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SIX IMPOSSIBLE THINGS BEFORE BREAKFAST
The Efficient Market Hypothesis is one of the most remarkable errors in the history of economic thought.
The idea that financial markets are efficient, fully incorporating all known information into some rational appraisal of assets’ discounted present values, occurs as obvious bunk to anyone who has observed markets for more than, oh, three weeks. Yet the “Efficient Market Hypothesis” (EMH) is still the standard theory taught in U.S. higher education finance departments – despite almost no professors actually believing the theory. No wonder we have problems! (Note: Just because the market is not efficient does not mean it is a simple matter to make money by taking advantage of that insight.)
In this recent John Mauldin Outside the Box column, James Montier of Société Générale in London performs a nice and thorough EMH evisceration. The effort is entertaining and informative. In the process we gain an understanding of some of the practices which are so off-base about the money management business and Wall Street research. To take only one obvious example, the earnings forecasting game is demonstrably futile and confers no advantage to its practitioners, while being ongoingly costly; yet it continues ad infinitum. Part of the blame for that rests partly with EMH. (Inertia and the herd instinct probably deserve the most blame.)
As Montier says: “To my mind the clear existence and ex ante diagnosis of bubbles represent by far and away the most compelling evidence of the gross inefficiency of markets.” Bubbles always pop. There are no exceptions. We are in a bubble now. Beware.
The Efficient Market Hypothesis, according to Shiller, is one of the most remarkable errors in the history of economic thought. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brainwashing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed it. Only two hands stayed up!
And we wonder why funds and banks, full of the best and brightest, have made such a mess of things. Part of the reason is that we have taught economic nonsense to two generations of students. They have come to rely upon models based on assumptions that are absurd on their face. And then they are shocked when the markets deliver them a “100-year flood” every 4 years. The models say this should not happen. But do they abandon their models? No, they use them to convince regulators that things should not be changed all that much. And who can argue with a model that was the basis for a Nobel Prize?
I am again out of town this week, but I have been saving a speech done by my friend James Montier of Société Générale in London on the problems with the Efficient Market Hypothesis (EFM). While parts of it are wonkish, there are also parts that are quite funny (at least to an economist).
Ideas have consequences, and bad ideas usually have bad consequences. The current maelstrom from which we are emerging (finally, if in fits and starts) has many culprits. A lot of bad ideas and poor management that came together to create the perfect storm. Today, we look at some of the ideas that are part of the problem but are too often glossed over because they are “academic” and not of the real world. However, gentle reader, academic ideas that are taught and accepted as gospel by 99% of the professors have real-world consequences. Where does your money manager stand on these topics? It does make a difference. And now, let us jump into James’s speech.
Six impossible things before breakfast, or how EMH has damaged our industry
What follows is the text of a speech to be delivered at the CFA UK conference on “What ever happened to EMH.” Dedicated to Peter Bernstein – Peter will be fondly remembered and sadly missed by all who work in investment. Although he and I often ended up on opposite sides of the debates, he was true gentleman and always a pleasure to discuss ideas with. I am sure Peter would have disagreed with some, much and perhaps all of my speech today, but I am equally sure he would have enjoyed the discussion.
The Dead Parrot of Finance
Given that this is the UK division of the CFA I am sure that The Monty Python Dead Parrot Sketch will be familiar to all of you. The EMH is the financial equivalent of the Dead Parrot. I feel like the John Cleese character (an exceedingly annoyed customer who recently purchased a parrot) returning to the petshop to berate the owner:
“He’s passed away, This parrot is no more, He has ceased to be! He’s expired and gone to meet his maker. He’s a stiff! Bereft of Life, he rests in peace! If you hadn’t nailed him to the perch he’d be pushing up daisies! His metabolic processes are now history! He’s off the twig! He kicked the bucket. He’s shuffled off his mortal coil, run down the curtain and joined the bleedin’ choir invisible! This is an ex-parrot!!!”
The shopkeeper (picture Gene Fama if you will) keeps insisting the parrot is simply resting. Incidentally, the Dead Parrot Sketch takes on even more meaning when you recall Stephen Ross’s words that “All it takes to turn a parrot into a learned financial economist is just one word – arbitrage.”
The EMH supporters have strong similarities with the Jesuit astronomers of the 17th Century who desperately wanted to maintain the assumption that the Sun revolved around the Earth. The reason for this desire to protect the maintained hypothesis was simple. If the Sun did not revolve around the Earth, then the Bible’s tale of Joshua asking God to make the Sun stand still in the sky was a lie. A bible that lies even once cannot be the inerrant foundation for faith!
The efficient market hypothesis (EMH) has done massive amounts of damage to our industry. But before I explore some errors embedded within the approach and the havoc that they have wreaked, I would like to say a few words on why the EMH exists at all.
Academic theories are notoriously subject to path dependence (or hysteresis, if you prefer). Once a theory has been adopted it takes an enormous amount of effort to dislocate it. As Max Planck said “Science advances one funeral at a time.”
The EMH has been around in one form or another since the Middle Ages (the earliest debate I can find is between St. Thomas Aquinas and other monks on the “just” price to charge for corn, with St. Thomas arguing that the “just” price was the market price). Just imagine we had all grown up in a parallel universe. David Hirschleifer did exactly that: welcome to his world of the Deficient Markets Hypothesis.
