The price of everything

Oil a load of nonsense

 

“The media select, they interpret, they emotionalize and they create facts.. The media not only reduce reality by lowering information density. They focus reality by accumulating information where “actually” none exists.. A typical stock market report looks like this: Stock X increased because.. Index Y crashed due to.. Prices Z continue to rise after.. Most of these explanations are post-hoc rationalizations.. An artificial logic is created, based on a simplistic understanding of the markets, which implies that there are simple explanations for most price movements; that price movements follow rules which then lead to systematic patterns; and of course that the news disseminated by the media decisively contribute to the emergence of price movements.”

- Thomas Schuster, ‘Meta-Communication and Market Dynamics: Reflexive Interactions of Financial Markets and the Mass Media’.

“Who’s afraid of cheap oil ?” asks ‘The Economist’ on its front page this week. Judging by the last fortnight in the stock market, just about everybody is. Forget supply and demand imbalances in the petrochemical market; there is evidently a huge demand for nonsense, because the financial media and a cavalcade of inane commentators have gone into overdrive in order to supply it. Stocks are off because the oil price has collapsed, we are told.

Here is a “lesson” from history. In October 1973, OPEC initiated an oil embargo in response to US involvement in the Yom Kippur War. Within five months, the oil price quadrupled. By the end of 1974, US stocks had fallen by over 45%. The US got off lightly. UK stocks fell by almost 75% during the same period. Oil up, stocks down. Now the oil price is down sharply, and many stock markets are down sharply. Since they fall when the oil price goes up, and when it goes down, perhaps stock markets will also collapse if the oil price goes sideways. Or if it enters some alternative dimension not wholly perceptible by human consciousness.

Or perhaps stock markets are complex systems, markets and investors are not entirely rational, and correlation is not the same as causality. In Britain in 1974, the oil shock was compounded by a property and banking crisis. This time round, the “reverse oil shock” has been compounded by clear deterioration in China’s economic prospects, uncertainty over its currency, and the conspicuous overvaluation of many stock markets, aided by years of Quantitative Easing.

Helpfully for the bulls, ECB President Mario Draghi promised the support of “plenty of instruments” on the part of the European Central Bank. By “plenty of instruments”, he probably means: plenty of euros. The money printing will likely continue. Stock market investors, hearing Pavlov’s bell, cheerfully started to salivate, on cue.

More QE is reality (and gravity) deferred. And a new front in the ongoing currency wars. Hold hard assets rather than paper.

Cheaper oil clearly has implications depending on the production and consumption habits of different economies. Oil producers, especially those with hefty foreign borrowings, should rightly be experiencing distress. But for net oil consumers, all things equal, this should be good news. This includes much of Asia, and notably Japan.

It is plausible, however, to see malign effects spreading from rising credit risk and infecting other parts of the global financial system, sub-prime style. Ailing oil producers with foreign debts face the rising likelihood of defaulting. Commercial banks, especially the more stupid ones, are on the other side of that trade. And in Europe, as we pointed out last week, a new bail-in regime happens to be in place. A causal linkage between cheaper oil and cheaper banking stocks is entirely justifiable. US banks, including Goldman Sachs (even after fines for mis-selling mortgage securities) reported better results than expected last week. But Deutsche Bank once again managed to fall off the top of the ugly tree and hit every branch on the way down. There is no obligation whatsoever for investors to own crappy bank stocks beset by rumours of insolvency.

The rather pathetic way in which the market greeted Mario Draghi’s nannyish attempts to make the nasty pain go away indicate that many investors have yet to learn to stand on their own two feet and look after themselves. From our perspective, we don’t seek solace from some paternalistic money-printing bureaucrat who looks like a crow. We try and protect our capital by not consciously overpaying for anything in the first place, be it stocks, bonds or anything else.

But not consciously overpaying is difficult when the great scam of QE looks set to be unleashed even more powerfully in the months to come. (It’s a good job that doctors haven’t discovered QE – all their patients would be dead by now.)

We resolve these various quandaries by, first, diversifying, and then by focusing solely on value from the bottom up.

Rather than speculate (in every sense) about unknowable macro stuff, we prefer to concentrate on hard fundamentals and the here-and-now.

Tony Jackson wrote the following in a piece for the Financial Times in September 2011:

“For as long as I have been around the business, analysis has been tilting away from the here-and-now towards the future. Go back several decades and the primary task of the analyst was to describe a company’s current condition, drawing on such balance-sheet arcana as the quick ratio or the stock turnover ratio. Then the pressure came on to predict the future. First came profit forecasts, then share price predictions. This was resisted initially by some firms, on the grounds that the first was shaky and the second impossible.

