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

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

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

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

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

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

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

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

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

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

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

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

The Daily Telegraph, 8 April 2014.

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

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

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

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

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

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

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

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

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

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

Doug Noland again:

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


“Everything we are told about deflation is a lie”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


Lured by plausible nonsense

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


More Bread and Circuses

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

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

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

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

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

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

Continue reading “More Bread and Circuses”



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

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

- ‘This day in financial history’ on

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

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

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

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

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

Data courtesy Fairfax Financial Holdings Ltd, March 7 2014.

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

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

So in summary, here are the cardinal errors:

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

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

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

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

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

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

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

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

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

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


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


Forty centuries of learning nothing

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Screen Shot 2014-02-25 at 09.21.31

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

Screen Shot 2014-02-25 at 09.22.40

Some thoughts:

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

This article was previously published at The price of everything.


Animal spirits deflating

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

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

- James Grant, recently interviewed on CNBC.

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

Screen Shot 2014-02-11 at 09.26.27

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

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

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

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

Screen Shot 2014-02-11 at 09.26.43

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

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

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

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

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

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

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

This article was previously published at The price of everything.


Not at Davos and proud of it

“We know Carney is blagging us, he knows we know but he has to keep a straight face and essentially say – look chaps no fundamental reason to keep rates at zero – in fact none whatsoever – but I need a couple of years to offload all our Gilts back onto you chumps.”

- Analysis of UK central bank policy from an anonymous but well-respected City source.

So farewell then, forward guidance. We barely knew you. We were never fans of this policy and said as much. Here, for example, is what we wrote in ‘The Spectator’ last October:

The financial crisis of 2007-8 was caused in large part by unsustainable property markets in the US, the UK and elsewhere. Credulous borrowers took on too much debt and credulous bankers encouraged them. The sudden abatement of that frenzy meant that governments had to step in to bail out otherwise insolvent banks. In the process, government finances disintegrated, hence the uneasy half-steps toward austerity undertaken throughout the indebted West. Yet central bankers now seem to believe the best medicine for a financial meltdown triggered by a housing bubble is a new housing bubble. George Osborne’s sudden urge to tinker with his own Help to Buy scheme is an indication of Downing Street’s nervousness about this trend.

But there is only so far central banks can go in the cause of economic stimulus. Traditionally, cutting base rates has always provided a ‘coup de whisky’ for jaded markets. So when base rates are stuck around zero, unorthodox stimulus is required. The Bank of England has provided it, in the form of its quantitative easing programme. For QE, read printing money. We’ve had £375 billion so far and not a whole lot of obvious economic recovery to show for it, other than in the property markets of Mayfair, Chelsea and Belgravia.

Five years on from the collapse of Lehman Brothers, which threatened a second Great Depression, our central bankers are treated as gods. Since there is no counterfactual, we will never know what might have happened if western governments had pursued free market policies and allowed a few bankrupt banks to fail (or be wholly nationalised, rather than perpetuate the illusion of a healthy financial sector). What’s clear is that central bank stimulus has entered hitherto uncharted territory: historically unprecedented base rates; trillions of dollars, pounds and yen conjured up to reconstruct bank balance sheets and support monstrous government borrowing; hyper-aggressive reflationary tendencies that have driven millions of investors into high-risk assets. If economic health could be measured in property values alone, the stimulus has been a success. In terms of maintaining sound currencies or encouraging a climate of confident business investment, central bank stimulus has been a disaster.

It’s time to ask whose interests the central banks really serve. While they pay lip service to the interests of embattled savers, it is clear that their primary function today is to act as lenders and stimulators of last resort to a venal banking system — Danegeld, if you prefer, paid by savers through artificially low deposit rates and channelled to a narrow financial elite. But it will be a pyrrhic victory for Carney and his peers if our banks have been ‘saved’ at the expense of everybody else.

The base rate — the fundamental reference rate for the price of money — is under the control of the Bank of England’s monetary policy committee. What the Bank of England cannot entirely control, however, is the gilt market, which dictates how cheaply or expensively the UK government can borrow money over various terms. Alarmingly for Carney, gilt investors have already voted with their feet. His much heralded ‘forward guidance’ — flashy central bank jargon for keeping interest rates on hold until there is tangible evidence of economic recovery in falling unemployment numbers — has been revealed as farce by rising gilt yields. The market, in other words, does not believe the governor’s pledge. In vowing to keep back the tide, Mark Carney is acting like a latter-day Cnut.

