The price of everything

An open letter to the Western banking establishment

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as the final and total catastrophe of the currency system involved.”

-          Ludwig von Mises, Human Action (1949).

 

“In a world of debt and deflation, inflation is our friend.”

 

-       Crispin Odey, Financial Times (28.1.2009)

 

“Not if you’re a saver.”

 

-       Anon (29.1.2009)

 

Re. your unauthorised overdraft

 

Dear Western banking establishment,

 

I notice that your unauthorised credit facility from international lenders of last resort now totals approximately $10 trillion. As a taxpayer and therefore your largest shareholder I would be grateful if you could repay this facility at your earliest convenience. I have charged you an additional £30 for this letter and a monthly unauthorised overdraft fee of £28. If you do not repay this facility shortly I will have no choice but to become further massively impoverished along with legions of fellow taxpayers for multiple generations to come.

 

I would also be grateful if the strategists and economists who work for you could abstain from publishing their unsolicited opinions about resolving the banking crisis within the financial media. I am sure you will agree that hearing from the same strategists who worked for the architects of such widespread financial destruction is likely to irritate those of us who were not actually complicit in the extraordinary and venal credit boom of the last several decades. There is an expression that if you’re not part of the solution, you’re part of the problem. Those of your employees who were the public face of the problem are, I think you will agree, unlikely to represent the solution, unless perhaps they are fired – en masse, from a giant howitzer, into an area where they can do no further harm. Alaska, perhaps. I would further suggest that the high profile commentators who work for you and who have implicitly played their part in marketing and then amplifying this catastrophe might consider quietly entering another field with superior ethics and enhanced value to society at large: perhaps as piano players in brothels. This note has been copied to the letters editors of The Financial Times and The Wall Street Journal (which I understand is shortly to be renamed simply The Journal on the basis that Wall Street no longer actually exists – as was noted this week by Messrs Wen Jiabao and Vladimir Putin at Davos. Don’t worry about not being there – you weren’t missed).

 

Since the start of the year is always a time for slimming and working off the excesses of the festive period, I wonder whether your industry would consider operating along similar lines. Just as there is no real need to have 18 different coffee bars all touting their wares along my High Street, there is probably no real need to have 18 different banks, not all of which are subsidiaries of Santander, clogging the High Street and busily not wanting to extend me back any of my own money so generously lent to them.

 

I would also be interested in your views as to the wisdom and efficacy of the monstrous pile of credit being shovelled at you and your peers by governments when it was overmuch credit creation that precipitated this crisis. I do not, of course, expect anything other than a self-interested response. But you may find the following observations pertinent. If they seem acutely relevant today it is because they were written in the early 1930s, by one Garet Garrett (and a grateful hat tip to M. Gandon):

 

“The general shape of this universal delusion [that is, credit] may be indicated by three of its familiar features.. First, the idea that the panacea for debt is credit.. The burden of Europe’s private debt to this country now is greater than the burden of her war debt; and the war debt, with arrears of interest, is greater than it was the day the peace was signed.. Debt was the economic terror of the world when the war ended. How to pay it was the colossal problem. Yet you will hardly find a nation, state, city, town or region that has not multiplied its debt since the war. The aggregate of this increase is prodigious, and a very high proportion of it represents recourse to credit to avoid payment of debt.

 

“Second, a social and political doctrine, now widely accepted, beginning with the premise that people are entitled to certain betterments of life. If they cannot immediately afford them.. nevertheless people are entitled to them, and credit must provide them.. Result: Probably one half of all government, national and civic, in the area of western civilization is either bankrupt or in acute distress from having over-borrowed according to this doctrine.. Now as credit fails and the standards of living tend to fall from the planes on which credit for a while sustained them, there is political dismay.. When [people] have been living on credit beyond their means the debt overtakes them. If they tax themselves to pay it, that means going back a little. If they repudiate their debt, that is the end of their credit. In this dilemma the ideal solution, so recommended even to the creditor, is more credit, more debt.

 

“Third, the argument that prosperity is a product of credit, whereas from the beginning of economic thought it had been supposed that prosperity was from the increase and exchange of wealth, and credit was its product.”

