Authors

Money

Money worries

“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency.”

–       Richard Cobden.

 

“Raj, 33, a London-based photographer and amateur commodities trader who has used Alpari since 2009, said he currently had about £24,000 trapped in his account at the company.

‘It was completely out of the blue, a total shock,’ he said. ‘I’ve never had any issues with them. I’ve been calling and I just keep getting their answerphone.’”

–       From ‘Forex brokers suffer escalating losses in fallout from Swiss ditching franc cap’, The Financial Times, 17 January 2015.

 

“I don’t know what to say. I’ve been investing since January and I’ve never seen anything like it.”

–       Unnamed Hong Kong housewife during the Asian financial crisis, 1997/8.

 

“But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland, they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity.

 

“The benighted Swiss, just down from their mountains where it was difficult to survive the winters, have a strong Neanderthal bias and have never paid any attention to the luminaries teaching economics in Princeton or Cambridge. Strange as it may seem, they still believe in such queer, outdated notions as sound money, balanced budgets, local democracy and the need for savings to finance investments. How quaint!

 

“Of course, the Swiss are paying a huge price for their lack of enlightenment. For example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175… in favour of Switzerland.

 

“And for most of that time Switzerland ran a current account surplus, a balanced budget and suffered almost no unemployment, all despite the fact that nobody knows the name of a single Swiss politician or central banker (or perhaps because nobody knows a single Swiss politician or

central banker, since they have such limited power? And that all these marvellous results come from that one simple fact: their lack of power).

 

“The last time I looked, the Swiss population had the highest standard of living in the world—another disastrous long term consequence of not having properly trained economists of the true faith.”

–       Charles Gave of Gavekal, ‘Swexit !’.

 

 

“An increase in the quantity of money only serves to dilute the exchange effectiveness of each franc or dollar; it confers no social benefit whatever. In fact, the reason why the government and its controlled banking system tend to keep inflating the money supply, is precisely because the increase is not granted to everyone equally. Instead, the nodal point of initial increase is the government itself and its central bank; other early receivers of the new money are favoured new borrowers from the banks, contractors to the government, and government bureaucrats themselves. These early receivers of the new money, Mises pointed out, benefit at the expense of those down the line of the chain, or ripple effect, who get the new money last, or of people on fixed incomes who never receive the new influx of money. In a profound sense, then, monetary inflation is a hidden form of taxation or redistribution of wealth, to the government and its favoured groups, and from the rest of the population.. every change in the supply of money stimulated by government can only be pernicious.”

–       Murray Rothbard.

 

 

“The longer the boom of inflationary bank credit continues, the greater the scope of  malinvestments in capital goods, and the greater the need for liquidation of these unsound  investments. When the credit expansion stops, reverses, or even significantly slows down, the  malinvestments are revealed. Mises demonstrated that the recession, far from being a strange, unexplainable aberration to be combated, is really a necessary process by which the market  economy liquidates the unsound  investments of the boom, and returns to the right consumption /  investment proportions to satisfy consumers in the most efficient way.

 

“Thus, in contrast to the interventionists and statists who believe that the government must  intervene to combat the recession process caused by the inner workings of free market capitalism,  Mises demonstrated precisely the opposite: that the government must keep its hands off the  recession, so that the recession process can quickly eliminate the distortions imposed by the government-created inflationary boom.”

–       Murray Rothbard, again.

 

 

“I don’t know what’s going to happen in Europe but there is one thing I am certain about – eventually, someone is going to take a big loss.  As investors, the most important thing we can do is to make sure that we aren’t the parties taking that loss.”

–       Jeffrey Gundlach, cited by Joshua Brown, September 2011.

 

 

“The designers of the good ship euro wanted to create the greatest liner of the age. But as everybody now knows, it was fit only for fair-weather sailing, with an anarchic crew and no lifeboat. Its rules of economic seamanship were rudimentary, and were broken anyway. When it  struck a reef two years ago, the water flooded one compartment after another.. European officials now recognise the folly of creating the euro without preparing for trouble. It would be wise to be  planning now for what to do if it sinks.. Even now, after decades of “European construction”, many Eurocrats cannot conceive of the euro as a wreck. Those who have worked hardest to keep it afloat are exhausted and know it is not in their power to save it anyway.”

–       Charlemagne in ‘The Economist’, November 2011.

 

 

“Sir, It was a very cruel joke to publish Richard Barwell‟s recent letter (“Exit from first round of QE now seems premature”), particularly as it followed hot on the heels of Fed chairman Ben Bernanke’s announcement of so much more of the stuff. It was certainly a delicious coinage of Mr Barwell’s to suggest that this argument “makes no sense in theory”. This reminded me of those scientists who also contend that bumble bees cannot fly – in theory. Can I suggest that the FT letters page imposes some kind of moratorium on self-interested and highly conflicted “advice” from an academic school – economics – that having brought us to the brink, is now in danger of theorising itself into total absurdity ? To read that Mr Barwell is employed by the one organisation that has done more than any other to destabilise if not destroy the UK financial system – RBS – was the icing on this particularly ironic cake.

 

“QE does nothing more than put yet more capital into the hands of bankers who can then either play in the markets with it, or sit on it. In doing so, it also devalues its practitioners’ currencies versus those of regimes that have fundamentally sound economic policy. If our government and central bank wanted to do something properly constructive with all this newly created money, perhaps it could invest it into our country’s jaded infrastructure, rather than inflating further asset bubbles, the “wealth effect” of which is likely to be wholly illusory.”

–       Tragically unpublished letter to the Financial Times from the author, November 2010.

 

“What really broke Germany was the constant taking of the soft political option in respect of money.”

–       Adam Fergusson, ‘When Money Dies’.

 

Still think QE is the answer for the euro zone ?

Economics

Beyond satire

Je ne suis pas Charlie. I am not Charlie, I am not brave enough.

“Across the world, and certainly across Twitter, people are showing solidarity with the murdered journalists of satirical French magazine Charlie Hebdo, proclaiming in black and white that they too share the values that got the cartoonists killed. Emotionally and morally I am entirely with that collective display — but actually I and almost all those declaring their solidarity are not Charlie because we simply do not have their courage.

“Charlie Hebdo’s leaders were much, much braver than most of us; maddeningly, preposterously and — in the light of their barbarous end — recklessly brave. The kind of impossibly courageous people who actually change the world. As George Bernard Shaw noted, the “reasonable man adapts himself to the world while the unreasonable man persists in trying to adapt the world to himself”, and therefore “all progress depends upon the unreasonable man”. Charlie Hebdo was the unreasonable man. It joined the battle that has largely been left to the police and security services..

“It is an easy thing to proclaim solidarity after their murder and it is heart-warming to see such a collective response. But in the end — like so many other examples of hashtag activism, like the #bringbackourgirls campaign over kidnapped Nigerian schoolchildren — it will not make a difference, except to make us feel better. Some took to the streets but most of those declaring themselves to be Charlie did so from the safety of a social media account. I don’t criticise them for wanting to do this; I just don’t think most of us have earned the right.”

“But the rest of us, like me, who sit safely in an office in western Europe — or all those in other professions who would never contemplate taking the kind of risks those French journalists took daily — we are not Charlie. We are just glad that someone had the courage to be.”

–       Robert Shrimsley in the Financial Times, 8 January 2015.

 

“Your right to swing your arms ends just where the other man’s nose begins.”

–       Zechariah Chafee , Jr.

 

“I do not agree with what you have to say, but I’ll defend to the death your right to say it.”

–       Voltaire.

 

On All Saint’s Day, 1st November 1755, an earthquake measuring roughly 9 on the Richter scale struck the Portuguese capital, Lisbon. At least 30,000 people are estimated to have perished. A little over half an hour after the original quake, a tsunami engulfed the lower half of the city. Those not affected by the quake or the tsunami were then beset by a succession of fires, which burned for five days. 85% of Lisbon’s buildings were destroyed. Ripples from the earthquake were felt far afield. Finland and North Africa felt aftershocks; a smaller tsunami made landfall in Cornwall.

