“Things are going to get a lot worse before they get worse.” - Lily Tomlin.
First the lights flickered. Then two powerful shudders shook the entire structure. 126 crew were spread throughout the rig, some sleeping, some watching TV or posting on Facebook. At around 9:47 p.m. on the evening of April 20, 2010, an uncontrollable mixture of oil, gas, water and mud surged past the blowout preventer on the Deepwater Horizon drilling vessel 40 miles southeast of the Louisiana coast and raced up its riser pipe, a 5,000-foot umbilical cord from the seabed to the rig. Drilling mud burst up through the well opening. It was followed by a stream of highly combustible gas. The general master alarm, which would signal evacuation of the entire platform, had been deactivated so that any sleeping workers wouldn’t be disturbed by false alarms. While the drilling team tried to shut in the well, the chief mate of the Damon B. Bankston work vessel moored alongside the Horizon noticed something spilling off the rig. Then drilling fluids started to pour onto his ship. Then dead seagulls, killed by the blast from the blowout. The Bankston’s captain was ordered to move away from the rig.
Then the rig exploded.
Everything about the Deepwater Horizon was monumental. The previous year, it had set a record for drilling the deepest oil well on earth, at some 35,055 feet. Its deck, almost as big as a football field, was overshadowed by a 25-story derrick and two cranes. Below deck was accommodation for up to 146 people, each room equipped with a bathroom and satellite TV. The rig had a gym, a sauna and its own cinema. The crew called it “a floating Hilton”.
Its destruction, along with the deaths of 11 crewmen and the biggest environmental disaster in US history, was preventable. So how did it happen ?
A final report issued by the Deepwater Horizon Study Group (DHSG), formed by members of the Center for Catastrophic Risk Management (CCRM), is generous in its attribution of blame for the disaster. Few involved escape censure. The report concludes:
“The organizational causes of this disaster are deeply rooted in the histories and cultures of the offshore oil and gas industry and the governance provided by the associated public regulatory agencies. While this particular disaster involves a particular group of organizations, the roots of the disaster transcend this group of organizations. This disaster involves an international industry and its governance.”
There were, effectively, two discrete parts to the Deepwater Horizon tragedy. The first failed to ensure the safety of the rig and its crew. If the rig’s blowout preventer had been functioning properly, the tragedy would never have occurred in the first place, nor escalated so catastrophically. The second failed to deal quickly or effectively with the environmental aftermath of a lost rig and of what would ultimately amount to 5 million barrels of oil spilling into the Gulf of Mexico. To date, the cost just to BP has been over $50 billion. The damage to the wider Gulf environment goes beyond any fair assessment of price.
The normalization of deviance
Disasters tend to have lots in common. Sociologist Diane Vaughan spent nine years investigating the 1986 explosion of the space shuttle Challenger, culminating in a book, The Challenger Launch Decision. Its conclusions will likely surprise you.
Vaughan found that
“[NASA] managers were, in fact, quite moral and rule abiding as they calculated risk. Following rules, doing their jobs, they made a disastrous decision.”
NASA managers weren’t “amoral calculators”. Rather, over time they allowed themselves to become deluded about the risks inherent in the shuttle’s solid fuel booster rockets, which had a tendency to leak small amounts of hot gas during take-off. Because these small leaks had never previously escalated to anything fatal, over time shuttle program managers got used to them. Over the years, NASA managers systematically deluded themselves in what Diane Vaughan calls “normalization of deviance”.
Normalization of deviance worked as follows in the shuttle program. Early on, small leaks from the rubber seals on the booster rockets provoked alarm from the program’s engineers. NASA set up a working group, which went through the motions and decided that the leaks would be manageable provided they didn’t exceed a certain threshold. For the want of a nail the kingdom was lost. Evidence that deviated from an acceptable standard soon became the new standard. Problems became normalized. As the shuttle missions continued, the leaks got bigger.
The DHSG report is even more damning. Its authors found disturbing similarities between Deepwater Horizon and another BP-sponsored disaster, at its Texas City refinery in March 2005. Those similarities included:
Both Deepwater Horizon and the space shuttle Challenger died because of irredeemable problems in corporate culture that built up insidiously over a period of years. They were not any one individual’s fault. They came about incrementally over time on the back of bad incentives and bad behaviour.