 

It will probably not have escaped your attention that the National Housing Federation this week urged the UK government and its wholly owned banking subsidiary, Northern Rock, to extend mortgages to people on lower incomes. “Given that Northern Rock has been nationalised it should now be made by ministers to take on a social purpose and ensure that those people on low-to-moderate incomes who can afford to buy a low cost home, and have a good credit rating, are given access to mortgages,” said NHF chief executive David Orr. Be careful what you wish for. The Nationwide building society, on the same day, reported UK house prices falling at an annualised 17%. Perhaps Mr. Orr wishes a whole new sub-class of low-to-moderate wage owners to be lured into a collapsing housing market. Nice one. Said wage owners should perhaps be grateful that the banking system is currently so dysfunctional (a.k.a. “finally prudent”) – it may end up saving them a fortune in lost housing equity.

 

Perhaps you, like I, find it richly ironic that members of the public still use your investment subsidiaries as a means to protect and grow their private wealth. I think you should promote the activities of these subsidiaries more widely. My idea for an advertising slogan: “When it comes to moral hazard, we’re Number One. We helped trigger the biggest financial and economic collapse in history through our imprudent lending and investment. Between 18 million and 30 million jobs throughout the world are almost certain to be lost. And more than 50 million jobs throughout the world are now in jeopardy. As a result of our investment expertise, we’ve lost billions, and those of us that still exist and aren’t owned by the taxpayer are technically insolvent. Now, how can we help you with your finances ?”

 

In any event, this letter is also to let you know that now that you and your members, in collusion with your governmental paymasters, are offering negative real returns to cash depositors, I am withdrawing what remains of my funds since I can find altogether better opportunities for the preservation and growth of my capital within high quality pockets of the equity and corporate bond markets, and I can get sufficient “insurance” for my increasingly worthless fiat currency in the form of gold. I appreciate that the withdrawal of my funds may send you spiralling into nationalisation. Sorry about that. And since you appear not to know the meaning of the word:

 

“Sorry. (“sQrI), a. Pained at heart; distressed, sad; full of grief or sorrow. In later use freq. in weakened sense, and often employed in the phrase “I’m sorry” to express mere sympathy or apology. But not by members of the banking profession.”

 

Yours sincerely

 

A. Customer.

Seems to be the hardest word

“..banks have done more injury to the religion, morality, tranquility, prosperity and even wealth of the nation, than they.. ever will do good. Our whole banking system, I ever abhorred, I continue to abhor, and shall die abhorring.. every bank of discount, every bank by which interest is to be paid or profit of any kind made by the deponent, is downright corruption.”

-          US President John Adams, 1799.

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."  

-          Henry Ford.

A moment comes while you’re watching Ron Howard’s outstanding ‘Frost / Nixon’ when you suddenly realise that director Ron Howard has crafted pure entertainment gold out of some ostensibly unpromising material. A televisual battle of wills between a glib showman and a disgraced politician ? But ‘Frost / Nixon’, boiled down to its essentials, is about just one thing: a bilked nation craving an apology.

So its relevance to the current financial débacle speaks for itself. The scale of the banking crisis is so huge, and the dislocating damage wrought across all financial assets so extensive, it challenges language and thought just to try and articulate it. But one response has been almost universal: having been monumentally cheated, we demand an apology. Yet answer comes there none.

The lack of contrition may have something to do with the breadth and diffusion of the guilt.

We can justifiably start with the politicians. The Gramm-Leach-Bliley Act of November 1999 repealed enough of 1933’s Glass-Steagall Act to allow commercial and investment banks to play in the same sandpit. (At the risk of appearing parochial or partisan, all of the proponents of Gramm-Leach-Bliley happened to be Republicans.) The regulators played their part, not least the SEC in its decision to outsource its regulatory function in overseeing the credit markets in the 1970s to three for-profit companies, the ratings agencies Standard & Poor’s, Moody’s and Fitch. The decision to require issuers of debt to pay for their own ratings, leaving credit ratings as a “freely provided” public good, it no longer requires noting, created monstrous conflicts of interest for the ratings agencies. And the role in the crisis played by fraudulent mortgage originators, and the ethical vacuum of the “originate to distribute” model, and deal-hungry bankers divorced from true accountability, has been widely discussed. But since a housing and credit bubble also requires the willing participation of a greedy and credulous public, there are really few people who emerge entirely untainted from the wreckage. By and large, we are all complicit. What matters is how we reach resolution.