A school of sociologists at the University of Chicago proposing the Deficient Markets Hypothesis – that prices inaccurately reflect all information. A brilliant Stanford psychologist, call him Bill Blunte, invents the Deranged Anticipation and Perception Model (DAPM), in which proxies for market misevaluation are used to predict security returns. Imagine the euphoria when researchers discovered that these mispricing proxies (such as book/market, earnings/price and past returns), and that mood indicators such as amount of sunlight, turned out to be strong predictors of future returns. At this point, it would seem that the Deficient Markets Hypothesis was the best-confirmed theory in social science.
To be sure, dissatisfied practitioners would have complained that it is harder to actually make money than the ivory tower theorists claim. One can even imagine some academic heretics documenting rapid short-term stock market responses to news arrival in event studies, and arguing that security return predictability results from rational premia for bearing risk. Would the old guard surrender easily? Not when they could appeal to intertemporal versions of the DAPM, in which mispricing is only corrected slowly. In such a setting, short window event studies cannot uncover the market’s inefficient response to new information. More generally, given the strong theoretical underpinnings of market inefficiency, the rebels would have an uphill fight.”
In finance we seem to have a chronic love affair with elegant theories. Our faculties for critical thinking seem to have been overcome by the seductive power of mathematical beauty. A long, long time ago, when I was a young and impressionable lad starting out in my study of economics I too was enthralled by the bewitching beauty and power of the EMH/rational expectations approach (akin to the Dark Side in Star Wars). However, in practice we should always remember that there are no points for elegance!
My own disillusionment with EMH and the ultra rational Homo Economius that it rests upon came in my third year of university. I sat on the oversight committee for my degree course as a student representative. Now at the university I attended it was possible to elect to graduate with a specialism in Business Economics, if you took a prescribed set of courses. The courses necessary to attain this degree were spread over two years. It was not possible to do all the courses in one year, so students needed to stagger their electives. Yet at the beginning of the third year I was horrified to find students coming to me to complain that they had not realized this! These young economists had failed to solve the simplest 2-period optimization problem I can imagine! What hope for the rest of the world. Perhaps I am living evidence that finance is like smoking. Ex-smokers always seem to provide the most ardent opposition to anyone lighting up. Perhaps the same thing is true in finance!
The Queen of Hearts and impossible beliefs
I am pretty sure that the Queen of Hearts would have made an excellent EMH economist.
Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.”
“I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.” ~~ Lewis Carroll, Alice in Wonderland.
Earlier I alluded to a startling lack of critical thinking in finance. This lack of “logic” is not specific to finance, in general we, as a species, suffer belief bias. This a tendency to evaluate the validity of an argument on the basis of whether or not one agrees with the conclusion, rather than on whether or not it follows logically from the premise.
Consider these four syllogisms:
These four syllogisms provide us with a mixture of validity and believability. The table below separates out the problems along these two dimensions. This enables us to assess which criteria people use in reaching their decisions.
- No police dogs are vicious.
Some highly trained dogs are vicious.
Therefore some highly trained dogs are not police dogs.
- No nutritional things are inexpensive.
Some vitamin pills are inexpensive.
Therefore, some vitamin pills are not nutritional.
- No addictive things are inexpensive.
Some cigarettes are inexpensive.
Therefore, some addictive things are not cigarettes.
- No millionaires are hard workers.
Some rich people are hard workers.
Therefore, some millionaires are not rich people.
We have a tendency to judge things by their believability rather than their validity – clear evidence that logic goes out of the window when beliefs are strong.
As the chart reveals, it is the believability not the validity of the concept that seems to drive behaviour. When validity and believability coincide, then 90% of subjects reach the correct conclusion. However, when the puzzle is invalid but believable, some 66% still accepted the conclusion as true. When the puzzle is valid but unbelievable only around 60% of subjects accepted the conclusion as true. Thus we have a tendency to judge things by their believability rather than their validity – clear evidence that logic goes out of the window when beliefs are strong.
All this talk about beliefs makes EMH sound like a religion. Indeed, it has some overlap with religion in that belief appears to be based on faith rather than proof. Debating the subject can also give rise to the equivalent of religious fanaticism. In his book The New Finance: The Case Against Efficient Markets, Robert Haugen (long regarded as a heretic by many in finance) recalls a conference he was speaking at where he listed various inefficiencies. Gene Fama was in the audience and at one point yelled “You’re a criminal. ... God knows markets are efficient.”
Slaves of some defunct economist
To be honest I would not really care if EMH was just some academic artifact. The real damage unleashed by the EMH stems from the fact that as Keynes long ago noted “practical men ... are usually the slaves of some defunct economist.”
So let us turn to the investment legacy that the EMH has burdened us with: first off is the Capital Asset Pricing Model (CAPM). I have criticized the CAPM elsewhere (see Chapter 35 of Behavioural Investing), so I will not dwell on the flaws here, but suffice it to say that my view remains that CAPM is CRAP (Completely Redundant Asset Pricing).
The separation of alpha and beta is at best an irrelevance and at worst a serious distraction from the true nature of investment.
The aspects of CAPM that we do need to address here briefly are the ones that hinder the investment process. One of the most pronounced of which is the obsession with performance measurement. The separation of alpha and beta is at best an irrelevance and at worst a serious distraction from the true nature of investment. Sir John Templeton said it best when he observed that “the aim of investment is maximum real returns after tax.” Yet instead of focusing on this target, we have spawned one industry that does nothing other than pigeonhole investors into categories.