The DHSG report also refers ominously to what looks suspiciously like over-reach on the part of the offshore oil and gas industry. As easy-to-access oil supplies become depleted, oil companies are obligated to drill in more remote and dangerous areas as they search for new, monster discoveries to replenish tired old fields:
“The oil and gas industry has embarked on an important next generation series of high hazard exploration and production operations in the ultra-deep waters of the northern Gulf of Mexico. These operations pose risks (likelihoods and consequences of major system failures) much greater than generally recognized. The significant increases in risks are due to: 1) complexities of hardware and human systems and emergent technologies used in these operations, 2) increased hazards posed by the ultra-deep water marine environment (geologic, oceanographic), 3) increased hazards posed by the hydrocarbon reservoirs (very high potential productivities, pressures, temperatures, gas-oil ratios, and low strength formations), and 4) the sensitivity of the marine environment to introduction of very large quantities of hydrocarbons.
“The Macondo well project failures demonstrated that the consequences of major offshore oil and gas system failures can be several orders of magnitude greater than associated with previous generations of these activities. If the risks of major system failures are to be as low as reasonably practicable.. the likelihoods of major failures (e.g., uncontrolled blowouts, production operations explosions and fires) must be orders of magnitude lower than in the BP Mocando well project and that may prevail in other similar projects planned or underway. In addition, major developments are needed to address the consequences of major failures; reliable systems are needed to enable effective and reliable containment and recovery of large releases of hydrocarbons in the marine environment.”
Deepwater, in other words, was a systemic failure within a new, dynamic system of almost unimaginable complexity.
In mid-September 2008, Jamie Dimon, the CEO of JP Morgan, America’s largest bank, hastily arranged a teleconference call with his board of directors from his home library. Lehman Brothers was about to seek Chapter 11 bankruptcy protection. Here is what Dimon told his team:
“You are about to experience the most unbelievable week in America ever, and we have to prepare for the absolutely worst case. Here’s the drill. We need to prepare right now for Lehman Brothers filing [for Chapter 11]. And for Merrill Lynch filing. And for AIG filing. And for Morgan Stanley filing. And potentially for Goldman Sachs filing.”
Lehman Brothers went on to file for Chapter 11 shortly after midnight on Sunday 14 September 2008 – a day after Dimon’s conference call.
The market’s blowout preventer failed to work. The result ? Five years after the failure of Lehman Brothers, the Dallas Federal Reserve estimated that the full cost of the financial crisis was as much as $14 trillion – nearly a full year of US GDP.
But by now, the cost of the damage and the supposed “clean-up” is incalculable.
Lehman Brothers on the edge represented a fork in the road for the global financial system.
The path to the left was the one that Jamie Dimon could see all too clearly – practically an extinction-level event for Wall Street. Lehman’s failure would have triggered contingent failure by Merrill Lynch, by the insurer AIG, by Morgan Stanley, probably by Goldman Sachs. Not a run on a bank, but a run on the banking system itself. What Dimon didn’t say, but what is implicit, is that by that stage, JP Morgan itself would probably not have been viable.
There would certainly have been a sharp deflationary shock, our very own 1929 moment. But ultimately, the system would have reset, and bad players (a.k.a. bankers) ethnically (and ethically) cleansed from the field of play. In time, new entrepreneurs with new capital would have replaced them. The free market would have survived – once the dust settled.
But that is not the path that the bureaucrats managing western economies elected to take.
The path to the right is the route that governments and central banks actually took. The US government went all-in to shore up Wall Street in 2008. The British government did the same for the City of London, Royal Bank of Scotland – briefly the world’s biggest bank – and Lloyds. As did those of the other developed economies with regard to their banking sectors.
Colossal Big State intervention did two things. It bought time for an overlevered banking system that would have collapsed without it. But it also set in motion a freight train of consequences. Not content with hosing trillions of dollars at the financial system, central banks went into overdrive in a bid to reflate a shocked global economy. By driving interest rates to zero and in some cases below it, the world’s major central banks started to distort the prices of everything – stocks, bonds, property.. Muck around with the risk-free rate that denotes the cost of lending to the government, and you muck around with the entire financial market.
