“There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.
“It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might. And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.
“I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.”
- Warren Buffett, ‘How inflation swindles the equity investor’, Fortune Magazine, May 1977.
Some investment truths are eternal. Here’s one from Warren Buffett, one of the most successful investors in history:
“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment.”
Buffett wrote that in an essay from May 1977 cited above, ‘How inflation swindles the equity investor’.
History is about to repeat.
After a more than decade-long bull run for the US stock market, mega-cap ‘growth’ stocks might seem invulnerable. The consensus is that they are the only game in town. There’s a superficial logic to the equity story which rests heavily if not exclusively on recency bias. But it critically ignores one gigantic elephant in the room: the future path of interest rates.
There is a clear warning from history. On 31 December, 1964, the Dow Jones Industrial Average stood at 874. On 31 December, 1981, it was 875. In Buffett’s words,
“I’m known as a long term investor and a patient guy, but that is not my idea of a big move.”
In that 17 year period, the GDP of the US rose by 370% and Fortune 500 company sales went up by a factor of six times. More than an entire decade for the US stock market was lost. Why ? Back to Buffett, again.
“To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: the higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line..
“… So there… lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.”
In one of his recent ‘Year in Review’ essays, Cornell chemistry professor and economic agent provocateur David Collum reminds us that,
“Optimists bray that rising rates are bullish, a sign that the world economy is recovering. In 1999, however, Buffett wrote a compelling article in Fortune attributing secular equity moves to one and only one parameter—the direction of long-term interest rates. Secular equity bull markets occur when long-term rates are dropping—not low but dropping—and secular bears occur when rates are rising. He didn’t equivocate..
“So are rates really that low? In a word, yes… The salad days of the bond market are in our rear-view mirror. The rate bottom and subsequent rise will be global. Rising rates will spread into the markets and economy at large, causing concurrent stagnation, dropping price earnings ratios (from nosebleed Case–Shiller estimates of 24), collapse of credit-fuelled/capex-lite corporate profit margins, and crush under-funded pensions and municipalities rendering them less funded. If rates have nowhere to go but up, what direction are they headed?”
As we now know, the tide is going out for a trend that has supported higher bond prices for 40+ years.
The problem with authority
There’s another reason we think it’s time to be cautious on the last decade’s secular ‘growth’ winners. Call it, if you like, ‘too much belief in authority’. Check out Craig Zobel’s 2012 thriller, ‘Compliance’. It makes for uncomfortable viewing. In the film, based on real events, a fast food restaurant receives a call from someone claiming to be a police officer. The manager is informed that a female staff member has stolen money from a customer’s purse and must be detained.
Despite denying the crime the employee, a young girl, is held by her colleagues in the backroom. She protests her innocence to no avail. On the basis that she might be hiding the evidence, the “police officer” then instructs the manager to carry out a strip search. The film plays out as she and her gullible staff are manipulated by the caller through their desire to “help the police”. In the end, the employees realise that they have been tricked into committing crimes themselves.
These are clearly actors playing their respective roles. But although the premise itself sounds ludicrous, it is convincingly staged. In fact, the events depicted in ‘Compliance’ are not purely fictitious… instead they’re based on 70 similar incidents that took place across North America.
The film’s message is that many of us automatically and even unthinkingly surrender to authority. It’s not malice that makes the (innocent) girl’s co-workers humiliate her. They do it because they think they’re following the legitimate orders of a police officer. As to why that officer can’t come to the restaurant: let’s just say he is very persuasive.
It was the poet Coleridge who coined the phrase “the willing suspension of disbelief”. If an artist can infuse his work with enough humanity – and the appearance of truth – we, the audience, will buy into the illusion. We’ll put our scepticism on hold.
That is the power of authority. We can’t help but draw parallels with the investment world… where the most successful players never cease to question the received wisdom.
‘Compliance’ follows two even more notorious US experiments in human psychology that are grimly relevant in our post-Covid dystopia.