And that is where the problems start piling up, because there is no broad agreement on how to solve the crisis, and perhaps there cannot be. Jeremy Grantham expresses it nicely: “even the near-consensus case for great stimulus is lacking in historical certainties or intellectual vigour”. By citing the work of Murray Rothbard last week, we expressed our scepticism of government bank support. But a completely non-interventionist approach would be politically unacceptable in every country groaning under the weight of the banking crisis. Perhaps the most ominous development in a rolling saga of gloom has been the sudden weakness of the Chinese economy: the recession is now confirmed as a global phenomenon.

In the face of an avalanche of worsening economic news, it is easy to become fatalistic or depressed, or both. But Grantham also makes a valid observation at least as regards the ailing property market: we have not lost real housing wealth, so much as the illusion of wealth. One could make the same point about the stock market: except for the lucky or uniquely gifted few who bailed out at the highs in 2007, the stock market values – before the Crash – were never real either, they were just the illusion of wealth. And investors either lucky or gifted to be sitting on significant cash reserves now have the luxury of picking up high quality stocks at huge discounts from their 2007 and 2008 prices. But outside a necessarily selective list of stock market investments, it is difficult to see compelling value in a number of asset types, either because there is still great anticipation of future waves of forced selling (for example in hedge funds, private equity and housing) or because the government has badly distorted free markets and left confusion and opacity in its wake (in the outlook for, and assessment of value within, both the government and corporate bond markets). Outside selective pockets of the equity market, then, the only really compelling investment – and portfolio insurance – opportunities now on offer would seem to be in precious metals and, at some later stage, in inflation-protected government bonds.

Because as Grantham points out, there is simply too much private debt clogging the markets (he suggests to the order of between $10 trillion and $15 trillion), and there are only three ways of making it go away. We can write it down (which would appear to be unpalatable politically – and that may have to change); we can let a combination of time and increased saving do the heavy lifting, as the Japanese have largely done; or we can inflate the hell out of this private debt mountain and collapse its real value. But as Grantham suggests,

“Each of the three realistic possibilities listed above would be extremely painful, each is loaded with uncertainties, and even the quickest of them would take several years. Our path this time is likely to involve a hybrid approach: we will certainly take some painful debt liquidations; this crisis will almost certainly take far longer than normal to play out; and probably, before a new equilibrium is reached, we will see inflation rates that are well above normal.”

Determined not to be overcome by gloom, Grantham also points out that “real wealth lies not in debt but in educated people, laws and work ethic, as well as in the quality and quantity of fixed assets and the effectiveness of corporate organisation”. In a 24/7 news culture that seems to venerate bad economic news, it is also worth taking the perspective of “economists of happiness” such as Warwick University’s Andrew Oswald, who has pointed out that our sense of well-being does not rise hand in hand with real national income: we seek economic growth without questioning its desirability relative to less tangible accomplishments, such as well-being itself. In a 1997 report (“Happiness and Economic Performance”), he suggests that given the significant role played by unemployment in causing unhappiness, governments might well choose to prioritize job creation over maintaining largely spurious economic growth:

 

“In a country that is already rich, policy aimed instead at raising economic growth may be of comparatively little value.”

 

And for readers wondering how best to deal with that constant flow of recession coverage and bad news, our best advice: just turn it off.

Lessons from the 1930s

“From Mr Thomas Janichen.

Sir, Why create another bad bank ? We have enough already.”

-          Letter to the editor, Financial Times, January 17/18, 2009.”

 

“Conspicuous intelligence seemed actively unwelcome in the Bush White House.”

-          David Frum, speechwriter for George W. Bush during his first term.

 

“His administration staged some 200 ‘town hall’ events attended by pre-screened participants.. yet at the end of it all, support for Mr Bush’s proposal was lower than when it began.”

-          The Economist, January 17-23, 2009.

Bush - or at least his reputation - is dead. Long live Obama. The Economist magazine makes a decent fist of providing a not entirely partisan assessment of the achievements of George Walker Bush (in a special article entitled “The frat boy ships out”, and to be fair they endorsed him the first time around) but it is plain where the journalistic, if not editorial, sympathies broadly lie now. Princeton historian Sean Wilentz is cited: “Many historians are now wondering whether Bush, in fact, will be remembered as the very worst president in all of American history.”

