“If you tell the truth, you don’t have to remember anything.” - Mark Twain.
Designed by the Frenchman Frederic-Auguste Bartholdi and weighing over 200 metric tonnes, the Statue of Liberty measures 93 metres from her base to the tip of her torch.
She has a 35-foot waistline, and if you could find enough leather to make it, she takes a size 879 shoe. 300 different types of hammer were used to make her external copper structure; Lady Liberty’s infrastructure is made of iron.
Dedicated on October 28, 1886, the Statue of Liberty (or strictly, ‘Liberty Enlightening the World’) was a gift from France to the United States, which came to be irrevocably, associated with immigration during the second half of the nineteenth century. For over 9 million immigrants to the United States, she was often the very first thing they saw as they approached New York by boat.
At least two people have committed suicide by jumping off the statue. When she was first erected in 1886 she was the tallest iron structure ever built. And on April 8, 1983, the magician David Copperfield, in front of an invited audience including Morgan Fairchild, and a TV audience of millions, made her disappear.
Just how do you make a well-lit, iconic, 93 metre-tall statue vanish into thin air? <Spoiler alert.> It seems that the following accounts for the act. Copperfield had erected two towers on his stage, supporting an arch to hold the huge curtain that temporarily fell, briefly obscuring the audience’s view of the statue while he conducted his trick.
The TV cameras and the live audience could only see Lady Liberty through this arch. When the curtain was dropped, Copperfield started a prepared speech, to music, while the stage was slowly and indiscernibly rotated. When the curtain was finally lifted, the statue was obscured by one of Copperfield’s giant towers, and the audience was looking out into a blank nightscape. A helicopter with an arc light helped with the illusion.
The secret to all ‘magic’ is misdirection. Admittedly, diverting people’s attention during a card trick is a lot easier than when they’re in front of a gigantic statue, but it comes down to misdirection all the same, just on a much bigger scale. Don’t look over here, look over there.
Ever since the first tremors of the global financial crisis as far back as 2007, we have been nursing a fear that all investors are in danger of falling victim to a similar kind of misdirection.
What the media report on a daily basis: coverage of the latest Wall Street research; brokerage firm updates on the latest glamour stocks; an unending circus of analysts, economic commentators and financial promoters of one type or another; breathless anticipation of the latest Fed monetary policy decision; 24/7 blanket coverage of, first, Covid, and more recently a distinctly confected-looking war between Russia and Ukraine.. It’s all misdirection.
At the height of the Global Financial Crisis, conventional economic theory seemed to be founded on sand. As bank after bank started to fail, it seemed to many that nobody could really account for what was going on. Both in the run-up to the failure of Lehman Brothers and especially thereafter, traditional, Keynesian economics seemed to have been caught with its pants down.
There’s a quote from Lord Keynes himself that sums up the predicament pretty well. He originally said it in his essay ‘The Great Slump of 1930’, written that same year:
“But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time – perhaps for a long time.”
Keynes was undoubtedly correct in anticipating that the ruin of what turned out to be the Great Depression would last “for a long time”. But his initial metaphor, of economy as some kind of delicate machine, is fundamentally flawed. It can be no surprise that one’s thinking is wrong if one’s use of metaphor is essentially wrong, too.
What we came to understand during 2007 and afterwards is that the entire Keynesian conception of economy-as-machine, with confident Keynesian financial engineers and monetary overlords standing at hand to direct it, is simply a fake.
Inappropriate metaphor, invalid thinking.
What we also came to understand is that we cannot in any fundamental sense even attempt to model something as complicated as the economy, because the economy is us. We, all of us, are the economy, all seven billion of us, all interacting with our various hopes and fears and financial aspirations. Try modelling that.
And this is a key insight from the one school in Economics that we do respect, namely the so-called Austrian, or classical, school. The magnum opus of one of its founding fathers, Ludwig von Mises, is titled Human Action. Human action, not some form of machine, is what drives our economy and financial markets.