Absolute power corrupts absolutely
1) The Stanford Prison Experiment
The Stanford Prison Experiment took place at Stanford University, California, in August 1971. 24 male students were assigned roles as either prisoner or guard in a mock prison in the basement of the university’s psychology department.
Psychology professor Philip Zimbardo was setting out to test the hypothesis that the main cause of abuse in prisons was the psychological make-up of the prisoners and their wardens. The ‘guards’ were equipped with wooden batons and mirrored sunglasses to prevent direct eye contact. The ‘prisoners’ were arrested at their homes, fingerprinted, then had their mug shots taken.
Order lasted for precisely one day. On day two, prisoners in one cell blockaded the door and refused to follow the guards’ instructions.
Then after 36 hours, one prisoner started to “act crazy, to scream, to curse, to go into a rage that seemed out of control.” When the experimenters realised he wasn’t acting, he was released.
Guards soon resorted to physical punishment. Sanitary conditions quickly deteriorated too, with guards refusing to allow prisoners to urinate or defecate anywhere but a bucket in their cell. Some prisoners had their mattresses removed; others were stripped naked as punishment.
The experiment then spiralled into more abuse, hunger strikes, and solitary confinement. After just six days, it was abandoned. One third of the guards were determined to have displayed “genuine sadistic tendencies”. Many of the prisoners were traumatised.
Such is the malign power of authority.
2) The Milgram Experiments
Equally notorious was the series of experiments run by Yale psychologist Stanley Milgram in 1961. You may have seen video footage of the original Milgram tests, or recreations of them. Each involved three participants. Two of them – the one coordinating the experiment, and the so-called ‘learner’, were “in” on the experiment. The third, the supposed ‘teacher’, was the unwitting subject of it.
So, the teacher began by reading a list of word pairs to the learner. Then they would read the first word of each pair again, and four possible ways to complete it. The learner would press a button to indicate his response.
If the answer was incorrect, the teacher would be instructed to deliver an electric shock to the learner. Each wrong answer increased the voltage by 15 volts. (Incidentally, in one version of the experiment, the learner would mention to the teacher that he or she suffered from a heart condition.)
The ‘teacher’ participants believed the shocks were real. They weren’t. The ‘learners’ were all actors, the electric shocks faked. But that didn’t stop 65 per cent of the participants in Milgram’s first experiment administering the final massive 450-volt dose. Every time any teacher was hesitant to continue delivering (and enhancing) the shocks, he was told by the experimenter:
- Please continue.
- The experiment requires that you continue.
- It is absolutely essential that you continue.
- You have no other choice, you must go on.
If a teacher still wanted to stop after receiving all of these verbal cues, the experiment was halted. Otherwise, it was halted only after the learner had received the maximum 450-volt shock three times in a row.
Milgram’s experiment started three months after the trial of the German Nazi war criminal Adolf Eichmann began in Jerusalem. Milgram set out to answer the question: could it be that Eichmann, and those like him, were simply “obeying orders”?
In the Milgram experiment, the bogeyman authority figure was not a senior army officer. It was just a man in a white coat… armed only with a clipboard.
Obedience and the system
Summarising his experiment, Milgram wrote:
“I set up a simple experiment at Yale University to test how much pain an ordinary citizen would inflict on another person simply because he was ordered to by an experimental scientist.
“Stark authority was pitted against the subjects’ strongest moral imperatives against hurting others, and, with the subjects’ ears ringing with the screams of the victims, authority won more often than not.
“The extreme willingness of adults to go to almost any lengths on the command of an authority constitutes the chief finding of the study and the fact most urgently demanding explanation.
“Ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process”.
Milgram’s results are hardly unique. The table below shows the average compliance level to the maximum voltage (450 volts) from a number of studies. University ethics boards (rightly) outlawed Milgram-style experiments in the late 1980s, so no other modern studies are available.
International Milgram studies
Study Country Percentage obedient to the highest level of shock
Milgram USA 62.5%
Rosenham USA 85%
Ancona & Pareyson Italy 85%
Mantell Germany 85%
Kilham and Mann Australia 40%
Burley, McGuinness UK 50%
Shanab, Yahya Jordan 62%
Miranda et al Spain 90%
Schurz Austria 80%
Meeus, Raaijmakers Holland 92%
Source: Smith and Bond (1994), James Montier
But what does all this mean for investment?