Americans, of course, do not follow the strict Anglo-Saxon “King is dead” protocol that venerates the role, if not necessarily the incumbent, following a change-over in the administrative hierarchy. But then they claim to be republicans, with that small ‘r’. In any case, Barack Obama has inherited a right royal mess of pottage.

Perhaps the biggest danger is to assume, in a crisis, that politicians are in much of a position to help anybody, other than themselves. From what I remember of my pre-O level days, my school didn’t commit the biggest resources to the study of the Great Depression. But I distinctly remember a half hour devoted to the topic, and the general implication was: Franklin Roosevelt helped end it. After reading Murray Rothbard’s “America’s Great Depression” (Fifth edition 2008, by the Ludwig von Mises Institute), I am no longer so sure. In fact, after reading Rothbard’s study of the economic disaster of 1930s North America / rest of the world, I am left wondering whether pretty much everything I had been led to believe about that time is wrong. Since we are poised on the precipice of our very own 1930s, the question bears repeating.

Rothbard died in 1995. He was therefore unable to comment about the colossal bonfire of vanities stoked by Wall Street and the mortgage banking system over the past decade. It is unlikely, however, that he would have approved. He was not exactly a fan of the role of banks, nor of the perhaps fundamentally flawed model known as fractional reserve banking.

If it were a more perfect world, schoolchildren would at least be taught the bare minimum about the real economy, and not least about the way banks work. (One of the statutory objectives of the UK’s Financial Services Authority is to “promote public understanding of the financial system”. If the UK financial regulator can’t pull that trick off now, it will never get a better opportunity in the history of the world.) What we know as fractional reserve banking equates to letting banks keep a tiny fraction of their deposits (their depositors’ money, one should perhaps add) in order to lend out the remainder for profit (theirs, not the depositors’, one should perhaps add). Simultaneously, they retain the obligation to redeem all depositors immediately upon demand. More astute readers, or anyone who has maintained a bank deposit account over the last two years, will see the subtle flaw in this system. In the words of Murray Rothbard,

“Banks are “inherently bankrupt” because they issue far more warehouse receipts to cash (nowadays in the form of “deposits” redeemable in cash on demand) than they have cash available. Hence, they are always vulnerable to bank runs. These runs are not like any other business failures, because they simply consist of depositors claiming their own rightful property, which the banks do not have. “Inherent bankruptcy,” then, is an essential feature of any “fractional reserve” banking system.”

Rothbard goes on to cite Frank Graham (“Partial Reserve Money and the 100% Proposal,” American Economic Review, September 1936):

“The attempt of the banks to realize the inconsistent aims of lending cash, or merely multiplied claims to cash, and still to represent that cash is available on demand is even more preposterous than.. eating one’s cake and counting on it for future consumption.. The alleged convertibility is a delusion dependent upon the right’s not being unduly exercised.”

Rothbard wrote the following in 1963. The subsequent 46 years have not dulled the message:

“There are other values in deflation, even in bank runs, which should not be overlooked. Banks should no more be exempt from paying their obligations than is any other business. Any interference with their comeuppance via bank runs will establish banks as a specifically privileged group, not obligated to pay their debts, and will lead to later inflations, credit expansions, and depressions. And if, as we contend, banks are inherently bankrupt and “runs” simply reveal that bankruptcy, it is beneficial for the economy for the banking system to be reformed, once and for all, by a thorough purge of the fractional reserve banking system. Such a purge would bring home forcefully to the public the dangers of fractional reserve banking, and, more than any academic theorizing, insure against such banking evils in the future.”

But the savaging of fractional reserve banking is only a small part of the message of Rothbard’s “America’s Great Depression”. Contrary to the received wisdom that interventionist government (under, Rothbard points out, the administration of Herbert Hoover for some years before Roosevelt took the presidency) ameliorates and foreshortens a dismal business depression, Rothbard suggests that the very intervention so clamorously called for (both then and now) actually extends and amplifies it:

“If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt ? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure. If, in fact, we list logically the various ways that government could hamper market adjustment, we will find that we have precisely listed the favourite “anti-depression” arsenal of government policy. Thus, here are the ways the adjustment process can be hobbled:

1)      Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.

