Surviving 'total war'

“Sweat saves blood.” - Erwin Rommel

In the 12th and 13th Centuries, a religious sect sprang up in southern France that would, over time, convert a growing number of believers to its cause. They were originally described as ‘Albigensians’ but they became more widely known as the Cathars, a type of Puritan.

The Cathars were a Manichaean sect. That is, they believed that a good spirit created the spiritual, and an evil spirit created the material world, including the human body, which was therefore always vulnerable to evil. The soul was a product of good, but the body that enclosed it was a prison of evil. The Cathars favoured abstention from marriage and preferred concubines.

The Cathars were a Christian community. But because they rejected the authority of the Pope, the Catholic Church labelled them heretics – hence they became known for their ‘Albigensian Heresy’.

By 1209, Pope Innocent III had had enough of them. On July 22nd, during the annual Feast of Mary Magdalene in the southern French town of Beziers, an army of crusaders sent by Pope Innocent arrived at the walls of the town. They were led by the French nobleman Simon de Montfort, who had been promised the land of any heretics he killed. The crusaders were accompanied by a French Cistercian monk, Arnaud Amalric.

De Montfort demanded that the town hand over the Cathar heretics within its walls. The town elders refused. The Crusaders attacked.

A soldier is said to have asked Amalric how he could tell between the townspeople who were Catholics and those who were Cathars. Amalric’s response:

“Kill them all. God will recognize his own.”

It turns out that the concept of ‘total war’ arrived in human society long before the Nazis would professionalize the idea during the 1930s and 1940s.

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In September 2008, the global financial system convulsed in a massive heart attack. The finest account of the crisis can be found in Andrew Ross Sorkin’s book ‘Too Big To Fail’, which benefits from the extraordinary access that Sorkin, a columnist for The New York Times, had to all the major players at the time.

Here is how Sorkin describes an emergency teleconference conducted from the home of Jamie Dimon, the CEO of JP Morgan, on the Saturday morning of the weekend that Lehman Brothers failed. Dimon told the executive board of the bank:

“You are about to experience the most unbelievable week in America ever, and we have to prepare for the absolutely worst case. Here’s the drill. We need to prepare right now for Lehman Brothers filing [for Chapter 11 bankruptcy protection]. And for Merrill Lynch filing. And for AIG filing. And for Morgan Stanley filing. And potentially for Goldman Sachs filing.”

Sorkin then adds:

“There was a collective gasp on the phone.”

One doubts if he was using any journalistic licence there.

Two roads diverged on the day that followed.

One road contained bankruptcy filings for Lehman, Merrill Lynch, AIG, Morgan Stanley, and Goldman Sachs. (The idea that Goldman could have survived an extinction-level event that took down the rest of Wall Street is quaint. You only have to look at its share price at the time. Perhaps even the mighty JP Morgan itself might not have survived a ‘chain reaction’ failure across Wall Street.)

In the blind, chaotic panic of the time, the authorities could not, or chose not to, rescue Lehman Brothers in time for the opening of the Tokyo markets on the following Monday morning. By now the distinction is academic. But as soon as the financial markets absorbed the implications of Lehman’s bankruptcy filing, all bets were off, markets froze up entirely in some eerie kind of nuclear winter, and the authorities then moved heaven and earth to underwrite the rest of the financial system.

The ‘free markets’ road was the one not taken. The road taken was signposted ‘State intervention’. Along this other road, Merrill Lynch, my alma mater, was bundled unceremoniously into Bank of America (which would come to regret the costs incurred by the shotgun wedding). AIG was rescued. Morgan Stanley was bailed out, with the help of $107 billion in loans from the Federal Reserve. Goldman Sachs, a brokerage company at the time, was allowed to convert itself into a bank holding company, a small but crucial change in permissions which enabled it to borrow directly from the Fed – a privilege denied to Lehman Brothers in its hour of urgent need.

Five years after the collapse of Lehman Brothers, which at the time was only a second-tier investment bank focused primarily on debt, the Dallas Federal Reserve estimated that the cost of the financial crisis amounted to $14 trillion – pretty much a full year of US GDP.

That was in 2013. But the costs have only gone on rising since. A crisis of debt that brought the system to the edge in 2008 has got demonstrably worse since. Add in the monstrous costs of lockdown, and now of a grotesque, self-inflicted global food and energy crisis..