“But eventually they had to swallow their principles and get out their crystal balls. While balance-sheet analysis may seem backward-looking, it has real predictive power in times like these. For while it is no guide to future earnings or dividends, it indicates a company’s capacity to resist shocks that we cannot yet specify.”

A company’s capacity to resist shocks that we cannot yet specify. Sounds like a solid approach to stock-picking in January 2016. Whatever happens to the oil price.

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio.

Bear necessities

 

“At first sign of crisis, the ignorant don’t panic because they don’t know what’s going on. Then later they panic precisely because they don’t know what’s going on.”
- Jarod Kintz.

In a crisis, it helps to have good counsel. Investment strategist Mike Tyson is pretty good at summing up the problem:

“Everyone has a plan ‘til they get punched in the mouth.”

Or as the military strategist Helmuth von Moltke the Elder put it, somewhat more formally:

“No battle plan ever survives contact with the enemy.”

The enemy has been quick to show himself this year, in the form of a bear market, at least for stocks. This bear has so far been quick, and indiscriminate: the US; Europe; China; stock markets have fallen sharply, internationally. Investors, being human, have scrabbled in search of an explanatory narrative.

Some have blamed the Fed’s baby steps towards normalising interest rates (if a rise from 0% to 0.25% can cause this much investor concern, get a load of history). Some blame the collapse in the oil price. Last week we watched David Cronenberg’s 2012 thriller ‘Cosmopolis’, which has Robert Pattinson playing a 28-year-old hedge fund billionaire driving around town and losing his entire fortune in a single day due to the unexpected rise of the yuan. Other than getting the direction of the renminbi wrong, it could have been shot yesterday. (The film, like the financial markets of 2016, is largely unfathomable.)

But as CLSA’s Christopher Wood points out, perceptions of emerging markets, including China’s, are becoming increasingly divorced from reality. The oil collapse, for one, is a huge red herring. Asia in aggregate

“is a massive beneficiary of lower oil prices.. [and] Asia now represents 72% of the MSCI Global Emerging Markets Index.”

So the narrative on oil is probably wrong, at least as regards most Asian economies, including Japan’s.

Fears that the Chinese authorities have lost control of their own markets, or have botched their own narrative regarding a measured devaluation of the renminbi against a trade-weighted basket of currencies, probably have more substance. CLSA suggest that the intent of the Chinese authorities may well be to devalue the renminbi against the US dollar while maintaining stability against a currency basket (à la Singapore). But the lack of policy guidance from the Chinese – by comparison “with the overdose of communication from G7 central bankers” is clearly unhelpful.

But it has certainly been a good week for bears. RBS told us to “Sell everything except high quality bonds”. This is somewhat problematic if there aren’t actually any high quality bonds to buy, hold or sell. But then nobody should expect nuance, foresight or intelligence from the bank whose management helped bring us Financial Crisis #1. And as The Spectator pointed out, the author of RBS’ ‘Sell everything’ note has been predicting disaster for the past five years.

Tuesday brought us SocGen’s Global Strategy Conference. Quantitative strategist Andrew Lapthorne’s advice was more measured: do nothing, on the basis that almost half of your real return from equities comes from compounding dividend income. Clearly, if you don’t hold equities, you don’t get that income. Or any compounding.

SocGen’s guest speaker Russell Napier pointed out that growth in emerging market foreign exchange reserves from 2008 to 2014 amounted to the most rapid increase in emerging market money supply in history. As this process goes into reverse, EM growth will clearly suffer.

And since many emerging market countries have over-borrowed in foreign currencies, the fighting in the global currency wars is set to get more intense this year. Many EM countries now look, in Napier’s words, “like Northern Rock on speed” – with too much local currency and foreign currency denominated debt issued to foreigners – mainly to European banks. As Napier warns, 2016 has also ushered in BRRD in the euro zone: new rules requiring bond and deposit holders to be bailed in when banks blow up. The EU (and many of its bank depositors) will come to regret not restructuring their banking system during the seven years post-Lehman when they had the opportunity.

The search for an easy narrative to explain the bear market is probably a waste of time. The financial market is a complex adaptive system and investors are prone to irrational behaviour and mood swings.

They are also prone to overpay. The great ‘value’ investor Benjamin Graham reminded us that

“Operations for profit should be based not on optimism but on arithmetic.”