 

Such destruction had a follow-on impact, in both philosophical and theological terms. In June 1756, the Inquisition responded with an auto-da-fé – a witch-hunt, effectively, for heretics.

 

One, much-loved, novel happens to cover both of these events, along with a third, from March 1757, when the British Admiral John Byng was executed for cowardice in the face of the French enemy at the battle of Minorca. This inspired the famous line, “Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres”: “In this country, it is wise to kill an admiral from time to time to encourage the others.”

 

That novel was written by a Frenchman, François-Marie Arouet, in 1758. We know him better today by his nom de plume: Voltaire. And his satirical magnum opus that catalogued these various disasters was called ‘Candide’.

 

‘Candide’ is a triumph of the style of novel best described as ‘picaresque’. It’s crammed with eminently quotable lines – the ‘Pulp Fiction’ of its day, if you will. Candide himself is a naïf who wanders with wide-eyed innocence through a savage and corrupt world. But in its Professor Pangloss it offers us the perfect encapsulation of today’s rogue economist, the unworldly and confused academic whose misguided practice of a false science has dreadful implications for the rest of us. A good modern-day example would be Martin Wolf, the FT’s chief economics correspondent, who on Friday complained about the UK’s property planning regime being “Stalinist”. Mr Wolf should try looking in the mirror more often – he is an ardent supporter of Stalinist monetary policy, for example.

 

As investors we are all now the subjects of a grotesque monetary experiment. This experiment has never been tried before, and its outcome remains uncertain. The unproven thesis, however, runs something like this: six years into a second Great Depression, the only “solution” is for central banks to print ever greater amounts of money. Somehow, gifting free money to the banks that helped precipitate the crisis will lead to a ‘trickle down’ wealth effect. Instead of impoverishing those with savings, inflation will be some kind of miraculous curative, and it must be encouraged at all costs.

 

It bears repeating: we are in an extraordinary financial environment. In the words of the fund managers at Incrementum AG,

 

“We are currently on a journey to the outer reaches of the monetary universe.”

 

On January 25th, Greece goes to the polls. Greek voters face the unedifying choice of re-electing the buffoons who got the country into its current mess or electing rival buffoons issuing comparably ridiculous economic promises that cannot possibly be fulfilled. Voltaire would be in his element. But Greece is hardly alone. Just about every government in the euro zone fiddled its figures to qualify for membership of this not particularly exclusive club, and now the electorate of the euro zone is paying the price. Not that any of this is new news; the euro zone has been in crisis more or less since its inception. If it hadn’t been for sterling’s inglorious ethnic cleansing from the exchange rate mechanism in September 1992, the UK might be in the same boat. Happily, for once, the market was allowed to prevail. The market triumphed over the cloudy vision of bewildered politicians, and the British chancellor ended up singing in the bath. (That he had been a keen advocate of EMU and the single currency need not concern us – consistency or principles are not necessarily required amongst politicians.)

But the market – a quaint concept of a bygone age – has largely disappeared. It has been replaced throughout the West by bureaucratic manipulation of prices, in part known as QE but better described as financial repression. Anyone who thinks the bureaucrats are going to succeed in whatever Panglossian vision they’re pursuing would be well advised to read Schuettinger and Butler’s ‘Forty centuries of wage and price controls’. The clueless bureaucrat has a lot of history behind him. In each case it is a history of failure, but history is clearly not much taught – and certainly not respected – in bureaucratic circles these days. The Mises bookstore describes the book as a “popular guide to ridiculous economic policy from the ancient world to modern times. This outstanding history illustrates the utter futility of fighting the market process through legislation. It always uses despotic measures to yield socially catastrophic results.”

The subtitle of Schuettinger and Butler’s book is ‘How not to fight inflation’. But inflation isn’t the thing that our clueless bureaucrats are fighting. The war has shifted to one against deflation – because consumers clearly have to be protected from everyday lower prices.

Among the coverage of last week’s dreadful events in Paris, there has been surprisingly little discussion about the belief systems of religions other than Islam. We think that Stephen Roberts spoke a good deal of sense when he remarked to a person of faith:

“I contend that we are both atheists. I just believe in one fewer god than you do. When you understand why you dismiss all the other possible gods, you will understand why I dismiss yours.”

There is altogether too much worship of false gods in our economy and what remains of our market system. Some hubris amongst our technocratic “leaders” would be most welcome. Until we get it, the requirement to concentrate on only the most explicit examples of value remains the only thing in investment that makes any sense at all.

 

Economics

An odd, non-linear world

“Sir, John Authers, in Loser’s Game (The Big Read, December 22), could have delved deeply into the flaws in the asset management business as it has evolved in recent decades, rather than accepting the industry’s own terms or focusing on tweaks to “active” management that might improve results..

“Mr Authers could also have challenged the bureaucratic thinking and methods asset management has adopted in the course of chasing its “bogeys”, starting with the Big Ideas.. Then there are the model portfolios, relative-weightings, “style drift”, investment committees, the requirement to be fully invested and so on — all bog down decision-making and most have nothing to do with genuine investing. In adopting these practices the fund management business has created a recipe for mediocrity.

“In investing, it is never a good idea to do what everyone else is doing. Piling into passive index funds during a year of decidedly poor relative results for active managers, and especially after a long period of rising security prices is likely to lead to future disappointment, just as it did in 1999. This leads us to another line of inquiry for Mr Authers: even assuming “beating” an index is worthwhile, why must we do it all of the time? It is a paradox of investment that in order to do well in the long run, you sometimes have to do “poorly” in the short run. You have to accept the fact that often you will not “beat” an index; sometimes you don’t even want to — think of the Nasdaq in 1999, for example..”

–       Letter to the FT from Mr. Dennis Butler, December 30, 2014.

 

 

A happy new year to all readers.

For historians, there are primary sources and secondary sources. Primary sources are the original documents that point to the raw history, like the original Magna Carta, for example. Secondary sources are effectively historical derivatives – they incorporate interpretation and analysis. In financial markets, the equivalent of primary sources are prices – the only raw data that speak unequivocally of what occurred by way of financial exchange between buyer and seller. Everything else amounts to interpretation and analysis, and must by definition be regarded as subjective. So-called fundamentals, therefore, are subjective. There is the price – and everything else is essentially chatter.

 

It says much for the quality and depth of our mainstream media that one of the most insightful and thought-provoking pieces of social and cultural analysis of the last year came in the form of a 5 minute essay within a satirical news review of 2014. The piece in question was by the cult documentary maker Adam Curtis and you can watch it here. The following extracts are taken directly from the film:

 

“So much of the news this year has been hopeless, depressing, and above all, confusing. To which the only response is to say, “oh dear.”
“What this film is going to suggest is that that defeatist response has become a central part of a new system of political control. And to understand how this is happening, you have to look to Russia, to a man called Vladislav Surkov, who is a hero of our time.
“Surkov is one of President Putin’s advisers, and has helped him maintain his power for 15 years, but he has done it in a very new way.
“He came originally from the avant-garde art world, and those who have studied his career, say that what Surkov has done, is to import ideas from conceptual art into the very heart of politics.

“His aim is to undermine people’s perceptions of the world, so they never know what is really happening.

“Surkov turned Russian politics into a bewildering, constantly changing piece of theatre. He sponsored all kinds of groups, from neo-Nazi skinheads to liberal human rights groups. He even backed parties that were opposed to President Putin.
“But the key thing was, that Surkov then let it be known that this was what he was doing, which meant that no-one was sure what was real or fake. As one journalist put it: “It is a strategy of power that keeps any opposition constantly confused.”
“A ceaseless shape-shifting that is unstoppable because it is undefinable..
“But maybe, we have something similar emerging here in Britain. Everything we’re told by journalists and politicians is confusing and contradictory. Of course, there is no Mr. Surkov in charge, but it is an odd, non-linear world that plays into the hands of those in power.