2)      Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government “easy money” policy prevents the market’s return to the necessary higher interest rates.

3)      Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.

4)      Keep prices up. Keeping prices above their free-market levels will create unsaleable surpluses, and prevent a return to prosperity.

5)      Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further.. Any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption.. Any increase in the relative size of government in the economy.. shifts the societal consumption-investment ration in favour of consumption, and prolongs the depression.

6)      Subsidize unemployment..”

One does not have to agree with every one of Rothbard’s admonitions to see the value in the general argument. What stand out most ominously amid the current “race to avoid (i.e. cause) depression” are features 1, 2 and 5 in the current crisis. When a surfeit of easy money largely provoked the banking crisis, it is difficult indeed to see how even more of the same can help to resolve it.

Rothbard was a fervent free marketeer. His conclusion:

“Only governmental inflation can generate a boom-and-bust cycle.. the depression will be prolonged and aggravated by inflationist and other interventionary measures. In contrast to the myth of laissez-faire, we have shown (in “America’s Great Depression”) how government intervention generated the unsound boom of the 1920s, and how Hoover’s new departure aggravated the Great Depression by massive measures of interference. The guilt for the Great Depression must, at long last, be lifted from the shoulders of the free-market economy, and placed where it properly belongs: at the doors of politicians, bureaucrats, and the mass of “enlightened” economists. And in any other depression, past and future, the story will be the same.”

The taxpayers’ money committed to the banking crisis has been, by any measure, stunning. Bloomberg suggests the total US tally of liabilities, to date, now sits at $7.8 trillion – or $24,000 for every man, woman and child in the country. The Daily Telegraph suggests that the UK total sum of taxpayers’ liabilities spent or pledged amounts to almost £1 trillion – or £33,000 per taxpayer. One is entitled, as voter and taxpayer, to ask precisely what “improvement” in economic or banking conditions such stupendous capital commitments have provoked.

It is not my wish to carve out of Rothbard’s stirring call-to-arms its fundamental appeal, merely to hint at it. Readers intrigued by his thesis, not least in how it stands markedly at odds with conventional wisdom in fighting the current banking crisis, should simply buy the book and read it for themselves. But profound depression is likely to be the inevitable outcome, in both senses of the word.

Dealing with ermflation

“Calm down, dear, it’s only a recession.”

 

-       A message on Michael Winner’s T-shirt, sported while in Barbados. (Hat tip to Money Week.)

 

 

In ‘Alice Through The Looking Glass’, the White Queen admits that she has sometimes believed as many as six impossible things before breakfast. She would be at home in today’s markets. Last week, pornographers Larry Flynt and Joe Francis lobbied Congress for a $5 billion bailout in line with that sought by the auto sector. “As long as the government is handing out money, we want to be there to take it,” said Francis. You can’t fault his logic. The appeal may have been brazen, opportunistic and self-serving – so perhaps he should really be working on Wall Street.

 

It turns out that Ronald Reagan had most of the best lines in anticipation of the current economic black comedy. “A recession is when your neighbour loses his job,” he said in 1976; “A depression is when you lose yours. And recovery is when Jimmy Carter loses his.” Refreshingly for a politician, he also suggested that “The ten most dangerous words in the English language are ‘Hi, I’m from the government, and I’m here to help’.” And on the same topic, he described government as “like a baby. An alimentary canal with a big appetite at one end and no responsibility at the other.” Where we stand today, a problem caused primarily by the unconstrained greed of the private sector is now being addressed by the dubious intentions of the public sector. History suggests it will not be handled well. When money is spent, it can only be under one of three conditions. You can spend your money on yourself. You can spend your money on other people. Or you can spend other people’s money on other people. This last version is the very definition of government spending.