The optimists have had things their own way in an almost unbroken line since March 2009. January 2016 so far would suggest that the pragmatists are now in charge.

So the pragmatic response to this month’s volatility – if any is indeed required at all – is as follows:

1) Diversify by asset type.

2) Limit or eliminate exposure to EM debt. Raise cash rather than cling to a benchmark with no conviction (and no obvious value).

3) Concentrate any debt exposure to bonds issued by creditors, not debtors.

4) Limit equity exposure to high quality and inexpensive markets offering a ‘margin of safety’. (Most of the US market does not qualify in this regard.) Russell Napier recommends Japanese equities, currency hedged, and so do we. And in a bear market, you don’t want to own expensive growth, you want to own defensive value.

5) Complement traditional investments with alternatives – we would advocate systematic trend-following funds (which can profit in bear markets just as they did in 2008), and gold – the one form of currency that comes with no counterparty risk because it is the one asset that is no-one’s liability.

6) Limit your exposure to financial media, and especially to economists employed by commercial banks.

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio.

Life finds a way

 

“The snag for them is that it happened on Monday. And all the official pronouncements in the State media were: “Well, it’s a blip. It’s a very rare event.” Well, it’s happened three days later so you then have to ask yourself, “How much of a blip is it ?” And some analysts question whether the authorities have got a grip on this, if they’re saying on Monday, “Look, don’t worry about it, it’s just a blip,” and then it happens again. The whole question arises of whether the authorities are trying to control the uncontrollable.”

- Correspondent Stephen Evans on BBC Radio 4’s ‘Today’ programme, 7 January 2016, discussing the second closure of the Chinese stock market that week.

“For [our investment process] to work we have consistently needed the following criteria to be met:

• Access to transparent and truthfully compiled data at both a macro and a company specific level..

• Logical decision making by macro-economic policy makers..

..China also presents further problems.. than just a weakening growth profile. This is the problem of the predictability (or rather lack of) of policy making. As its growth rate has slowed and as China – due to its sheer size – has become more important to the functioning of the rest of the global economy, so external scrutiny has increased. Unfortunately, instead of responding with greater transparency, which would reduce the level of enquiry, the Chinese government has responded by drawing in on itself and hiding behind a welter of official statistics that quite frankly no longer add up..”

- Nevsky Capital in a letter to investors explaining why it is closing the $1.5 billion Nevsky Fund.

Chaos theory studies the behaviour of dynamic systems that are highly sensitive to initial conditions. In a chaotic system, tiny changes in initial conditions lead to wildly divergent outcomes further down the line. Under chaos, short term prediction may yield certain benefits, but long term prediction is impossible.

Chaos theory has relevance to a variety of discipline, among them weather and climate. When snow settles on a snow mass, at a certain point, under certain conditions, that mass will shift from a stable equilibrium – safety – to an unstable equilibrium – the risk of an avalanche. But the precise snowflake that triggers the avalanche cannot be predicted. The same holds for dropping grains of sand onto a table. For some time, the sand pile will remain stable. At a certain point, it will shift to being unstable. One single grain of sand then has the capacity to shift the sand pile over. But we cannot predict in advance which grain that will be.

The film ‘Jurassic Park’, adapted from Michael Crighton’s novel, brought chaos theory into the popular realm. A wealthy scientist, John Hammond (Richard Attenborough), using DNA derived from fossilised mosquitoes, decides to recreate dinosaurs on a remote island. But once brought back to life, won’t they breed ? No, says Hammond. Because all the dinosaurs on the island are engineered to be female, by way of chromosome control. Dr Ian Malcolm, played by Jeff Goldblum, has been brought along to assess the project. His assessment is sceptical to the point of hostility:

“.. the kind of control you’re attempting is not possible. If there’s one thing the history of evolution has taught us, it’s that life will not be contained. Life breaks free. It expands to new territories. It crashes through barriers. Painfully, maybe even.. dangerously..

“I’m simply saying that life.. finds a way.”

Life – nature – does indeed find a way. Malcolm survives into the inevitable sequel, and gets to be (justifiably) sceptical and hostile all over again. One of his companions is overwhelmed at the spectacle of the CGI dinosaurs. His response:

“Oh yeah. [Facetiously] Oooh ! Aaah ! That’s how it always starts. Then later there’s running and, um, screaming..”

‘Jurassic Park’ is, of course, fiction.

That central banks exist today, on the other hand, is fact. And it is fact that for several years they have been attempting to impose artificial constraints on market prices. For an object lesson in the efficacy of State interference in the market process, we give you the Shanghai and Shenzhen stock exchanges.