“British troops have come home from Afghanistan, but nobody seems to know whether it was a victory or whether it was a defeat.
“Ageing disk jockeys are prosecuted for crimes they committed decades ago, while practically no one in the City of London is prosecuted for the endless financial crimes that have been revealed there..

“..the real epicentre of this non-linear world is the economy, and the closest we have to our own shape-shifting post-modern politician is [U.K. Chancellor of the Exchequer] George Osborne.

“He tells us proudly that the economy is growing, but at the same time, wages are going down.

“He says he is reducing the deficit, but then it is revealed that the deficit is going up.

“But the dark heart of this shape-shifting world is Quantitative Easing. The government is insisting on taking billions of Pounds out of the economy through its austerity programme, yet at the very same time it is pumping billions of Pounds into the economy through Quantitative Easing, the equivalent of 24,000 Pounds for every family in Britain.
“But it gets even more confusing, because the Bank of England has admitted that those billions of Pounds are not going where they are supposed to. A vast majority of that money has actually found its way into the hands of the wealthiest five percent in Britain. It has been described as the biggest transfer of wealth to the rich in recent documented history.
“It could be a huge scandal, comparable to the greedy oligarchs in Russia. A ruthless elite, siphoning off billions in public money. But nobody seems to know.
“It sums up the strange mood of our time, where nothing really makes any coherent sense. We live with a constant vaudeville of contradictory stories that makes it impossible for any real opposition to emerge, because they can’t counter it with any coherent narrative of their own.

“And it means that we as individuals become ever more powerless, unable to challenge anything, because we live in a state of confusion and uncertainty. To which the response is: Oh dear. But that is what they want you to say.”

 

The start of the New Year is traditionally a time for issuing financial forecasts. But there seems little point in doing so given the impact of widespread financial repression on the price mechanism itself. Are prices real, or fake ? The cornerstone of the market structure is the price of money itself – the interest rate. But interest rates aren’t being set by a free market. Policy rates are being kept artificially low by central banks, while the term structure of interest rates has been hopelessly distorted by monetary policy conducted by those same central banks. Inasmuch as ‘real’ investors are participating in the bond market at all, those institutional investors have no personal skin in the game – they are economic agents with no real accountability for their actions. Other institutional players can be confidently assumed simply to be chasing price momentum – they likely have no ‘view’ on valuation, per se. The world’s bond markets have become a giant Potemkin village – nobody actually lives there.

 

So of the four asset classes to which we allocate, three of them offer at least some protection against the material depradations and endless price distortions of the State. ‘Value’ listed equities give us exposure to the source of all fundamental wealth – the actions of the honest entrepreneur. Systematic trend-following funds are the closest thing we can find to truly uncorrelated investments – and we note how 2014 saw a welcome return to form. The monetary metals, gold and silver, give us Stateless money that cannot be printed on demand by the debt-addicted. We are slowly coming to appreciate the counsel of a friend who suggested that the merit of gold lies not in its price so much as in its ownership. What matters is that you own it. (It also matters why.) Which leaves debt. Objectively high quality debt – a small market and getting smaller by the day.

 

The practice of sensible investment becomes difficult when our secondary information sources (“fundamentals”) are inherently subjective. It becomes almost impossible when our primary information sources (prices) can’t be trusted because they have politicians’ paw-prints all over them. “Nothing really makes any coherent sense.. We live with a constant vaudeville of contradictory stories.. We live in a state of confusion and uncertainty.” If the pursuit of certainty is absurd, the only rational conclusion is to acknowledge the doubt, and invest accordingly.

Economics

“We hate you guys but there is nothing much we can do”

“Except for US Treasuries, what can you hold ? US Treasuries are the safe haven. For everyone, including China, it is the only option.. Once you [Americans] start issuing $1 trillion – $2 trillion.. we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

–       Luo Ping, official at the China Banking Regulatory Commission, addressing an audience in New York in early 2009.
“This is a big change and it cannot happen too quickly, but we want to use our reserves more constructively by investing in development projects around the world rather than just reflexively buying US Treasuries. In any case, we usually lose money on Treasuries, so we need to find ways to improve our return on investment.”

–       Unnamed senior Chinese official, cited in an FT article, ‘Turning away from the dollar’, 10th December 2014.

 

The Commentary will shortly be off for its winter break. We wish all clients and readers a merry Christmas and a peaceful and prosperous New Year. See you in 2015.

“Mutually assured destruction” was a doctrine that rose to prominence during the Cold War, when the US and the USSR faced each other with nuclear arsenals so populous that they ensured that any nuclear exchange between the two great military powers would quickly lead to mutual overkill in the most literal sense. Notwithstanding the newly dismal relations between the US and Russia, “mutually assured destruction” now best describes the uneasy stand-off between an increasingly indebted US government and an increasingly monetarily frustrated China, with several trillion dollars’ worth of foreign exchange reserves looking, it would now appear, for a more productive home than US Treasury bonds of questionable inherent value. Until now, the Chinese have had little choice where to park their trillions, because only markets like the US Treasury market (and to a certain extent, gold) have been deep and liquid enough to accommodate their reserves.

The FT article, by James Kynge and Josh Noble, points to three related policy developments on the part of the Chinese authorities:

1)    China’s appetite for US Treasury bonds is on the wane;

2)    China is ramping up its overseas development programme for both financial and geopolitical reasons;

3)    The promotion of the renminbi as a global currency “is gradually liberating Beijing from the dollar zone”.

The US has long enjoyed what Giscard d’Estaing called the “exorbitant privilege” of issuing a currency that happens to be the global reserve currency. The FT article would seem to suggest that the days of exorbitant privilege may be coming to an end – to be replaced, in time, with a bi-polar reserve currency world incorporating both the US dollar and the renminbi. (The euro might be involved, if that demonstrably dysfunctional currency bloc lasts long enough.) Here’s a quiz we often wheel out for prospective clients:

1)    Which country is the world’s largest sovereign miner of gold ?

2)    Which country doesn’t allow an ounce of that gold to be exported ?

3)    Which country has advised its citizenry to purchase gold ?

Three questions. One answer. In each case: China. Is it plausible that, at some point yet to be determined, a (largely gold-backed) renminbi will either dethrone the US dollar or co-exist alongside it in a new global currency regime ? We think the answer is yes, on both counts.

Meanwhile the US appears to be doing everything in its power to hasten the relative decline of its own currency. There is a new ‘big figure’ to account for the size of the US national debt, which now stands at some $18 trillion. That only accounts for the on-balance sheet stuff. Factor in the off-balance sheet liabilities of the US administration and pretty soon you get to a figure (un)comfortably north of $100 trillion. It will never be paid back, of course. It never can be. The only question is which poison extinguishes it: formal repudiation, or informal inflation. Perhaps we, or future generations, get both.

So the direction of travel of two colossal ‘macro’ themes is clear (the insolvency of the US administration, and its replacement on the geopolitical / currency stage by that of the Chinese). The one question neither we, nor anybody else, can answer precisely is: when ?

There are other statements that beg the response: when Government bond yields have already entered a ‘twilight zone’ of practical irrelevance to rational and unconstrained investors. But when do they go into reverse ? When will the world’s most frustrating trade (‘the widow-maker’, i.e. shorting the Japanese government bond market) start finally to work ? When will investors be able to enter or re-enter stock markets without having to worry about the malign impact of central bank price support mechanisms (a polite way of describing asset price boosterism and state-sanctioned inflationism) ?

Here’s another statement that begs the response: when ? The US stock market is already heavily overvalued by any objective historical measure. When is Jack Bogle, the founder of the world’s largest index-tracking business, Vanguard, going to acknowledge that advocating 100% market exposure to one of the world’s most expensive markets, at its all-time high, might amount to something akin to “overly concentrated investment risk” ? Barron’s Magazine asks broadly the same question.

