The price of everything

Goldhead revisited

 

The following article first appeared in the print edition of The Spectator magazine, dated 4 May 2013.

Few assets are more misunderstood than gold. I might even refine that statement — if you’ll pardon the pun — and say that few assets are more misunderstood than money. Gold happens to be both. Technically, of course, we are constrained by government edict to use pounds sterling for the payment of our taxes and debts. My take on this dismal state of affairs, but also my optimism, can best be summarised in the title of Nathan Lewis’s recent book, Gold: The Once and Future Money.

Economists give money three attributes. It should be a unit of account (we can price things in it). It should be a medium of exchange — which avoids the inconvenience of barter. And it should be a store of value, something which enables us to maintain our purchasing power in real terms if we choose to defer spending and save instead. Our current ‘fiat’ paper money does a passable job of the first two, but is disastrous in relation to the third. To put it another way, since the 1913 establishment of the US Federal Reserve, which acts as America’s central bank, the US dollar has lost 98 per cent of its purchasing power. Over the same period, sterling has done even worse.

The likes of gold and silver developed as money in a free market. They were in competition with all kinds of other ‘monies’ such as cattle, shells, nails, tobacco and cotton; and they won. People tended over time to favour the precious metals as money because of their scarcity, durability, malleability, and beauty. Using paper certificates to represent reserved gold was a logical next step. But then the rot set in, when greedy bankers realised that they could print certificates for more physical gold than they actually possessed. Nothing really ever changes. The reason that heavily indebted governments and central banks have such a love-hate relationship with gold today is that a rising gold price signifies a growing suspicion by investors of the paper currency that governments are determined to print in ever more absurd quantities. And yet the world’s central banks have continued to build their gold reserves over recent years despite consistently higher prices. Cyprus, for reasons of urgent necessity, is a rare seller.

Goldbugs — those of us who believe that gold is a better store of value than unbacked paper currency — tend to see 1971 as ‘Year Zero’, because that is when President Nixon took the US dollar ‘off gold’. In severing the last link between paper money and the precious metal that had previously backed it, Nixon ushered in a 40-year experiment in money. A meaningful part of that experiment allowed the world’s central and commercial banks effectively unlimited powers of credit creation: if your printing of money is no longer constrained by finite bullion, you can print, and borrow, as much as you like. Now that a heavily indebted West has gone conclusively ex-growth, central banks are making the most of that privilege. Those of us nursing any exposure to paper money are paying the price. Every day of additional quantitative easing makes today’s pounds (or dollars, or Japanese yen) worth less tomorrow.

But when the price of gold fell below $1,400 an ounce last month from its earlier high of over $1,900 in 2011, commentators rushed to claim that the gold bull market was over. Well, perhaps. More likely, it simply reflects the fact that if investors and traders choose to dump 400 tonnes of gold into the market at one go, the equivalent of 15 per cent of annual gold mine production — as they did in mid-April — it causes indigestion and the price falls. At this point, it’s also worth pointing out that not all investors in gold are created equal. Some of them are purely speculators — they chase the price up, and they’re happy to sell short when the price goes down. They have no interest in taking possession of the physical asset and are content to play games on computer screens and futures exchanges. Could the same people that brought you Libor-fixing be guilty of manipulating the gold price? Do bears shed ballast in the woods?

But some of us are buying and holding gold for entirely different reasons. Not as a form of speculation, but entirely the opposite. In the words of the management consultant Andreas Acavalos, the decision to buy gold is not an investment. Instead, ‘It is a conscious decision to refrain from investing until an honest monetary regime makes rational calculation of relative asset prices possible.’ Will we ever see an honest monetary regime? That depends in part on how long the present grotesque fraud on savers lasts. I am not hopeful that we live in the most stable of banking or financial environments, which is why I put a premium on bullion.