Western market observers have no claim to moral or cultural superiority here. Western central banks have, for years, been pulling the same stunt in relation to interest rates and the price of money itself. In the ailing euro zone, the Richard Attenborough role has been played by Mario Draghi, who made the following timeless pronouncement in July 2012:

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

We think the not-so-secret objective of QE all along was to trigger inflation (or avoid deflation). How’s that project coming along ? Euro zone annual inflation has been below 0.5% since July 2014. Almost 11% of the euro zone workforce is jobless. There’s a plausible argument that QE, ZIRP and NIRP are not inflationary, but deflationary: by allowing otherwise insolvent businesses to operate, they are creating a surplus of goods and services that, in an otherwise weak economic environment with inadequate demand, is causing prices to fall. Perhaps they should stop with these policies. But that is not the way of the bureaucrat. The beatings must continue until morale improves.

Since the global financial crisis, the financial markets have been a battleground between the forces of deflation and inflation. Deflation represents the free market. A free market wants to reset the game, and clear all the redundant pieces from the table. Inflation represents the State, and its economic agents, the central banks, whose notional independence from the State may be unlikely to survive this ongoing crisis. The State ‘merely’ wants to perpetuate itself, and is somewhat indifferent to the costs incurred to its citizenry in the process.

Financial analyst and market historian Russell Napier uses the analogy of the falcon and the falconer. The falcon is the markets; the falconer is the State.

“The attempt to train the wild forces of supply and demand by the authorities has really ramped up since 2009. Just four trading days into 2016 [it is obvious] that they have failed to create a pet to do their bidding. The wild forces of supply and demand have sought to deliver deflation, at least since 2008, but the falconer has demanded the lift-off of inflation..”

“’Whatever it takes’ may ultimately be constitutionally impossible and the ECB may not be prepared to print sufficient Euros to ensure that every government of the Eurozone makes all payment of principal and interest. If that reality dawns then yield spreads widen in the Eurozone and ultimately your interest and principal may not be paid in Euros.

“For those investors who have to be in equities, North Asia is the only game in town. They, in the form of China, Japan, and probably also South Korea, will win the currency wars. Their success in winning this game triggers the scale of deflation that generates the global credit crunch that is virtually inevitable as deflation takes hold..

“If you had not noticed, 2016 has begun with gold and the USD rising simultaneously. This is different and important. This is very positive for gold and very bad for the world..

“Real rates have further to rise but a few more days of a strong USD and a strong gold price means gold has probably entered a bull market that should last for decades rather than years; its value boosted initially by its ability to avoid conscription, but underpinned by the authorities’ mass mobilization of resources to ultimately generate inflation.

“From 2009-2015 investors were well paid, at least in the developed world, to believe the most impossible of the six things before breakfast: that central bankers can subvert the desires, wishes, greed and fear of millions of people who set prices every day through their actions.

“You now have two choices: keep believing the most impossible thing, or accept that the wild force that establishes market prices has not been tamed. It’s not a pet, it’s a falcon and ‘The falcon cannot hear the falconer’.”

Judging just from the first week of market activity of 2016, life is finding a way. Nevsky Capital have decided to close their fund, citing the risks of investing in a world where opaque central bank activity, questionable data and the rise of algorithmic trading make the rational analysis of relative prices impossible.

We elect to fight on, making pragmatic use of the least risky (i.e. powerfully inexpensive) high quality equities, predominantly in Asian markets (though we have no exposure to China); well risk-managed systematic trend-following funds that offer the potential to benefit in falling as well as rising markets; and gold.

The skies are darkening with financial market chickens coming home to roost. What’s in your investment armoury ?

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio.

History repeats

 

“The proper behaviour all through the holiday season is to be drunk. This drunkenness culminates on New Year’s Eve, when you get so drunk you kiss the person you’re married to.”

- P.J. O’Rourke.

 

On May 29th 1969, Warren Buffett wrote to his partners at the Buffett Partnership, informing them of his intention to retire, and wind up the business. The letter expressed his concerns with admirable candour:

“Quite frankly, in spite of any factors set forth on the earlier pages, I would continue to operate the Partnership in 1970, or even 1971, if I had some really first class ideas. Not because I want to, but simply because I would so much rather end with a good year than a poor one. However, I just don’t see anything available that gives any reasonable hope of delivering such a good year and I have no desire to grope around, hoping to “get lucky” with other people’s money. I am not attuned to this market environment, and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.”