There is now no longer a risk-free rate. Now, there is just risk. After the tech bubble burst at the start of the new millennium, the Fed’s reflationary efforts focused on mortgage credit and housing. Then the housing bubble burst. The difference is that after the housing bubble burst, the Fed – and the world’s other major central banks – went ridiculously further: they reflated the prices of stocks, corporate debt and housing, forcing bond market yields to collapse (bond yields move inversely to bond prices), forcing savers out of the safety of bank deposits and money market funds, and into risk assets like stocks instead, not least through cheap exchange traded funds, or ETFs.
The role of central banks has entirely changed. Institutions originally tasked with preventing inflation have now concentrated all their efforts on encouraging it. They have become enablers of the very chaos they were instituted to avert.
Once again the system’s blowout preventer has failed. In today’s case, central banks have deliberately “blown up” financial assets – in the sense of inflating them out of all proportion.
System integrity is starting to fail
But cracks are starting to show. Among the most popular investments of recent years has been a type of company we call the “global mega-caps” – giant consumer brands that by dint of their supposed defensive properties and seemingly robust dividend yields have been bid up by investors to unsustainable levels. Now some of these shares are starting to fall back to earth.
Within our wealth management business we allocate the (largely irreplaceable) capital of our private clients across three asset classes:
Our first article of faith: genuine asset class diversification is the last remaining free lunch in finance.
Most financial advisers tend to focus on just two asset classes, in what’s often referred to as the ‘60/40 portfolio’. That is, they typically allocate the lion’s share of any client portfolio to stocks, often on an indexed basis that reflects the composition of some equity benchmark like the S&P 500 or the MSCI World Equity Index, and then allocate the rest to bonds.
There are at least two problems with this approach.
One is that global stock markets, notably that of the US (69% of the MSCI World Index), are expensive.
The second is that global bond markets are outrageously expensive.
What we recommend is something a good deal more flexible.
A margin of safety
Our first allocation is to defensive value stocks. These are typically businesses run by principled, shareholder-friendly management who are also excellent allocators of their firm’s capital. Having identified these type of companies, it’s then simply a question of waiting until you can pick up their shares at no significant premium to their inherent (or book) value – and better yet, if you can buy their shares at a discount to book. Then, for as long as these companies continue to generate reasonable levels of cash, you hold them. And as Warren Buffett has said, your ideal holding period should really be forever.
If stock markets do decline, value stocks will doubtless be impacted. But we feel much happier owning stocks that we’ve never had to pay over the odds for, stocks that offer what Benjamin Graham described as a “margin of safety”. There is no “margin of safety” in the likes of Amazon or Facebook or Tesla.
Make the trend your friend
The second type of investment we make for clients is in the form of systematic trend-following funds. We strongly believe that there are only two ways of sustainedly harvesting superior returns from the financial markets. One is to favour ‘value’ investing: high quality companies bought extremely cheaply. The other is to benefit from price momentum. Systematic trend-following funds do the latter. This is a trading strategy rather than a long term investment approach. Trend-followers monitor prices across all the financial markets – across interest rates, equity indices, hard and soft commodities, and currencies – and when their systems identify specific instruments that are trending strongly in price, either higher or lower, trend-followers simply hitch a ride on the back of that trend. They pursue a trading approach that can be summarised as “cut your losses, and let your winners run”. Loss-making positions are typically quickly eliminated so that trend-following managers can concentrate on their winners.
In 2008, one of the worst years for financial markets in living memory, trend-following funds all made money – unlike traditional funds, who were essentially locked into a declining market, trend-followers were perfectly happy to go short and sell all the markets that were falling, with a view to covering those short positions at cheaper levels later on. In 2008, the prices of just about everything fell, and trend-followers had a field day. The most conservative trend-following fund we use delivered a +21% return in 2008. The most aggressive trend-following fund we use delivered a +108% return in 2008. As and when the markets turn en masse, as they inevitably will, we expect trend-following funds, once again, to offer the potential to generate super-normal returns.
