The Return of Swamp Thing

There really are monsters in this world

There are decades where nothing happens, and there are weeks where decades happen. We have just experienced three such shocks, and in fairly short order. First there was Brexit. Then there was the election of Donald Trump. Then there was Covid. Let’s start with Brexit.

Britain’s knife-edge decision to leave the European Union reversed forty years of history and political integration. It was met with a gale of market volatility as powerful as on any day during the Lehman crisis of 2008 (for example). The storm was all the more shocking because it was fuelled by months of growing complacency that the UK would “do the right thing”, as instructed by the massed ranks of euro zone institutions, the IMF, the OECD, all of the British political establishment, and a raft of big businesses and investment banks. In the few hours between the polls closing and the verdict coming in, Sterling fell by more than 10% – a move of such magnitude for a major currency that it beggars belief – or at least it did until Liz Truss and Kwasi Kwarteng unveiled their short-lived budget of September 2022. 10 year UK Gilt yields fell to new all-time lows. The FTSE 100 share index at one point during the new trading day fell by almost 9%. European markets fared worse: Italian and Spanish markets, for example, closed the post-Brexit session more than 12% lower. The storm has now passed, or rather been replaced. But questions remain. Among the most prominent –

How to invest during uncertainty ?

Ben Hunt of Salient Partners called the Brexit vote a Bear Stearns moment, not a Lehman Brothers moment, and he’s almost certainly right. The difference ? Bear Stearns, when it failed, was containable – and everybody saw the train wreck coming. Markets had time to prepare. The business was tidied up and presented to JP Morgan, together with a dowry from the Federal Reserve, on a silver platter.

Lehman Brothers, of course, was another matter entirely.

Its bankruptcy was the largest in US history. Wall Street and everybody else assumed that the problem would be solved somehow before the markets reopened on September 15, 2008. So when it wasn’t, all hell broke loose. The Dow Jones Industrial Average suffered its largest ever one day point loss. The Lehman failure triggered a wave of forced banking mergers as the Fed ambulance rushed to the scene. Wall Street’s out of control locomotive smashed into Main Street; for a period, there were fears that no planes would fly, on account of the dominant role that the ailing AIG played within the aviation insurance market. The global financial system, for a few moments, found itself looking into the abyss.

So Brexit was no Lehman Brothers event. If you think about it, the very idea that a country simply choosing to leave a political and economic union should trigger such extraordinary market volatility is a little absurd. But it did force investors to wake up suddenly to a changed financial environment and the rising risk of systemic problems ahead.

What risk really means

For all the supposed analytical and quantitative sophistication of the modern financial system, we have lost touch with what risk really is.

Investment theory started to go badly astray in March 1952. That was when the young Harry Markowitz published his article ‘Portfolio Selection’ in the Journal of Finance. Markowitz at the time was a fresh-faced mathematician with no investment experience whatsoever. That didn’t stop him from advocating a bold investment argument, namely that a diversified portfolio is always preferable to an undiversified one.

The heart of his thesis was that volatility in a portfolio is undesirable. In other words, that volatility equates to risk.

But for the theory to work involved a definition of risk. How can we calculate risk if we cannot first define and then measure it ?

So the financial services industry adopted volatility as the standard expression of risk, and defined volatility as the annualised standard deviation of a portfolio’s return – the extent to which a portfolio’s net asset value wobbled versus the market.

Previous generations of economists had never dared to define risk. They acknowledged that it existed, but they weren’t audacious or presumptuous enough to put a figure on it.

Albert Einstein once remarked that

“Not everything that can be counted counts, and not everything that counts can be counted.”

There are limits, in other words, in trying to capture risk in a bottle, to define it, to pin it down to a simple equation.

The writer Aldous Huxley, who came from a family of distinguished scientists, once wrote that science simply ignores anything that it cannot measure.

The reality, of course, is that risk can’t ever be quantified.

But as a rule of thumb, it’s not a bad idea to define risk, instead, as the likelihood of permanent capital loss. Seeing a portfolio, a stock, or a currency holding go down in value by 10% or 20% is regrettable, for sure, but if the loss isn’t permanent, it’s really just volatility. And volatility is an inevitable characteristic of tradeable markets – because human beings are emotional, and prone to extremes of greed and fear. Having your portfolio wiped out by a Lehman Brothers event, on the other hand – that’s risk.

Human beings also crave certainty. But certainty is an unattainable goal. Nobody ever told this to Piers Hillier, the chief investment officer for the fund manager Royal London Asset Management back in 2016. Hillier told the Wall Street Journal over the post-Brexit weekend that

“If you’re making five to 10-year capital commitments, you want to know what the prospects for that region are. Markets hate uncertainty and I think people will hold off making that decision until things are clearer.”

Well Piers, you might be waiting for a very long time.

