Markets are now absurd

..here's how to invest in them

https://www.pricevaluepartners.com/how-to-invest-at-the-point-of-absurdity/

“Nothing sedates rationality like large doses of effortless money.”

• Warren Buffett.

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Two books have shaped our understanding of investing and the financial markets more than any other. The first is Benjamin Graham’s The Intelligent Investor, which is practically the Bible of value investing. That Ben Graham was mentor to Warren Buffett says it all. The second is Peter L. Bernstein’s Against the Gods, which we first read at the height of the dotcom boom (the book was initially published in 1996). Against the Gods is a biography of risk. It begins with an audacious statement: that modern thinking itself began when man abandoned the belief that events in this world are down to the whims and caprices of the gods, and when we began to accept the notion that we can control our own destiny, in part through the active management of risk.

Risk means different things to different people. The financial regulator and therefore in turn the investment industry tends to regard risk as effectively the same thing as volatility – the more volatility in price a given investment experiences, the riskier it is.

But that strikes us as overly simplistic. Our friend Guy Fraser-Sampson, in his book The Pillars of Finance, points out that three of the great thinkers in economics – Frank Knight, Ludwig von Mises and John Maynard Keynes – never dared to define risk:

“..while before the Second World War, there was eager discussion as to what risk might be, and whether it was the same thing as uncertainty, there was total agreement that whatever it was it was probably too complex an animal ever to be fully understood and, in particular, that it was incapable of mathematical calculation. After the War this view was simply quietly abandoned and ignored without ever being refuted, or even discussed.”

In The Ultimate Foundation of Economic Science (1962), von Mises wrote that

“Statistics provides numerical information about historical facts, that is, about events that happened at a definite period of time to definite people in a definite area. It deals with the past and not with the future. Like any other past experience, it can occasionally render important services in planning for the future, but it does not say anything that is directly valid for the future.”

This touches on our major reservation when it comes to matters of economic and investment theory. Mises was making the point that you can only use the techniques of natural sciences such as physics if you can use things like empirical observation drawn from scientific experiments and then apply mathematical techniques to analyse the data. But financial data – prices, if you will – are the result not of physical phenomena but of human action (Mises’ magnum opus was titled Human Action, and for good reason), which is in turn caused by human decision making, which is influenced in turn by human emotion. So the business of investing is behavioural, not physical. As Guy puts it,

“[Finance] is at best a social science studying human behaviour, like psychology or sociology, and can never be a physical science such as physics. It is for this reason that neither observation nor mathematical techniques can ever offer any valid universal guide to future outcomes.”

This matters, and it matters a lot. Adherence to flawed economic models helped trigger the Global Financial Crisis. Adherence to questionable economic theories dictated our authorities’ response to the GFC. What if the authorities were simply wrong? Trillions of dollars have been spent on quantitative easing and extraordinary monetary stimulus since the bankruptcy of Lehman Brothers. Right or wrong, it has been an expensive way to find out.

But on the topic specifically of risk, here is our preferred definition. Risk is the probability of a permanent loss of capital. Day-to-day price volatility, on the other hand, is just that – and in financial markets it simply cannot be avoided.

An 18th century maxim that still holds true

One sentence in particular leapt out at us from Bernstein’s book, and it has informed our investment philosophy ever since. It is a quotation attributed to the Swiss mathematician, physicist and ‘Renaissance man’ Daniel Bernoulli. It goes like this:

“[If you’re managing money for wealthy people] the practical utility of any gain in portfolio value inversely relates to the size of the portfolio..”

Sounds somewhat dry, doesn’t it. But in plainer English it amounts to this:

“[If you’re managing money for wealthy people], just don’t lose it.”

In other words, once you get to a certain level of wealth, further investment returns start to become less relevant. Which isn’t to say that the wealthy don’t want to make money. But what Bernoulli was getting at was the observation that as a general rule, large investors should care more about capital preservation than about capital growth. After all, they’re already wealthy, so they should be more concerned about maintaining the value of their pot than about doubling it or tripling it. Especially if those future returns come at the expense of jeopardising their wealth in the first place.

It’s clearly a sweeping statement, and it may not apply to everyone. But we think in many respects, it should, whether we’re talking about the hugely wealthy or the ‘average’ investor – if there even is such a thing.

In our view, Daniel Bernoulli should get credit as one of the world’s first behavioural economists. Plenty of research now shows that there is a general tendency for human beings, however much money they possess, to be loss-averse. In other words, we would much rather avoid a loss than experience a gain. Given a gain or loss of equivalent value, incurring the loss is ‘felt’ with between two and three times the intensity of the feeling of pleasure associated with the gain. We will go out of our way to avoid losses, if at all possible. A notable study was conducted by Kahneman and Tversky in what became ‘prospect theory’, i.e. how people choose between probabilistic alternatives involving risk. That is practically a definition of investing. Kahneman would go on to win a Nobel Prize for his work on prospect theory.

What we immediately took from that quote by Daniel Bernoulli is that wealthy investors should seek absolute returns, not market-relative ones. To put it another way, their primary investment benchmark should be cash, as opposed to a market benchmark comprising something like an equity index: the FTSE 100 index, or the MSCI World equity index, for example. The reason is not that cash is a particularly easy investment hurdle to beat today, but because cash – under normal economic conditions, at least – is the one and only asset class that cannot decline in nominal terms. Every other asset class clearly can, whether we are talking about stocks, bonds (which we now hate), property, or commodities (which we currently love).

