting to capital-raising from the Middle East that is now subject to a criminal probe by the Serious Fraud Office, has been wrestling with a £12.8 billion capital “hole” and seemingly been less than transparent in its own capital reporting, would suggest that the UK banking system is not exactly as healthily restructured as it really should be, five years after the Lehman bankruptcy. James Ferguson of the MacroStrategy Partnership asks,
How many other banks, concerned that their leverage looks borderline, are similarly fudging their capital numbers? With so many banks only just on the right side of the regulatory minimum hurdle and incentivised to stay there, this is of paramount importance. Banks that are hiding the fact that they are below the regulatory minimum capital requirement are not merely technically insolvent but are unlikely, indeed unable, to address other balance sheet issues like forbearance on NPLs [non-performing loans] and hidden losses.
And it is not just Britain’s banks that are “wrestling” to right-size their capital and leverage ratios five years after the Lehman bankruptcy. The chart below, via Grant Williams and Zero Hedge, shows the problem of bank lending is just as serious in the beleaguered euro zone:
Deutsche Bank, for example, has just said that it intends to shrink its balance sheet by another €250 billion over the next two years to comply with stricter leverage rules. So here’s the bottom line. As far as we’re concerned, whether or not the western banking system is insolvent, it makes sense to behave, as an investor, as if it is – especially after the Bank of Cyprus confirmed that depositors with savings over the €100,000 “guaranteed” threshold will lose 47.5% of their money.
This commentary will deliberately not include any charts relating to market performance – because they would be meaningless, given the extent to which the financial markets have become mesmerised by promises, hopes or fears of further monetary largesse from their respective central banks. Instead, we restrict chart use to economic statistics (for better or worse). As the chart below shows, we can to all intents and purposes ignore what the FTSE 100 is saying about UK economic prospects (and we acknowledge that the FTSE is a poor barometer for purely domestic UK economic health given its international composition). Rather, we can simply acknowledge that this “recession” would appear to be more severe than the 1920s or 1930s Depressions, on the basis of duration to date and the lack of any obvious recovery (as opposed to QE-driven stock market string-pulling). If it is a recovery, it is one that economist Liam Halligan ￼calls “the most feeble in our history”.
In summary, we do not inhabit a remotely “normal” economy. We inhabit a recessionary slump ￼that our monetary authorities seem determined to perpetuate by any means possible. Now that they have driven monetary policy rates to zero, conventional policy no longer works, so we are faced with the prospect of further quantitative easing until the system collapses on itself. Given the inherent unattractiveness of bank deposits and pretty much any form of fiat currency in a world beset by competitive currency devaluation, we would much rather hold gold. Yes, its “value” in inconstant and ever-depreciating dollars is volatile, but as fund manager Tony Deden points out,
In ten years’ time, our gold bars will still be gold bars. In fifty years too. And in one hundred. In fact, our gold bars will still be gold bars in a thousand years from now, and will have roughly the same purchasing power. Therefore, gold has a property which is unique in comparison with everything else we know: the risk of a permanent loss of purchasing power is close to zero. This is worth reflecting on. It is a most powerful property and implies that the loss of purchasing power such as that [which gold holders have experienced] in the last quarter can only be temporary.
Once again, we do not inhabit a “normal” economy. We live in a financialised world in which our banks cannot be trusted, our politicians cannot be trusted, our money cannot be trusted, and – not least thanks to ongoing spasms of QE and expectations of much more of the same – our markets cannot be trusted. But we have to play the hand we’re dealt. So in addition to holding the monetary metals as a long term insurance against the loss of purchasing power consistent with holding paper money in a money-printing orgy, we also hold the highest quality bonds we can identify, and market neutral trend-following funds, alongside ultra-defensive equities with genuine secular growth potential (not least the Halley Asian Prosperity Fund, a classic Graham-and-Dodd deep value fund which focuses on Asian domestic consumption without the taint of exposure to western economies that have gone conclusively ex-growth).
At some point (though the timing is impossible to predict), asset markets that cannot be pumped artificially higher will start moving, under the forces of inevitable gravitation, lower. The possibility of a secular dual bear market in equities and bonds does not seem unrealistic. In such an environment, conventionally positioned portfolios (that are long stocks in line with an index, and long bonds in line with an index) will incur massive losses. Yes, the suspense is terrible, and as fiduciaries we are obligated to survive through it as best we can, by diversifying our clients’ capital as prudently as present conditions allow. But unlike for Wilde’s Gwendolen, for us the reckoning cannot come soon enough.
This article was previously published at The price of everything.
“No bubbles. Because it’s normal for large liquid asset classes to nearly double in value over less than a year and then drop 10% in a day.”