We can never know what the future holds – the best we can do is prepare for an uncertain future by making calm, probabilistic assessments about events to come. In a word, that means diversification. Not holding all your eggs in one basket. That applies across asset classes, currencies, individual stock holdings, and geographies. The next step is to ensure that whatever investments you do make are filtered through a prism of value. Be judicious, and don’t overpay, for anything. And as a private investor, you don’t have to be benchmarked against an index. So if you’re genuinely concerned about a given market, there’s no shame in holding cash (or gold).

Brexit 1.0

Investment advice is all very well, but there are some things that can never really be understood until you’ve experienced them first-hand. The emotions generated by a seismic market shift can make measured, rational thinking incredibly difficult.

The European Exchange Rate Mechanism (ERM) crisis of September 1992 was this correspondent’s first experience of a big market crisis. It also turned out to be a giant dress rehearsal for Brexit. It combined Groupthink, monetary policy incompetence, complacency and then sudden, blind, unthinking panic.

A vast swathe of economists had encouraged the UK to join the ERM as a way of tackling inflation. Britain’s monetary policy was reduced to just one objective: have Sterling shadow the Deutschemark.

The problem (then, as now in the euro zone) was that a one-size-fits-all monetary policy wasn’t viable across Europe.

Germany had recently experienced the inflationary effects of integrating East Germany – at the wrong exchange rate. So Germany’s interest rates were appropriate for its domestic situation but wildly inappropriate for a Britain still in recession.

The realisation in the currency markets that something had to give came late in the day.

As Sterling came under sustained selling pressure in the currency markets, the Bank of England hiked interest rates from an already uncomfortable 10%, to 12%. When Sterling didn’t budge from its permitted floor against the Deutschemark of 2.7780, the Bank of England hiked again, from 12% to 15%. Panic ruled.

But the response to the panic varied by firm. In the dealing room of this correspondent (that of a Japanese bank not exactly of the highest quality), the first rate hike was greeted by shock, as traders started to fret about the implications for the cost of their mortgage payments. The second hike was met with anger.

In the dealing room where this correspondent’s brother worked (namely that of a sophisticated market operator part-owned by JP Morgan), both rate hike announcements were met, instead, by ever more raucous laughter. The traders there rapidly appreciated that the game was up, and the Bank of England held a weak hand, and was bluffing. Badly.

The foreign exchange market finally, belatedly, realised that the UK’s monetary policy experiment was doomed. There was no way that the Bank of England could realistically maintain UK interest rates at such punitive levels in the middle of a recession. Eventually, after sustaining losses of over £3 billion, the British government threw in the towel. (At the time that seemed like a lot of taxpayers’ money. One financial magazine wrote that it was as if the UK Treasury had spent the afternoon lobbing schools and hospitals into the North Sea.)

Sterling left the ERM, never to return.

And what all the economists had warned about completely failed to materialise.

The British economy thrived after its ethnic cleansing from the ERM. No longer shackled by an inappropriately severe monetary policy, Sterling quickly adjusted to a new, cheaper level. (Something that no member countries of the euro zone can enjoy today – competitive devaluation is impossible within the latter-day gold standard of the euro bloc.)

UK GDP rose. Inflation subsided. The economy stabilised. The British Chancellor, Norman Lamont, later revealed that he had spent the morning after Sterling’s departure from the ERM singing in the bath. Memo: never trust politicians.

Now six  years on, it doesn’t seem unreasonable to expect the UK’s economic fortunes post-Brexit to be similar to those it experienced after September 1992. A weaker currency makes UK exporters more competitive. The financial services sector may suffer – but compared to its peers in the euro zone, the damage looks likely to be contained. Bonds are best avoided – but nothing changes there. The EU as a political construct, on the other hand, runs the very real risk of experiencing an extinction-level event. So we are still not huge fans of the euro today.

Panic means opportunity

At times of profound and unexpected political and economic change, markets over-react. Consider the gravity of what happened in June 2016. We voted, by a narrow but vital margin, to leave the European Union. Sterling collapsed. The FTSE 100 fell through the floor. Our Prime Minister resigned.

The media loved it. Bloomberg, for example, pointed out that the 400 richest people on the planet lost a collective $127 billion on the post-Brexit Friday alone.

Martin Wolf, chief economics correspondent for the Financial Times, went somewhat further. Brexit was

“probably the most disastrous single event in British history since the second world war.”

This gives an indication of just how shocking the Brexit result was for the British establishment. (And how out of touch with much of Britain the Financial Times is.)

Shift your perspective beyond the hourly, however, and what you see is something utterly different. Sterling rallied. The FTSE ended up closing on a weekly high – 2.4% up on the previous week, its best performance for four months.

(Bloomberg never reported on the trillions of dollars that the 400 richest people made in the months before Brexit.)

Slowly the political dimension stabilised too.

President Obama decided that we wouldn’t be at the “back of the queue” after all, and that our special relationship was still strong.

The President of the European Commission stated that Brexit negotiations would be “orderly” and that the UK would continue to be a “close partner” of the EU.