Some creditors and depositors now believe that our banks are safer than they were in 2008. They are wrong – not least because government and central bank finances are dramatically worse. The stop-gap solution to the credit bubble in 2008 was to shunt the liabilities of the private sector on to governments. A banking sector problem was kicked upstairs to become a sovereign problem. Now that sovereigns themselves are in the same mess, but without the latitude for their central banks to cut rates demonstrably further, where can the problem be kicked up to next ?

There are now early tremors in the bond markets pointing to some kind of defining correction. Government bond yields around the world have started to rise in recent weeks and months. A 40-year bull market in interest rates seems to be finally on the turn. With central banks already so overextended, this time they may be in no position to turn back the tide.

A reckoning postponed

On the fifth anniversary of Lehman Brothers’ bankruptcy, the author and former Salomon Brothers bond salesman Michael Lewis was asked in an interview with Bloomberg BusinessWeek whether he thought the company had been unfairly singled out when it was allowed to fail (given that every other investment bank would then be quickly rescued, courtesy of the US taxpayer).

Lewis’ response:

“Lehman Brothers was the only one that experienced justice. They should’ve all been left to the mercy of the marketplace. I don’t feel, oh, how sad that Lehman went down. I feel, how sad that Goldman Sachs and Morgan Stanley didn’t follow. I would’ve liked to have seen the crisis play itself out more. The problem is, we would’ve all paid the price. It’s a close call, but I think the long-term effects would’ve been better.”

The road not travelled would have been a victory for the market. Banks would have been left to the market’s tender mercies, meaning that bad economic players would have been swept away and replaced by better ones, by more successful entrepreneurs and business operators. It would have led to a sharp deflationary recession – but the world would still have turned, bad debts in the system would have been purged, and the markets, over time, would have cleared. ‘Normality’ would have intervened, and the slate would have been wiped clean to allow a new business cycle to start over, with investors, entrepreneurs and imprisoned bankers experiencing a heightened appreciation of risk.

The road actually travelled, of course, was the polar opposite. The monetary authorities worldwide would mobilise the capital of taxpayers to support every bank in the system, whether a sound counterparty or not. Along this road would be endless financial intervention with the aim of inflating away an unpayable debt mountain: various iterations of QE, ZIRP (Zero Interest Rate Policy), NIRP (Negative Interest Rate Policy), Operation Twist, negative bond yields, global currency wars, even a war on cash itself.

The growing forces of financial repression would ultimately become a declaration of ‘total war’ on the saver, in the cause of simply perpetuating an already over-mighty State.

The problem with market intervention is that it brings in its wake a host of unintended consequences. Those unintended consequences, in turn, require some form of policy response, until intervention breeds on itself, and the market environment becomes totally chaotic. It is no longer possible to invest sensibly, or safely, because the dead hand of the State is directing everything. This is the point we have now collectively reached.

The next front in the war: an outright ban on cash

Andrew Haldane, chief economist of the Bank of England, was one of the first to float the trial balloon of banning cash outright. For as long as cash exists, depositors worried about the paucity of returns from their savings accounts – and the solvency of the banks themselves – can always save in physical cash outside the system. Savers can resort to a safe. Ban cash, and you force all savers into purely electronic money – and interest rates can then be driven as far into negative territory as the central bankers wish them to go.

The Norwegian academic Trond Andresen in 2013 published a paper arguing that

“electronic monetary systems offer a big step forward for macro-economic control, among other things by giving a government new and potent steering tools.”

Most recently, the Harvard academic Kenneth Rogoff has picked up the baton on behalf of Orwellian Big Government. His latest book is titled ‘The Curse of Cash’ and it is a handbook for state control. Rogoff advocates banning most forms of cash in the name of fighting crime and tax evasion – the flimsiest of excuses for relinquishing individual freedom and allowing the government control over the saving and spending of the electorate.

In a sense, of course, there’s no use debating past history. There can be no counter-factual. We will never know what might have happened had Tim Geithner, at the Federal Reserve Bank of New York, or Ben Bernanke, or Hank Paulson, US Treasury Secretary, grown a pair.

What we do know is that the failure of Lehman Brothers ushered in a whole new climate of heightened state intervention in the markets and brought us all into a brave new world of financial repression.

Lehman Brothers itself was not cause, but symptom.

In November 2007, almost a year before the Lehman collapse, our friend Tim Lee of pi Economics wrote as follows:

“There is little doubt, to my mind, that we are now at a defining moment in financial history, a time that, once it has passed will be referred by economic and market historians in much the same way as the Wall Street Crash of 1929 or the credit and banking crisis of 1973-4 are now.