- Tweet from financial journalist Alen Mattich, 23 May 2013.
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
- Benjamin Graham and David Dodd, ‘Security Analysis’.
“No warning can save people determined to grow suddenly rich.”
- Lord Overstone
At the height of the financial crisis (i.e. 2008) it was easy to despise just the bankers for their serial and colossal ineptitude and rank hypocrisy. Now, five years into one of history’s most alarming bubbles, it’s easy to despise just about everyone in a position of financial or political authority, and for the same reasons. Take the FT front page from last Wednesday: “America’s corporate titans fight back”. With just a cursory look at the layout of the page, one could be forgiven for thinking that “America’s corporate titans” were somehow fighting against a common foe. But on closer reading it transpired that JP Morgan’s Jamie Dimon had merely succeeded in defending his own interests – as chairman and CEO of America’s most iconic bank – versus those of the people who notionally own his company, i.e. JP Morgan’s shareholders. Apple’s CEO, Tim Cook, on the other hand, was defending his company against the predations of some of America’s biggest crooks, a.k.a. the US government. “We pay all the taxes we owe,” said Mr Cook; “every single dollar. We not only comply with the laws but we comply with the spirit of the laws.” In sympathy with Mr Cook, the Republican senator Rand Paul added,
I’m offended by the spectacle of dragging in executives from an American company for doing nothing illegal. If anyone should be on trial here it should be Congress.
There was a similar atmosphere of populist corporate tax avoidance witch-hunt mania here in the UK, as Google’s executive chairman Eric Schmidt suggested that it was not for companies to decide what tax policies should be, but rather for duly elected governments. This prompted the FT’s political columnist Janan Ganesh to tweet, somewhat archly:
Eric Schmidt is sparing the time to teach C-list MPs who have never created or run anything the difference between law and morality. Impressed.
The ‘debate’ over corporate tax is really no such thing. Rather, it is a classic piece of misdirection by cynical governments whose own fiscal affairs are out of control. “As times change,” writes Erwin Grandinger in his devastating critique of Germany’s own stability as a sound sovereign entity, ‘Beyond Repair’, “so do the methods of sanction”:
In today’s Germany nobody has to fear for his life or fear ending up in a.. concentration camp. As is evident, a media-led or tax-based execution is quite sufficient. That is the subtle art of execution. The need to be seen to be acting and the creativity of the state when it comes to tax revenue issues lead to attempts to channel mass perception and to make the scandal personal. [This may be why the UK authorities started their tax avoidance pogrom against ￼high profile entertainers before attacking equally high profile corporations.] The strategy of the system is always to employ a secondary theatre of war as a replacement for the central action in order to avoid the firing line.
Lord Clyde gave the last word on tax avoidance, and it applies equally to corporations as it does to individuals. Indeed, for-profit corporations and the entrepreneurs who build them are the true wealth creators; all government can do is shuffle other people’s wealth around. Said Clyde:
No man [he could have added: or company] in the country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or property as to enable the Inland Revenue to put the largest possible shovel in his stores. The Inland Revenue is not slow, and quite rightly, to take every advantage which is open to it under the Taxing Statutes for the purposes of depleting the taxpayer’s pocket. And the taxpayer is in like manner entitled to be astute to prevent, as far as he honestly can, the depletion of his means by the Inland Revenue.
And it’s not even an equal fight. Which makes the hysterical posturing by politicians that much more absurd. If politicians don’t like the tax regime that they themselves have conjured into being through regulatory fiat, they have it in their power to change the laws they make. That they are too stupid or lazy to understand this basic principle suggests that the quality of our political class, and their respect for the electorate, stands at an all-time low.
But tax itself is just a sideshow. The real black comedy lies in the manipulation of market prices that is now endemic throughout the global financial system. As Japan is now showing, even with the unrestrained commitment of a central bank and its magical powers to create money out of nothing, there are practical limits to market rigging activity. Last week’s price action within the Japanese government bond market and stock market suggests that both of these markets are in the early stages of shaking themselves to pieces. The fallout of unintended (counter-intended?) ￼consequences from massive market manipulation will be awesome.
