“We live in a time of great uncertainty and confusion. Events keep happening that seem inexplicable and out of control. Donald Trump, Brexit, the War in Syria, the endless migrant crisis, random bomb attacks.. And those who are supposed to be in power are paralysed – they have no idea what to do. This film is the epic story of how we got to this strange place. It explains not only why these chaotic events are happening – but also why we, and our politicians, cannot understand them.” - Introduction to the documentary HyperNormalisation by Adam Curtis (2016).
The White Sands Proving Ground sits in the Jornada del Muerto desert, southeast of Socorro, New Mexico. On July 16, 1945, it became the test site for the world’s first nuclear detonation. The Manhattan Project – the race to build the bomb – had started modestly enough six years earlier, but as it gained momentum, it would go on to employ more than 130,000 people, burning through the equivalent of $26 billion in today’s money in the process. That was once considered an unusual amount of money.
Among the scientists and military men in attendance, there was no consensus as to what the results might be. The physicist Norman Ramsey forecast that the bomb would fail to go off completely. Robert Oppenheimer predicted an explosive yield equivalent to 300 tons of TNT. The Ukrainian-American chemist George Kistiakowsky plumped for 1,400 tons of TNT. The German-American physicist Hans Bethe went for 8,000 tons of TNT. The Polish-born physicist Isidor Isaac Rabi chose 18,000 tons of TNT (he would win the bet).
But the Italian physicist Enrico Fermi proposed a different wager altogether. He darkly suggested two options: given that the atmosphere would ignite, would the blast destroy ‘just’ the state of New Mexico, or would it go on to incinerate the entire planet ?
Fermi’s prediction was not as outlandish as it might sound. Earlier in the war, in the spring of 1942, German physicists approached Hitler’s Minister for War Production, Albert Speer, to discuss the possibility of their building a nuclear bomb. Speer asked Werner Heisenberg, spokesman for the scientists, whether a successful detonation could be kept under control or whether it might continue, unchecked, throughout the atmosphere. Heisenberg did not give a definitive answer.
Speer later wrote in his memoirs,
Hitler was plainly not delighted with the possibility that the earth under his rule might be transformed into a glowing star.
One of the American physicists who worked on the Manhattan Project would go on to have a glittering career. Richard Feynman, one of the most charismatic and brilliant scientists to have lived, was always aware of the limitations of human knowledge. He once excoriated the pretensions of ‘social scientists’ and supposed experts:
They don’t do scientific…they follow the forms…you gather data, you do so and so and so forth but they don’t get any laws, they haven’t found anything, they haven’t got anywhere yet, maybe someday they will but it’s not very well developed, but what happens is…even on a more mundane level we get experts on everything. They sound like a sort of scientific experts. They are not scientists. They sit at the typewriter and make up something.. Maybe true but it hasn’t been demonstrated one way or the other but they sit there on the typewriter and make up all that stuff as if it’s science and then become experts on food, organic foods and so on. There is all kind of myths and pseudoscience all over the place. Now I might be quite wrong, maybe they do know all these things but I don’t think I’m wrong. You see, I have the advantage of having found out how hard it is to know something, how careful you have to be about checking the experiments, how easy it is to make mistakes and fool yourself. I know what it means to know something and therefore I can’t…I see how they get their information and I can’t believe that they know it. They haven’t done the work necessary, haven’t done the checks necessary, haven’t done the care necessary. I have a great suspicion that they don’t know that this stuff is…and they are intimidating people by it.
The problem is bigger than false science. Because the public craves certainty, even – and especially – where it simply cannot exist.
In his lecture ‘This Unscientific Age’, Feynman put it as follows:
Suppose two politicians are running for president, and one goes through the farm section and is asked, ‘What are you going to do about the farm question ?’ And he knows right away – bang, bang, bang. Now he goes to the next campaigner who comes through. ‘What are you going to do about the farm problem ?’ ‘Well, I don’t know. I used to be a general, and I don’t know anything about farming. But it seems to me it must be a very difficult problem, because for twelve, fifteen, twenty years people have been struggling with it, and people say that they know how to solve the farm problem. And it must be a hard problem. So the way that I intend to solve the farm problem is to gather around me a lot of people who know something about it, to look at all the experience that we have had with this problem before, to take a certain amount of time at it, and then to come to some conclusion in a reasonable way about it. Now, I can’t tell you ahead of time what conclusion, but I can give you some of the principles I’ll try to use – not to make things difficult for individual farmers, if there are any special problems we will have to have some way to take care of them,’ etc. etc.
Now such a man would never get anywhere in this country, I think. It’s never been tried, anyway. This is in the attitude of mind of the populace, that they have to have an answer and that a man who gives an answer is better than a man who gives no answer, when the real fact of the matter is, in most cases, it is the other way around. And the result of this of course is that the politician must give an answer. And the result of this is that political promises can never be kept. It is a mechanical fact; it is impossible. The result of that is that nobody believes campaign promises. And the result of that is a general disparaging of politics, a general lack of respect for the people who are trying to solve problems, and so forth.. It’s all generated, maybe, by the fact that the attitude of the populace is to try to find the answer instead of trying to find a man who has a way of getting at the answer.