As the late, great Bob Kirby opined, “Performance measurement is one of those basically good ideas that somehow got totally out of control. In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to serve.”
The obsession with benchmarking also gives rise to one of the biggest sources of bias in our industry – career risk. For a benchmarked investor, risk is measured as tracking error. This gives rise to Homo Ovinus – a species who are concerned purely with where they stand relative to the rest of the crowd. (For those who are not up in time to listen to Farming Today, Ovine is the proper name for sheep). This species is the living embodiment of Keynes’s edict that “it is better for reputation to fail conventionally than to succeed unconventionally.” More on this poor creature a little later.
Only in an efficient market is a market cap-weighted index the “best” index.
Whilst on the subject of benchmarking, we cannot leave without observing that EMH and CAPM also give rise to market indexing. Only in an efficient market is a market cap-weighted index the “best” index. If markets are not efficient then cap weighting leads us to overweight the most expensive stocks and underweight the cheapest stocks!
Before we leave risk behind, we should also note the way in which fans of EMH protect themselves against evidence that anomalies such as value and momentum exist. In a wonderfully tautological move, they argue that only risk factors can generate returns in an efficient market, so these factors must clearly be risk factors!
Those of us working in the behavioural camp argue that behavioural and institutional biases are the root causes of the outperformance of the various anomalies. I have even written papers showing that value is not riskier than growth on any definition that the EMH fans might choose to use (see Mind Matters, 21 April 2008 for details).
For instance, if we take the simplest definition of risk used by the EMH fans (the standard deviation of returns), then the chart below shows an immediate issue for EMH. The return on value stocks is higher than the return on growth stocks, but the so-called “risk” of value stocks is lower than the risk of growth stocks – in complete contradiction to the EMH viewpoint.
This overt focus on risk has again given rise to what is in my view yet another largely redundant industry – risk management. The tools and techniques are deeply flawed. The use of measures such as VaR [Value at Risk] gives rise to the illusion of safety. All too often they use trailing inputs calculated over short periods of time, and forget that their model inputs are effectively endogenous. The “risk” inputs such as correlation and volatility are a function of a market which functions more like poker than roulette (i.e., the behaviour of the other players matters).
Risk should not be defined as standard deviation (or volatility). I have never met a long-only investor who gives a damn about upside volatility. Risk is an altogether more complex topic – I have argued that a trinity of risk sums up the aspects that investors should be looking at. Valuation risk, business or earnings risk, and balance sheet risk.
Of course, under CAPM the proper measure of risk is beta. However, as Ben Graham pointed out, beta measures price variability, not risk. Beta is probably most often used by analysts in their calculations of the cost of capital, and indeed by CFOs in similar calculations. However, even here beta is unhelpful. Far from the theoretical upward sloping relationship between risk and return, the evidence (including that collected by Fama and French) shows no relationship, and even arguably an inverse one from the model prediction.
This, of course, ignores the difficulties and vagaries of actually calculating beta. Do you use, daily, weekly or monthly data, over what time period? The answers to these questions are non-trivial in their impact upon the analysts calculations. In a very recent paper, Fernandez and Bermejo showed that the best approach might simply to assume that beta equals 1.0 for all stocks. (Another reminder that there are no points for elegance in this world!)
The EMH has also given us the Modigliani and Miller propositions on dividend irrelevance, and capital structure irrelevance. These concepts have both been used by unscrupulous practitioners to further their own causes. For instance, those in favor of repurchases over dividends, or even those in favor of retained earnings over distributed earnings, have effectively relied upon the M&M propositions to argue that shareholders should be indifferent to the way in which they receive their return (ignoring the inconvenient evidence that firms tend to piss away their retained earnings, and that repurchases are far more transitory in nature than dividends).
Similarly, the M&M capital structure irrelevance proposition has encouraged corporate financiers and corporates themselves to gear up on debt. After all, according to this theory investors should not care whether “investment” is financed by retained earnings, equity issuance or debt issuance.
The EMH also gave rise to another fallacious distraction of our world – shareholder value. Ironically this started out as a movement to stop the focus on short-term earnings. Under EMH, the price of a company is, of course, just the net present value of all future cash flows. So focusing on maximizing the share price was exactly the same thing as maximizing future profitability. Unfortunately in a myopic world this all breaks down, and we end up with a quest to maximize short-term earnings!
But perhaps the most insidious aspect of the EMH is the way in which it has influenced the behaviour of active managers in their pursuit of adding value. This might sound odd, but bear with me while I try to explain what might upon cursory inspection sound like an oxymoron.
All but the most diehard of EMH fans admit that there is a role for active management. After all, who else would keep the market efficient – a point first made by Grossman and Stigliz in their classic paper, “The impossibility of the informational efficient market.” The extreme diehards probably would not even tolerate this, but their arguments do not withstand the reductio ad absurdum that if the market were efficient, prices would of course be correct, and thus volumes should be equal to zero.
The EMH is pretty clear that active managers can add value via one of two routes. First there is inside information – which we will ignore today because it is generally illegal in most markets. Second, they could outperform if they could see the future more accurately than everyone else.
The EMH also teaches us that opportunities will be fleeting as someone will surely try to arbitrage them away. This, of course, is akin to the age old joke about the economist and his friend walking along the street. The friend points out a $100 bill lying on the pavement. The economist says, “It isn’t really there because if it were someone would have already picked it up.”
EMH urges investors to try and forecast the future. In my opinion this is one of the biggest wastes of time, yet one that is nearly universal in our industry.