So now we wonder whether Bernoulli’s counsel, and the pursuit of absolute returns, isn’t just relevant to wealthy investors, but to all investors. We entirely appreciate that investors of all shapes and sizes want a return on their money, but we think it’s crucial that we at least acknowledge the uniquely challenging – and undoubtedly risky – times in which we live.

There are essentially two ways to build an investment portfolio: ‘top-down’ and ‘bottom-up’. It needn’t be an either/or decision: both have their place.

‘Top-down’ is to select from among different asset classes and make an asset allocation call. We view the investment world through a prism of four discrete asset classes: ‘cash and bonds’; ‘value equities’; ‘uncorrelated / absolute return funds’; and ‘real assets’.

Cash has its place, albeit as a source of optionality and dry powder rather than as a meaningful investment. Bonds we regard as uninvestible.

The remainder of our portfolio is allocated between ‘value’ stocks, uncorrelated or ‘absolute return’ funds, and real assets, primarily attractively priced commodities companies. ‘Absolute return’ funds may or may not succeed in their stated objective, but they probably have a higher likelihood of succeeding than any straightforward equity or bond fund will, in the event of a bear market for either of those asset classes. ‘Real assets’, especially the monetary metals, offer us a combination of inflation protection and insurance against systemic failure. Neither of those risks have exactly gone away.

This asset allocation template suggested above isn’t meant to be prescriptive. As we discussed earlier, risk means different things to different people; it’s inherently subjective. What looks conservative to a 30-something might seem outrageously aggressive to a pensioner living on a fixed income. Only you can know what feels right for your own situation, but we hope that the discussion here can help you reach that conclusion.

Then we come to the portfolio from a ‘bottom-up’ perspective. What sort of stocks do we want to own? What sort of bonds, or bond funds? (Right now: none.) Which ‘absolute return’ strategies make sense? How much gold should we own?

Most of the financial risk that concerns us at the moment relate to the bond market. The two primary asset classes in this world are bonds and stocks – but the world of bonds completely dominates the world of stocks, when it comes down to market value. And it is bonds that have the most questionable and probably unsustainable (high) prices, and (comparatively low, but rising) yields today.

Bonds are acutely vulnerable in large part because interest rates, having trended lower for four decades, are spiking higher, and have trended higher ever since the US responded to the Russian invasion of Ukraine by reminding everyone that its own Treasury debt or other dollar assets could be cancelled on a whim. Bond investors have benefited since the early 1980s from ever-declining interest rates. A dramatic move higher in interest rates will prove interesting for a generation of bond investors that have only ever seen lower rates.

At the Peterson Institute for International Economics’ sixth annual summit, Lawrence Lindsey, a former Federal Reserve governor, issued the following warning:

“We’re at the point of absurdity. Maybe it made sense when you had a crisis. It does not make sense now. At some point what is going to happen – and this gets to my eight or nine cataclysmic number [on a scale of 1 to 10] – is that we’re going to get a series of bad numbers – a little higher inflation, higher average hourly earnings or whatever – and the market is suddenly going to say, “Oh my God, they are so far behind the curve that they will never catch up.” And the market is going to force an adjustment on the Fed that will be wrenching. That’s the cataclysmic outcome. If the Fed were to get a little bit ahead of the curve – or even maybe move a little bit closer to the curve – that’s the best we can hope for – we would mitigate that. We would phase into it gradually. And that’s why so much is at stake in the monetary policy that we adopt now..”

Lindsey also pointed to prior occasions in history when government administrations have lost control of their borrowing:

“It always ends this way. If you go back and you look at Rome, you look at the Ming Dynasty or you look at Zimbabwe – it always, always, always ends this way. And the question is how can you delay it… The end game we’re all talking about here is a very unpleasant one. It means that the financial arrangement that the state has created is no longer sustainable by society. And that’s how overly indebted societies end and they move on to a new type of arrangement. So it isn’t going to be a pretty change – if we get there. And that’s why it is so urgent that we act now. It is not just a matter of numbers. It’s a matter really of political liberty. Because the government will not voluntarily let itself go out of business. It will use all of its powers – I’m not talking about just our government but any government – will use all of its powers in order to fund itself… It isn’t hard to get the math to work for America to save itself – and that’s why I’m optimistic like my colleagues here that we could do it. But we’ve got to get on the wagon and get doing it soon because time is running out.”

So any sensible investment policy has to involve both minimal exposure to poor-quality bond investments and true diversification as a hedge against the other genuine risks facing investors today.

Having addressed those risks as well as we practically can, it finally comes down simply to patience, and discipline (behavioural economics, again). We make no secret of the fact that, notwithstanding our commitment to sensibly priced real assets, we pursue an investment policy of ‘safety first’ – and this goes all the way back to that first encounter we had with Against the Gods and with Mr. Bernoulli. But that doesn’t necessarily make us pessimists (though we will certainly accept the charge of being ‘realists’). In the words of Winston Churchill,

“I am an optimist. It doesn’t seem too much use being anything else.”

And in the context of this remarkable period in financial history, and whether our diversified and disciplined portfolio approach can survive whatever might come, we are very optimistic indeed.

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As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio – with no obligation at all:

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Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com.

Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and real assets, and also in systematic trend-following funds.