“You have to be smart. The easy days are over.” - Robert Kiyosaki.
The history of modern financial markets is already so rich with data and anecdote that you can argue pretty much any investment case you like and cite credible evidence on its behalf. Two examples follow.
Bear thesis: that financial markets are sometimes unable to price in a political cataclysm until it’s already too late to act. Evidence: Europe’s financial markets were 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 in which Russia sided with Serbia, both bonds and stocks started to sag as the more proactive financial players began to raise liquidity. European investors began selling first Russian securities, then American. This repatriation of capital led to a flight to quality: sterling surged (being then the global reserve currency) while the rouble and dollar sold off. The historian Niall Fergusson points out that stock-jobbers on the London Stock Exchange, being heavily reliant on borrowed money to finance their equity holdings, started going bankrupt. (Shades of Bear Stearns in 2008, and then the cascade of failing banks that followed.) Counterparty risk blossomed, with bill brokers caught with customers on the continent unable to remit funds. There were fears of a banking crisis. Vienna’s stock market was the first to close, on July 27, 1914. Within a week, all the continental exchanges had followed, along with those of London and New York. The world’s major stock markets would remain closed for up to five months. Some of them would never re-open.
Bull thesis: that there is tremendous wisdom in the market crowd. Evidence: the British stock market bottomed for all time in the summer of 1940, just before the Battle of Britain. The US stock market turned forever toward the end of May 1942 at the time of the Battle of Midway. The German stock market peaked at the high-water mark of the attack on Russia just before advance German patrols glimpsed the spires of Moscow in early December 1941. At the time, no-one except the stock markets recognized the pivotal nature of these developments. In the words of Morgan Stanley’s veteran strategist, the late Barton Biggs,
“Mr Market is a smart, canny old soul, and during World War II he often, not always but often, sensed important tipping points that at the time few of the elite grasped. The ebbs and flows of the stock market reflect the collective opinion of the investor crowd, and.. I maintain that markets have great wisdom. The investor ignores their message at his extreme peril.”
So which is the correct view – bull thesis or bear ? The answer, as always, is probably somewhere in between. The full-on bull thesis is certainly easy to refute in the form of just one lurid date, namely that of October 19th 1987, ‘Black Monday’. How could the entire US economy be worth 23 percent less at the end of that day’s trading session than at the start of it ? The answer, of course, is that the stock market is not some cool, dispassionate calculating engine. The stock market is us: every human being that comes into contact with it, with all their hopes, fears, greed for gain, and terror at the prospect or sudden delivery of loss. One doubts if there is anyone alive who now genuinely believes in the Efficient Market Hypothesis. So how to account for the fact that Vanguard Group, which doesn’t even attempt to outperform the market but merely to track it cheaply, is now a $7 trillion asset manager ? If we recognize that the financial markets are not truly efficient, we also have to acknowledge that investors are not truly rational, either. “Just get me in cheaply – I demand the average market return, less the cost of fees !” When the market does break, some of those investors may come to regret the cost of their cheap market access.
So we now have an unholy mix of widespread economic slowdown, rising interest rates, generalised stagflation, and war in Europe. What, if anything, is the appropriate portfolio response ?
Provided you’ve diversified your investments widely and sensibly, the answer, of course, is: nothing. There is no requirement to change a thing. We continue to advocate the use of three discrete asset classes:
Harry Browne’s original ‘Permanent Portfolio’ was allocated equally across cash, stocks, bonds and gold. We’ve taken this approach a little further (by effectively eliminating cash and bonds on valuation grounds, and incorporating trend-following vehicles). For this approach to retain its relevance, however, investors should continue to maintain at least some exposure to each asset type, or the diversification argument becomes fundamentally flawed. We cannot forecast the future, nor should we expect to. But we can prepare for it as sensibly and pragmatically as possible.
Are there legitimate safe havens in the equity market ?
The ‘Bear Busters’, revisited
The journalist John Rothchild published The Bear Book in 1998. Its subtitle: ‘How to survive and profit in ferocious markets’. In his chapter The Bear Busters he identifies nine “defensive sector selections” which performed comparatively well during 11 prior market declines:
We’ll come back to gold. As to the others, it should probably go without saying that quite a bit has changed since Rothchild compiled his original list.