Open a financial newspaper or visit any financial website and what will you see? Chances are, it will be melodramatic features on the fast-evolving strategies of ‘exciting’ companies and their ‘glamorous’ management; breathless reports of the latest product launches; giddy coverage of the next, hotly anticipated IPO or cryptocurrency experiment. An endless stream of financial promotions and hucksterism, with the stock market as the Circus Maximus and gravitational hub to all financial things.5
To add gravitas, you’ll also find feverish analysis of current economic trends and worrisome reports hinting archly at the prospects for a slowing economy. There will be four key subtexts:
All of which, of course, is complete nonsense – but these subtexts constitute the prism through which almost all financial journalists and investment commentators view the world.
Perpetual growth is taken utterly for granted, as if the business cycle were some quaint memory from a bygone age. The impossibility or even desirability of perpetual growth and consumption in a finite world is never questioned. And the idea that interest rates – the most important price in the entire market, the price of money itself – should be left to the tender mercies of central bankers is never disputed for a moment.
The growth and consumption canard was refuted powerfully by the late Albert Allen Bartlett, emeritus Professor of Physics at the University of Colorado at Boulder. During his lifetime Dr. Bartlett gave literally thousands of presentations on the seemingly dull topic of ‘Arithmetic, Population and Energy’. Over five million people have watched his presentation on YouTube, which you can see here.
But the essence of Bartlett’s argument is extremely simple.
First, mankind’s biggest weakness is our inability to understand the power of the exponential function – the extraordinary future growth inherent in anything growing at a fixed rate over time. Einstein made exactly the same point when he described compound interest as the eighth wonder of the world.
Second, Bartlett asked the question:
Can you think of any problem in any area of human endeavour on any scale, from microscopic to global, whose long-term solution is in any demonstrable way aided, assisted, or advanced by further increases in population, locally, nationally, or globally?
To put it in a broader context than population alone, Bartlett made another observation; that for any entity, beyond a certain level, further growth equates to either obesity, or cancer.
This latter observation gets to the heart of the financial crisis. The financial system itself has metastasised. Freed from any last vestige of restraint by President Nixon’s suspension of US dollar convertibility into gold in 1971, the growth of credit has become uncontrollable.
This accounts for the investment world and media’s focus on constant economic growth: only constant economic growth can allow the US government to even attempt to service otherwise utterly unpayable debts (the $30 trillion US national debt is merely the tip of the iceberg above the waterline – once you factor in the off-balance sheet debts, unfunded liabilities like Social Security and Medicare, the real total rises to well over one hundred trillion dollars).
The collapse of Lehman Brothers in 2008 was the moment at which we saw that the Emperor wore no clothes. Which, in due course, is why central banks throughout the indebted West have been so accommodating to their client national treasuries: interest rates have been forced to all-time lows to try and ensure that deflation does not bring down the entire government debt edifice. (In a true deflation, the real cost of servicing government debt rises.)
But actions have consequences. In their increasingly desperate attempts to keep the government bond bandwagon on the road, central banks have impoverished savers and all those on fixed incomes, like pensioners.
With bond yields at all-time lows, despite the grotesque surge in the supply of the stuff, desperate investors have, in turn, stampeded into the one asset class where they feel they can earn a decent real return: stocks.
Investment bank dealing rooms once resonated with one specific piece of advice: don’t fight the Fed. No investor, whatever his size, has a chance against the firepower and the unlimited ability to print money possessed by the US Federal Reserve. When the Fed is easing monetary policy, don’t resist the trend.
But now the market environment is that much more perilous. Just as the “Greenspan put” was developed as a theory to account for boundless optimism when it came to stock market investing (the Fed has your back, in other words, and will act swiftly to support the market, come what may), so the “Bernanke put”, then the “Yellen put” and now the “Powell put” have persuaded a whole new generation of investors that the stock market only ever rises. In a Battle Royale between the capital markets and the State, does the State always win? We are about to find out.
One lesson we do know from history is that a fundamentally dysfunctional system can still outlast our worst expectations. Take the former Soviet Union, for example. Born in the Russian Revolution of 1917, a thoroughly dysfunctional and economically bankrupt regime survived the most apocalyptic of prognostications until the Berlin Wall finally fell in 1989. 72 years is a long time to wait to be proved right.