Last month’s savaging of the gold price no doubt put the fear of God into recent buyers. It certainly triggered floods of uninformed commentary by the Twitterati. (We’ll know that our culture has improved when goldbugs are no longer being permanently digitally assaulted by the paperbugs who are their polar opposites, and who fail to grasp the principles of sound, honest money.) The reality is that investors have no idea where gold will be trading in dollar terms a day, a week, a month or a year from now. But unless and until politicians suddenly get religion and start running balanced budgets, or unless our central bankers suddenly stop printing money even as it goes out of fashion, it is entirely plausible to believe that the rally in gold has merely been temporarily halted. We know that central banks have been busily accumulating the stuff throughout the duration of our financial crisis. Are they doing that simply because they have a penchant for bling?

For those of us charged with shepherding the sacred assets of our clients through a period of unprecedented monetary debauchery, gold represents a flight away from dishonest money towards a haven that is scarce, independent and permanent. As my fellow investor Tony Deden of Edelweiss Holdings puts it, wherever the paper-money price of gold goes, before you decide to sell you should first decide why you own it.

 

Author’s update, July 27th 2015:

 

The latest plunge in the dollar price of gold has caused all sorts of paperbugs to come crawling out of the woodwork. Perhaps the highest profile among them was that of Jason Zweig, columnist for the Wall Street Journal, who suggested that

“.. even as Greece has defaulted, the euro has sunk against the dollar, and the Chinese stock market has stumbled, gold [has] been sitting there like a pet rock.”

Zweig is right that it is time “to call owning gold what it is: an act of faith.” But he fails to take the next logical step and ask for the corollary: why have so many investors (as opposed to speculators) undertaken this act of faith ? Just as pertinently, why does he not ask why investors (as opposed to milch cows) should retain any faith in the paper currencies that central banks are doing everything in their power to depreciate ?

As Zweig observes, it is legitimate to point out that unlike stocks, bonds and real estate, gold generates no income. But nobody ever demanded that it should. Crucially, as part of this debate, paper currency itself pays no income, either – an argument that even Warren Buffett has never acknowledged, preferring, disingenuously, to compare the apples of productive assets with the orange that is unproductive gold. Paper currency itself is comparably inert, but a lot more impermanent and flammable. Paper currency can only become an income-generative asset by converting it into a bank deposit, whereupon one relinquishes any last claim to financial independence and becomes an unsecured creditor of the bank. Perhaps gold is not a financial asset per se or “simply” a commodity. Perhaps gold, too, is money ?

JP Morgan certainly thought so, a century ago. So do central banks, today – or why else do they continue to hold gold as part of their reserves ? It is surely not, as Ben Bernanke once weaselled, just down to “tradition”.

The debate continues to rage because most of the debaters refuse to agree on terms. We ourselves regard gold as a monetary metal, an alternative currency and a store of value – over a period perhaps best described as ‘the medium term’. It is not an investment but, per Mr. Acavalos, a conscious decision to refrain from investing. Gold, in other words, is the part of the portfolio that isn’t “in the market”, so to speak. In our client portfolios we hold gold alongside more conventional investments such as high quality bonds (assuming they can be found), ‘value’ equity investments, and alongside less conventional investments, such as systematic trend-following funds. Do we expect each and all of these types of ‘assets’ to rise in value at the same time and to the same extent ? No, because they’re not correlated to each other. That’s precisely the point. The whole purpose of the exercise is to ensure that a portfolio contains genuinely independent parts that behave in different ways during different market environments. We will look to sell our gold holdings when the financial environment that gave rise to its purchase in the first place – one that included all-time high levels of debt, globally, and widespread currency warfare, and the risk of systemic financial crisis – finally transforms into something demonstrably more stable. The “fundamentals” of this environment have in actuality worsened even as the price of gold has slid in US dollar terms. That experience has been surprising, but any gains in value by more traditional assets over the period will have mitigated the surprise somewhat.

James Grant, writing in last week’s Financial Times, humbly suggested, against the spirit of the times, that

“Prices should be discovered in the market, not administered by a government. Actually, we do not all so agree. In response to the incentives set before them, investors pursue the main chance. In the case of European sovereign debt, they continue to buy, more or less without regard to the underlying strength (or lack thereof) of debtor states. They buy because the ECB has pledged to buy.