Take pharmaceuticals, for example. The likes of Britain’s GlaxoSmithKline and AstraZeneca are the mainstay of many UK private client and pension portfolios, predicated primarily on those companies’ “reliable” and relatively high dividends. Doubtless this will be replicated by US portfolios and their holdings of shares in the likes of Pfizer, Roche and Bristol Myers-Squibb.
Consider valuation. Glaxo trades on an unaggressive current price / earnings ratio of roughly 14 times but its dividend cover is a meagre 1.1 times. (That is to say, there is a slender 10 percent buffer between the company’s entire net profits and what it’s allocating to shareholders by way of dividend payments. We would never normally even consider owning a company with dividend cover of less than 2 times, and clearly the higher the figure, the better.)
The classic value investor Benjamin Graham cautioned against overpaying – for anything:
“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 [i.e. by Wall Street]. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.” [Emphasis ours.]
Defensiveness, in other words, is not a characteristic of an investment that exists independently of price. It is almost entirely dependent on price. Above a certain share price, no company can be regarded as safe. There is nothing intrinsically safe about Glaxo’s share price or its dividend cover – and that’s before we raise the thorny issue of possible litigation.
There are other reasons to be sceptical with regard to Rothchild’s list. “Major oils” is another sector with a cloud hanging over it in the form of the seemingly out-of-control ESG monster. As is “Telephones”, a sector that has changed beyond all recognition over the past 20 years.
To be fair, Rothchild recognises that his list isn’t perfect. He also rightly highlights two situations in which supposed safe havens will not work out as safety-seeking investors expect. One is “when a crash brings rapid and indiscriminate selling. In the Crash of 1987, five of the nine groups mentioned above were down 20 percent or more, and only the telephones and utilities managed to hold their losses to around 10 percent.” The other, which is of at least equal concern today, is “when defensive stocks are overpriced going into a bear [market].”
So we don’t put too much store by sectors associated by tradition with safety, be they in food, soft drinks, healthcare, utilities, or anything else. We think it’s more important to be properly diversified across different sectors, and geographies to boot, and to use valuation as the primary driver toward stock selection – the cheaper the stock, the greater its margin of safety, especially if you can identify companies run by disciplined, shareholder-friendly management.
What we don’t advocate is market timing. We know we can’t perform it well (so we don’t try to), and we’re not really sure that there’s anyone out there who can, on a sustained basis. But that’s ok – it merely reinforces the logic behind the diversified multi-asset portfolio, and the rationale for owning cheap rather than expensive stocks. The real problem with market timing – of exiting the stock market in anticipation of a dramatic decline – is a second-order problem. You may get lucky and miss the fall – but how do you know when to get back in ? In the shocking bear market of 1973 – 1974, for example, the UK stock market lost 73% of its value in less than two years. From a peak of over 700 it fell to well under 200. The index ultimately recovered, of course – but it did so without warning. Those who had got out in time and therefore had the luxury of market timing never had the opportunity to get back in. In 1975 the index rose by 150% – but you needed to already be invested to benefit from the rally.
The inexorable rise of gold
Our interest in gold is not a trading recommendation as such, rather a long term portfolio hedge against two outcomes: heightened inflation, and systemic distress. Our thesis is, we think, straightforward. Since the dollar’s last links to gold were severed in 1971, the developed world has seen an explosion in debt creation. Most western governments now labour under a colossal debt load, which is unlikely ever to be repaid.
Resolving this debt ‘predicament’ can only be achieved in one of three ways.
The first is for governments to engineer sufficient economic growth to keep the debt serviced. In the euro zone, for example, we now consider that task impossible.
The second is for governments to default. If you prefer lighter-hearted language, we can call it something more polite, like “debt restructuring” or a “debt jubilee” but they all amount to the same thing: governments walking away from their obligations. There is just one problem with this strategy. It would instantaneously bankrupt the banking and pension fund industries. So let’s park this option for the time being.
The third resolution to the global debt problem happens to be the one that all indebted governments since time immemorial have resorted: inflate the debt away. This is what QE has been all about. In our view, the inflationary beatings by our central banks will continue until morale improves. That is to say, the inflationism will continue until governments succeed at their objective of starting to inflate away their debt piles. The signs are now that the inflationary genie is well and truly out of the bottle, and it may not be so easy tempting him back in.