Sadly these simple edicts are no joking matter as they are probably the most damaging aspects of the EMH legacy. Thus the EMH urges investors to try and forecast the future. In my opinion this is one of the biggest wastes of time, yet one that is nearly universal in our industry. Pretty much 80-90% of the investment processes that I come across revolve around forecasting. Yet there is not a scrap of evidence to suggest that we can actually see the future at all. [See here, here and here.]
The EMH’s insistence on the fleeting nature of opportunities combined with the career risk that bedevils Homo Ovinus has led to an overt focus on the short-term. This is typified by the chart below which shows the average holding period for a stock on the New York Stock Exchange. It is now just six months!
The undue focus upon benchmark and relative performance also leads Homo Ovinus to engage in Keynes’s beauty contest. As Keynes wrote:
“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the price being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
This game can be easily replicated by asking people to pick a number between 0 and 100, and telling them the winner will be the person who picks the number closest to 2/3 the average number picked. The chart below shows the results from the largest incidence of the game that I have played – in fact the 3rd largest game ever played, and the only one played purely among professional investors.
The highest possible correct answer is 67. To go for 67 you have to believe that every other muppet in the known universe has just gone for 100. The fact we got a whole raft of responses above 67 is more than slightly alarming.
You can see spikes which represent various levels of thinking. The spike at 50 reflects what we (somewhat rudely) call level zero thinkers. They are the investment equivalent of Homer Simpson, 0, 100, duh 50! Not a vast amount of cognitive effort expended here!
There is a spike at 33 – of those who expect everyone else in the world to be Homer. There is a spike at 22, again those who obviously think everyone else is at 33. As you can see there is also a spike at zero. Here we find all the economists, game theorists and mathematicians of the world. They are the only people trained to solve these problems backwards. And indeed the only stable Nash equilibrium is zero (2/3 of zero is still zero). However, it is only the “correct” answer when everyone chooses zero.
The final noticeable spike is at one. These are economists who have (mistakenly ...) been invited to one dinner party (economists only ever get invited to one dinner party). They have gone out into the world and realized the rest of the world does not think like them. So they try to estimate the scale of irrationality. However, they end up suffering the curse of knowledge (once you know the true answer, you tend to anchor to it). In this game, which is fairly typical, the average number picked was 26, giving a 2/3 average of 17. Just three people out of more than 1000 picked the number 17.
I play this game to try to illustrate just how hard it is to be just one step ahead of everyone else – to get in before everyone else, and get out before everyone else. Yet despite this fact, it seems to be that this is exactly what a large number of investors spend their time doing.
Prima facie case against EMH – Forever blowing bubbles
Let me now turn to the prima facie case against the EMH. Oddly enough it is one that does not attract much attention in academia. As Larry Summers pointed out in his wonderful parody of financial economics, “Traditional finance is more concerned with checking that two 8oz bottles of ketchup is close to the price of one 16oz bottle, than in understanding the price of the 16oz bottle.”
The first stock exchange was founded in 1602. The first equity bubble occurred just 118 years later – the South Sea bubble. Since then we have encountered bubbles with an alarming regularity. My friends at GMO define a bubble as a (real) price movement that is at least two standard deviations from trend. Now a two standard deviation event should occur roughly every 44 years. Yet since 1925, GMO have found a staggering 30 plus bubbles. That is equivalent to slightly more than one every three years!
Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate.
In my own work I have examined the patterns that bubbles tend to follow. By looking at some of the major bubbles in history (including the South Sea Bubble, the railroad bubble of the 1840s, the Japanese bubble of the late 1980s, and the NASDAQ bubble*), I have been able to extract the following underlying pattern. Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate. This bursting is generally slightly more rapidly than the inflation, taking around two years.
* Two economists have written a paper arguing that the NASDAQ bubble might not have been a bubble after all – only an academic with no experience of the real world could ever posit such a thing.
To my mind the clear existence and ex ante diagnosis of bubbles represent by far and away the most compelling evidence of the gross inefficiency of markets.
While the details and technicalities of each episode are different, the underlying dynamics follow a very similar pattern. As Mark Twain put it “History doesn’t repeat but it does rhyme.” Indeed, the first well-documented analysis of the underlying patterns of bubbles that I can find is a paper by J.S. Mills in 1867. He lays out a framework that is very close to the Minsky/Kindleberger model that I have used for years to understand the inflation and deflation of bubbles. This makes it hard to understand why so many among the learned classes seem to believe that you cannot identify a bubble before it bursts. To my mind the clear existence and ex ante diagnosis of bubbles represent by far and away the most compelling evidence of the gross inefficiency of markets.
The EMH “Nuclear Bomb”
Now as a behaviouralist I am constantly telling people to beware of confirmatory bias – the habit of looking for information that agrees you. So in an effort to avert the accusation that I am guilty of failing to allow for my own biases (something I have done before), I will now turn to the evidence that the EMH fans argue is the strongest defence of their belief – the simple fact that active management does not outperform. Mark Rubinstein describes this as the nuclear bomb of the EMH, and says we behaviouralists have nothing in our arsenal to match it, our evidence of inefficiencies and irrationalities amounts to puny rifles.
However, I will argue that this viewpoint is flawed both theoretically and empirically. The logical error is a simple one. It is to confuse the absence of evidence with evidence of the absence. That is to say, if the EMH leads active investors to focus on the wrong sources of performance (i.e., forecasting), then it is not any wonder that active management will not be able to outperform.