But rather than throw up our hands in disgust at the financial repression being conducted throughout the ‘developed’ economies of the West, as investors it makes sense to try and make the best of our situation.
Bond markets are clearly a bug in search of a windshield. Traditional asset allocation holds that investment grade bonds represent the risk-free rate of return. But traditional asset allocation has been turned on its head by years of emergency monetary stimulus.
In short, the cynical answer as to why bond yields are at their lowest level in history even as the US national debt is at its highest level in history, would be: because the central bank has rigged the market. So-called quantitative easing (QE) involves the Fed creating money out of thin air and using it to buy Treasury bonds and other debt securities.
The theory – based on the flimsiest logic – has it that the banks holding US Treasuries that are bought by the Fed will be increasingly willing to lend out their sudden cash windfalls; and that investors suddenly enriched by this money creation and its attendant spur to asset prices will go on a spending spree that will ignite the economy.
Economic data would tend to suggest otherwise. But it is undeniable that QE has, at least until recently, been a huge boon to financial asset prices, notably stocks. So what happens to asset prices, notably stocks, when, as planned, the Fed’s ‘tapering’ and climactic reversal of QE finally begins in earnest ? Again, we will soon find out.
Our suspicion is that the Fed has now entirely lost control of the bond market. And since the size of the bond market completely dwarfs the value of listed stocks, this is a market you don’t want to lose control of.
In any event, there is one thing close to an iron law in financial markets: if interest rates rise, bond prices fall. This is entirely logical, since conventional bonds carry a fixed coupon or interest rate. If official interest rates, such as the Fed Funds Rate, go up, they make the fixed coupons on bonds comparatively less attractive, so bond prices fall to compensate the investor. Since bonds are now at close to their most expensive levels in history, the future prognosis for bondholders is hardly rosy.
So by a process of elimination, we end up scouring the equity market for opportunities instead. But equity prices have also been distorted by QE, and it is anybody’s guess how Fed tapering – if it conclusively terminates official purchases of government debt – will impact an already febrile stock market. Which is why ‘value’ equity investing, for us, is now the only game in town.
When we use the phrase ‘value investing’, we are essentially referring to the style of investing first described in detail by the veteran investor Benjamin Graham, mentor to Warren Buffett, in his classic book on the subject, ‘The Intelligent Investor’, first published in 1949. If you don’t already have a copy, buy one. It will transform your outlook on equity investing. And don’t worry about its apparent age – its message is timeless. Human nature doesn’t change, and neither do successful investment principles.
Graham warned that:
“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.”
There you have it. There is no crime in “buying good stocks at fair prices”. The risk is in buying garbage (one might cite any number of speculative technology stocks here), or in simply overpaying (“buying good stocks in the upper reaches of bull markets”). And the risk of overpaying today is high. We know that bonds are expensive. But stocks are hardly cheap.
Our favourite metric for assessing the overall expensiveness or cheapness of the stock market is Robert Shiller’s cyclically adjusted price/earnings ratio for the market, or CAPE. CAPE simply takes the 10-year average of P/E ratios for the market to smooth out the spikes in short-term volatility so we can see the broader trend.11
The Shiller P/E (at around 34x) has rarely been higher. More specifically, it has been higher only once before in history. In 2000. At around 45x. It did not end well.
For the entire history of the US stock market, the average Shiller P/E has been 16.9x. The two historic outliers were in December 1920, when a war-ravaged market traded at just 4.8 times (a huge buying opportunity, with hindsight), and in December 1999, when during the insanity of the dotcom bubble the market reached an unsustainable Shiller P/E of 44 times. But today’s level of 34x is still pricy.
The beauty of a classic ‘value’ approach to stocks is that it forces us not to overpay. Following Ben Graham’s advice, we are not interested in buying junk. And we’re not interested in paying over the odds. But a quality business at a fair or very fair price – that’s a different proposition entirely.
To revisit the David Copperfield ‘trick’ with which we began this missive, as investors we can choose to believe in maths, or we can believe in magic. Favour maths.
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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