“The phenomenon goes further — much further. Be it the US Federal Reserve, the People’s Bank of China, the Bank of Japan or the ECB, central bankers’ first financial-markets objective is not the integrity of prices and exchange rates. It is rather crisis prevention — to keep the bouncing bond and stock market balls moving in their sanctioned orbits. (For an individual to fix Libor is a crime. For a central bank to suppress European bond yields is an act of financial statesmanship.)”

A question. Is there a price for any financial asset, anywhere in the world, that does not in some way reflect official price manipulation of one kind or another ? In the case of western bond markets, or Chinese stocks, the question answers itself. If gold were somehow divorced from this trend, the only difference would be that it is the only ‘asset’ whose price is being artificially suppressed as opposed to boosted.

We don’t know whether or to what extent the price of paper gold is being manipulated. We can observe that some of the games being played in financial futures markets make no commercial sense, other than to smash prices lower in the cause of making a quick momentum-driven buck. But we repeat: until the financial environment improves to a sufficient extent to make the requirement for portfolio and / or systemic risk insurance obsolete, we’re not changing a strategy founded on the principles of asset diversification and capital preservation. We still live with unprecedented monetary debauchery.

It’s not about what gold’s worth, in dollar terms. It’s more fundamental than that. What’s the dollar – or any other currency, for that matter – worth, as expressed in anything else ? Jason Zweig correctly refers to the decision to hold gold as an act of faith. He should ask himself what, then, is backing all those trillions of dollars, pounds, euros and yen all being cheerily printed out of nothing.

 

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio (www.pricevaluepartners.com).

Investing in the right place

 

 
“That men do not learn very much from the lessons of history is the most important of all the lessons of history.”

- Aldous Huxley.

 

Wise man, Huxley. The financial markets are now brimming over with examples of cognitive dissonance. Observers in the West gaze in disbelief at the $200 billion provided by China’s state-owned banks to help prop up their equity markets. Those same observers are either blind to the trillions of dollars, pounds and euros that have been printed by western states to help prop up their bond markets – or they choose wilfully to ignore them.

 

Attitudes to the protagonists in the euro zone debt crisis are similarly conflicted and wildly illogical. The Germans are widely perceived to be the bad guys, and the Greeks somehow innocent victims of some kind of coup. But it is the Germans who have been virtually a lone voice in Europe warning of the risks of unsound money and credit expansion. It is only the Bundesbank and its diminishing number of “hard money” advocates in Europe who have fought to keep Mario Draghi’s ECB from abandoning sound money principles altogether.

 

A rich vein of unreality runs through the capital markets of 2015. The word “unhinged” barely does them justice. Doug Noland does an excellent job of chronicling the confusion.  On the one hand, financial market participants hang on every word of our monetary policy-makers in anticipation of a tightening in interest rates – fully seven years after the financial crisis reached fever pitch. On the other, there is barely any debate over the efficacy of allowing the most important price in the market, that of money itself, to be controlled by a small, private banking cabal. As Doug Noland shrewdly observes,

 

“..a promoter of asset price inflation sacrifices its capacity to be an effective financial regulator.”

 

It is all very well to identify the problem(s): too much faith in central bankers and not enough faith in free markets to direct capital to its most productive ends. But investors also require some kind of solution, some means of protecting their capital from the more injurious actions of monetary policy agents and guiding it towards more profitable havens.

 

The crowning irony of the current financial situation is that policy makers in conjunction with regulators have made traditionally safe assets the most unsafe investments of any. Western market government bonds no longer offer any attraction either in terms of income or capital preservation. They are simply instruments of confiscation yet to be fully recognised as such.

 

That clearly leaves equities as the preferred risk asset, by – and pardon the inadvertent but relevant pun – default. But what sort of equities ?

 

History offers some useful clues.

 

James O’Shaughnessy in his book ‘What works on Wall Street’ conducted extensive research on common stocks in the US market. Perhaps the most compelling strategy for delivering attractive long term returns came from value investing.

 

O’Shaughnessy analysed a 3,000 stock universe over a period of 52 years. For each year he identified the 50 most expensive and least expensive stocks by a variety of metrics. He then rebalanced that 50 stock portfolio each year, ensuring that only the most and least expensive stocks were retained. The results were instructive.

