Such terrible suspense

“This suspense is terrible. I hope it will last.”

–        Oscar Wilde.


Is there any investor out there not suffering from crisis fatigue ? The Greek black comedy rolls on. German bonds – especially at the long end – continue to fall faster than FIFA’s credibility. Fears of a Chinese credit bubble duke it out with worries over US interest rate policy. It can all be quite exhausting. But it needn’t be – we can choose what to worry about. The pragmatic investor might well be blithely indifferent to these concerns, on the basis that a) there’s nothing we can do about them and b) none of it really matters. Provided that we’ve positioned our investible assets appropriately.

First, Greece. The country is toast. This is hardly a revelation. Clearly, a Grexit has implications for the future stability of the euro zone. But if you take the view, which we are inclined to, that the euro zone is anyway destined for perhaps a decade of sub-optimal growth, what real difference will a Grexit make ?

Next, euro zone bonds. David Oakley in the FT writes that a Greek default “[would] likely prompt.. a switch out of peripheral bond markets into havens such as gilts and US Treasuries.” There was once a time – say, as far back as March this year – when any mention of “havens” would have included German government bonds, or Bunds. Not any longer. Our favourite “risk-free” reference rate is the yield on the German government 2.5% bond maturing in August 2046. Since mid-April, the yield of this bond has risen by just over 1 percent, from 0.46% to 1.54% at the end of last week. Sounds relatively innocuous, no ? That rise in yield equates to a fall in price of roughly 36%. In just over a month. We thought the collapse in Bund prices was grisly, until we spotted the carnage unfolding in the Austrian government bond market. Ladies and gentlemen, we give you the Austrian government 3.8% bond maturing in January 2062. The price of this “risk-free” asset has fallen from roughly 220 to 162 as at the end of last week. That is a fall in price of nearly 60%. Those who are mathematically inclined might want to consider that when this bond matures (if this bond matures), in January 2062, it will do so at a price of 100. Anybody buying this bond today and intending to hold to term will incur a guaranteed capital loss of a further 62%. Well, that’s bond investors for you. Ben Graham had a nice line about the definition of investment:

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

He was probably referring to activity in stocks. But it might give Austrian government bond “investors” pause if they consider that by Ben Graham’s definition, what they are really dealing in is highly “speculative”.

Next, China. Is the Chinese economy demonstrating signs of a bubble ? David Stockmanthinks so. As he suggests delicately,

“China is the greatest construction boom and credit bubble in recorded history. An entire nation of 1.3 billion has gone mad building, borrowing, speculating, scheming, cheating, lying and stealing. [And we thought it was just our own banks.] The source of this demented outbreak is not a flaw in Chinese culture or character – nor even the kind of raw greed and gluttony that afflicts all people in the late stages of a financial bubble.. Instead, the cause is monetary madness with a red accent.”

We certainly agree on the “monetary madness” front – and the madness is not restricted to China. It is alive and well in the US. Last week, over six years since the financial crisis and the collapse of Lehman Brothers, the IMF called for the US Federal Reserve to delay its first increase in interest rates in nearly a decade. Former Fed governor Lawrence Lindsay does not share the IMF’s doveish view on rates:

“We’re delaying a normalization of rates way, way beyond what is prudent. We have a monetary policy that’s now in place that was adopted for the crisis conditions of 2008 and 2009. This summer we’re going to be getting the seventh year of this recovery. It’s been a lousy recovery, but it’s still the seventh year of a recovery. That is totally inappropriate..

“We’re at the point of absurdity. Maybe it made sense when you had a crisis. It does not make sense now. At some point what is going to happen – and this gets to my eight or nine cataclysmic number [on a scale of 1 to 10] – is that we’re going to get a series of bad numbers – a little higher inflation, higher average hourly earnings or whatever – and the market is suddenly going to say, “Oh my God, they are so far behind the curve that they will never catch up.” And the market is going to force an adjustment on the Fed that will be wrenching. That’s the cataclysmic outcome. If the Fed were to get a little bit ahead of the curve – or even maybe move a little bit closer to the curve – that’s the best we can hope for – we would mitigate that.  We would phase into it gradually. And that’s why so much is at stake in the monetary policy that we adopt now.”

Greece may default. So what ?

Supposedly safe bond markets are collapsing. So what ?

Chinese credit looks bubbly. So what ?

US interest rate policy is grotesque. So what ?

For a moment, look at the world not from a top-down perspective, but from the bottom up. The top-down problems are legion. But so are the bottom-up opportunities, especially if you look at them from a global and not narrowly local perspective. Ben Graham, author of ‘The Intelligent Investor’, recommended that the defensive investor in common stocks should follow four key rules:

  1. Maintain adequate “though not excessive” diversification – in other words, owning between 10 and “about 30” individual holdings.
  2. Ensure that each company selected “be large, prominent and conservatively financed. Indefinite as these adjectives must be, their general sense is clear.”
  3. “Each company should have a long record of continuous dividend payments.”
  4. The investor should be careful not to overpay for such companies.

When the price momentum of easy money fades or cracks, “growth” stocks (and perhaps bonds too) are risky all the way down. But when high quality and explicit “value” stocks happen to cheapen up in price due to a broad-based market sell-off, that doesn’t make them riskier, simply even more attractive. Even a meltdown in the bond market is of little practical relevance to a company that has little or no debt.

So yes, there are plenty of things to worry about. And there’s also no need for concern at all. Perversely, both of these statements could be correct, depending on how you choose to invest.

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