Lots of questions, and not many definitive answers. Some suggestions, though:

  • At the asset class level, diversification – by geography, and underlying asset type – makes more sense than ever, unless you strongly believe you can anticipate the actions and intentions of central banking bureaucrats throughout the world. Warren Buffett once said that wide diversification was only required when investors do not understand what they are doing. We would revise that statement to take into account the unusual risks at play in the global macro-economic arena today: wide diversification is precisely required when central bankers do not understand what they are doing. 
  • Expanding on the diversification theme, explicit value (“cheapness”) today only exists meaningfully in the analytically less charted territories of the world. @RobustCap highlights the discrepancy between valuations in the US stock market versus those of Russia, China and emerging Europe. There are clearly ‘fundamental’ and corporate governance reasons that account for some of this discrepancy, but in our view certainly not the entirety of it. Some examples:

Country                                         C.A.P.E.                       P/E                              P/B

North America                                23.8                             20.2                             2.7x

Russia                                            5.2                               6.8                               0.7x

China                                             17.2                             6.9                               1.1x

Austria                                           6.8                               43.4                             0.9x

In emerging and ‘challenged’ markets, there are always reasons not to invest. Nevertheless, price is what you pay and value is what you get.

  • Some form of renminbi exposure makes total sense as part of a diversified currency portfolio.
  • US equities should be selected, if at all, with extreme care; ditto the shares of global mega-cap consumer brands, where valuations point strongly to the triumph of the herd.
  • And whatever their direction of travel in the short to medium term, US Treasuries at current levels make no sense whatsoever to the discerning investor. The same holds for Gilts, Bunds, JGBs, OATs.. Arguments about Treasury yields reverting to a much lower longer term mean completely ignore a) the overwhelming current and future oversupply, and b) the utter lack of endorsement from one of their largest foreign holders. Foreign holders of US Treasuries, you have been warned. The irony is that many of you are completely price-insensitive so you will not care.
  • There are other reasons to be fearful of stock market valuations, notably in pricey western markets, over and above concerns over the debt burden. As Russell Napier points out in his latest ‘The Solid Ground’ piece,

“In 1919-1921, 1929-1932, 2000-2003, 2007-2009 it was not a resurgence in wages, Fed-controlled interest rates or corporate taxes which produced a collapse in corporate profits and a bear market in equities. On those four occasions equity investors suffered losses of 32%, 85%, 41% and 51% respectively despite the continued dormancy of labour, creditors and the state. It was deflation, or the fear of deflation, which cost equity investors so much. There is a simple reason why deflation has always been so damaging to corporate profits and equity valuations: it brings a credit crisis..

“Investors forget at their peril what can happen to the credit system in a highly leveraged world when cash-flows, whether of the corporate, the household or the state variety, decline. In a deflationary world credit is much more difficult to access, economic activity slows and often one very large institution or country fails and creates a systemic risk to the whole system. The collapse in commodity prices and Emerging Market currencies in conjunction with the general rise of the US$ suggests another credit crisis cannot be far away. With nominal interest rates already so low, monetary remedies to a credit seizure today would be much less effective. Such a shock, after five and a half years of QE, might suggest that the patient does not respond to this type of medicine.”

  • And since Christmas fast approaches, we can’t speak to the merits of frankincense and myrrh, but gold, that famous “6,000 year old bubble”, has always been popular, but rarely more relevant to the investor seeking a true safe haven from forced currency depreciation and an ever vaster mountain of unrepayable debt.

Happy holidays.

Economics

We seem to have miscalculated

“What will futurity make of the Ph.D. standard ? Likely, it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence – after the Crash of, say, 2016, that wiped out the youngster’s inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal Reserve’s methods.

“I expect you’ll wind up saying something like this: “My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates. We put the cart of asset prices before the horse of enterprise. We entertained the fantasy that high asset prices made for prosperity, rather than the other way around. We actually worked to foster inflation, which we called ‘price stability’ (this was on the eve of the hyperinflation of 2017). We seem to have miscalculated.”

– Excerpt from James Grant’s November 2014 Cato speech. Hat-tip to Alex Stanczyk.

You can be for gold, or you can be for paper, but you cannot possibly be for both. It may soon be time to take a stand. The arguments in favour of gold are well known, and just as widely ignored by the paperbugs, who have a belief system at least as curious because its end product is destined to fail – we just do not know precisely when. The price of gold is weakly correlated to other prices in financial markets, as the last three years have clearly demonstrated. Indeed gold may be the only asset whose price is being suppressed by the monetary authorities, as opposed to those sundry instruments whose prices are being just as artificially inflated to offer the illusion of health in the financial system (stocks and bonds being the primary financial victims). Beware appearances in an unhinged financial system, because they can be dangerously deceptive. It is quite easy to manipulate the paper price of gold on a financial futures exchange if you never have to make delivery of the physical asset and are content to play games with paper. At some point that will change. Contrary to popular belief, gold is supremely liquid, though its supply is not inexhaustible. It is no-one’s liability – this aspect may be one of the most crucial in the months to come, as and when investors learn to start fearing counterparty risk all over again. Gold offers a degree of protection against uncertainty. And unlike paper money, there are fundamental and finite limits to its creation and supply.

What protection ? There is, of course, one argument against gold that seems to trump all others and blares loudly to sceptical ears. Its price in US dollars has recently fallen. Not in rubles, and not perhaps in yen, of course, but certainly in US dollars. Perhaps gold is really a currency, then, as opposed to a tiresome commodity ? But the belief system of the paperbug dies hard.

The curious might ask why so many central banks are busily repatriating their gold ? Or why so many Asian central banks are busily accumulating it ? It is surely not just, in Ben Bernanke’s weasel words, tradition ?

If you plot the assets of central banks against the gold price, you see a more or less perfect fit going back at least to 2002. It is almost as if gold were linked in some way to money. That correlative trend for some reason broke down in 2012 and has yet to re-emerge. We think it will return, because 6,000 years of human history weigh heavily in its favour.

Or you can put your faith in paper. History, however, would not recommend it. Fiat money has a 100% failure rate.

Please note that we are not advocating gold to the exclusion of all else within the context of a balanced investment portfolio. There is a role for objectively creditworthy debt, especially if deflation really does take hold – it’s just that the provision of objectively creditworthy bonds in a global debt bubble is now vanishingly small. There is a role for listed businesses run by principled, decent management, where the market’s assessment of value for those businesses sits comfortably below those businesses’ intrinsic worth. But you need to look far and wide for such opportunities, because six years of central and commercial banks playing games with paper have made many stock markets thoroughly unattractive to the discerning value investor. We suggest looking in Asia. There is a role for price momentum strategies which, having disappointed for several years, though not catastrophically so, now appear to be getting a second wind, from the likes of deflating oil prices, periphery currencies, and so on.

As investors we are all trapped within a horrifying bubble. We must play the hand we’ve been dealt, however bad it is. But there are now growing signs of end-of-bubble instability. The system does not appear remotely sound. Since political vision in Europe, in particular, is clearly absent, the field has been left to central bankers to run amok. The only question we cannot answer is: precisely when does the centre fail ? The correct response is to recall the words of the famed value investor Peter Cundill, when he confided in his diary:

“The most important attribute for success in value investing is patience, patience, and more patience. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”

But the absence of patience by the majority of investors is fine, because it leaves more money on the table for the rest of us. The only question remaining is: in what exact form should we hold that money ?

Be patient, and do please set aside thirty minutes to listen to James Grant’s quietly passionate and wonderfully articulate Cato Institute speech. It will be time well spent.

Money

Striking gold

“Sir, Martin Wolf in his article “Radical cures for unusual economic ills” suggests an abandonment of free market capitalism, as it has been practised these past couple of hundred years, and instead wants some kind of witch-doctoring economic quackery to take its place. Savings are the capital that forms the basis of capitalism. You can’t have capitalism without capital. And without interest rates pegged at levels that encourage savings, you won’t generate the quantities of savings necessary to sustain a capitalist economy.

“We need to stop the insanity. For example, savings rates in the US fluctuate around zero per cent along with interest rates set by the Fed. To hide this stab in the back to savers, the Federal Reserve simulates savings with ersatz monetary hokum like quantitative easing designed to create the illusion of a solvent economy that can run fine without actually having any savings.