 

If you had bought the 50 ‘growth’ stocks with the highest price / earnings ratio, for example, after 52 years, a portfolio with an initial value of $10,000 would have grown to $793,558. That sounds like a decent return. Until you compare it with a portfolio comprising the 50 stocks with the lowest price / earnings ratio. This ‘value’ portfolio, with an initial value of $10,000, would have grown to $8,189,182.

 

If you had bought the 50 ‘growth’ stocks with the highest price / book ratio, the results were even more extraordinary. Your initial $10,000 would have compounded, over time, to $267,147. But if you had bought instead the 50 ‘value’ stocks with the lowest price / book ratio, a portfolio with a starting value of $10,000 would have grown, over time, to be worth $22,004,691.

 

A period of 52 years is a statistically meaningful period of time. The O’Shaughnessy study strongly suggests that over time, ‘value’ completely trumps growth. A bias to ‘value’ may not work every year, but it’s unlikely that any strategy will. ‘Value’ investing requires an element of patience, not least because it has much in common with contrarian investing, and it takes time for the crowd to appreciate, or be taught at its own expense, that it’s wrong.

 

But the problem today – for the conventionally minded – is that many traditional markets are expensive. The US stock market, for example, currently accounts for over 56% of the MSCI World Equity Index. Anybody benchmarked against the MSCI World is obligated to own US stocks to a greater extent than those of any other market. Robert Shiller’s cyclically adjusted price / earnings (CAPE) ratio for the S&P 500 index currently stands at 27.3. On a CAPE basis, the US stock market has only realistically been more expensive twice in history – once in 1929, and once in early 2000. Its long run average is 16.6.

 

Not all stock markets are as expensive as those of the US. Roughly 70% of the US market trades on a price / book ratio, for example, above 2 times. Roughly 40% of the Japanese stock market (which incidentally accounts for just 8.7% of the MSCI World Equity Index) trades on a price / book ratio of less than 1. So it should hardly be a surprise to learn that within our own fund, for example, Japan is our single largest country exposure. Or that Asia accounts for the majority of our holdings. Asia, by comparison with Europe, we would suggest, has, on average, superior demographics, superior prospects for economic growth, a far lower welfare burden, and a healthier banking system. At a time when headlines are dominated by the travails of the euro zone and a deeply indebted West more generally, the real investment news is quietly been made elsewhere.

 

 

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio (www.pricevaluepartners.com).

Rigged

“One woman, who declined to give her name but said she is almost 80, invested RMB 20,000 ($3,200) when the market was at 5,000 points. “I’ve lost two thirds of my money,” she said, her voice cracking. “I really want it back and when I get it, I will never invest in the stock market again.”

“..These elderly investors were entering the back half of their lives at the moment when China began to embrace reform. “Old people often don’t understand economics,” says Nie Riming, a pensions expert at the Shanghai Institute of Finance and Law. “They are easily duped.”

- From ‘A bull market with Chinese characteristics’ in The Financial Times, by Tom Mitchell, Gabriel Wildau and Josh Noble, 11 July 2015.

 

A man may be extremely intelligent, but mankind, as a whole, is pig-ignorant. We are all fools. To put it another way, we can, as individuals, gain much knowledge and perhaps even wisdom during a lifetime, but the likelihood of that knowledge and wisdom persisting through generations may well be vanishingly small.

How else to explain the festival of incompetence currently barrelling its way through the financial markets ?

“It couldn’t happen here,” conclude western investors as they watch the increasingly desperate machinations of the Chinese authorities, for example, as they attempt to put a floor under stock prices. Desperate, as in ridiculous, desperate, Basil Fawlty-ish lengths to prevent reality from crashing in upon a deflating stock market bubble.

Government buying stock to support the market ? Check.

Government halting trading in half the stocks on the market ? Check.

Government banning large shareholders from selling for six months ? Check.

Government suspending any further IPOs ? Check.

Government slashing interest rates ? Check.

Government ordering companies to buy their own shares ? Check.