“Unfortunately, as is becoming increasingly clear, this crisis is not really just about subprime mortgages. It is much more serious than that. It is the beginning of an inevitable realignment of credit and wealth with incomes and accumulated savings… subprime is merely the first part of the credit edifice to give way, rather than the whole story…”

Note that turn of phrase: “the first part of the credit edifice to give way..”

Lehman did not cause the crisis – it was a victim of it.

The seeds of the crisis were sown back in 1971, when the US, being crushed beneath the financial burden of the ‘Guns and Butter’ policies instituted during the previous decade – prosecuting the Vietnam War at the same time as establishing a welfare state – under President Nixon’s direction took the US dollar off gold.

By removing the last traces of the Bretton Woods system that had lasted for a quarter of a century, in which all currencies were linked to the US dollar, and the US dollar itself was linked to gold, Nixon brought in a system of purely fiat currency, in which money would be backed, directly or indirectly, not by precious metal, but by nothing more substantial than faith in politicians’ promises.

The great Irish playwright George Bernard Shaw anticipated this state of affairs decades before it came to pass:

“You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the government. And, with due respect for these gentlemen, I advise you.. to vote for gold.”

Free politicians and bankers from hard money constraints, and they will print money, and spend.

The Bretton Woods system established the price of gold at $35 an ounce.

Four decades of uncontrolled money and credit creation have lifted the gold price to its current level of $1700 or so – an increase of 4,800%. Since the central banks are determined that the credit creation will go on, and are indeed existentially obliged to let it continue, it seems plausible that the gold price has some way yet to rise.

Protecting your portfolio from a historic storm

So gold is clearly an answer, of sorts. It can fairly be expected to continue to act as a form of both inflation hedge and systemic hedge if stresses in the banking (and government debt) system become intolerable again. Our client portfolios include a number of bullion-related equities – we like to own a process as well as just a product.

There are also innumerable ways of owning physical bullion. One of the funds we own for clients in the UK is the Sprott Physical Gold and Silver Trust (ticker CEF on the New York Stock Exchange in US dollars, and CEF/A on the Toronto Stock Exchange, in Canadian dollars). CEF comprises gold and silver bullion (holding roughly 68% of its assets in gold and the balance in silver) in the form of a closed-ended trust. Its shares can be bought and sold on the stock market like any other listed stock. The trust’s bullion is stored on an allocated and segregated basis in underground Canadian vaults controlled by the trust’s custodian, the Royal Canadian Mint.  You can read more about CEF here.

Our argument for owning precious metal is simple. Over the last 20 years, the rate at which mining companies have been able to create ‘new gold’ through extraction out of the ground has not been higher than an annualised rate of roughly 1 or 1.5%.

The annualised rate at which paper money has been created by the world’s central banks through their various QE programmes has completely dwarfed that.

When the supply of fiat currencies grows faster than the stock of bullion, the gold price should rise and vice versa. Either the gold price has corrected too much since its recent peak, or central bank balance sheets are set to stagnate or decline in the future. There is little likelihood of central banks reducing the size of their balance sheets any time soon – so there is plenty of potential for the gold price, and the relationship between gold and other (less desirable) currencies, to recover. This is not a view predicated on expectations of looming financial disaster, just plain mathematics.

If you want to hold gold, or silver, in the form of a fund, always ensure it’s in allocated form (i.e. in a dedicated account in your name, which cannot be lent out (or ‘rehypothecated’) to third parties). There are too many ‘paper’ claims to gold in the market, and not enough physical bullion to satisfy those claims – so the next leg up in the gold market could start a run on gold in which those with only paper claims to gold will be caught short and will end up without the precious physical asset they thought they owned. Allocated gold is your property; unallocated gold is the property of the bank which custodies it on your behalf. Owning unallocated gold is on a par with having cash deposits in the bank – which are technically the property of the bank, and no longer yours (you are simply an unsecured creditor of the bank).

But physical gold has been declared illegal in the US in the past – courtesy of Executive Order 6102, issued by President Roosevelt in 1933. That was admittedly when the US was still on the gold standard. But it points to an ominous precedent. Just as the bank-robber Willie Sutton is said to have robbed banks “because that’s where the money is,” so cash-strapped governments can be expected to go after your money, wherever it might be – and if it’s in the form of bullion held in an onshore account, let alone a bank vault, that won’t stop them.