It’s difficult to read those lines without thinking of our current predicament. In short, in dealing with an outbreak of a flu-like virus, the economies of the West have essentially bankrupted themselves, in all but name. The western economies, notably Europe, require deep economic restructuring in order to restore some semblance of vigour. But politicians are unable, or unwilling, to take the hard choices required. Since nature abhors a vacuum, the central bankers have stepped in to fill the void. Expect to hear much more about the dread acronym CBDC.
But, creepy crypto projects aside, central bankers only have a handful of policy tools, primarily discretionary authority over interest rates, and latterly the power to print ex nihilo money, and they’ve already deployed them to unprecedented, but entirely questionable, effect.
Different, but not stupid
Few countries have been more aggressive over the past quarter century or so when it comes to monetary stimulus than Japan.
A few years ago, a Mr Takashi Ito wrote a remarkable letter to the Financial Times. Here is what it said:
“Sir, ‘Can the Fed prevent Japanese-style deflation, a period of falling prices associated with economic stagnation, from taking hold ?’ is a common refrain nowadays.
“The US Federal Reserve’s obsession with Japan is pretty disastrous. First, Alan Greenspan [the former Fed chairman] opened the taps wide for too long, fearing Japanese-style deflation, which fuelled the housing bubble that led to the recent financial crisis. Now, fearing the lost decade plus, the Fed is probably going to keep easing until some different but unpleasant outcome is the result. Stagflation, perhaps, or hyperinflation ?
“This is so ironic, because for so long people have sneered at the Japanese for their inability to steer their economy to recovery. Perhaps because they have sneered so much, it is no longer possible to admit that after a huge housing bubble bursts, there is nothing to do except suffer years of economic indignity.
“The fixation with Japan was not helpful during Mr Greenspan’s watch, nor I fear will it be of much use this time. The Japanese may be different, but they were not stupid.”
Consider that wonderfully Japanese phrase: the country has had no option but to suffer “years of economic indignity”. It recalls the sort of ultra-nuanced, delicate Japanese language used by Emperor Hirohito when he addressed the country in a four-minute radio address to announce unconditional surrender after the atomic bombing of Hiroshima and Nagasaki in 1945:
“..the war situation has developed not necessarily to Japan’s advantage..”
“We have resolved to pave the way for a grand peace for all the generations to come by enduring the unendurable and suffering what is not sufferable..”
Whatever else you may think about the Japanese, what is non-negotiable is that they’re a stoic people. Consider the tragic calm that engulfed the country after it endured the terrible earthquake and tsunami of 2011. Do you remember the mass rioting and the looters on the streets ? No, neither do we. Japan has a long and glorious history of enduring the unendurable.
More to the point, Japan’s “lost decade” itself may be an example of gross historical misrepresentation. The Nikkei 225 stock index peaked at 38,957 on December 29, 1989. Concerned at the extent of an asset price bubble, the Bank of Japan tightened monetary policy, and the stock market crashed. Highly inflated property prices also crashed, along with the banking system. Between 1995 and 2007, Japanese GDP fell from $5.3 trillion (equivalent) to $4.4 trillion, and real wages fell by roughly 5%. But now look at what happened (or rather, what didn’t happen) to the Japanese jobless rate:
Despite a crushing asset price collapse and near terminal damage to the property market and the banking sector that persisted for well over a decade, Japanese unemployment never rose above the 5.5% level. The rest of the world should be so lucky.
But there was clearly damage to the real economy, and that was naturally reflected in the stock market.
As a further sign of how the narrative can get distorted, Japan tends to be treated as a bond market basket-case (a view with which we happen to agree), but not as a stock market with huge potential. (The Japanese economy remains the third largest in the world.)
At some point, the Japanese bond market is likely to go bang. The well-respected Texas-based hedge fund manager Kyle Bass has described it as a bug in search of a windshield. The situation is certainly surreal; despite having a sovereign debt-to-GDP ratio that is higher than any country in Europe and more than twice the OECD average, Japanese bonds barely yield anything at all. Have the laws of supply and demand been rescinded ?
Given that the Japanese government is more or less bankrupt, the popularity of JGBs (Japanese Government Bonds) is certainly baffling. But it’s a sign of how distorted asset prices can become in an environment of ubiquitous monetary distortion. For reserve managers at foreign central banks, Japanese government bonds still maintain some kind of allure.
But we are not here to highlight the looming train wreck that is the Japanese government bond market, but rather the value opportunity that much of the Japanese stock market now represents.
Consider price / book. This is the ratio of a stock’s market value to its book value (or intrinsic true worth, or inherent replacement cost). If a company’s stock trades at a price / book of 1, it implies that the company’s market value could exactly be realised by liquidating its assets at current market prices. If a company’s stock trades at a price / book ratio of below 1, it suggests that the company’s stock could be cheap, in that the business could be liquidated and the payout would be higher than the current stock price.