 

Answering just one question correctly should be sufficient to navigate the markets successfully during 2009 and for the foreseeable future: inflation, deflation, or both ? And when ? Unfortunately the future is more than ordinarily unforeseeable (spot how many chief executives use the word ‘visibility’ over the coming months), because none of us has been here before. On the deflationary side, take the largest credit expansion in world history – an expansion that of course has now become a contraction, and the largest debt deflation in world history. On the inflationary side, take the largest fiscal and monetary infusions in world history. Then pay your money and take your choice. Of course, there is a middle way. Since western governments have effectively extinguished cash as a meaningful asset choice, ‘twin primacy’ in investment terms goes to blue chip equities and high quality bonds. Arguably the best way of dealing with ‘ermflation’ – the sheer inability to forecast which particular threat will be the most severe, and over what kind of timeline – is to maintain exposure to both types of asset. Blue chip stocks offer a hedge, of sorts, against eventual inflation, given that they represent a claim on the real economy. Blue chip bonds (and the value is now firmly in the corporate credit market as opposed to government debt, unless deflation kicks in with a vengeance) offer a realistic hedge against deflation. The caveat in both cases is that extreme selectivity will be required. The recession we are entering is going to be peculiarly savage. We already know that the High Street will be awash with blood, and vacant lots, before it is over.

 

So the onus on investors is to use a particularly robust screening process to identify the probable winners and losers in the Darwinian economic marathon ahead. Measures like the Altman Z Score work for selecting both equities and bonds. Indeed the trick in 2009 will be to treat equities like bonds, as primarily income-generating assets (and something has to replace those deposit accounts at dodgy banks, which is to say all of them). So if the stocks in your portfolio are unlikely to maintain their dividend, or worse still don’t even pay a dividend, you would be well advised to eject them with extreme prejudice. We are long beyond the simple pursuit of capital growth: a deflationary (or ermflationary) depression is an environment that demands a commitment to capital preservation, inasmuch as anything so concrete is achievable in such freakish economic and market conditions. Positive straws in the wind ? High yield seems to have turned something of a corner, but there have been enough false dawns on the way here to be a permasceptic. (And last Wednesday’s troubled German government bond auction sets an ominous precedent for megaborrowers like the UK.) But perhaps the most promising development is that we have entered the last days of the presidency of George W. Bush – a politician who reset the bar when it came to defining ignorance and ineffectuality. Which in turn begs the question of whether any populace deserves the government it gets. Overmuch contemplation on that score is just too horrible to bear.

 

The third part of the investment triumvirate for 2009, now that Bernie Madoff has effectively destroyed confidence in funds of hedge funds, and given that the unavailability of credit has performed the same function for private equity, is real assets. As we wrote last week, commodities performed well in the 1930s, and history is showing every sign of repeating itself – though whether as tragedy or farce is for the reader to decide.

Farewell to all that

“A fool and his money are lucky enough to get together in the first place.”

 

-       Gordon Gekko (Michael Douglas) in the film ‘Wall Street’.

 

 

First, a happy new year to all readers. There was a fitting circularity to 2008, in that a year that began with the largest apparent fraud in banking history (Jérôme Kerviel’s €5 billion loss at Société Générale) also ended with it, in the form of Bernard Madoff’s self-confessed Ponzi scheme and losses that have been stated at approaching $50 billion. Kerviel showed that investment banks were not necessarily the most competent handlers of risk – a point that Bear Stearns and Lehman Brothers, and the effective termination of Wall Street as a private entity, later underlined. Bernard Madoff in turn showed that those local councils with deposits in Icelandic banks did not have an absolute monopoly on credulity, nor on negligence in conducting appropriate due diligence – supposedly sophisticated institutional investors were just as capable of being taken for a hugely expensive ride.

 

There was a circularity, too, to the circumstances of the Madoff fraud. Just as last year’s spike in Volkswagen stock was a modern echo of the much earlier 1920 ‘corner’ in the stock of the Stutz Motor Car Company, so Madoff himself bears more than a token similarity to Richard Whitney, whose downfall after the Great Crash of 1929 is also ably told in John Brooks’ excellent ‘Once in Golconda’ (Wiley, 1999). Like Madoff, Whitney was a member of the Wall Street establishment: he had his own brokerage business, and a seat on the New York Stock Exchange, where he had once been President. Madoff, of course, has his own brokerage business, and is a former chairman of Nasdaq. Having lost money in a variety of speculative investments, Whitney borrowed heavily from friends and family, and finally turned to embezzlement. He ended up serving a little over three years in Sing Sing.