For Craig Zobel in ‘Compliance’, authority was an unseen policeman. For Philip Zimbardo at Stanford, authority was a prison guard. For Stanley Milgram, authority was a man in a white coat.
For us, ‘authority’ is the US Federal Reserve. In fact, it’s any central banker. And they are all just as susceptible to the corruption of power as the participants in the studies listed above. The individuals working at central banks are possibly normal and well-intentioned. But they operate within a perverse system, which does the world a great deal of damage.
Western central banks are dangerous for a number of reasons.
- Quantitative easing
The QE programmes they have pushed so aggressively have distorted relative prices across all asset types. They have only delayed the inevitable deleveraging.
- Artificially low rates
Having driven policy rates down to zero, they have forced investors to chase yield. That means exposing themselves to higher degrees of risk than they might have otherwise. That’s because cash deposits were until recently eliminated as a viable investment choice.
- Kicking the can down the road
In pumping up the money supply (and their balance sheets), they have set the scene for a potentially dangerous inflationary mess further down the line. If not now.
- A false sense of security
Many investors accept that the central banks know what they are doing. Even that “they have everyone’s back”, or what used to be known as the “Greenspan put” – supporting equity markets – is alive and well.
Don’t fight the Fed
In the markets, there’s a simple rule of thumb: don’t fight the Fed.
Given its almost unlimited monetary firepower, it has never made sense to bet against Fed policy. But that was before the Fed and its international peers went “all-in” with quantitative easing. Now the West’s central bankers have an existential problem: their influence over markets only works while investors believe that that influence still holds.
Be wary of rising interest rates. Short term monetary policy rates can theoretically stay anchored in both the US and the UK and in Europe. But neither the Fed nor the Bank of England nor the ECB can definitively prevent yields from rising in longer-dated government debt markets. And if even higher bond yields do manifest, equity markets are unlikely to be immune to them.
Is there a risk, then, that the “ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process”.
The good news is, we can also own gold.
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Get your Free
financial review
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: info@pricevaluepartners.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.
“There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.
“It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might. And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.
“I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.”
Some investment truths are eternal. Here’s one from Warren Buffett, one of the most successful investors in history:
“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment.”
Buffett wrote that in an essay from May 1977 cited above, ‘How inflation swindles the equity investor’.
History is about to repeat.
After a more than decade-long bull run for the US stock market, mega-cap ‘growth’ stocks might seem invulnerable. The consensus is that they are the only game in town. There’s a superficial logic to the equity story which rests heavily if not exclusively on recency bias. But it critically ignores one gigantic elephant in the room: the future path of interest rates.
There is a clear warning from history. On 31 December, 1964, the Dow Jones Industrial Average stood at 874. On 31 December, 1981, it was 875. In Buffett’s words,
“I’m known as a long term investor and a patient guy, but that is not my idea of a big move.”
In that 17 year period, the GDP of the US rose by 370% and Fortune 500 company sales went up by a factor of six times. More than an entire decade for the US stock market was lost. Why ? Back to Buffett, again.
“To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: the higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line..
“… So there… lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.”
In one of his recent ‘Year in Review’ essays, Cornell chemistry professor and economic agent provocateur David Collum reminds us that,
“Optimists bray that rising rates are bullish, a sign that the world economy is recovering. In 1999, however, Buffett wrote a compelling article in Fortune attributing secular equity moves to one and only one parameter—the direction of long-term interest rates. Secular equity bull markets occur when long-term rates are dropping—not low but dropping—and secular bears occur when rates are rising. He didn’t equivocate..
“So are rates really that low? In a word, yes… The salad days of the bond market are in our rear-view mirror. The rate bottom and subsequent rise will be global. Rising rates will spread into the markets and economy at large, causing concurrent stagnation, dropping price earnings ratios (from nosebleed Case–Shiller estimates of 24), collapse of credit-fuelled/capex-lite corporate profit margins, and crush under-funded pensions and municipalities rendering them less funded. If rates have nowhere to go but up, what direction are they headed?”
