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Asking the Right Question of Your Money

Central banks have made pursuing low-risk investing virtually impossible...
 
WHAT question should investors be asking themselves now? asks Tim Price on his ThePriceOfEverything blog.
 
We think it should be: how can we best protect our capital given that the financial markets appear, once again, to have gone mad?
 
First, the evidence for the prosecution. Analysis from SocGen's Andrew Lapthorne shows the nominal yield on a mix of different assets held by institutional funds, the Quality Index, is close to its all-time low of 2.4%. While equity market valuations give some concern, the real risks are concentrated in sovereign debt. Irish 10 year bond yields, for example, are close to US 10 year bond yields. Greece's recent 5-year bond was floated at a yield of less than 5% and was seven times oversubscribed.
 
The Economist has just published a feature on fund management. It points out that within the $64 trillion global asset management industry, low cost index funds account for just 11% of the market. It highlights the belief on the part of many investors that they "can do better than the index by picking a hot fund: money for old hope." But this assumes that most investors are actively seeking to beat the (stock) market. This may be true, but it does not address the entirety of the fund management community. There are plenty of investors, ourselves included, who have no particular interest in what "the market" does: we are seeking, instead, to preserve capital over the medium term and generate a positive real return. 
 
The sad dilemma of our times is that the monetary authorities have made the successful pursuit of low-risk investing virtually impossible. By driving deposit rates down to below the rate of genuine real world inflation, investors are effectively forced to take on much more price risk than they might otherwise choose. By deploying ever more aggressive quantitative easing and monetary stimulus, central banks have a) reemphasised the risks in holding cash in currencies that are being actively devalued and b) driven the yields on government debt – and by extension all other forms of credit investment – to well below their "ordinary" levels. Investors have responded to this gale of financial repression by seeking solace in the stock market. And indeed, quantitative easing has shown a wonderful tendency to make stock prices rise.
 
So far Frederic Bastiat's 'broken windows fallacy' is one of the most widely discussed essays in economics. A shopkeeper has his window accidentally broken by his son. A crowd gathers, and pretty soon they become somewhat philosophical:
 "It's an ill wind that blows nobody any good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"
The essay is titled 'That which is seen, and that which is not seen'. What is seen is the broken window, and the six francs that the happy glazier receives for fixing it. Those six francs will circulate in the economy. 
 
What is not seen is what the shopkeeper might have done with those six francs, had he not been obliged to give them to the glazier. Society is no better off.
"Neither industry in general, nor the sum total of national labour, is affected, whether windows are broken or not."
Bastiat's essay might as well have been titled 'The law of unintended consequences'. We can see with our eyes what the impact of quantitative easing has been on the stock market.
 
Every time a new iteration of QE has been announced and deployed, stock prices have typically risen. We can see the market price level on our computer screens. What we cannot see is what projects might have been supported, what investments made, with capital that ended up in the stock market instead. And we can also fear what projects will have been supported, what investments made, on the back of interest rates that are being artificially suppressed at well below their natural level. 
 
The Austrian School would term at least some of these projects 'malinvestments'. Those 'malinvestments' might well include some of the residential properties in London and the south-east that seem to have become the compulsory investment choice of the rich. 
 
It seems as clear as crystal to us that, once again, with tiresome regularity, developed world central banks are busily inflating bubbles that will inevitably burst. We know that they will burst, we just do not know when. Bubble candidates include stocks, bonds and property: only the three major asset classes, so nothing to worry about. We have long held that asset class diversification remains the last free lunch in finance. But asset class diversification alone is insufficient if there is genuinely a bubble in everything. What is then required is an unusual extra commitment to selectivity. Indices should be abandoned.
 
The Economist's recommendation to concentrate on low-cost index trackers should be treated as the lazy advice it is, because it misses the wood for the trees. Prudent investors should look for attractive valuations along the roads less travelled, less-crowded by hordes of index-trackers determined ultimately to fall exactly in line with the index. 
 
If you had Einstein's hour to solve the problem, what question would you ask? We think this dismal financial environment requires a root-and-branch return to first principles. It isn't just: what do we want to own? Should it be a combination of appropriately valued stocks, bonds, property, cash, and gold? How can we best avoid the more obvious risks to our capital?
 
It's a question of what do we want to achieve with our capital in the first place? We think for our clients, trying to "beat the market" is entirely the wrong objective today.
 
Markets are much less efficient and rational, in our view, than they are widely held to be, not least by the nominating committee for the Nobel Prize. Europe's stock markets were also buoyant well into the summer of 1914. They initially shrugged off the assassination of the Austrian heir, Archduke Franz Ferdinand, in Sarajevo.
 
But as investors began to grasp the implications of a European war with Russia siding with Serbia, both bonds and stocks started to sag as the more proactive investors began to raise liquidity. Historian Niall Ferguson points out that stock-jobberson the London Stock Exchange, heavily reliant on borrowed money to finance their equity holdings, started going bankrupt.
 
Counterparty risk blossomed, with bill brokers caught with customers on the continent unable to remit funds. There were fears of bank runs. The Viennese stock market closed, on July 27, 1914. Within a week all the continental exchanges had followed, along with London and New York. The world's major stock markets remained closed for up to five months.
 
Today we have western stock markets either at, or close to, record nominal highs. Interest rates remain at 300-year lows. This despite fears of a slowdown, and deflating credit bubble, in China, the looming end of QE in the United States, and military escalation in Ukraine. And an unreconstructed banking system in the Euro zone.
 
What did you want to do with your capital again?
London-based director at Price Value Partners Ltd, Tim Price has over 25 years of experience in both private client and institutional investment management. He has been shortlisted for the Private Asset Managers Awards program five years running, and is a previous winner in the category of Defensive Investment Performance. Tim regularly shares his views on his blog, The Price of Everything.
 
See the full archive of Tim Price articles.

 

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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