FYI | May 09 2014
By Tim Price, PFP Wealth Management (UK)
Balloon Dog (Orange)
“If I had an hour to solve a problem and my life depended on it, I would use the first 55 minutes determining the proper question to ask, for once I knew the proper question, I could solve the problem in less than five minutes.”
– Albert Einstein, quoted on the new Library of Mistakes.
“The art market provides an excellent barometer of the speculative mood, given art prices depend entirely upon what other people are prepared to pay. A bubble in modern and contemporary art, which was evident before the financial crisis, has returned. Last November, a sculpture by Jeff Koons – Balloon Dog (Orange) – fetched $58 million at auction, a record sum for a work by a living artist. The contemporary collector apparently isn’t fazed by the fact that this dog was one of five “unique” versions or that Koons himself didn’t produce the work by his own hand but had it made in a factory. The same month, a painting by Francis Bacon sold for $142 million, the highest price ever paid for any work at auction.”
– Edward Chancellor of GMO, ‘Looking for bubbles, part two’.
“I’ve historically encouraged buy-and-hold investors to maintain their own investment discipline, though with a realistic and historically informed understanding of prospective return and risk. At present, my concern is that many buy-and-hold investors are unaware of how dismal prospective returns are likely to be from current prices, over every investment horizon of a decade or less. Given the duration of the equity market (which mathematically works out to be roughly the market price/dividend multiple), a passive 100% exposure to equities is appropriate only for investors with a horizon of about 50 years. Passive buy-and-hold investors would be well-advised to scale their equity exposures accordingly, based on their own actual investment horizons. Meanwhile, it seems clear that investors have mentally minimized their concept of potential downside, despite two 50% bear market losses in recent memory that were both accompanied by aggressive Fed easing all the way down.
“..The central message to investors with unhedged equity positions and investment horizons shorter than about 7 years: Prospective returns have reached zero. The value you seek from selling in the future is already on the table today. The future is now.”
– John Hussman, ‘The future is now’.
To return to Einstein’s problem: what question should investors be asking themselves now ? We think it should be: how can we best protect our capital given that the financial markets appear, once again, to have gone mad ?
First, the evidence for the prosecution. The chart below, from SocGen’s Andrew Lapthorne by way of the [UK] Daily Telegraph, shows the nominal yield on a mix of different assets held by institutional funds. The return on SocGen’s Quality Index is close to its all-time low of 2.4%.
While equity market valuations give some concern, the real risks are concentrated in sovereign debt. Irish 10 year bond yields, for example, are close to US 10 year bond yields. Greece’s recent 5 year bond was floated at a yield of less than 5% and was seven times oversubscribed.
The Economist magazine has just published a feature on fund management. It points out that within the $64 trillion global asset management industry, low cost index funds account for just 11% of the market. It highlights the belief on the part of many investors that they “can do better than the index by picking a hot fund: money for old hope.” But this assumes that most investors are actively seeking to beat the (stock) market. This may be true, but it does not address the entirety of the fund management community. There are plenty of investors, ourselves included, who have no particular interest in what “the market” does: we are seeking, instead, to preserve capital over the medium term and generate a positive real return.
The sad dilemma of our times is that the monetary authorities have made the successful pursuit of low risk investing virtually impossible. By driving deposit rates down to below the rate of genuine real world inflation, investors are effectively forced to take on much more price risk than they might otherwise choose. By deploying ever more aggressive quantitative easing and monetary stimulus, central banks have a) reemphasised the risks in holding cash in currencies that are being actively devalued and b) driven the yields on government debt – and by extension all other forms of credit investment – to well below their “ordinary” levels. Investors have responded to this gale of financial repression by seeking solace in the stock market. And indeed, quantitative easing has shown a wonderful tendency to make stock prices rise. So far.
Frederic Bastiat’s ‘broken windows fallacy’ is one of the most widely discussed essays in economics. A shopkeeper has his window accidentally broken by his son. A crowd gathers, and pretty soon they become somewhat philosophical:
“It’s an ill wind that blows nobody any good. Everybody must live, and what would become of the glaziers if panes of glass were never broken ?”
The essay is titled ‘That which is seen, and that which is not seen’. What is seen is the broken window, and the six francs that the happy glazier receives for fixing it. Those six francs will circulate in the economy.
What is not seen is what the shopkeeper might have done with those six francs, had he not been obliged to give them to the glazier. Society is no better off:
“..neither industry in general, nor the sum total of national labour, is affected, whether windows are broken or not.”
Bastiat’s essay might as well have been titled ‘The law of unintended consequences’. We can see with our eyes what the impact of quantitative easing has been on the stock market. Every time a new iteration of QE has been announced and deployed, stock prices have typically risen. We can see the market price level on our computer screens. What we cannot see is what projects might have been supported, what investments made, with capital that ended up in the stock market instead. And we can also fear what projects will have been supported, what investments made, on the back of interest rates that are being artificially suppressed at well below their natural level. The Austrian School would term at least some of these projects ‘malinvestments’. Those ‘malinvestments’ might well include some of the residential properties in London and the south-east that seem to have become the compulsory investment choice of the rich.
It seems as clear as crystal to us that, once again, with tiresome regularity, developed world central banks are busily inflating bubbles that will inevitably burst. We know that they will burst, we just do not know when. Bubble candidates include stocks, bonds and property: only the three major asset classes, so nothing to worry about. We have long held that asset class diversification remains the last free lunch in finance. But asset class diversification alone is insufficient if there is genuinely a bubble in everything. What is then required is an unusual extra commitment to selectivity. Indices should be abandoned. The Economist’s recommendation to concentrate on low cost index trackers should be treated as the lazy advice it is, because it misses the wood for the trees. Prudent investors should look for attractive valuations along the roads less travelled, less crowded by hordes of index-trackers determined ultimately to fall exactly in line with the index.
If you had Einstein’s hour to solve the problem, what question would you ask ? We think this dismal financial environment requires a root-and-branch return to first principles. It isn’t just: what do we want to own ? Should it be a combination of appropriately valued stocks, bonds, property, cash, and gold ? How can we best avoid the more obvious risks to our capital ? It’s a question of: what do we want to achieve with our capital in the first place ? (We think for our clients, trying to “beat the market” is entirely the wrong objective today.)
Markets are much less efficient and rational, in our view, than they are widely held to be, not least by the nominating committee for the Nobel Prize. Europe’s stock markets were also buoyant well into the summer of 1914. They initially shrugged off the assassination of the Austrian heir, Archduke Franz Ferdinand, in Sarajevo. But as investors began to grasp the implications of a European war with Russia siding with Serbia, both bonds and stocks started to sag as the more proactive investors began to raise liquidity. Historian Niall Ferguson points out that stock-jobbers on the London Stock Exchange, heavily reliant on borrowed money to finance their equity holdings, started going bankrupt. Counterparty risk blossomed, with bill brokers caught with customers on the continent unable to remit funds. There were fears of bank runs. The Viennese stock market closed, on July 27, 1914. Within a week all the continental exchanges had followed, along with London and New York. The world’s major stock markets remained closed for up to five months.
Today we have western stock markets either at, or close to, record nominal highs. Interest rates remain at 300-year lows. This despite fears of a slowdown, and deflating credit bubble, in China, the looming end of QE in the United States, and military escalation in Ukraine. And an unreconstructed banking system in the euro zone. What did you want to do with your capital again ?
Tim Price
Director of Investment
PFP Wealth Management
6th May 2014.
Follow me on twitter: timfprice
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