Longstanding readers will also appreciate that we feel toward central bankers the way lamp-posts would feel toward dogs – if they were capable of feeling anything at all. It’s a sad thought that there is apparently nobody better qualified than Mark Carney from within this sceptered isle’s native population of 63 million – but then we must accept that there are only so many Goldman Sachs alumni out there, let alone those that must squeak by on a housing allowance of just £250,000. If it were down to us, we would replace more or less the entire executive staff of the Bank of England (and the Fed, and the ECB..) with an old sock. With a nod to the democratic impulse, we could perhaps be allowed to vote for our favourite old sock from a roster of different socks, as opposed to suffer the economic indignity of unelected bureaucrats manipulating interest rates, and much else besides, in the cause of bailing out their buddies at otherwise insolvent banks (and governments).

But there’s the world as we might like it, and there’s the world as is. In the world as is, a popular January pastime for economists, fund managers and financial analysts is to issue unsolicited predictions about how the balance of the year will shape up, investment-wise. We have to assume that these are always self-interested and conflicted: Chinese equity managers will mysteriously forecast extraordinarily strong economic growth in China (and no blow-up of the shadow banking system); Gilt investors will mysteriously foresee strong performance from UK government bonds despite the fact that real yields are non-existent and Mark Carney is caught between a rock and a hard place (see above) when it comes to exiting from now unnecessary monetary stimulus; etc. etc. ad infinitum for all the different asset classes and their respective managers.

Well, we don’t see the point. What’s more interesting to those of us not sufficiently self-important to be wining and dining at Davos this year (Matt Damon? Really?) is to get an assessment of consensus expectations from the City, and then consider those. Helpfully, this is exactly what Espirito Santo’s Marcus Ashworth has done. Here is his Top Ten summary of ‘Street consensus’ for 2014:

  1. Equities to continue to grind higher, an up year but not as strong as 2013. Despite the fact that earnings are anaemic and buy-backs are the only response.
  2. Bonds might be doing a bit better now, led by credit, but bond yields must go up substantially at some point this year.
  3. Dollar to go higher, Yen lower, Euro to crack at some point surely.
  4. Nikkei to put in another banner year, ahead of the pack as Yen weakens.
  5. Oil lower as US supply alters the world dynamic, Iran and others become less pressing with supply snafus dissipating.
  6. China to struggle to keep growth pace up, Government forced to prevent bankruptcies.
  7. Gold to wallow as risk on makes it ever less of a hedge fund toy but gold bugs will continue to fret about the Bundesbank’s gold and China buying it all.
  8. Bank of England to be the first to raise rates but not before the ECB takes them negative. Fed will be all tapered out by the summer, November latest.
  9. Credit [i.e. corporate debt] is about as tight as it can possibly get, in the trough, only a muppet would buy it down here.
  10. Emerging markets are so, like, 2013; current account deficits and currency weakness will force slow money back to the major markets. Europe the new (only) alpha source?

Of course, one response to apparently consensus positions is to take the other side of the trade. But contrarianism for contrarianism’s sake is also a dangerous game. More to the point, while any of us can state a market forecast with a degree of confidence, nobody really knows. From our own perspective, Marcus’ Top Ten feels intuitively correct – these seem to us to represent a fair reflection of many investors’ hopes / fears / biases / portfolios. So what could be the shockers?

  1. Equities don’t necessarily grind higher for FY2014 as a whole, but mean revert on the basis of some exogenous shock that no-one saw coming; or for that matter in response to one of the many problems that are already well flagged.
  2. Bond yields “go Japanese” to low levels well below consensus.
  3. Fears / flows over (Fed) tapering cause currency markets to go mental.
  4. Japanese stocks disappoint.
  5. Some or other Middle Eastern black comedy in the making goes full Strangelove.
  6. China fails to crash. (Or Renminbi fails to appreciate.)
  7. Gold goes sharply higher in response to 3.
  8. Gilt yields collapse as economic growth is revealed to be a fantasy conjured up by a central London property bubble.
  9. Credit spreads remain tight (they are clearly poor value).
  10. Emerging markets outperform.

So far, so entertaining. A harmless enough diversion. Mostly irrelevant to us, since we spend more time avoiding obvious flashpoints than flirting with them. We’re positioned in

  1. Creditworthy sovereign and quasi-sovereign bonds, with a growing allocation to floating rate exposure.
  2. Deep value equities, concentrated in Asia and Japan (with currency selectively hedged).
  3. Systematic trend-followers, which are nothing if not consistently uncorrelated to stocks and bonds.
  4. Real assets, notably the monetary metals, gold and silver. This was obviously a pain trade last year, but for us it wasn’t a trade at all, rather a conscious decision not to play in paper currency conflagrations-to-come.

It strikes us, in the light of Mr Carney’s awkward gyrations over forward guidance, and anticipating a less than smooth tapering process from Janet Yellen at the Fed, that 2014 will be the year in which the central banking emperors’ new clothes[1] are revealed to be from Primark rather than Prada.