“Despite the evidence proving the failure of this approach, Mr Wolf continues to recommend attacking savers, including the so-called “savings glut” held by countries in the east that hold large cash reserves as protection against the reckless policies like those suggested by Mr Wolf, who appears ignorant of the history of why these reserves exist in the first place: to protect these countries and currencies from the unorthodox (read “failed”) policy suggestions of pundits and academics who would do us all a great favour by simply admitting that their prescriptions for global growth have completely, unequivocally, failed.”

–       Letter to the Financial Times from Mr Max Keiser, London W1, 28 November 2014.

 

 

So the Swiss have decided not to force their central bank into underpinning its reserves with harder assets than increasingly worthless euros. At least they had the chance to vote. But in the bigger picture, the rejection of the “Save Our Swiss Gold” initiative flies in the face of a broader trend towards repatriation and consolidation of sovereign bullion holdings – following on the heels of similar attempts by the Bundesbank, the Dutch central bank, for example, recently announced that it had moved a fifth of its total gold reserves from New York to Amsterdam. And the physical metal continues its inexorable exodus eastwards, into stronger hands that are unlikely to relinquish it any time soon.

The Swiss vote was preceded by some fairly extraordinary black propaganda, most notoriously by Willem Buiter of the banking organisation that now styles itself ‘Citi’. Once again we were treated to the intriguing claim that gold is nothing more than “a six thousand year-old bubble”, and a “fiat commodity currency” (whatever that might mean) that has “insignificant intrinsic value”. Izabella Kaminska for the FT’s Alphaville republished much of Buiter’s ‘research’; the resultant to-and-fro between FT readers on the paper’s website makes for a fascinating scrap between goldbugs and paperbugs. Among the highlights was Vlady, who wrote:

“When a social construct (gold as money) survives for 6,000 years I would expect curious people to inquire as to whether it is tied to some immutable underlying law, or otherwise investigate if there is something more here than meets the eye.  Not so curiously inclined, our court economists prefer to write this off as a 6,000 year old delusion. That says a lot about the sorry state of the economics discipline today.”

Another was the artfully named ‘Financially Repressed by Central Banks’, who wrote:

“I think that the reason bankers and governments dislike gold backed hard currencies is that it limits their ability to devalue their fiat currency and redistribute wealth in order to stay in power.

The governmental solution to all the debt in the world is to try to inflate it away and slowly take money away from the people via currency depreciation and manipulating interest rates such savers and forced owners of government debt (such as pension schemes) make a negative return.

I think this is robbery – Pure and simple.   The market is not free, it is controlled.

A move away from fiat currency and back to using gold backed currency would remove the ability of governments to print money and this in turn would remove their ability constantly try to avoid facing the consequences of building up huge debts, which in term means they would have to face the music and actually have a plan to repay it.

It is the central banks and private banks who are complicit in this government sponsored process of stealing and their rewards are their ability themselves big bonuses and the occasional tax payer funded rescue..

Mr  Buiter works for a bank.  What a surprise that he dislikes Gold and is presumably very concerned when a central bank (Switzerland) looks like it might do something silly like buying some gold.  Don’t they realize that in acknowledging the concerns of holders of fiat currency (the people of Switzerland) that their actions might encourage others to think that maybe just maybe fiat currency is not quite as useful as gold?

/ rant on / I am not a gold bug, but I am a hard working tax payer who is getting pretty fed up with having my savings earning no interest and possibly being devalued (see Japan) and of not being able to find any sensible place to invest my hard earned due to central bank policies making it impossible to make any return anywhere without taking crazy risks. / rant off /” [Emphasis ours.]

The financial markets feel increasingly unhinged. All-time low bond yields co-exist with all-time high stock markets. Oil has collapsed along with much of the commodities complex. Emerging market currencies have been hit for six. China threatens the West with another strong deflationary impulse. Speaking of matters Chinese, Doug Nolandwrites:

“With global “hot money” now on the move in major fashion, it’s time to start paying close attention to happenings in China. It’s also time for U.S. equities bulls to wake up from their dream world. There are trillions of problematic debts in the world, including some in the U.S. energy patch. There are surely trillions more engaged in leveraged securities speculation. Our markets are not immune to a full-fledged global “risk off” dynamic. And this week saw fragility at the global bubble’s periphery attain some significant momentum. Global currency and commodities markets are dislocating, portending global instability in prices, financial flows, credit and economies.”

Gold is difficult to value at the best of times, in large part because it’s not a productive asset, and partly because it’s conventionally priced in a currency (the dollar) that, like all others, is destined to lose its purchasing power over time. Viewed purely through the prism of price, gold increasingly feels like something close to a ‘value’ investment, given that ‘value’ investing is essentially about picking up dollar bills for something closer to fifty cents. We’re currently reading Christopher Risso-Gill’s biography of the legendary ‘value’ investor Peter Cundill, and some of Cundill’s diary entries seem to be peculiarly relevant to this strange, dysfunctional environment in which we are all trapped. One in particular stands out, which Cundill himself wrote in upper case to make his point:

“THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE, AND MORE PATIENCE. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”

And there’s another, originally from Horace, that was also used by the godfather of ‘value’ investing, Ben Graham himself:

“Many shall be restored that now are fallen, and many shall fall that are now held in honour.”

Economics

“Smacking a skunk with a tennis racket”

“Finally, as expectations of rapid inflation evaporate, I want to contribute to the debate about the November 15, 2010 letter signed by 23 US academics, economists and money managers warning on the Fed’s QE strategy. Bloomberg News did what I would call a hatchet job on the signatories essentially saying how wrong they have been and seeking their current views. It certainly made for an entertaining read. Needless to say, shortly afterwards Paul Krugman waded in with his typically understated style to twist the knife in still deeper. Cliff Asness, one of the signatories of the original letter, despite observing that “responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it’s necessary”, penned a rather wittyresponse. Do read these articles at your leisure. But having been one of the few to accurately predict the deflation quagmire into which we have now sunk, I believe I am more entitled than many to have a view on this subject. Had I been asked I would certainly have signed the letter and would still sign it now. The unfolding deflationary quagmire into which we are sinking will get worse and there will be more Fed QE. But do I think QE will solve our problems? I certainly do not. I think ultimately it will make things far, far worse.”

 

–       SocGen’s Albert Edwards, ‘Is the next (and last) phase of the Ice Age now upon us ?’ (20 November 2014)

 

 

On Monday 15th November 2010, the following open letter to Ben Bernanke was published:

“We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued.  We do not believe such a plan is necessary or advisable under current circumstances.  The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

“We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.”  In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

“We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

“The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.”

Among the 23 signatories to the letter were Cliff Asness of AQR Capital, Jim Chanos of Kynikos Associates, Niall Ferguson of Harvard University, James Grant of Grant’s Interest Rate Observer, and Seth Klarman of Baupost Group.

Words matter. Their meanings matter. Since we have a high degree of respect for the so-called Austrian economic school, we will use Mises’ own definition of inflation:

“..an increase in the quantity of money.. that is not offset by a corresponding increase in the need for money.”

In other words, inflation has already occurred, inasmuch as the Federal Reserve has increased the US monetary base from roughly $800 billion, pre-Lehman Crisis, to roughly $3.9 trillion today.

What the signatories likely meant when they referred to inflation in their original open letter to Bernanke was the popular interpretation of the word – that second-order rise in the prices of goods and services that typically follows aggressive base money inflation. Note, as many of them observed when prodded by Bloomberg’s yellow journalists, that their original warning carried no specific date on which their inflation might arise. To put it in terms which Ben Bernanke himself might struggle to understand, just because something has not happened during the course of four years does not mean it will never happen. We say this advisedly, given that the former central bank governor himself made the following observation in response to a question about the US housing market in July 2005:

“INTERVIEWER: Tell me, what is the worst-case scenario? Sir, we have so many economists coming on our air and saying, “Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?

“BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.” [Emphasis ours.]

To paraphrase Ben Bernanke, “We’ve never had a decline in house prices on a nationwide basis – therefore we never will.”

One more quote from Mises is relevant here, when he warns about the essential characteristic of inflation being its creation by the State:

“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague.Inflation is a policy.”

Many observers of today’s financial situation are scouring the markets for evidence of second-order inflation (specifically, CPI inflation) whilst either losing sight of, or not even being aware of, the primary inflation, per the Austrian school definition.

James Grant, responding to Bloomberg, commented:

“People say, you guys are all wrong because you predicted inflation and it hasn’t happened. I think there’s plenty of inflation – not at the checkout counter, necessarily, but on Wall Street.”

“The S&P 500 might be covering its fixed charges better, it might be earning more Ebitda, but that’s at the expense of other things, including the people who saved all their lives and are now earning nothing on their savings.”

“That to me is the principal distortion, is the distortion of the credit markets. The central bankers have in deeds, if not exactly in words – although I think there have been some words as well – have prodded people into riskier assets than they would have had to purchase in the absence of these great gusts of credit creation from the central banks. It’s the question of suitability.”

And from the vantage point of November 2014, only an academic could deny that the signatories were wholly correct to warn of the financial market distortion that ensues from aggressive money printing.

Ever since Lehman Brothers failed and the Second Great Depression began, like every other investor on the planet we have wrestled with the arguments over inflation (as commonly understood) versus deflation. Now some of the fog has lifted from the battlefield. Despite the creation of trillions of dollars (and pounds and yen) in base money, the forces of deflation – a.k.a. the financial markets – are in the ascendancy, testimony to the scale of private sector deleveraging that has occurred even as government money and debt issuance have gone into overdrive. And Albert Edwards is surely right that as the forces of deflation worsen, they will be met with ever more aggressive QE from the Fed and from representatives of other heavily indebted governments. This is not a recipe for stability. This is the precursor to absolute financial chaos.

Because the price of every tradeable financial asset is now subject to the whim and caprice of government, rational macro-economic analysis (i.e. top-down investing and asset allocation) has become impossible. Only bottom-up analysis now offers any real potential for adding value at the portfolio level. We discount the relevance of debt instruments almost entirely, but we continue to see merit in listed businesses run by principled and shareholder-friendly management, where the shares of those businesses trade at a significant discount to any fair assessment of their underlying intrinsic value. A word of caution is warranted – these sort of value opportunities are vanishingly scarce in the US markets, precisely because of the distorting market effects of which the signatories to the November 2010 letter warned; today, value investors must venture much further afield. The safe havens may be all gone, but we still believe that pockets of inherent value are out there for those with the tenacity, conviction and patience to seek them out.

Economics

Brave new world

“Sir, Adair Turner suggests some version of monetary financing is the only way to break Japan’s deflation and deal with the debt overhang (“Print money to fund the deficit – that is the fastest way to raise rates”, Comment, November 11). This was precisely how Korekiyo Takahashi, Japanese finance minister from 1931 to 1936, broke the deflation of the 1930s. The policy was discredited because of the hyperinflation that followed.”

–       Letter to the Financial Times, 11th November 2014. Emphasis ours. Name withheld to protect the innocent.

 

 

“Don’t need to read the book – here is the premise. Business dreams are nothing more than greed. And you greedy business people should pay for those who are not cut out to take risk. You did not build your business – you owe everyone for your opportunity – you may have worked harder, taken more risk and even failed and picked yourself up at great personal risk and injury     (yes we often lose relationships and loved ones fall out along the way). However, none the less you are not entitled to what you make. Forget the fact that the real reason we have massive wealth today is we can now reach the global consumers – not just local – so the numbers are larger. Nonetheless the fact is that is not fair – and fair is something life now guarantees – social engineers demand that you suspend the laws of nature and reward all things equally. 2 plus 2 = 5 so does 3 plus 3 = 5; everything is now levelled by social engineers.  We need to be responsible for those who choose not to take risk, want a 9 to 5 job and health benefits and vacation. The world is entitled to that – it is only right – so you must be taxed to make up for those who are too lazy to compete, simply don’t try, or fail. In short the rich must mop up the gap for the also ran’s. Everyone gets a ribbon. There are exceptions – if you are Google, BAIDU, Apple or someone so cool or cute or a liberal who will tell people they should pay more taxes – you aren’t to be held to the same standard as everyone else.”

–       ‘cg12348’ responds to the FT’s announcement that Thomas Piketty’s ‘Capital’ has won the FT / McKinsey Business Book of the Year Award, 11th November 2014.
“@cg12348, I think you succeeded in discrediting yourself comprehensively. You didn’t read the book. You do not in fact know what is in it. But you just “know” what is in it. One can only hope that you do a little more work in your business ventures.”

–       Martin Wolf responds to ‘cg12348’.

“Socialism in general has a record of failure so blatant that only an intellectual could ignore or evade it..”

 

“Since this is an era when many people are concerned about ‘fairness’ and ‘social justice,’ what is your ‘fair share’ of what someone else has worked for?”

 

–       Thomas Sowell.

 

 

Forbes recently published an article suggesting that Google might be poised to enter the fund management sector. The article in question linked to an earlier FT piece by Madison Marriage (‘Google study heightens fund industry fears’, 28.9.2014) reporting that the company had, two years ago, commissioned a specialist research firm for advice about initiating an asset management offering. An unnamed US fund house reportedly told FTfm that Google entering the market was its “biggest fear”. An executive from Schroders was reported to be “concerned” and senior executives at Barclays Wealth & Investment Management were reported to perceive the arrival of the likes of Google and Facebook on their turf as a “real threat”. Campbell Fleming of Threadneedle was quoted in the FT piece as saying,

“Google would find the fund management market more difficult than it thinks. There are significant barriers to entry and it’s not something you could get into overnight.”

Bluntly, faced with backing Google or a large fund management incumbent, we’d be inclined to back Google. Perhaps most surprising, though, were the remarks by Catherine Tillotson of Scorpio Partnership, who said,

“There probably is a subsection of investors who would have confidence in Google, but I think the vast majority of investors want a relationship with an entity which can supply them with high quality information, market knowledge and a view on that market. I think it is unlikely they would turn to Google for those qualities.”

We happen to think that many investors would turn precisely to Google for those qualities – assuming they found those qualities remotely relevant to their objective in the first place. So what, precisely, do we think investors really want from their fund manager ? All things equal, it’s quite likely that investment performance consistent with an agreed mandate is likely to be high on the list; “high quality information, market knowledge and a view on that market” are, to our way of thinking, almost entirely subjective attributes and largely irrelevant compared to the fundamental premise of delivering decent investment returns.

After roughly 20 years of the Internet slowly achieving almost complete penetration of the investor market across the developed world, fund management feels destined to get ‘Internetted’ (or disintermediated) in the same way that the music and journalism industries have been. The time is ripe, in other words, for a fresh approach; the pickings for incumbents have been easy for far too long, and investors are surely open to the prospect of dealing with new entrants with a fundamentally different approach.

Another thing prospective digital entrants into the fund management marketplace have going for them is that they haven’t spent the last several years routinely cheating their clients, be it in the form of the subprime mortgage debacle, payment protection insurance mis-selling, Libor rigging, foreign exchange rigging, precious metals rigging.. Virtually no subsidiary of a full service banking organisation can say the same.

Sean Park, founder of Anthemis, suggests (quite fairly, in our view) that the demand for a fresh approach to financial services has never been stronger. In part, this is because

“..the global wealth management and asset allocation paradigm is fundamentally broken.  Or rather it’s a model that is past its sell-by date and is increasingly failing its ultimate customers. The “conventional wisdom” has disconnected from its “source code” meaning that the industry has forgotten the original reasons why things were initially done in a certain way and these practices have simply taken on quasi-mystical status, above questioning.. which means that the system is unable and unwilling to adapt to fundamentally changed conditions (technological, economic, financial, cultural, demographic..)