Money managers are not necessarily known for their integrity, and as the fund management profession has become more and more institutionalized, it is unlikely that many practitioners today would have the moral courage to pen similar words to their investors, even if they shared Buffett’s sentiments.

Times may change, but human nature doesn’t. Here is an excerpt from a Financial Times piece published on December 29th 2015:

“Investment guru Warren Buffett is headed for his worst year relative to the rest of the US stock market since 2009, with shares in his conglomerate Berkshire Hathaway down 11 per cent with two more trading days to go.

“The underperformance comes in Mr Buffett’s Golden Anniversary year at the helm, when he told investors for the first time that they should judge his record based on Berkshire’s share price, rather than just the book value of the company, which had been his preferred yardstick for decades.

“Mr Buffett urged them to make that judgment based on the long term, rather than on a single year, reflecting investing mentor Benjamin Graham’s view that the stock market may be a “weighing machine” in the long run, but in the short term it is a “voting machine”.

“But in 2015, the market has been voting negatively on Berkshire’s prospects..”

To paraphrase: “Warren Buffett urges his investors to take the long view, but look at how his stock performed last year !”

Buffett’s decision to shut up shop would be vindicated by subsequent market performance. Between November 1968 and May 1970, the S&P 500 fell by 36 per cent.

Investors in US stocks may be forgiven a certain feeling of déjà vu. Robert Shiller’s cyclically adjusted p/e ratio for the S&P 500 (‘CAPE’) currently stands at a multiple of 26. Its long run average is 16.6. If history is any guide, there are grounds for concluding that the US stock market today is overvalued by roughly 50 per cent. And reversion to the mean may be the most dependable trend in financial markets.

But plausible overvaluation is not limited to the US stock market. Fund managers GMO recently published their 7 year real return forecasts for a variety of asset classes – all of which have been made expensive by unprecedented monetary stimulus and the suppression of natural interest rates. Given current valuations, GMO’s assessment of likely 7 year real, annualised returns from a variety of markets is as follows:

• US large cap stocks: - 2%
• US small cap stocks: -0.5%
• International large cap stocks: +0.2%
• International small cap stocks: -0.8%
• US bonds: -0.9%
• International bonds: -2.7%
• Cash: -0.2%

In terms of traditional assets (stocks and bonds), the only markets GMO expects to do better than international large cap stocks are emerging market bonds (+2.2%) and emerging market stocks (+4%). But if their forecasts are correct, pickings from traditional markets are going to be slim. A question. Are your assets under the control of a conventional manager hoping to “get lucky” with “other people’s money” ?

But then not all markets are created equal.

While the (overvalued) US stock market accounts for fully 59% of the MSCI World Equity Index, private investors are under no obligation whatsoever to replicate the index weights of MSCI. Their portfolio managers, however, may be.

Logic practically compels today’s unconstrained investor to go off benchmark. If traditional markets are expensive by any conventional measure, then it makes sense to look for value in less traditional markets.

Which markets are our favourites ?

Within our unconstrained value fund, our single largest allocation is to Japan, a market which returned 9 per cent for 2015. Notwithstanding last year’s rally, the Japanese market continues to offer up a trove of value opportunities. The absolute number of Japanese stocks valued at less than 10 times earnings, for example, is greater than across the markets of China, the US and the UK put together.

Another significant allocation is to Vietnam, a frontier market making the transition to emerging market status. Its market cap to GDP ratio, at 30 per cent, is the lowest in Asia (Thailand and the Philippines, for example, trade at 116 and 95 per cent respectively). Vietnam has a large, young, technologically literate population and the country is rapidly industrialising. It also has the second lowest forward p/e ratio in Asia, at roughly 12 times, just above South Korea (also one of our larger allocations). Vietnam returned 6 percent for 2015 – the only gainer in south-east Asia.

Warren Buffett wound up his partnership after making the frank admission that the US stock market was sufficiently expensive that he could find no real opportunities for investment. History seems to be repeating itself. The great insight of his mentor, Benjamin Graham, was that if it was possible to buy high quality businesses at a discount to their inherent value, such discounts offered a ‘margin of safety’ to the discerning investor. Traditional assets (stocks and bonds in developed markets, notably those of the US) offer no margin of safety today. But there are plenty of low risk investible equity opportunities with a ‘margin of safety’ out there, provided one can free oneself from benchmark constraints and hunt for value, across the world, on a bottom-up basis instead.

We wish all our readers a happy and prosperous new year.

Tim Price is Director of Investment at PFP Wealth Management and co-manager of the VT Price Value Portfolio.