In the past we have highlighted a study by James O’Shaughnessy (drawn from his book, ‘What works on Wall Street’) which makes a fairly compelling case for buying stocks on low price / book multiples. Over the course of over 50 years, low price / book stocks generated average annual returns of 15.95%. Buying stocks with high price / book ratios resulted in returns of just 6.52% by comparison. In other words, buying stocks using this classic value metric tends to deliver superior returns.
Much of the Japanese market has a price / book ratio between 0.5 and 1. The Japanese stock market is cheap. Some of these stocks may end up being ‘value traps’ (i.e. they never end up trading at a materially higher price) but equally many of them are, in our view, likely to end up generating attractive returns to investors bold enough to take advantage of them.
Now look at the US.
Different story altogether. The lion’s share of the US stock market trades above 2 times book. That doesn’t necessarily mean those are bad businesses, or expensive businesses, but that’s not our point. The Japanese market simply trades on a much lower value multiple than that of the US.
It’s a similar story when it comes to the price / earnings ratio. A p/e ratio describes a company’s share price divided by its earnings per share. The market accords high p/e multiples to ‘growth’ companies, and relatively lowly multiples for ‘value’ companies. Since most growth companies pay little or nothing by way of dividends, the entirety of their return comes from price action alone.
But across two centuries of stock market data (drawn from the US and UK stock markets), we know that the average annual return from listed stocks stands at between 6% and 7%, on average. Of that return, more than half comes from reinvested dividend income. In other words, if your stocks aren’t giving you any income, the chances are that you’re playing the wrong game.
In the original O’Shaughnessy study, high p/e stocks generated average annual returns of 8.78%. Hardly a disaster. But buying low p/e stocks yielded you 13.77%. And that’s a higher return despite taking less risk, effectively, because you weren’t paying a premium to own more lowly priced value stocks.
So how do the markets stack up on a p/e basis ?
Once again, Japan remains the outlier. Over a quarter of the Japanese stock market trades on a p/e of less than 10 times. Not only that, but this universe of over 800 stocks attracts very little broker coverage.
Now consider the US.
By comparison, very few companies in the US stock market trade at p/e multiples that could be called cheap. Almost half the market trades on a p/e of more than 20 times.
There’s another point worth bearing in mind when it comes to the merits of Japanese stocks versus those of the Anglosphere. Most companies are not covered by analysts at brokerage houses.
A 20 year+ bear market has shattered public confidence in stocks. As the banks have retrenched, so have their equity analysts. There is little or no research coverage of many public companies in Japan. People will not buy what they don’t know.
This is clearly an opportunity in disguise for foreign investors willing to back value over popularity.
Japanese investment institutions today are full of tired, old hands who stick rigidly to formulas and to proscribed lists of favoured investments.
There is a chronic lack of coverage of many important listed companies.
There is a widespread feeling that all Japanese companies are somehow “broken”, without discriminating between zombie companies and dynamic companies that are busily growing earnings.
Many Japanese businesses have been performing much better than their stock prices would imply. There is a myth at the heart of conventional investment theory and it’s called the efficient market hypothesis. But sometimes markets simply aren’t as efficient as they’re widely believed to be. When markets are hopelessly inefficient at identifying value, as Japan is and has been for some years, it creates tremendous opportunities for unconstrained investors.
Fooling nature ?
At the end of a life sadly cut short by a rare cancer, Richard Feynman would go on to sit on Ronald Reagan’s investigatory committee into the space shuttle Challenger disaster. It was Feynman who traced the cause of the explosion, to rubber O-rings just a quarter of an inch thick that were supposed to seal the sections of the shuttle’s solid rocket boosters. The structural integrity of these O-rings would be seriously compromised at low temperatures. Ice had built up on the night before the shuttle’s launch.
During the hearings into the shuttle tragedy, Richard Feynman released a damning summary of NASA’s chronic inability to assess risk. Decision making smothered by bureaucracy became
“a kind of Russian roulette. . [The shuttle] flies [with O-ring erosion] and nothing happens. Then it is suggested, therefore, that the risk is no longer so high for the next flights. We can lower our standards a little bit because we got away with it last time.. You got away with it, but it shouldn’t be done over and over again like that.”
Science offers practical tools to help address these risks. NASA chose not to utilise them. A random array of data points – the depth of erosion in those rubber O-rings, for example – would be reduced by NASA engineers to overly simplified, linear rules of thumb. But a hot jet of super-powered gas carving channels in rubber is highly non-linear. The response to a scattered range of data should be probability distributions rather than single discrete numbers. The science of a shuttle flight is complex and complicated. It is probabilistic rather than certain.
Richard Feynman concluded his personal report on the Challenger disaster with the following words:
“For a successful technology, reality must take precedence over public relations, for nature cannot be fooled.”
Nature cannot be fooled. And neither can the markets, not forever. Rather than rely on the spurious precision and fundamental overconfidence of economists, central bankers and market strategists, there are three words we should voice as we navigate these treacherous waters. Sometimes:
We don’t know.
So we don’t attach too much significance to subjective macro forecasts that might be wildly misguided – or plain wrong. We simply look at the opportunity set on a bottom-up basis, crunch the numbers, avoid the obvious overvaluation risks.. and wait for the magic of mean reversion to do the rest.
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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