“And so opportunities (to take a step back and do things differently) abound..

“Coming back to the.. “broken asset allocation paradigm” – the constraints (real, i.e. regulatory and imagined, i.e. convention) and processes around traditional asset management and allocation (across the spectrum of asset classes) now mean that it is almost impossible to do anything but offer mediocre products and returns if operating from within the mainstream framework. (Indeed the rise and rise of low cost ETF / passive products is testimony to this – if you can’t do anything clever, at least minimise the costs as much as possible..)  The real opportunities arise when you have an unconstrained approach – when the only thing driving investment decisions is, well, analysis of investment opportunities – irrespective of what they may be, how they may be structured, and how many boxes in some cover-my-ass due diligence list they may tick (or not)..”

As we have written extensively of late, one of those practices that have taken on “quasi-mystical status” is benchmarking, especially with reference to the bond market. This is an accident waiting to happen given that we coexist with the world’s biggest bond market bubble.

Another problem is that low cost tracking products are fine provided that they’re not flying off the shelf with various asset markets at their all-time highs. But they are, and they are.

We have a great deal of sympathy with the view that the fundamental nature of business became transformed with the widespread adoption of the worldwide web. There is no reason why fund management should be exempt from this trend. What was previously an almost entirely adversarial competition between a limited number of gigantic firms has now become a more collaborational competition between a much more diverse array of boutique managers who also happen to be fighting gigantic incumbents. Here is just one example. Last week we came across a tweet from @FritzValue (blog:http://fritzinvestments.wordpress.com/) that touched on the theme of ‘discipline in an investment process’. With his approval we republish it here:

“Daily checklist:

8am – 10am: Read trade journals and regional newspapers for ideas on companies with 1) new products, 2) new regulation, 3) restructurings, 4) expansions, 5) context for investment ideas

10am – 6pm: Find new ideas. Read 1) company announcements.. 2) annual reports from A-Z or 3) annual reports of companies screened for buybacks / insider buying / dividend omission, etc.

7pm – 10pm: Read books to understand the world / improve forecasts / fine tune investment process

Before each investment:

1)    What do you think will happen to the company and by consequence the stock price ?

2)    Go through a personal investment checklist

3)    Use someone else or yourself as a devil’s advocate to disprove your own investment theses

4)    Have we reached “peak negativity” / has narrative played out ?

5)    Are fundamentals improving ?

6)    Why is it cheap ? Especially if it screens well in the eyes of other investors – i.e. exciting story, other investors, low P/E, etc.

7)    Decide what will be needed for you to admit defeat / sell the position

If you lose focus, sell all the positions, take a break and start again.

Only expose yourself to serious and intelligent people on Twitter / investor letters / media and avoid the noise that other investors expose themselves to.”

Fabulous advice, that has the additional advantage of being completely free. While we spend quite a bit of time agonising over the State’s ever more desperate attempts to keep a debt-fuelled Ponzi scheme on the road, we take heart from the fact that – through social media – an alternative community exists that doesn’t just know what’s going on but is perfectly happy to share its informed opinions with that community at no cost to users whatsoever. O brave new world, that has such people in it !

Economics

Road to nowhere

Spring 2010: A gradual recovery
Autumn 2010: A gradual and uneven recovery
Spring 2011: European recovery maintains momentum amid new risks
Autumn 2011: A recovery in distress
Spring 2012: Towards a slow recovery
Autumn 2012: Sailing through rough waters
Winter 2012: Gradually overcoming headwinds
Spring 2013: Adjustment continues
Autumn 2013: Gradual recovery, external risks
Winter 2013: Recovery gaining ground
Spring 2014: Growth becoming broader-based
Autumn 2014: Slow recovery with very low inflation.. ”

European Commission economic headlines, as highlighted by Jason Karaian of Quartz, in ‘How to talk about a European recovery that never arrives’.

“Well we know where we’re going
But we don’t know where we’ve been
And we know what we’re knowing
But we can’t say what we’ve seen
And we’re not little children
And we know what we want
And the future is certain
Give us time to work it out
We’re on a road to nowhere..”

‘Road to nowhere’ by Talking Heads.

In 1975, Charles Ellis, the founder of Greenwich Associates, wrote one of the most powerful and memorable metaphors in the history of finance. Simon Ramo had previously studied the strategy of one particular sport in ‘Extraordinary tennis for the ordinary tennis player’. Ellis went on to adapt Ramo’s study to describe the practical business of investing. His 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. His thesis runs as follows. Whereas the game of tennis is won by professionals, the game of investing is ‘lost’ by professionals and amateurs alike. Whereas professional sportspeople win their matches through natural talent honed by long practice, investors tend to lose (in relative, if not necessarily absolute terms) through unforced errors. Success in investing, in other words, comes not from over-reach, in straining to make the winning shot, but simply through the avoidance of easy errors.
Ellis was making another point. As far back as the 1970s, investment managers were not beating the market; rather, the market was beating them. This was a mathematical inevitability given the over-crowded nature of the institutional fund marketplace, the fact that every buyer requires a seller, and the impact of management fees on returns from an index. 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; and 6,800 hedge funds.

Perhaps the most pernicious characteristic of active fund management is the tendency towards benchmarking (whether closet or overt). 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.

There is now a grave risk that an overzealous commitment to benchmarking is about to lead hundreds of billions of dollars of invested capital off a cliff. Why ? To begin with, trillions of dollars’ worth of equities and bonds now sport prices that can no longer be trusted in any way, having been roundly boosted, squeezed, coaxed and manipulated for the dubious ends of quantitative easing. The most important characteristic of any investment is the price at which it is bought, which will ultimately determine whether that investment falls into the camp of ‘success’ or ‘failure’. At some point, enough elephantine funds will come to appreciate that the assets they have been so blithely accumulating may end up being vulnerable to the last bid – or lack thereof – on an exchange. When a sufficient number of elephants start charging inelegantly towards the door, not all of them will make it through unscathed. Corporate bonds, in particular, thanks to heightened regulatory oversight, are not so much a wonderland of infinite liquidity, but an accident in the secondary market waiting to happen. We recall words we last heard in the dark days of 2008:

“When you’re a distressed seller of an illiquid asset in a market panic, it’s not even like being in a crowded theatre that’s on fire. It’s like being in a crowded theatre that’s on fire and the only way you can get out is by persuading somebody outside to swap places with you.”

The second reason we may soon see a true bonfire of inanities is that benchmarked government bond investors have chosen collectively to lose their minds (or the capital of their end investors). They have stampeded into an asset class historically and euphemistically referred to as “risk free” which is actually fraught with rising credit risk and systemic inflation risk – inflation, perversely, being the only solution to the debt mountain that will enable the debt culture to persist in any form. (Sufficient economic growth for ongoing debt service we now consider impossible, certainly within the context of the euro zone; any major act of default or debt repudiation, in a debt-based monetary system, is the equivalent of Armageddon.) As Japan has just demonstrated, whatever deflationary tendencies are experienced in the indebted western economies will be met with ever greater inflationary impulses. The beatings will continue until morale improves – and until bondholders have been largely destroyed. When will the elephants start thinking about banking profits and shuffling nervously towards the door ?

Meanwhile, central bankers continue to waltz effetely in the policy vacuum left by politicians. As Paul Singer of Elliott Management recently wrote,

“Either out of ideology or incompetence, all major developed governments have given up (did they ever really try?) attempting to use solid, fundamental policies to create sustainable, strong growth in output, incomes, innovation, entrepreneurship and good jobs. The policies that are needed (in the areas of tax, regulatory, labour, education and training, energy, rule of law, and trade) are not unknown, nor are they too complicated for even the most simple-minded politician to understand. But in most developed countries, there is and has been complete policy paralysis on the growth-generation side, as elected officials have delegated the entirety of the task to central bankers.”

And as Singer fairly points out, whether as workers, consumers or investors, we inhabit a world of “fake growth, fake money, fake jobs, fake stability, fake inflation numbers”.