Empirically, the “nuclear bomb” is also suspect. Today I want to present two pieces of evidence that highlight the suspect nature of the EMH claim. The first is work by Jonathan Lewellen of Dartmouth College.
In a recent paper, Lewellen looked at the aggregate holdings of U.S. institutional investors over the period 1980-2007. He finds that essentially they hold the market portfolio. To some extent this is not a surprise, as the share of institutional ownership has risen steadily over time from around 30% in 1980 to almost 70% at the end of 2007. This confirms the zero sum game aspect of active management (or negative sum, after costs) and also the validity of Keynes’s observation that it [the market] is professional investors trying to outsmart each other.
However, Lewellen also shows that, in aggregate, institutions do not try to outperform! He sorts stocks into quintiles based on a variety of characteristics and then compares the fraction of the institutional portfolio invested in each (relative to institutions’ investment in all five quintiles) with the quintile’s weight in the market portfolio (the quintile’s market cap relative to the market cap of all five quintiles) – i.e., he measures the weight institutional investors place on a characteristic relative to the weight the market places on each trait.
The chart below shows the results for a sample of the characteristics that Lewellen used. With the exception of size, the aggregate institutional portfolio barely deviates from the market weights. So institutions are not even really trying to tilt their portfolios towards the factors we know generate outperformance over the long term.
“Quite simply, institutions overall seem to do little more than hold the market portfolio, at least from the standpoint of their pre-cost and pre-fee returns. Their aggregate portfolio almost perfectly mimics the value-weighted index, with a market beta of 1.01 and an economically small, precisely estimated CAPM alpha of 0.08% quarterly. Institutions overall take essentially no bet on any of the most important stock characteristics known to predict returns, like book-to-market, momentum, or accruals. The implication is that to the extent that institutions deviate from the market portfolio, they seem to bet primarily on idiosyncratic returns – bets that are not particularly successful. Another implication is that institutions, in aggregate, do not exploit anomalies in the way they should if they rationally tried to maximize the (pre-cost) mean variance trade-off of their portfolios, either relative or absolute.”
Put into our terms, institutions are more worried about career risk (losing your job) or business risk (losing funds under management) than they are about doing the right thing!
The second piece of evidence I would like to bring to your addition is a paper by Randy Cohen, Christopher Polk and Bernhard Silli. They examined the “best ideas” of U.S. fund managers over the period 1991-2005. “Best ideas” are measured as the biggest difference between the managers’ holdings and the weights in the index.
The performance of these best ideas is impressive. Focusing on the top 25% of best ideas across the universe of active managers, Cohen et al find that the average return is over 19% per annum against a market return of 12% p.a. That is to say, the stocks in which the managers display most confidence did outperform the market by a significant degree.
The corollary to this is that the other stocks they hold are dragging down their performance. Hence it appears that the focus on relative performance – and the fear of underperformance against an arbitrary benchmark – is a key source of underperformance.
At an anecdotal level I have never quite recovered from discovering that a value manager at a large fund was made to operate with a “completion portfolio.” This was a euphemism for an add-on to the manager’s selected holdings that essentially made his fund behave much more like the index!
“The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over-diversify.”
As Cohen et al conclude “The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over-diversify.” Thus as Sir John Templeton said, “It is impossible to produce a superior performance unless you do something different from the majority.”
The bottom line is that the EMH nuclear bomb is more of a party popper than a weapon of mass destruction. The EMH would have driven Sherlock Holmes to despair. As Holmes opined “It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.”
The EMH, as Shiller puts it, is “one of the most remarkable errors in the history of economic thought.” EMH should be consigned to the dustbin of history. We need to stop teaching it, and brain washing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed in it. ... Only two hands remained up!
A similar sentiment seems to have been expressed by the recent CFA UK survey which revealed that 67% of respondents thought that the market failed to behave rationally. When a journalist asked me what I thought of this, I simply said “About bloody time.” However, 76% said that behavioural finance was not yet sufficiently robust to replace modern portfolio theory (MPT) as the basis of investment thought. This is, of course, utter nonsense. Successful investors existed long before EMH and MPT. Indeed, the vast majority of successful long-term investors are value investors who reject pretty much all the precepts of EMH and MPT.
Will we ever be successful at finally killing off the EMH? I am a pessimist. As Jeremy Grantham said when asked what investors would learn from this crisis: “In the short term, a lot. In the medium term, a little. In the long term, nothing at all. That is the historical precedent.” Or as JK Galbraith put it, markets are characterized by “Extreme brevity of financial memory. ... There can be few fields of human endeavour in which history counts for so little as in the world of finance.”
FIAT MONEY IN DEATH THROES
Make no mistake about it: In this credit collapse we are witnessing the death throes of irredeemable currency.
Antal Fekete is an original thinker, no doubt about it. We have featured his work once before – his article “Can we Have Inflation and Deflation All at the Same Time?” Obviously this debate has yet to be resolved. Mr. Fekete’s then suggested outcome was touched upon in last week’s Finance Digest posting “Inflation No Threat in a Collapsing Economy.”
In his paper “The Revisionist Theory and History of Depressions,” available from his website, Prof. Fekete presents an interesting and credible alternative to the Austrian economists’ theory of what happens during a central bank instigated credit boom, even as he claims an affinity to that school’s thought.