The FT’s James Kynge reports:

“On Sunday, the new graduates of Tsinghua University are set to gather in their smartest attire to celebrate degrees from one of China’s most prestigious institutions, a place that has fostered generations of political leaders. Just after the ceremony starts – according to a written agenda – the graduates must “follow the instruction and shout loudly the slogan,

‘revive the A shares, benefit the people; revive the A shares, benefit the people’.”

“It couldn’t happen here..”

Apart from western governments bailing out their own bad banks, or creating trillions of dollars, pounds and euros of ex nihilo money and using that money to suppress interest rates and bond yields and currencies, and boost their own stock markets..

“Nobody knows anything,” was William Goldman’s sardonic assessment of Hollywood in his classic memoir on the movie business, ‘Adventures in the screen trade’.

In finance, things are subtly different. “Nobody learns anything,” appears to be the mantra. If one generation happens to stumble upon knowledge – probably involuntarily, and learnt at great cost – then the next generation scampers blithely away from it and on towards some fresh disaster.

From ‘America’s Great Depression’ by Murray Rothbard:

“Mr. Hoover met the challenge of the Great Depression by acting quickly and decisively, indeed almost continuously throughout his term of office, putting into effect “the greatest program of offence and defence” against depression ever attempted in America. Bravely he used every modern economic “tool,” every device of progressive and “enlightened” economics, every facet of government planning, to combat the depression. For the first time, laissez-faire was boldly thrown overboard and every governmental weapon thrown into the breach. America had awakened, and was now ready to use the State to the hilt, unhampered by the supposed shibboleths of laissez-faire. President Hoover was a bold and audacious leader in this awakening. By every “progressive” tenet of our day, he should have ended his term a conquering hero; instead he left America in utter and complete ruin – a ruin unprecedented in length and intensity.

“What was the trouble ? Economic theory demonstrates that only governmental inflation can generate a boom-and-bust cycle, and that the depression will be prolonged and aggravated by inflationist and other interventionary measures. In contrast to the myth of laissez-faire, we have shown [here] 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 properly where it belongs: at the doors of politicians, bureaucrats, and the mass of “enlightened” economists. And in any other depression, past or future, the story will be the same.” [Emphasis ours.]

There’s a line in ‘Macbeth’ when the protagonist, beginning to understand the havoc he has caused, starts to succumb to exhaustion:

“I am in blood

Stepp’d in so far that, should I wade no more,

Returning were as tedious as go o’er..”

Precisely as Rothbard predicted, the politicians, bureaucrats and “enlightened” economists of the euro zone are now coming to terms with their own terrible legacy in the form of Greece. Return, or go on ? Either choice requires wading through an unconscionable deal of blood.

Mario Draghi at the ECB gave us the phrase “whatever it takes”. Now the policy chiefs of China are running with it.

This is the most absurd global financial situation we can remember. There may have been wilder outbreaks of mass fatuous behaviour – as Adam Smith could easily have said, there’s a great deal of absurdity in a market. But we have long held that if you don’t understand the rules of the game, best not to play the game. Doing anything in credit markets today involves making a macro market call that is fundamentally impossible. All debt markets have become speculative arenas courtesy of central bank activity. Participating in stock markets today absolutely requires a margin of safety (and a strong stomach). But value, we believe, does exist out there – provided you have a manager with the geographical flexibility and mandate to look for it. If your fund manager simply tells you that stock markets are too expensive, he’s looking in the wrong places; time to find a new manager.

 

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio (www.pricevaluepartners.com).

Bull in a China shock

 

“No warning can save people determined to grow suddenly rich.”

-       Lord Overstone.

 

History, wrote John W. Campbell Jr., doesn’t always repeat itself. Sometimes it just screams, “Why don’t you listen to me ?” and lets fly with a big stick. The definitive new millennium bubble, namely the Nasdaq Composite Index, peaked on the 10th of March 2000, at a level of 5,132. Within two years that same index would be trading at just above 1,000. $5 trillion in market value ended up going to money heaven.

History’s big stick is flying again. The Shanghai Composite Index peaked on the 12th of June, at the rather eerily similar level of 5,166. As things stand it has lost a quarter of its value and over $2 trillion in the space of two weeks. The April 10th edition of the Financial Times carried a helpful anecdotal warning within an article entitled ‘China investors: stock market fever’. It contained the following classic:

“Li Shengnan, a 33-year-old sales associate for a consumer goods company in Shanghai, called a friend last week seeking investment advice. Ms Li wanted to know whether to take out a mortgage on her apartment and use the funds to invest in China’s red-hot equity market.