Morgan Stanley denied reports that it would shift 2000 staff overseas.

The Confederation of British Industry, the CBI, which had been violently anti-Brexit during the referendum campaign, stated that British business was resilient and would adapt.

Several countries outside the EU announced that they would begin bi-lateral trade talks with the UK immediately.

If this was Armageddon, it was a rather British version.

When you’re swept up in the emotion of a seismic event, you no longer see things clearly. Tunnel vision and myopia kick in. Events seemingly spiral out of control. The concept of the long term vanishes into irrelevance. Everything becomes the moment.

If you can manage to control your emotions, though, you have an advantage over all those investors still swept up on their own massive emotional tide and being carried out to sea. But mastering your emotions at times of profound change is extraordinarily difficult. Four things help to counter the swirl of emotion triggered by turbulent markets:

• Stay diversified;

• Remind yourself of your commitment to the longer term (if in doubt, simply turn the news off);

• Favour defensive value and those investments that come with an inherent ‘margin of safety’ because they were purchased at attractive prices;

• Take advantage of other people’s panic, and Mr Market’s schizophrenia, when it occurs. Don’t allow yourself to be led by the herd. Treat the market as your servant, not your master.

As the great value investor Ben Graham put it,

“The true investor scarcely ever has to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgement.”

What’s next ?

The risks around some kind of ‘liquidity event’ in the markets are hardly trivial. Given the financial situation of early 2023, it’s unlikely that we’ve just experienced such heightened volatility in currency and stock markets this past year without one or more bathers being revealed as having been swimming naked. We should expect to see some hedge fund and possibly mainstream banking failures – and given the systemic adoption of leverage, price volatility in all sorts of financial instruments will likely remain elevated for quite a while.

In the longer term, there is now the very real possibility of a euro zone break-up. This may account for why the authorities went “all-in” back in 2016 to try and persuade the Brits to remain. And that could realistically lead in turn to some kind of Lehman moment.

Is there a risk that a Bear Stearns moment morphs into a Lehman style emergency ? Of course there is. But since 2008 we have been living with the prospect of global systemic distress, so on that front nothing has really changed. The sensible responses are the same now as they were then: only put into the market money you can afford to lose. Diversify. Hold cash and gold. Avoid most bonds. Buy value. Hedge market risk with vehicles like systematic trend-following funds.

But remember: financial theory – the sort of financial theory widely practised by the global investment community – is wrong. 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. It cannot be avoided – but it can be exploited when the market over-reacts. Warren Buffett put it nicely:

“Cash combined with courage to invest in a crisis is priceless.”

A little more Buffett helps make the point:

“A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

“You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.”

That doesn’t mean we load up the truck with risk. Any study of human interaction on a large scale – an economy, in other words – requires an element of humility. In the absence of knowledge about the future, we simply diversify, and hedge our bets.

As Francis Bacon observed,

“If we begin with certainties, we will end in doubt. But if we begin with doubts and bear them patiently, we may end in certainty.”

The Brexit vote was a cataclysmic shock to the system. The UK’s revolt against Europe was so forceful that it may ultimately destroy the EU project.

But that’s great news.

The vote was not about right or left, or about hate or fear.

It was about freedom. About the right size of the State (smaller being our clear preference).

And it was a protest vote against supposed experts.

Those who, like this correspondent, voted to Leave increasingly sensed that “the fix was in”. There was a growing sense across the entire country that the EU elites were both corrupt and wrong about the consequences they warned about. The experts were just expert at one thing: being patronising.

After Brexit, the world of impossible outcomes gave us Trump – another conclusion deemed unthinkable by the experts. It seemed that Washington’s Swamp was set to be conclusively drained. But then, in short order, we had Covid – and ever since, the Swamp monster has been throwing its weight around like a weighty thing carrying very heavy weights. The Big State has shown its capacity for efficiency and human dignity by destroying the global economy, destroying energy infrastructure, destroying jobs, livelihoods and lives – all so that a few friends in certain preferred sectors (the vampiric management of Bad Pharma) can feast off the corpse. Something now seems set to break.

Created by Len Wein and Bernie Wrightson, the original Swamp Thing first emerged from the boggier dimensions of the DC Comics universe in 1971. (Unlike the Donald Trump coinage, the original Swamp Thing was actually a hero, as opposed to a dark, malign force for technocratic evil.) Or, consider the original Blob, which first oozed out at cinemagoers in 1958 in a film most notable for introducing the world to the then self-styled Steven McQueen. Just as now, The Blob, like its Westminster namesake, was a carnivorous amoeboidal monster dedicated to destroying humanity. But whether we term it the Swamp, or the Blob, or the Uniparty, they are all variations on the same theme: a motley amalgam of the Big State, legacy media and sundry fascistic corporate interests, all determinedly attacking what remains of free market democracy and individual liberty. Covid allowed this foul monster back into the world, and it is now our job to destroy it, once and for 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 specialist managed funds.