So if gold and silver are likely to form a meaningful part of your investment or savings portfolio, it makes sense to hold them offshore, through a service like GoldMoney or BullionVault. Even then, governments might bring in some kind of ‘supertax’ to cheat bullion investors of their gains – in a financial ‘total war’, there can be no single panacea; investors will need to diversify as broadly as possible to try and cover any eventuality.

A ‘third way’ to fight State control

From the inception of our business in 2014, we have concentrated on opportunities in value stocks internationally.

But in addition to gold and Benjamin Graham-style value equities, there’s a ‘third way’ of attempting to protect and grow your capital even in the midst of a global financial war.

This ‘third way’ investment is a hedge fund strategy known as systematic trend-following.

In our wealth management practice, we allocate roughly 20% of our client portfolios to trend-following funds.

Trend-following managers make no attempt whatsoever to predict the future. What they do attempt is to ride strong price trends as and when they occur.

Those trends might be in interest rates. Or in currencies. Or in hard or soft commodities. Or in equity indices.

If a trend-following manager can’t identify a strong price trend – whether up or down is largely irrelevant – he’ll simply keep his powder dry in the form of T-Bills.

But if he – or his system, which is invariably a computer-driven algorithm following some basic trading rules – can identify a strong trend, then he’ll allocate a small portion of his risk capital to that trend, and ride it for as long as it lasts.

The trending asset might be S&P 500 index futures. It might be soybeans, or wheat. It might be gold, or Nikkei futures.

What makes trend-followers different, again, is that they have no view about the future. They don’t have a market view to be wedded to. They simply follow their own pre-set rules. One of those rules might be: when a given asset reaches a new 52-week high, then buy it. Another might be: when a given asset reaches a new 52-week low, then sell it (irrespective of whether you own it).

They use a variety of risk controls to ensure that they’re not easily bounced into heavily loss-making trades.

And if they have the discipline to follow through on their basic strategy, they tend to deliver two things to their investors:

1)    Whatever their returns, they’ll be in a form that is utterly uncorrelated to the behaviour of stock and bond markets. This is intuitive, to the extent that at any one time, they may have no positions in stock or bond markets – and if they do, they are as likely to be short as they are long. In a diversified portfolio, uncorrelated investments are just what the doctor ordered;

2)    When financial markets undergo a serious correction, trend-followers tend to make significant returns. This is also intuitive, to the extent that when multiple markets head south, trend-followers simply go short those markets for as long as the downward price trend lasts. This gives them a key advantage over conventional fund managers, who during bear markets can do little other than shelter in cash. Conventional (long-only) fund managers cannot benefit from bear markets, but trend-following managers can.

Two examples may be instructive.

2008 was the worst financial market environment in living memory.

Our most conservative trend-following fund, in 2008, made 21%. That’s our most conservative trend-follower.

Our most aggressive trend-following fund in 2008 made 108%. During the worst financial market environment in living memory.

If you share our fears about the market environment we may be about to enter, one of heightened price volatility and perhaps the start of a new multi-year bear market in interest rates, then you’ll see why we put a premium on exposure to trend-following managers.

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Adam Fergusson’s ‘When money dies’, a shattering account of the Weimar era hyperinflation in Germany of 1923, was originally published in the inflationary chaos of the 1970s and was recently, and perhaps somewhat ominously, reissued in the UK.

The book is required reading as a primer for what happens when financial ‘total war’ spirals out of control and reaches its terminal stages. It’s not easy reading, but then we’re not in an easy financial environment.

One of the great insights of the Austrian School of Economics, under the likes of Ludwig von Mises and Friedrich Hayek, was that value is subjective. This is also the conclusion of Adam Fergusson’s sombre but instructive book:

“What is precious is that which sustains life. When life is secure, society acknowledges the value of luxuries, those objects, materials, services or enjoyments, civilised or merely extravagant, without which life can proceed perfectly well but which make it much pleasanter notwithstanding. When life is insecure, or conditions are harsh, values change..

“In war, boots; in flight, a place in a boat or a seat on a lorry may be the most vital thing in the world, more desirable than untold millions. In hyperinflation, a kilo of potatoes was worth, to some, more than the family silver; a side of pork more than the grand piano. A prostitute in the family was better than an infant corpse; theft was preferable to starvation; warmth was finer than honour, clothing more essential than democracy, food more needed than freedom.”

Sobering words for sobering times.

Happily, as the battle between the Big State, on one side, and savers and investors on the other intensifies, there are a variety of strategies that offer us all the potential of a successful way through the fog of war. 

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 specialist managed funds.