And this is invariably what happens when government – which in the opinion of this observer shouldn’t be entrusted to play with a ball of string – is allowed to control money. Call it the anti- Midas effect. Everything that government touches, whatever its initial value or worth, ultimately turns to ashes. Investors are now reduced to all sorts of linguistic contortions and analysis in order to try and parse the meaning from Fed chairman Bernanke’s latest pronouncements about quantitative easing, and whether the magic money tree will continue to shower its seemingly effortless largesse over the financial markets of the US. From our perspective, if we cannot understand the dynamics of a market (or if we have scant respect for the pronouncements of the central banker pulling the strings of that market), then we would prefer not to participate in that same market. This is by no means sour grapes. On a cyclically adjusted price / earnings basis, the US equity market trading at around 23 times is expensive even without the imponderable (and impossible to price in) inflationary aspect of QE. There are compelling valuations elsewhere, in markets like Russia (with large cap, single stock p/e’s down at 4 or 5) or more broadly across Asia, where domestic consumer-focused businesses are still available in single digit p/e’s and at price / book levels of one or less.
￼Brent Johnson of Santiago Capital wrote a while back that the greatest trick central bankers ever pulled was convincing the world they work for the public and not for the banks. Now that asset bubbles are alive and well across stock markets, bond markets and credit markets, it takes a brave – and probably foolish – investor to accept market risk at face value, rather than adopting a
perspective of extreme selectivity and aloofness – unless you’re indifferent to the prospect of permanent loss of capital, and we aren’t. We are content to allow the trend-following managers with whom we invest to ride the momentum of markets, and in both directions, up and down. But for the much larger percentage of client portfolios that are under our own discretionary control, we feel more concerned than we ever have as we watch markets like Japan’s writhing and roiling with extraordinary volatility, as investors, traders and speculators alike tie themselves up in knots trying to assess what the end-game of a money printing bubble means for their own bottom line. Playing a game of chicken with one central bank – or siding with it, for that matter – is bad, and difficult, enough. Playing a game of chicken with all of them seems tantamount, to this asset manager at least, to career suicide. So this is a game we elect not to play. We disregard the conventional indices and benchmarks (someone else’s rules altogether), and we make more nuanced investments across only those assets and asset classes that we think, in a hopelessly distorted world of disparately inflated prices, have genuine value. In other words we play our own game, by our own rules.
This article was previously published at The price of everything.
“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.”
- Ernest Hemingway.
“Recovery in sight, says departing Bank of England governor Mervyn King..”
- The Daily Telegraph.
In one of the most powerful and memorable metaphors in finance, Charles Ellis, the founder of Greenwich Associates, cited the work of Simon Ramo in a study of the strategy of one particular sport: ‘Extraordinary tennis for the ordinary tennis player’. Ellis’ essay is titled ‘The loser’s game’, which in his view is what the ‘sport’ of investing had become by the time he wrote it in 1975. Whereas tennis is ‘won’ by professionals, the practice of investing is ‘lost’ by professionals and amateurs alike. Whereas professional sportspeople win their matches, investors tend to lose the equivalent of theirs through unforced errors. Success in investing, in other words, comes not from over-reaching, in straining to make the shot, but simply through the avoidance of easy errors.
Ellis was also making the point that as far back as the 1970s, investment managers were not beating the market; rather, the market was beating them. This is a mathematical inevitability given the crowded nature of the institutional fund management marketplace and the impact of management fees on end investor returns. Ben W. Heineman, Jr. and Stephen Davis for the Yale School of Management asked in their report of October 2011, ‘Are institutional investors part of the problem or part of the solution?’ By their analysis, in 1987, some 12 years after Ellis’ earlier piece, institutional investors accounted for the ownership of 46.6% of the top 1000 listed companies in the US. By 2009 that figure had risen to 73%. That percentage is itself likely understated because it takes no account of the role of hedge funds. Also by 2009 the US institutional landscape contained more than 700,000 pension funds; 8,600 mutual funds (almost all of whom were not mutual funds in the strict sense of the term, but rather for-profit entities); 7,900 insurance companies; 6,800 hedge funds; and more than 2,000 funds of funds (the horror! the horror!)
Following immediately on from this latter figure, it is worth observing that something has gone seriously awry in the order of the universe when the number of listed equity funds in a given market comes to outnumber the number of listed equities in that same market – a fantastic example of a fund management industry happily consuming itself.
In what ways do institutional asset managers create a rod for their own backs? The most widespread, and probably the most damaging to the interests of end investors, is in benchmarking. Being assessed relative to the performance of an equity or bond benchmark effectively guarantees (post the impact of fees) the institutional manager’s inability to outperform that benchmark – but does ensure that in bear markets, index-benchmarked funds are more or less guaranteed to lose money for their investors. In equity fund management the malign impact of benchmarking is bad enough; in bond fund management the malign impact of ‘market capitalisation’ benchmarking is disastrous from the get-go. Since a capitalisation benchmark assigns the heaviest weightings in a bond index to the largest bond markets by asset size, and since the largest bond markets by asset size represent the most heavily indebted issuers – whether sovereign or corporate – a bond- indexed manager is compelled to have the highest exposure to the most heavily indebted issuers. All things equal, therefore, it is likely that the bond index-tracking manager is by definition heavily exposed to objectively poor quality (because most heavily indebted) credits. Given that we are living through a once-in-a-generation crisis in the bond markets, chances are that this game will not end well for benchmarked managers.