The Austrians posit that the artificially low interest rates cause “malinvestment– in “higher level” goods – capital goods. Entrepreneurs use an artificially low discount rate in determining whether the return on their investments generate a positive discounted present value. This seems to fit with what we observe, that investments made after a boom has been underway a while usually turn out to be poor ones.
But Prof. Fekete wonders whether entrepreneurs truly keep making the same mistakes again and again. It is not as if artificial booms financed by central bank funny-money are a new or infrequent phenomenon. His alternative theory is that by artificially driving down interest rates across the whole yield curve, capital is actually economically destroyed. For instance, the present value of the required investment to replace the used up capital good at the end of its useful life is raised due to the lower interest rate. Thus depreciation rates based on historic cost or higher interest rates will be too low and capital will be consumed. We are not convinced – interested readers should check the source paper – but we trust people will glean that Mr. Fekete has some original ideas.
In a less academic piece, Fekete expresses the concept thusly: “A falling interest-rate structure is lethal. It is an insidious destroyer of capital. It means that wealth is stealthily siphoned away from the capital accounts of the producers, in order to enrich the latter-day pirates, the bond speculators who make obscene profits in the falling interest-rate environment.”
As can be seen, Mr. Fekete is one heck of a polemicist. Below he heaps measure upon measure of scorn on the arrogant central bankers and politicians who supposed that they could actually “create wealth by sprinkling some ink on little scraps of paper.” The alchemists’ time is now up, says Prof. Fekete, and the fiat currency experiment will soon be buried on the ash heap of history. Wouldst that it depart in shame and stealth rather than with all guns blazing. No such luck.
Fiat money is not just anti-reality and theft. The gold standard (Fekete’s alternative to fiat money – he does not dwell on other non-fiat money systems) is an indispensable prerequisite of freedom: “The right to demand gold in exchange for bank notes and bank deposits far transcends the mere technicality of exchange of one form of money for another. It is the only way to check the unlimited power of the government manifested by the unlimited creation of bank deposits.” And so on. The challenge is extracting ourselves from the ruinous fiat regime.
Unfortunately Mr. Fekete’s prognostication here is not optimistic: “[T]here is no hope for change through peaceful means. When change finally does come, it will be through violence. When the economic pain inflicted on the people reaches unbearable heights, law and order will break down, anarchy and chaos will ensue.”
“Banking was conceived in iniquity and born in sin. The Bankers own the earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen they will create enough deposits to buy it back again. However, take away that power, and all the great fortunes like mine will disappear – as they ought to in order to make this a happier and better world to live in. But, if you wish to remain the slaves of Bankers and pay the cost of your own slavery, then let them continue to create deposits.” ~~ Sir Josiah Stamp (1880-1941), one time governor of the Bank of England, in his Commencement Address at the University of Texas in 1927. Reportedly he was the 2nd wealthiest individual in Britain.
Make no mistake about it: In this credit collapse we are witnessing the death throes of irredeemable currency. In vain have governments and their client banks tried, for hundreds of years, to graft this repulsive and degenerate bastard on the living organism of society. The result was always the same: The healthy organism rejected the unnatural implant in its own good time. The present episode is no different from earlier ones except, perhaps, in the degree of the conceitedness of the perpetrators, and in their contempt for the native intelligence of man.
When on August 15, 1971, Richard Nixon defaulted on the gold obligations of the United States and declared the irredeemable dollar the “ultimate” means of payments and liquidator of debt, he was relying on the expert advice of Chicago economist Milton Friedman. Five years later the world’s oldest central bank, the Swedish Riksbank would bestow upon Friedman the prize it established in memory of Alfred Nobel. The reward would be in recognition of the brilliance of Friedman’s idea that if a central bank robs the people piecemeal (read: it dilutes the currency at a fixed rate of, say, 3% per annum) then the victims would not cry “we wuz robbed!” They would never notice the robbery.
In all previous episodes, shame and disgrace were part and parcel of the government’s default on its promises to pay. Not so in 1971. In this latest experiment with irredeemable currency there was a new feature: Far from being a disgrace, the default was presented as a scientific breakthrough; conquering “monetary superstition” epitomized by gold; a triumph of progress. Sycophant governments and central banks overseas that were victimized by it and had to swallow unprecedented losses due to the devaluation of the dollar were not even allowed to say “ouch!” They were forced to celebrate their own undoing and hail the advent of the New Age of synthetic credit, irredeemable currencies and irredeemable debts.
The regime of the irredeemable dollar was put to the test soon enough. In 1979 the genie escaped from the bottle. The price of oil, silver, and gold were quoted at 20 times that prior to 1971. In the case of sugar the rate of increase was more like 40 times, so much so that the Coca Cola Company found it too expensive to put into coke and started using corn syrup instead. Interest rates were quoted in double digits well past the teens. There was panic across the land and around the globe. Hoarding of goods became a way of life. Everybody was expecting the worst.
It was at this time that the notion of “targeting inflation” was invented. Previously the claims of central bank power were rather modest. Central banks were supposed to target short-term interest rates. Later they graduated to targeting the money supply. Now they were claiming supernatural powers of micromanaging price increases. It was apparently working, and the genie was put back in the bottle.