What is the one asset that stands in the way of such inflationism ?
It is, of course, gold.
Unlike paper currency, gold cannot be printed on demand. It cannot be printed at all. It is extremely costly to produce. And unlike paper currency, gold is at one and the same time an asset that is nobody’s liability.
It is true that the price of gold, as expressed in money terms, can be volatile. But to express it in this way is like looking through the wrong end of a telescope. Gold has a fixed value in the form of its weight. An ounce of gold will always be an ounce of gold. How much that ounce of gold is worth in currency terms depends on the purchasing power of the dollar, or whichever currency we are using to value gold, at the time of valuation. It is the purchasing power of the dollar that is volatile, not the inherent stability of gold. And since the establishment of the US Federal Reserve in 1913, the US dollar has lost roughly 98% of its purchasing power.
So gold has a legitimate case for being treated as a store of value over the longer term. It also has a historic role as the ultimate safe haven asset. Gold is independent, scarce and permanent in a way that no other form of fiat currency ever is or can be. So gold has utility whenever the geopolitical climate cools, or heats up, dramatically. No unbacked paper currency has ever lasted. Gold, on the other hand, has always been valued. Whenever confidence in our politicians or our government or our currency fades, gold stands on the other side of the argument, quietly justifying its role as a protector of true wealth.
How much gold should you hold ?
There can be no definitive answer – we all have different objectives and risk appetites.
But the asset manager Tony Deden has an excellent way of addressing this question:
“Dishonest money,” he writes, “has created a culture of speculation out of ordinary producers and savers. As a result, we confuse financial markets for the source of wealth. Our time preference has been altered so that we seek returns incompatible with the real risks we take. We focus on market activity rather than on the substance that it fails to imply.
“Substance is something that is real. It does not necessarily have to be tangible, but that would be preferable. Whether it is in gold – a form of money – or honest entrepreneurship, substance is rooted in economic reality.
“And so, understanding substance, whether it is in money or in entrepreneurial and wealth creating activity, is the most important practical skill we must acquire. Indeed, the price of gold in money may increase. It may also decrease. When do you sell it ? You ought to first decide why you own it. But even then, let me ask: “What sort of substance will you acquire with the proceeds from the sale ?”
“One of the greatest lessons in classical economics is that value is subjective. It is subjective to the aims and criteria and judgment of the person doing the valuing. And frankly, in our dishonest world, such subjective value is the cornerstone to what kind of capital you are likely to command in the future.”
We will, however, answer the question on our own terms. When will we sell our gold ? It will not be a decision predicated on some arbitrary target price in dollars or pounds or euros (if Europe’s common currency even lasts that long).
We will sell our gold when the debt crisis that caused us to buy it has been resolved. Suffice to say we do not anticipate selling any of our gold any time soon.
A different perspective, shaped by song
Louis Sarno died in April 2017. If the name is unfamiliar to you, Sarno was an American romantic who abandoned big city life to decamp to the Central African rain forest and record the music of the Bayaka Pygmies who lived there, in one of the poorest countries on the planet. His story was made into a multi-award-winning documentary and the Bayaka music he recorded for posterity is enchanting. Oxford’s Pitt Rivers museum has also archived some of these wonderful songs. Spending time among these remote people clearly affected Sarno profoundly, along with his world view, which has much to be said for it as we peer into the geopolitical gloom ahead. So the last word this week goes to Louis Sarno himself:
“You’re living in the present; the past doesn’t exist any more. And it’s good, otherwise you get hung up about problems in the past and grudges. The past is finished. You’ve got to make the present as pleasant as possible. And the future, well it hasn’t happened yet, so why should you worry about it?”
When the future seems grim, it’s always worth remembering that markets constantly test patience and reward conviction. The best returns go to those who avoid being jolted out of positions on a whim. Meanwhile, we hope the material in this week’s letter offers some useful guidance to crisis investing – even if the ultimate decision is to do precisely nothing, because there’s no inherent need to.
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: firstname.lastname@example.org.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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