December 10, 2012
[Editor's Note: Tim Price, Director of Investment at PFP Wealth Management and frequent Sovereign Man contributor, is filling in for Simon today.]
Clearly, investing is a probabilistic endeavour. There are no certainties to speak of. We can only operate on the basis of rational analysis and prudent, considered risk.
That, in turn, presumes that free financial markets are being allowed to operate. But they are not… not in the case of government debt markets, at any rate.
Cash-strapped, heavily indebted western governments are rigging the bond markets for their own ends. They are keeping borrowing costs artificially low by coercing banks and pension schemes to hold government debt through financial repression.
Their agents, in the form of central banks under their direct or indirect control, are willfully cooperating in this scam. If private sector companies operated in this way in the management of their own debt, their chief executives would end up in a prison cell.
One really cannot trust the price and yield signals from the government bond markets of the world (notably those of the egregiously indebted western economies).
One of the key problems in financial markets, however, is that they tend to be populated by specialists, expert or otherwise, whose entire careers (and compensation structures) are dominated by a single asset class.
Just as Warren Buffett has pointed out that you don’t go to a barber asking if you need a haircut, we should not be surprised that professional bond specialists see no particular evidence of a bubble in the one asset class that remunerates them.
The most dangerous advice that this writer considers he ever received was as a bond salesman at Merrill Lynch in the late 1990s (a place that dispensed plenty of dangerous advice in its own right): to thrive, one should specialize.
We didn’t buy that advice then, and we don’t buy it now. Rather than being expert specialists, we would much rather try to be competent generalists. And further, we would argue that there are insufficient generalists operating in the capital markets.
While a constrained specialist will cling to the bull story in debt, and unconstrained generalist will consider all sides… and consider other asset classes, in particular real assets.
On the subject, Dylan Grice wrote a paean of praise to the humble cockroach in his farewell letter to clients of his erstwhile employer, French bank SocGen:
The oldest cockroach fossil is 350 million years old, which is quite remarkable when you think about it. We humans have been around for around for a mere fifty thousand years (so we’re one seven thousandth as successful as cockroaches).
According to the record of the rocks, cockroaches first appeared just after the second of the earth’s five mass extinctions (defined as the loss of 75% of all species). In other words, that means they survived the third, fourth and fifth mass extinctions which followed, the last one being the Cretaceous event which wiped out the dinosaurs.
They can go without air for 45 minutes, survive submerged underwater for half an hour, survive freezing temperatures and withstand fifteen times more radiation than humans. They eat pretty much anything, including the glue on the back of stamps. And when that runs out, they can last a month without anything at all before finally starving.
Cockroaches may not be able to build nuclear bombs. But they can withstand nuclear war. They survive. Don’t get me wrong. Thriving is great. Prospering isn’t bad either. But neither mean much if you’re unable to survive.
Applying this view to investing, Grice goes on to suggest that a cockroach’s portfolio “would be inflation resistant, deflation resistant, credit inflation resistant, credit deflation resistant… despite having ‘no view’ on which scenario was more likely at any one point in time.” In short, a generalist approach.
It should be clear to any longstanding readers that we nurse grave fears for the future. So we have, at least, two choices–
We can vote in favor of the asset specialists who, putting the wrong end of the telescope to a blind eye, suggest that there are no problems ahead, and no bubbles visible.
Or we can vote in favor of a somewhat generalist strategy that allocates to a diversified array of disparate asset types (creditworthy bonds, defensive equities, real assets, uncorrelated funds) and that then attempts to pick value in those dusty, neglected corners where it might exist.
We are more worried about risk than we are greedy for return. And if that makes us cockroaches, we can certainly live with the label.