In the intervening three decades policymakers and mainstream economists became ever more confident that in inflation-targeting they have found the holy grail of irredeemable currency. Professor Frederic Mishkin of Columbia University, a former governor of the Federal Reserve, published the gospel of inflation targeting with the title Monetary Policy Strategy in 2007. In his book he calls inflation targeting “an information-inclusive strategy for the conduct of monetary policy.” Martin Wolf, the chief economic columnist of the Financial Times of London explains: inflation targeting makes allowance for all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation. This, then, is the new modified holy grail. Cast your net wide enough to catch all that you want to control. If you do it boldly, you will make people believe that the government can control everything it wants to control. It is amazing how much can be accomplished by piling prestidigitation upon prestidigitation.
Ironically, disaster struck just at the time when the prophets of inflation-targeting became cocky beyond any measure of modesty.
Ironically, disaster struck just at the time when the prophets of inflation-targeting became cocky beyond any measure of modesty. They actually had a whole debate going on in American journals, but also English ones. Ben Bernanke, who in the meantime was made the chairman of the Federal Reserve, contributed the keynote address and the title to the debate: “The Great Moderation”. Their description, up to and including the beginning of 2007 of what was happening in the macro economy, was a reduction in the volatility in the trade cycle: more consistent growth, less bouts of inflation, more stability. The London Times published a jubilant piece as recently as early 2007 with the title “The Great Moderation” which began with the line: “History will marvel at the stability of our era.” It was not meant to be a joke. It was meant to be believed. Complacency about the almighty nature of monetary policy reached its peak. They celebrated the success of inflation targeting just when it started to unravel. Policymakers, central bankers, and their lackeys in academia and journalism, felt inordinately proud of themselves. They thought they held the whole world in their hands.
The celebration and self-congratulation was premature. Bernanke & Co. did not know that they were about to be humbled by the markets. Blinded by the glare of their own glory, none of them foresaw the coming disaster.
Martin Wolf in his column on May 7 talks about “this unforeseen crisis” as an unmitigated disaster for monetary policy. It leaves fiat money with just one last chance to put its act together and save its hide. He says: “The holy grail turned out to be a mirage. If fiat money is not made to work better than it has, who knows what our children might decide to do in desperation. They might even decide to bring back and embrace gold.” Oh horror of horrors! Wolf still considers the gold standard an absurdity.
It is kind of strange. It is not the regime of irredeemable currency, whereby governments are supposed to create wealth by sprinkling some ink on little scraps of paper, that is considered an absurdity.
It is kind of strange. It is not the regime of irredeemable currency, whereby governments are supposed to create wealth by sprinkling some ink on little scraps of paper, that is considered an absurdity. Of course, Mr. Wolf has the right of wanting to be pilfered and plundered. But he has no right to advocate that the rest of us be cheated through this crudest form of plunder forever and ever.
He is also mistaken when he assumes that Bernanke & Co. still has one more chance. The chance they just blew was the last. We are witnessing the closing of the regime of irredeemable currency and irredeemable debt. We may not know how long its death throes will take, but there will be no other chance. Financial journalists and mainstream economists, in their blind stupor acting as cheerleaders for the disastrous monetary policy of the government and the insane credit policy of the banks, have exhausted and destroyed their own credibility for once and all.
Martin Wolf, like most of his colleagues, is a victim of brainwashing inspired by Keynes that has been going on to discredit the gold standard for some 75 years, but which got a new lift after Friedman inspired Nixon to default. Here are the facts about the gold dollar that should be made available to the world through the opening of the Mint to gold, as demanded by the U.S. Constitution. [The what??]
The government exempts banks from the effects of contract law in exchange for the banks’ special treatment accorded to government debt.
The gold standard is an indispensable prerequisite of freedom. Without it individuals are helpless in facing the constant and ongoing encroachment of their property rights by the government and the banks. The right to demand gold in exchange for bank notes and bank deposits far transcends the mere technicality of exchange of one form of money for another. It is the only way to check the unlimited power of the government manifested by the unlimited creation of bank deposits. The combination of governmental power and the power of the banks to create deposits is especially dangerous for the freedom of the individual, because of the double standard involved. The government exempts banks from the effects of contract law in exchange for the banks’ special treatment accorded to government debt.
Gold hoarding is not a blemish on the gold standard; it is its main excellence. When a sufficient number of individuals are disturbed by the encroachment of this combination of powers, or disapprove the monetary policy of the government and the credit policy of the banks, they are not helpless under a gold standard. They can withdraw bank reserves, namely gold, from the system, thereby putting the government and the banks on notice that unless they mend their ways, and stop their adventures in debt creation, they will find themselves insolvent and out of power. The gold standard gives people the upper hand.
All totalitarian regimes inflict irredeemable currency on the people as an instrument of servitude and bondage. The ideal of limited government is meaningless unless reinforced by a gold standard denying to the government the power of issuing unlimited amounts of currency.
It is no accident that all dictatorships set out by limiting the people’s access to gold. It makes no difference whether they march under the banner of national or international socialism. All totalitarian regimes inflict irredeemable currency on the people as an instrument of servitude and bondage. Martin Wolf should know this. The ideal of limited government is meaningless unless reinforced by a gold standard denying to the government the power of issuing unlimited amounts of currency. There is no other way of doing this than making the promises of the government redeemable in something other than more promises of the same shabby kind.
Once the government makes the currency irredeemable, it puts itself in the position to curtail the rights and freedoms of the people as it sees fit. Constitutional government is effectively overthrown. Once the government usurps the public purse, its power becomes uncontrollable. Budget debate in Parliament or in Congress becomes an annual farce. Nothing stands in the way of unscrupulous politicians to undermine constitutional government. The purchasing power of the currency is constantly undermined year in, year out. The banks are freed from constraints on them exercised by the people under the gold standard. Pandora’s box of corruption is opened and its contents contaminate the nation’s economic, political, and social system.