The one wrinkle with trend-following funds is that, being a form of hedge fund, they can be difficult for individual investors to access, and many financial advisers are terrified of recommending them, not least for regulatory reasons. But we are convinced they have a role to play in any diversified portfolio, not least because their historic correlation to the stock market (the statistical extent to which their performance has been linked to that of the stock market) has tended to be precisely zero. For more information about the trend-following industry, Michael Covel recently published a revised new issue of his bible on the subject, Trend following: how to make a fortune in bull, bear and black swan markets, published by Wiley Trading. It is the single best resource on the subject that we know of.
Which takes us to our third and final allocation: real assets, notably the monetary metals, gold and silver.
Why gold ?
If you accept our general thesis that the ills of our financial world all stem from an overabundance of debt which is now clogging the arteries of the global economy, it follows that there can only be three ways of tackling that debt.
Option 1 is for heavily indebted governments to engineer enough economic growth to service the debt. We think, in the aftermath of Big Government’s disastrous response to Covid, that we are way past that point today.
Option 2 is for heavily indebted governments to default on their debt. This would immediately bankrupt the pension and banking industries who are the major owners of that debt.
Option 3 is for heavily indebted governments to do what heavily indebted governments have always done since the beginning of recorded time – inflate it away.
So QE (quantitative easing) and ZIRP (zero interest rate policies) are a deliberate policy of state-sanctioned inflationism that will end in the erosion of the purchasing power of money. Arguably they are already doing so. That both had failed to trigger meaningful increases in CPI and RPI measures of inflation until comparatively recently (clearly the prices of most financial assets have been sent into the stratosphere) simply means that we are destined to be treated to more of the same before this crisis is resolved. The central bank beatings will continue until morale improves. And if we tip into outright deflation, then in the words of SocGen’s analyst Albert Edwards, “you will hear the roar of the printing presses from Mars.”
Why own gold ? Because it’s a form of money that simply cannot be printed at will by desperate governments. And for 5,000 years, it’s been money good. It’s also a form of money that is nobody’s liability. A dollar bill, a euro note or a pound sterling depends on a central bank’s ability to maintain the perception that that currency has value. By continually printing more and more unbacked paper money, central banks are walking a treacherous tightrope: at some point, the marginal investor will point out that the Emperor has no clothes, and the international currency system will also fall back to earth, with all the destruction of capital that that entails. Let’s not even think about CBDCs..
Gold frees you from the doom-loop.
Summary – be prepared
So to sum up, our overall asset allocation approach incorporates three core asset types.
Defensive value stocks with a “margin of safety” offer exposure to the stock markets of the world, but with a much reduced risk of a permanent loss of capital versus the broad stock indices, which in most cases are significantly overvalued.
Systematic trend-following funds offer exposure to a potential return stream uncorrelated to the stock and bond markets, and to a trading approach which has shown a proven historic ability to generate positive returns especially in savage bear markets.
The monetary metals, gold and silver, and related listed mining concerns trading on low multiples, offer a degree of portfolio insurance, and a hedge against both systemic crisis and a build-up in monetary inflation.
In a uniquely challenging market environment, we happen to think that three hands are even better than two. So even though an investor’s exposure to any one of these asset classes might be relatively modest, by dint of being uncorrelated with each other, they all contribute to a diversified approach to capital preservation.
Deepwater Horizon happened because in a system of unimaginable complexity, management overreached themselves. Bad incentives; bad behaviour. The project was behind schedule, and managers were under pressure to cut corners. When disaster did strike, BP then found itself utterly unable to contain the damage in a timely manner. There was no Plan B.
What central banks have done since 2008 is almost infinitely worse, because the scale of the problem is global, and insanely, unforecastably complex. The failure of Lehman Brothers at the height of the crisis triggered the initial blowout. Government administrators who felt compelled by political pressure and by their friends in industry to “do something” also overreached themselves, and elected to flush cheap money into the system without limit and without any regard for the consequences. The pressure is now building again in almost every financial asset. The release valve of free markets has been jammed beneath the twin torrents of QE and ZIRP, and something, at some point, has to give. Once again, there is no Plan B.
The status quo cannot last. The system will buckle, we just don’t know when. But better, surely, to be even a year too soon than a day too late.
Are you prepared for system failure ?
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: email@example.com.
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.
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