Quite how this institutional insistence on benchmarking arose – whether versus indices or versus peer groups – is not precisely clear. But it would seem to give the majority of asset managers regulatory cover for sheltering amongst the consensus. And as SocGen’s Albert Edwards puts it, “The late Margaret Thatcher had a strong view about consensus. She called it: ‘The process of abandoning all beliefs, principles, values and policies in search of something in which no-one believes, but to which no-one objects.’” And the prevailing institutional imperative is to give customers what they think they want, or what can easily be sold, which most of the time is probably the same thing. Which accounts for the thousands of me-too fund offerings clogging the ‘Managed Funds’ section of the FT, most of which would be completely superfluous in a properly efficient market.
James Montier, in his bible on behavioural finance, ‘Behavioural investing’, points out two recent discoveries by neuroscientists that have relevance to all investors: we are hard-wired for the short term, and we seem to be hard-wired to herd. The first characteristic makes for an uncomfortable psychological journey whenever a portfolio incurs losses (in whole or in part); the second characteristic makes for an uncomfortable psychological journey whenever a portfolio pursues a remotely contrarian tack. Once again, the power of conformity is acute.
A particularly intriguing experiment used by Montier relates to our tendency towards anchoring. Feel free to follow it yourself. It goes as follows:
1. Please write down the last four digits of your telephone number.
2. Is the number of physicians in London higher or lower than this number?
3. What is your best guess as to the number of physicians in London?
In Montier’s words, anchoring is “our tendency to grab hold of irrelevant and often subliminal inputs in the face of uncertainty.”
The idea of the experiment, then, is to see whether respondents were influenced by their (random and irrelevant) phone number as a gauge in trying to estimate the number of doctors in London. The results of the experiment can be seen below:
As the chart indicates, those respondents with telephone numbers above 7,000 suggested, on average, that there were just over 8,000 doctors in London. Those with telephone numbers below 3,000 suggested 4,000 doctors. “This represents a very clear difference of opinion driven by the fact that investors are using their telephone numbers, albeit subconsciously, as inputs into their forecast.”
So our thesis goes as follows. In the absence of reliable knowledge about the future, investors have a tendency to anchor onto something – anything – to help them assess or predict future market returns. What better anchor to use for future market returns than prior ones? This is where the story gets more intriguing still.
The chart above attempts to answer a rhetorical question: why do so many financial advisers advocate equity-centric portfolios? We think the reason is: because so many of them worked during the most recent financial period. On a discrete 20 year basis, the period 1980-1999 is the only period of the last 300 years in which annual, real returns from the UK market offered investors between 8% and 10% on average. Note that for much of that three-century period, annualised real returns ended up either side of zero.
We think the story gets more intriguing still. We would advocate the thesis that a good part of those returns was somewhat illusory in nature. More specifically, given that they occurred during a once-in-a-century period of extraordinary credit creation, those market returns were in large part borrowed from the future, in the same way that governments have been funded, and their colossal bond markets serviced, by essentially loading the ultimate cost and the final reckoning onto the next generation.
If this thesis is even half correct, investors piling into stocks now, at current highs, on the premise of recapturing some of those 8% – 10% real annual returns, are being at least somewhat delusional. The credit bubble has burst. Messily. The stock market has not necessarily woken up to the fact. This does not detract from the sensible analysis of equity market opportunities. But for any investment, its most important characteristic is its starting valuation. Buy attractive equities at sufficiently undemanding multiples and you should rightly expect to do well. Buy – let us call it the index – expensively, and after a grotesque bubble of credit and associated distortions throughout the capital market structure, egged on by central banks who have long abandoned what limited policy mandates they previously pursued, and expect things to end in a train wreck. Winning the loser’s game is fine. Losing the loser’s game is not something to which we aspire.
“When the cover of a major financial magazine features a cartoon of a bull leaping through the air on a pogo stick, it’s probably about time to cash in the chips.”
- John Hussman of Hussman Funds in his April letter.