[1] Mixed metaphors, of a sort. We know that the emperor’s new clothes consisted of his birthday suit and nothing else. Perhaps we should have said, after Warren Buffett, that 2014 will be the year when we get to see, from a universe comprising governments and investors, just who’s been swimming naked.

This article was previously published at The price of everything.


Rate expectations

“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment.”

- Warren Buffett, ‘How inflation swindles the equity investor’, May 1977.

A happy new year to all readers.

On December 31st, 1964, the Dow Jones Industrial Average stood at 874. On December 31st, 1981, it stood at 875. In Buffett’s words,

I’m known as a long term investor and a patient guy, but that is not my idea of a big move.

To see in stark black and white how the US stock market could spend 17 years going nowhere – even when the GDP of the US rose by 370% and Fortune 500 company sales went up by a factor of six times during the same period – the price chart for the Dow is shown below.

17 years and not much to show for it: Dow Jones Industrial Average, 1964-1981


So the US stock market suffered a Japan-style lost decade, and then some. Back to Buffett, again.

To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line..

In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there–in that tripling of the gravitational pull of interest rates- -lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.

In his magisterial (and deeply witty) 2013 Year In Review, Cornell chemistry professor and economic agent provocateur David Collum reminds us that

The 32-year-old bond bull is long in the tooth, fully priced for an inflation-free world. We have central bankers on a bond buying spree that has the surreal effect of keeping interest rates low by printing money. Of course, these shenanigans will end, and price discovery in bonds will be accompanied by investors’ self-discovery. Optimists bray that rising rates are bullish, a sign that the world economy is recovering. In 1999, however, Buffett wrote a compelling article in Fortune attributing secular equity moves to one and only one parameter—the direction of long-term interest rates. Secular equity bull markets occur when long-term rates are dropping—not low but dropping—and secular bears occur when rates are rising. He didn’t equivocate..

“So are rates really that low? In a word, yes.. The salad days of the bond market are in our rear- view mirror. The rate bottom and subsequent rise will be global. Rising rates will spread into the markets and economy at large, causing concurrent stagnation, dropping price earnings ratios (from nosebleed Case–Shiller estimates of 24), collapse of credit-fuelled/capex-lite corporate profit margins, and crush under-funded pensions and municipalities rendering them less funded. If rates have nowhere to go but up, what direction are they headed?

So how you feel about asset allocation this year should largely be a function of how you feel about interest rates. And if you fear that interest rates are more likely to rise – triggered, perhaps, by a combination of Fed tapering and general weariness / revulsion at the manipulation of so many financial assets – then you should perhaps question your commitment to western equity markets as well as to bonds, given Buffett’s and Collum’s assertions above. The observation bears repeating. “Secular equity bull markets occur when long-term rates are dropping.. and secular bears occur when rates are rising.” This is hardly rocket science.

Of course, 2014 could be yet another year in which equity markets rise further, driven by hopes and expectations of still more QE, but that’s not a bet we’re entirely comfortable making. Since we’re primarily attracted by valuations and not by momentum, we’re now fishing for equities in a clearly demarcated pool (Asia and Japan – because that’s where values are most compelling). We are not interested in most western markets because the value isn’t visible to us and the underlying growth (fundamentals, anybody?) looks pathetic.

And our monetary authorities have showered financial markets with kerosene by ensuring that the conventional ‘risk-free’ alternative to equities (i.e. government debt) is anything but. So we find ourselves trimming fixed interest exposure and duration risk, and largely replacing it with floating rate exposure instead. (It has been several years since we held Gilts, and we’ve never held US Treasuries.)

Our two allocations to ‘alternative’ assets proved variously problematic in 2013. With a few exceptions, trend-following funds struggled to find sufficient strong trends to harvest meaningful returns. But we retain the exposure in large part because we think that a) human nature is unlikely to change profoundly this year, so any return to the primacy of fear over greed could easily generate profits to be reaped from the downside of markets and b) the position-sizing and in particular the risk management generally practised by trend-following managers offers some significant insurance in the event of any pronounced market ‘accidents’. Our other exposure to ‘alternative’ assets was, of course, in the monetary metals and related holdings. As David Collum accurately concedes,

It was a very expensive year to be in the Church of Austrian Economics and Hard Assets.

2013 was the year that the mainstream financial media went aggressively anti-gold, and Collum cites three pertinent quotations from the New York Times:

There is simply nothing in the economic picture today to cause a rush into gold. The technical damage caused by the decline is enormous and it cannot be erased quickly. Avoid gold and gold stocks.