As we now know, the tide is going out for a trend that has supported higher bond prices for 40+ years.
The problem with authority
There’s another reason we think it’s time to be cautious on the last decade’s secular ‘growth’ winners. Call it, if you like, ‘too much belief in authority’. Check out Craig Zobel’s 2012 thriller, ‘Compliance’. It makes for uncomfortable viewing. In the film, based on real events, a fast food restaurant receives a call from someone claiming to be a police officer. The manager is informed that a female staff member has stolen money from a customer’s purse and must be detained.
Despite denying the crime the employee, a young girl, is held by her colleagues in the backroom. She protests her innocence to no avail. On the basis that she might be hiding the evidence, the “police officer” then instructs the manager to carry out a strip search. The film plays out as she and her gullible staff are manipulated by the caller through their desire to “help the police”. In the end, the employees realise that they have been tricked into committing crimes themselves.
These are clearly actors playing their respective roles. But although the premise itself sounds ludicrous, it is convincingly staged. In fact, the events depicted in ‘Compliance’ are not purely fictitious… instead they’re based on 70 similar incidents that took place across North America.
The film’s message is that many of us automatically and even unthinkingly surrender to authority. It’s not malice that makes the (innocent) girl’s co-workers humiliate her. They do it because they think they’re following the legitimate orders of a police officer. As to why that officer can’t come to the restaurant: let’s just say he is very persuasive.
It was the poet Coleridge who coined the phrase “the willing suspension of disbelief”. If an artist can infuse his work with enough humanity – and the appearance of truth – we, the audience, will buy into the illusion. We’ll put our scepticism on hold.
That is the power of authority. We can’t help but draw parallels with the investment world… where the most successful players never cease to question the received wisdom.
‘Compliance’ follows two even more notorious US experiments in human psychology that are grimly relevant in our post-Covid dystopia.
Absolute power corrupts absolutely
1) The Stanford Prison Experiment
The Stanford Prison Experiment took place at Stanford University, California, in August 1971. 24 male students were assigned roles as either prisoner or guard in a mock prison in the basement of the university’s psychology department.
Psychology professor Philip Zimbardo was setting out to test the hypothesis that the main cause of abuse in prisons was the psychological make-up of the prisoners and their wardens. The ‘guards’ were equipped with wooden batons and mirrored sunglasses to prevent direct eye contact. The ‘prisoners’ were arrested at their homes, fingerprinted, then had their mug shots taken.
Order lasted for precisely one day. On day two, prisoners in one cell blockaded the door and refused to follow the guards’ instructions.
Then after 36 hours, one prisoner started to “act crazy, to scream, to curse, to go into a rage that seemed out of control.” When the experimenters realised he wasn’t acting, he was released.
Guards soon resorted to physical punishment. Sanitary conditions quickly deteriorated too, with guards refusing to allow prisoners to urinate or defecate anywhere but a bucket in their cell. Some prisoners had their mattresses removed; others were stripped naked as punishment.
The experiment then spiralled into more abuse, hunger strikes, and solitary confinement. After just six days, it was abandoned. One third of the guards were determined to have displayed “genuine sadistic tendencies”. Many of the prisoners were traumatised.
Such is the malign power of authority.
2) The Milgram Experiments
Equally notorious was the series of experiments run by Yale psychologist Stanley Milgram in 1961. You may have seen video footage of the original Milgram tests, or recreations of them. Each involved three participants. Two of them – the one coordinating the experiment, and the so-called ‘learner’, were “in” on the experiment. The third, the supposed ‘teacher’, was the unwitting subject of it.
So, the teacher began by reading a list of word pairs to the learner. Then they would read the first word of each pair again, and four possible ways to complete it. The learner would press a button to indicate his response.
If the answer was incorrect, the teacher would be instructed to deliver an electric shock to the learner. Each wrong answer increased the voltage by 15 volts. (Incidentally, in one version of the experiment, the learner would mention to the teacher that he or she suffered from a heart condition.)