“I never played the market before, but since March it seems like all my friends and co-workers are all getting rich, so I got excited,” she said.

Recent investors in the Chinese market are getting excited, but not in a good way. The Wall Street Journal reports that the 10 worst performing funds of the past month are ‘structured’ funds – i.e. they’re leveraged index trackers. The three worst performers, all run by fund managers with less than a year’s experience, fell by an average of 77% during the month.

This being China, bull markets aren’t allowed to die without a fight, and the authorities are pulling out all the stops. The People’s Bank of China has already cut interest rates and eased reserve requirements. The China Securities Regulatory Commission has relaxed collateral rules on margin loans. Not to be outdone, the Asset Management Association of China has issued a statement titled ‘Beautiful sunlight always comes after wind and rain’.

Such belief in the institutionalised defence of the market rather poignantly recalls JK Galbraith’s spirited account of ‘The Great Crash 1929’:

“The papers agreed, and this was also the informed view on Wall Street, that the worst was over. And it was predicted that on the following day the market would begin to receive organised support. Weakness, should it appear, would be tolerated no longer.

“Never was there a phrase with more magic than “organised support”. Almost immediately it was on every tongue and in every news story about the market. Organised support meant that powerful people would organise to keep prices of stock at a reasonable level.. With so many people wanting to avoid a further fall, a further fall would clearly be avoided.”

There are many ways of losing money in the markets, but the belief by retail investors that the authorities will always look after retail investors is probably the most certain. And retail investors account for between 80% and 90% of trading in Chinese stocks. (The month of May saw more than 14 million trading accounts opened.) A large constituency of neophyte investors is now in the process of appreciating that financial markets can go in a direction other than up.

And there are, fundamentally, only two real ways of making money in the markets, and they are mutually exclusive. One is to follow price momentum. This is typically a shorter term trading strategy, or what one might refer to technically as speculation. The other is to buy high quality assets at less than their inherent worth. This is a longer term approach which one might refer to technically as value investing.

The Chinese stock markets are a gigantic playground for momentum traders, but are something of a desert for value investors. A recent research paper (‘The real value of China’s stock market’ by Jennifer Carpenter and Robert Whitelaw of New York University and Fangzhou Lu of MIT) puts it as follows:

“Though it has become the second largest in the world, with a market capitalisation of $6 trillion at the end of 2014, China’s stock market is still a sideshow in a financial system dominated by a massive state-controlled banking system. After a rocky first decade from 1990 to 2000, China’s stock market earned a reputation as a casino manipulated by speculators and insiders.”

So it is progress of sorts that it is now a casino manipulated by the State.

Happily for foreign investors, what China’s stock markets lack by way of corporate governance they also lack by way of foreign sponsorship; Capital Economics reckon that foreign investors account for just 1.5% of Chinese shares. The pain of this collapse will be felt almost entirely at home. And since stock returns in China display very low correlation with those of other large economies, there is no reason to presume that this latest China crisis will embark on an international tour.

Chinese stock markets may amount to ‘here be dragons’ land, but it would be unfair to tar all of Asia with the same brush. Two markets that look especially attractive to us are Japan and Vietnam. Almost half of the Japanese stock market trades on a price / book ratio of less than 1. (Only 15% of the US stock market trades at a comparable multiple.) Vietnam, separately, looks set to benefit from the removal of limits on the foreign ownership of listed businesses. As UBS point out, Vietnam’s market cap-to-GDP ratio is the lowest in Asia, at only 30%. Having been the worst performing market in Asia for the last five years, Vietnam has the potential to be one of the best over the next five years. If jitters in Chinese markets happen to make other Asian investments cheaper in the short run, that clearly makes them even more compelling.

 

Tim Price is Director of Investment at PFP Wealth Management (www.pfpg.co.uk) and co-manager of the VT Price Value Portfolio (www.pricevaluepartners.com).