Two years ago gold bugs ran wild as the price of gold rose nearly six times. But since cresting two years ago it has steadily declined, almost by half, putting the gold bugs in flight. The most recent advisory from a leading Wall Street firm suggests that the price will continue to drift downward, and may ultimately settle 40% below current levels.

The fear that dominated two years ago has largely vanished, replaced by a recovery that has turned the gold speculators’ dreams into a nightmare.

But as he also points out, these quotes are from 1976, when the spot price of gold fell from $200 to $100 an ounce. Thereafter, gold rose from $100 to $850. Why do we continue to keep the faith with gold (and silver) ? We can encapsulate the argument in one statistic. Last year, the US Federal Reserve enjoyed its 100th anniversary, having been founded in a blaze of secrecy in 1913. By 2007, the Fed’s balance sheet had grown to $800 billion. Under its current QE programme (which may or may not get tapered according to the Fed’s current intentions), the Fed is printing $1 trillion a year. To put it another way, the Fed is printing roughly 100 years’ worth of money every 12 months. (Now that’s inflation.) Conjuring up a similar amount of gold from thin air is not so easy.

This article was previously published at The price of everything.


The Fright Before Christmas, revisited

“One good thing about Christmas shopping – it toughens you up for the January sales.” – Grace Kriley.

We first published the following doggerel in December 2007. In the finest tradition of reheating old Christmas chestnuts, we publish it again today. With some annotations to mark the passing of six extraordinary years and, in some cases, no substantive change or progress at all.

‘Twas the fright before Christmas; the merchants did grouse [1],
Not a damn thing was selling, not even a house [2];
Restocking was futile with goods still on shelves,
And the streets were now teeming with unemployed elves [3].
The FSA [4] warned of a housing collapse,
An environment hitherto known just to Japs [5].

And Shanghai and Shenzhen encountered sharp falls [6]
An ominous sign when east Asia appalls.
(Only Tesco [7] was thriving – and that was before
‘Fresh and Easy’ was launched – how Wal-Mart did guffaw.)
The bankers were choking on alphabet soup
Of CDOs, SIVs; all sorts of gloop [8].
Bond salesmen were sweating, awake in their beds,
With visions of dole queues [9] (and widening spreads).

In Floridian fund pools there was such a clatter
As portfolios blew up with foul fecal matter.
Their managers, much like their bonds, were distressed,
With the agents who’d rated them under arrest [10],
And the banks that had sold everyone down the river
Saw their equity ratios down to a sliver;
Man turned against man, and the brokers the same
Lashed out at their rivals (it was all just so lame):

Punk, Ziegel slashed Goldman Sachs, Morgan and Merrill,
And Bear Stearns [11] and Lehman [12] they did also imperil,
The markets a-brim with black swans and fat tails –
What happens when mania with credit prevails.
The quant funds were savaged as bell curves deflated
And CFOs had to be strongly sedated.

Will central banks save us [13]? The stock markets rally,
But interbank lending now feels like Death Valley.
The bulls now see good news in looming recession [14]
But try to get upbeat about repossession.

The bank stocks are cheap now but could yet get cheaper
As retailers cower at the sight of the Reaper.
Diversification in assets should work
If lending conditions [15] continue berserk.

Some market neutrality also appeals
For when event-driven runs out of new deals,
And if the unthinkable does now unfold
There’ll be merit in silver and still more in gold [16].
Amid confidence crisis and capital flight
Happy Christmas to all, and to all a good night.

[1] Six years ago there were evidently signs of retail recession. Happily, the central banks have solved all the world’s problems now.

[2] And there were also visible issues in property markets. Happily, the central banks have solved all the world’s problems now.

[3] And there were evidently concerns about unemployment. Happily, the central banks have solved all the world’s problems now. Apart from the (youth) unemployment rates in Greece, Italy, Portugal, Spain..

[4] Now FCA. Which sounds like a rude acronym even if it isn’t.

[5] With apologies to any Japanese readers.

[6] Plus ça change..

[7] Happier days..

[8] Can’t believe this was six years ago.

[9] The City has shed 100,000 jobs since 2007. That noise you hear is the sound of the world’s smallest violin, playing just for them.

[10] Credit ratings agency staff were never actually imprisoned. Or fired – from giant howitzers into the sea.

[11,12] Takes you back, doesn’t it?

[13] Clearly, they already have, and will continue to do so in perpetuity.

[14] For the West to re-enter recession in 2014 would be to imply it ever enjoyed a recovery.

[15] It’s no longer bank lending we should be worried about, but central bank lending.

[16] Gold stood at $802 when this was first written, versus $1200+ today. The death / irrelevance of gold has been somewhat overstated during the ‘Panic of ‘13’.

This article was previously published at The price of everything