 

From a year for markets that has already entered the history books, the Kerviel and Madoff scandals also highlight some central aspects of the financial crisis. Trust as a commodity is increasingly hard to come by. As Michael Lewis and David Einhorn point out, the pertinent issue was how little interest anyone inside the financial system had in exposing such stupendous levels of fraud: “The fixable problem isn’t the greed of the few but the misaligned interests of the many.” And the sheer scale of the fraud involved – a scale matched only by the enormity of the financial bailouts from western governments – gives rise to a lingering uncertainty about the value of money in the first place. If so much money can be stolen (or distributed by government fiat, for that matter) with such apparent ease, what is that money really worth ?

 

The foreign exchange markets (and gold, for that matter) have already started to tell us. Since July last year, Sterling has lost roughly a third of its value against the US dollar. On an annualised basis that equates to a loss of 50%. But the comparison with a seemingly strong dollar only gives one side of the story. Against the Japanese yen over the same period, the US dollar has itself lost 20% of its value. Even without a rise in international trade tariffs (India, Russia and Vietnam have all recently raised tariffs), the threat of competitive de facto currency devaluations looms large over the global economy. And while manipulated currency weakness aids exporters, it comes laden with the heavy possibility of unintended consequences: “Japan should write off its holdings of US Treasuries because the US government will struggle to finance increasing debt levels needed to dig the economy out of recession,” commented Akio Mikuni, president of the eponymous credit ratings agency.

 

And if any asset class came close to bubble territory in 2008, US Treasuries were it. Three month US T-Bills now yield 0.08%, having at one stage last year traded at a negative yield. The yields of inflation-linked bonds, by contrast, suggest that investors see zero CPI inflation for at least the next five years. Given the extent of the announced fiscal and monetary pump-priming, let alone the Obama pump-priming destined to come, inflation-linked US Treasuries look like the better risk-reward. And better still is the value on offer from investment grade corporate credits. Risk-averse investors uncomfortable with the meagre returns available from cash deposits may well find high quality corporate bonds an acceptable, and comparatively yieldy, alternative. The most cost-efficient vehicles to access them, as ever, will be exchange-traded funds.

 

Expecting further gains from equity markets this year seems reasonable, not least because a malign combination of governments and banks are practically forcing investors out of cash. Whether those gains are durable is another question. Rather than bet the ranch on black, it makes more sense to remain extremely selective as to equity market exposure. In sectoral terms, what was stunningly out of favour in 2008 is unlikely to work in 2009. That includes banks and financials, homebuilders and construction stocks, and consumer cyclicals. For some time now we have alluded to the one measure above any other that matters for equity investors in the year ahead: the Altman Z Score. Bloomberg defines this rating as follows:  a measure that

 

“Indicates the probability of a company entering bankruptcy within the next two years. The higher the value, the lower the probability of bankruptcy. A score above 3 indicates that bankruptcy is unlikely; below 1.8, bankruptcy is possible..”

 

For the technically minded, the Altman Z Score is calculated as follows:

 

Z –Score = 1.2 x [Working Capital / Tangible Assets] + 1.4 x [Retained Earnings / Tangible Assets] + 3.3 x [Earnings Before Interest and Taxes / Tangible Assets] + 0.6 x [Market Value of Equity / Total Debt] + [Sales / Tangible Assets].

 

Stocks with high Altman scores will feature prominently in our commentaries as the year unwinds. Where those high scores coincide with sensible defensive sectors, low price / book ratios, low price / earnings ratios, and modest or no debt, the investments are likely to be compelling.

 

And now a brief return to the most-referenced decade in investment markets to the current one, the 1930s. Barrie Wigmore, in ‘The Crash and its aftermath’ (Greenwood Press, 1985) shows the relative performance of industrial sectors following the 1929 collapse:

 

“Most of the heavy industries suffered disproportionately in 1930. Auto production dropped to 50% of capacity, and auto stocks dropped to 21% of their highest 1929 prices, compared with the average for all stocks of 36%. Several heavy industries which had satisfactory earnings in 1929 suddenly registered deficits or virtually break-even levels of earnings in 1930 and were revealed to have much greater economic problems than anticipated. Railroad, steel and tyre companies fell into that group, and their stock prices dropped to two-thirds of book value, compared with the average for all stocks of 139%. The heavy, commodities-based industries, such as the oil, mining, farm equipment, and pulp and paper industries, had similar profit and stock price performances, and the companies’ problems were exacerbated by sharp commodities prices declines and intense foreign competition with cheaper costs.