Top down macro-economic analysis is all well and good, but in an investment world beset by such profound fakery, only bottom-up analysis can offer anything approaching tangible value. In the words of one Asian fund manager,

“The owner of a[n Asian] biscuit company doesn’t sit fretting about Portuguese debt but worries about selling more biscuits than the guy down the road.”

So there is hope of a sort for the survival of true capitalism, albeit from Asian biscuit makers. Perhaps even from the shares of biscuit makers in Europe – at the right price.

Economics

Into the unknown

“Sir, Your headline “Fed’s grand experiment draws to a close” (FT.com, October 29) combines ignorance of what quantitative easing is with insouciance as to its potential effects – both of these mistakes being perennial features of FT coverage of QE. The “experiment”, as you call it, is not at an end; it is, with the purchases now ending, at its height. Only when the Fed starts selling the securities it has purchased back into the market will the US’s QE begin its withdrawal from that height; only when the last purchased security has been sold back into the market, or allowed to expire with consequent permanent expansion of the money supply, will the “grand experiment” (I would prefer that you called it “reckless gamble”) be at its end.

“Only at that point will we even start to see the results – on interest rates, on securities prices, on the economy. The outcome, as has so often been the case with such Keynesian experiments, is unlikely to be pretty.”

  • Letter to the FT from Jon Moynihan, London SW3.

The other potential cause of a sell-off in markets is through a central bank mistake. Some think the liquidity created by QE will eventually leak into higher inflation, but there is no sign of this as yet. More likely is a decline into deflation which would lead to financial distress as debts become more difficult to repay.

“If that does show signs of happening, then we may indeed get to see QE4 rolled out. Daddy might have let go of the market’s hand for the moment but he’s still close by.”

Strange things are happening in the bond market. Few of them are stranger than the reports that a French fund management colleague of Bill Gross (formerly of Pimco) took such exception to public excoriation from his stamp-collecting associate that he quit the business to sell croques monsieur from a food truck. According to the Wall Street Journal, Gross told Jeremie Banet in front of Pimco’s entire investment committee that, “I never understand what you’re saying. Ever.” With those credentials, M. Banet is clearly supremely qualified to become the next chairman of the Federal Reserve. As it is, he elected to return to his job managing an inflation-linked bond portfolio.

He has his work cut out. Consider the sort of volatility that the 10 year US Treasury bond – the closest thing the financial world has to a “risk-free rate” – experienced on 15th October (below).

Intra-day yield, 10 year US Treasury bond, 15th October 2014

10 day Treasury Bond Yield

Source: Bloomberg LLP

Having begun the day sporting a 2.2% yield, the 10 year note during the trading session experienced an extraordinary surge in price that took its yield down briefly towards 1.85%. Later in the same session the buying abated, and the bond closed with a yield of roughly 2.14%. During the same trading session, equity markets sold off aggressively (the UK’s FTSE 100 index, for example, closed down almost 3% on the day). What accounts for such melodrama ?

Analyst Russell Napier takes up the story:

“There it was — a real market come and gone in half an hour, like a pregnant panda at Edinburgh zoo. What did it mean and what should you do? You should pay attention to what happens to the direction of prices when volumes surge and markets work. When the veil is lifted, pay attention to what you see beneath. Last Wednesday, in the space of half an hour of active trading, the Treasury market had one of its most rapid rises ever recorded and equities fell sharply.

“There is a very simple lesson that when the markets finally break through the manipulation they move to price in deflation and not inflation. This is key because it means financial repression has failed. Such repression requires the artificial depression of interest rates but, crucially, it must be paired with boosting inflation above such rates. On October 15th 2014, if only for a few short minutes, market forces broke out and the failure of central bankers was briefly evident.”

These days, you don’t tend to hear the words ‘failure’ and ‘central bankers’ in the same sentence (unless the topic happens to be Zimbabwe). But perhaps the omniscience and omnipotence of central bankers is somewhat overstated. On October 29th, the US Federal Reserve followed a long-rehearsed script and announced that it had “decided to conclude its asset purchase program [also known as QE] this month.”

So now stock and bond markets will have to look after themselves, so to speak. The Economist’s Buttonwood columnist described it as “Letting go of Daddy’s hand”. That coinage nicely speaks to the juvenilisation to which markets have been reduced during six long years of financial repression, unprecedented central bank asset purchases, and the official manipulation of interest rates. Only the asset purchases have abated (for now): the financial repression, one way or another, will go on.

Whether the asset purchases have really disappeared, or merely been suspended, will be a function of how risk markets behave over the coming months and years. We would not be in the least surprised to see petulant markets rewarded with yet more infusions of sweets.

Yet some still associate QE with success. The Telegraph’s Ambrose Evans-Pritchard, or his sub-editor, reckon that central bankers deserve a medal for saving society. He dismisses any scepticism as “hard money bluster”. Economist David Howden, on the other hand, can see somewhat further than the end of his own nose:

“One of the true marks of a great economist is an ability to see past the obvious outcomes and into the veiled results of policies. Friedrich Bastiat’s great essay on “that which is seen, and that which is not seen” provides a cautionary parable that disastrous analyses result when people don’t bother looking further than the immediate results of an action.

“Nowhere is this lesson more instructive than with the Fed’s QE policies of the past 6 years.

“Consider the Austrian business cycle theory. The nub of the theory is that changes in the money market have broader results on the greater economy. In its most succinct form, when a central bank pushes interest rates lower than they should be (by buying assets, for example), the greater economy gets distorted. Some of these distortions are immediately apparent, as consumers buy more goods and everyone takes on more debt as a result of lower interest rates. Some of the distortions are not immediately apparent. The investment decision of firms gets skewed as interest rates no longer reflect savings preferences, and the whole economy becomes fragile over time as erroneous investments add up (what Mises coined “malinvestments”).

“When a financial crisis or economic recession hits, it’s almost never because of some event that apparently happened at the same time. The crisis of 2008 did not occur because of the collapse of Lehman Brothers. It happened because the whole financial system and greater economy were fragile following years of cheap credit at the hands of the Greenspan Fed. If anything, Lehman was a result of this and a great (if unfortunate) example of the type of bad business decisions firms are lured into by loose money. It wasn’t the cause of the troubles but a result of them. And if Lehman didn’t go under to spark the credit crunch, some other fragile financial institution would have.

“The Great Depression is a similar case in point. It wasn’t the stock market crash in 1929 that “created” the Great Depression. It was a decade of loose money policies by the Fed that created a shaky economy. Again, if anything the stock market crash was the result of stock prices being too buoyant and in need of a repricing to reflect economic fundamentals. Just like today, stocks rose to such storied heights as a result of cheap credit, not because of the seemingly “great” investments funded by it.

“The Fed has lowered interest rates since July 2006. We have just come off the period with the most rapid and extreme increase in the money supply ever recorded in American history. The seeds of the next Austrian business cycle have been sown. In fact, they are probably especially fertile seeds when one considers that the monetary policy has been so loose by historical standards. Just as cheap credit of the 1920s beget the Great Depression, that of the 1990s beget the dot-com bust and that of the mid-2000s beget the crisis of 2008, this most recent period will also give birth to a financial crisis.”

Although our crystal ball is no more polished than anyone else’s, our fundamental views are clear. Bonds are already grotesquely expensive, yet may get more so (we’re not investing in “the usual suspects” so we don’t much care). Most stock markets are pricey – but in a world beset by QE (and prospects for more, in Europe and Asia) which prices can we really trust ? By a process of logic, elimination and deduction, out of the major asset classes, only quality listed businesses trading at or ideally well below a fair assessment of their intrinsic worth offer any semblance of value or attractiveness. Pretty much everything else amounts to nothing more than paper, prone to arbitrary gusts from some very powerful, and very windy, bureaucrats. We note also that former Fed chairman Alan Greenspan, no doubt looking to polish his legacy, managed to front-run the Fed’s QE announcement by pointing to the merits of gold within a government-controlled, fiat currency system. Strange days indeed.