The ‘teacher’ participants believed the shocks were real. They weren’t. The ‘learners’ were all actors, the electric shocks faked. But that didn’t stop 65 per cent of the participants in Milgram’s first experiment administering the final massive 450-volt dose. Every time any teacher was hesitant to continue delivering (and enhancing) the shocks, he was told by the experimenter:
If a teacher still wanted to stop after receiving all of these verbal cues, the experiment was halted. Otherwise, it was halted only after the learner had received the maximum 450-volt shock three times in a row.
Milgram’s experiment started three months after the trial of the German Nazi war criminal Adolf Eichmann began in Jerusalem. Milgram set out to answer the question: could it be that Eichmann, and those like him, were simply “obeying orders”?
In the Milgram experiment, the bogeyman authority figure was not a senior army officer. It was just a man in a white coat… armed only with a clipboard.
Obedience and the system
Summarising his experiment, Milgram wrote:
“I set up a simple experiment at Yale University to test how much pain an ordinary citizen would inflict on another person simply because he was ordered to by an experimental scientist.
“Stark authority was pitted against the subjects’ strongest moral imperatives against hurting others, and, with the subjects’ ears ringing with the screams of the victims, authority won more often than not.
“The extreme willingness of adults to go to almost any lengths on the command of an authority constitutes the chief finding of the study and the fact most urgently demanding explanation.
“Ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process”.
Milgram’s results are hardly unique. The table below shows the average compliance level to the maximum voltage (450 volts) from a number of studies. University ethics boards (rightly) outlawed Milgram-style experiments in the late 1980s, so no other modern studies are available.
International Milgram studies
Study Country Percentage obedient to the highest level of shock
Milgram USA 62.5%
Rosenham USA 85%
Ancona & Pareyson Italy 85%
Mantell Germany 85%
Kilham and Mann Australia 40%
Burley, McGuinness UK 50%
Shanab, Yahya Jordan 62%
Miranda et al Spain 90%
Schurz Austria 80%
Meeus, Raaijmakers Holland 92%
Source: Smith and Bond (1994), James Montier
But what does all this mean for investment?
For Craig Zobel in ‘Compliance’, authority was an unseen policeman. For Philip Zimbardo at Stanford, authority was a prison guard. For Stanley Milgram, authority was a man in a white coat.
For us, ‘authority’ is the US Federal Reserve. In fact, it’s any central banker. And they are all just as susceptible to the corruption of power as the participants in the studies listed above. The individuals working at central banks are possibly normal and well-intentioned. But they operate within a perverse system, which does the world a great deal of damage.
Western central banks are dangerous for a number of reasons.
The QE programmes they have pushed so aggressively have distorted relative prices across all asset types. They have only delayed the inevitable deleveraging.
Having driven policy rates down to zero, they have forced investors to chase yield. That means exposing themselves to higher degrees of risk than they might have otherwise. That’s because cash deposits were until recently eliminated as a viable investment choice.
In pumping up the money supply (and their balance sheets), they have set the scene for a potentially dangerous inflationary mess further down the line. If not now.
Many investors accept that the central banks know what they are doing. Even that “they have everyone’s back”, or what used to be known as the “Greenspan put” – supporting equity markets – is alive and well.
Don’t fight the Fed
In the markets, there’s a simple rule of thumb: don’t fight the Fed.
Given its almost unlimited monetary firepower, it has never made sense to bet against Fed policy. But that was before the Fed and its international peers went “all-in” with quantitative easing. Now the West’s central bankers have an existential problem: their influence over markets only works while investors believe that that influence still holds.
Be wary of rising interest rates. Short term monetary policy rates can theoretically stay anchored in both the US and the UK and in Europe. But neither the Fed nor the Bank of England nor the ECB can definitively prevent yields from rising in longer-dated government debt markets. And if even higher bond yields do manifest, equity markets are unlikely to be immune to them.
Is there a risk, then, that the “ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process”.
The good news is, we can also own gold.
………….
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Get your Free
financial review
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: info@pricevaluepartners.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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