 

“The industries which emerged in 1930 with small profit declines, or even profit increases, were less capital intensive and oriented towards consumers rather than business, as in the food, consumer products and tobacco industries. These industries still had returns on equity of 20% or more, compared with the average of 11.6% and their stocks generally declined 50% or less from their highest 1929 prices. The chemical and operating public utility industries were not as profitable as these consumer-oriented industries, but were clearly stable, profitable industries whose stocks were undergoing a favourable reevaluation.”

 

Further historical reinforcement, in other words, of the defensive case for consumer staples, utilities, food and tobacco stocks. The reference to industrial company stocks in 1930 dropping to two thirds of book value is particularly interesting, given the number of stocks in the FTSE 350 now trading at tiny fractions of their book value. So again on a selective basis, equities have real appeal, both on explicit valuation grounds in an absolute sense, and relative to their traditional asset peers, bonds (particularly government bonds) and cash.

 

Intriguingly, a ranking of the FTSE 350 by Altman Z-Score shows that many of the highest-rated companies – i.e. those expected to weather the recession better than much of the market – sit within the energy and mining sectors. And as Diapason’s Chief Strategist Sean Corrigan recently wrote, with governments “taking the lead role in.. economic trench warfare, inefficiencies will abound.. and spending will be largely concentrated on goods, not assets and undertaken largely for its make-work possibilities..” which also implies that “the steep inflationary slopes which flank the far side of our present deep valley will be focused much more on things material and not on those financial, as was the case in the recent past. Commodities will not languish long at these depressed levels once this becomes more widely appreciated.”

 

The history of the 1930s is instructive. Commodity prices entered a bull market in the early 1930s on the back of inflationary policies pursued by the Roosevelt ‘New Deal’ administration. The boom came to an end in 1937 but was followed by even bigger stimulus. Commodities entered into a multi-year bull market, triggered in large part by the devaluation of the dollar.

 

Investors betting on deflation are betting against the historic success of western governments at fostering inflation. While the timing will inevitably be a matter for debate, hence Sean Corrigan’s reference to the “far side” of our present “deep valley”, deflationists are also underestimating the historic scale of the current intervention. Jim Bianco of Bianco Research recently tried to put just the US figures into context. He concluded that the extent of the US bailout to date is currently bigger than all of the following US government expenditures combined:

 

• The Marshall Plan. Cost: $12.7 billion. Inflation-adjusted cost: $115.3 billion.
• The Lousiana Purchase. Cost: $15 million. Inflation-adjusted cost: $217 billion.
• Race to the moon. Cost: $36.4 billion. Inflation-adjusted cost: $237 billion.
• Savings and Loan crisis. Cost: $153 billion. Inflation-adjusted cost: $256 billion.
• Korean War. Cost: $54 billion. Inflation-adjusted cost: $454 billion.
• The New Deal. Cost: $32 billion (est.). Inflation-adjusted cost: $500 billion (est.)
• Invasion of Iraq. Cost: $551 billion. Inflation-adjusted cost: $597 billion.
• Vietnam War. Cost: $111 billion. Inflation-adjusted cost: $698 billion.
• NASA. Cost: $416.7 billion. Inflation-adjusted cost: $851.2 billion.

That aggregate total of $3.9 trillion is $686 billion less than the cost of the credit crisis in the US thus far. And as commentator Barry Ritholtz points out, the only event that comes close to the cost of the current financial crisis is World War II, with the inflation-adjusted cost borne by the United States summing to some $3.6 trillion. Bloomberg calculates that the US taxpayer is on the hook for a total of $7.76 trillion of liabilities, which equates to $24,000 for every man, woman and child in the country.

 

Some exposure to government and high quality corporate debt currently makes sense as an alternative to miserly deposit rates and as the logical response to depression / deflation fears. But as soon as we see evidence of general price acceleration – and that evidence admittedly may not come this year – it will then make even greater sense to have exposure to high quality equities, commodities and precious metals as classic inflation hedges. Asset diversification didn’t work in 2008 – a wholly extraordinary year for any number of reasons. That does not mean that it will fail investors in perpetuity.