￼Amsterdam, March 1637 (Ruyters): The latest Dutch tulip harvest is in, and experts confidently predict another bumper year for tulip growers and tulip investors alike. Billionaire hedge farmer Jon Paulsen is rumoured to have added hyacinths to his multi-strategy offering and has just launched a fund denominated in daffodils. Tulip stocks climbed by a few millimetres, as they are prone to every day if they grow at their normal organic rate; Couleren bulbs rallied another 2 guilders in heavy Antwerp trading; Rosen and Violetten bulbs ended the trading session more or less unchanged, albeit a bit squashed, and at record highs. The market has been further buoyed in recent weeks by a tide of manure issued by the leading tulip advocate Pol Kruygman from his op-ed column in the New Amsterdam Times, ‘Witterings of a Tulip Fanatic’. Kruygman promised to keep the manure coming, whether anybody wanted it or not.
The popularity and rising value of this colourful perennial plant evidently know no bounds and this is surely a golden age that is never likely to end. Future generations will evidently marvel at the effortless wealth on offer to investors committing their capital unreservedly to tulips today. Dutch housewives bedecked in tulip hats, tulip scarves, tulip dresses and tulip shoes danced gaily in the streets of Tuliptown (formerly Amsterdam) whilst smoking tulip cigarettes, slurping tulip soup, and drinking tulip beer from tulip beer glasses with tulip straws. Given that the anthocyanin Tulipanin is toxic to horses, cats and dogs, the inhabitants of Amsterdam have long since stopped rearing horses, cats and dogs; they have chosen to rear tulips as pets instead.
Many Dutch households have also abandoned the traditional export trades in herring, gin and cheese in order to concentrate their energies where the action is: tulips. Tulip promoter Dirck Pieter Tulip commented:
Tulip tulip tulip! At my tulip worship museum and emporium, ‘All Things Tulip’, you can see the very latest in tulip technology, tulip breeding and tulip trading strategies.
Dirck Pieter Tulip is offering courses in tulip cash / futures arbitrage. Price: One Tulip. Mr Tulip was formerly a stockbroker. In addition to curating his tulip museum he also edits the specialist tulip fanciers’ magazine, ‘Bulb!’
“I have just sold my house, its contents and all my family in order to speculate indefinitely in tulips, heavily on margin, and advised all my friends to do the same,” he added. “What can possibly go wrong?”
Tulip Reserve Bank Governor Ben Berninckje agreed, and greeted the news of the tulip harvest warmly.
“There has never hitherto been a nationwide fall in tulip prices,” he pointed out, “So evidently that can never ever happen.”
And Governor Berninckje pledged to support tulip prices down to the very last taxpayer, now that the tulip-related economy accounted for about 99.6% of Dutch GDP. Lending against tulips accounted for the other 0.4%.
Analysts at the business network ZeeNBZee were quick to voice their compliance with the almost universal approbation for the pretty, multi-hued offspring of Tulipa gesneriana.
“Tulips are definitely the way forward,” said one.
“Although I have only been in the market since about 7.30 this morning, this is the most incredible and exciting thing I have ever seen. So I recommend long tulip positions to anyone witless enough to listen to me.”
New derivative markets in tulips are sprouting up daily to enable people to speculate in tulip price appreciation without having to worry about the tiresome fuss of actually taking delivery of the attractively patterned flowers. And prices are continually reaching new highs, even in new digital- only varieties of the plant, or bit-tulips. Talk of tulip millionaires is all the rage. Popular balladeer Jostin Beebor is said to have been an early investor, but he is rumoured to have sold all his tulip positions now.
Sceptics of the tulip cult are obviously fusty-minded dullards who lack imagination, vision or a healthy sense of disbelief. One sceptic, speaking on condition of anonymity although his name is Cornelis Tromp and he resides at 33 Medomsley Road, Utrecht, remarked,
Something about this environment feels dreadfully wrong to me – a contradiction in terms of logic, common sense and fundamental economics. Every day new tulips come onto the market and the supply of them has never been higher, and yet every day the prices also reach new records. But the market is drowning in tulips and there is almost nobody left who doesn’t already own them. There’s not a whole lot you can do with them. And they only bloom for a week. Unless the laws of supply and demand have been magically rescinded, this fantastical bubble in
dotcom stocks US property bank stocks subprime credit government bonds equities tulips is likely to end very badly, particularly for neophyte investors who have been urged by irresponsible reserve banks and an unregulated financial media into the tulip market to the exclusion of just about everything else.
Commentators aside from Mr Tromp, however, were unanimous in their confidence that for as long as the tulip reserve banks stood ready and willing to throw liquidity at the tulip market, and for as long as that market was going up, there were no clouds on the horizon, although the weather correspondent for the New Amsterdam Times pointed out that there was actually a gigantic, dense, threatening mass of clouds on the horizon.
This article was previously published at The price of everything.