Governments which employ irredeemable currency grab unconditional control over foreign trade, exchange rates, foreign investments and travel, even the amount of currency an individual can take in or out of the country.
Governments which employ irredeemable currency grab unconditional control over foreign trade, exchange rates, foreign investments and travel, even the amount of currency an individual can take in or out of the country. The more powerful governments will buy the allegiance of the less powerful. Out of this feudalistic web of allegiances financed by irredeemable currency come various adventures in fomenting and waging wars in far-away lands, spilling the blood of the young people of the nation for causes alien to them.
Under a gold standard prolonged budget deficits and prolonged unfavorable balance of payments cannot occur. There are forces limiting persistent losses of gold which tend to correct the underlying distortion. By contrast, under the regime of irredeemable currency economic distortions can persist indefinitely. They ultimately become destructive. This is so because government bureaucrats cannot possibly provide the same level of wisdom that a people free to act in their own interest can.
As problems in foreign trade mount, governments will find ever more excuses for ever more controls. There is no end to the expansion of government power over the individual until the nation regains the benefits of a gold standard, requiring that the government retire to its proper role of umpire and relinquish its role as dominant partner and dictator.
Irredeemable currency must be seen as the habit-forming drug that the government uses to intoxicate people. Under this intoxication people will want more and more national spending, more and more government control, and more and more debt. This intoxication obscures the sad end that arrives when the merry-go-round is coming to a jerky halt.
A government can take total control of the people either by the use of military force, or by the use of irredeemable currency. The former is readily understood, while the latter is a subtle national drug that is not generally recognized as such. Rather, it is readily embraced by its victims. For these and similar reasons irredeemable currency is the favorite device of modern governments that want to bring people under total control. Indeed, it enables the government to succeed in controlling the masses while, at the same time, earning their approval and even their enthusiastic support. Irredeemable currency must be seen as the habit-forming drug that the government uses to intoxicate people. Under this intoxication people will want more and more national spending, more and more government control, and more and more debt.
This intoxication obscures the sad end that arrives when the merry-go-round is coming to a jerky halt, when credit is exhausted or withdrawn, and the kitty is found empty. The nation is facing a most serious economic disaster followed by prolonged economic pain. Unfortunately, government economists, university professors, and financial journalists have taken their share of the fun and they failed miserably in their duty to forewarn people of the coming disaster.
It is useless to expect a mass movement on behalf of a sound currency. The daily experiences of people provide them with a warped outlook. They confirm in their minds the alleged virtues and benefits of an infinitely inflatable currency. People lack sufficient understanding of monetary science to see that no currency can be made infinitely inflatable without inviting disaster. Like a drug addict, people exposed to irredeemable currency do not regard it as a dangerous and undermining narcotic agent. Even the loss of purchasing power does not disturb them to any great extent. Their response is to demand more money, and they take pride in the fact that the government listens sympathetically to their demand. They welcome the soaring stock indexes and real estate prices, and put great stores on them. Heavy taxes and burgeoning debt are not regarded with anxiety. A frequent and common agitation is for ever more government spending.
If we are to be saved from the ultimate evil consequences of the regime of irredeemable currency, needed action must come from the leadership of the opposition party when it is its turn to take over government. The new President and his Secretary of the Treasury, or the new Prime Minister and his Secretary of the Exchequer must be statesmen. They must act as informed and tough monetary surgeons, men who can and will persuade Congress or Parliament to reinstate redeemable currency.
Once that step is taken, the people should experience a breath of fresh air. Government would once more be subordinated to the Constitution, bringing greater freedom to the people. Optimism should be wide-spread, because the currency of the people would once more had integrity. Business should prosper, domestic and foreign trade expand. Imbalances in foreign trade should rectify themselves. Gold should start to circulate and flow in from abroad. The control of the public purse would be returned to the people where it belongs if human freedom is to be preserved and responsible government is to be obtained.
As the last U.S. presidential election showed, the needed leadership is lacking. The party of the opposition is just as much in thrall to the same toxic ideology as the governing party. The new president appointed officials at the Treasury, confirmed others at the Federal Reserve, and named economic advisors who turned out to be the same men who were responsible for the credit collapse in the first place.
But as the last presidential election in the United States has shown, the needed leadership is lacking. The party of the opposition is just as much in thrall to the same toxic ideology as the governing party. The last change of guards took place in the middle of a financial and economic crisis involving the destruction of quantities of wealth unprecedented in all history, with more destruction coming. Yet when the new president appointed officials at the Treasury, confirmed others at the Federal Reserve, and named economic advisors, they turned out to be the same men who were responsible for the credit collapse in the first place. Not only do these officials continue the dangerous course of the previous administration; they increase the stakes by several orders of magnitude in announcing more bailouts, more stimulus packages, hence more government spending, more government debt, and more fiat money creation.
The situation is no better in the United Kingdom, another important country expecting a change of guards, which could take the initiative to put a peaceful end to the regime of irredeemable currency now in its death throes. Rather than initiating a national debate on the utter failure of the present financial system which was supposed to end bank runs, deflations and depressions, serial bankruptcies and unemployment for once and all, and on the return to sound money and sound book-keeping, Her Majesty’s Loyal Opposition is plotting a course how to cure the collapse of bad debt with the injection of more bad debt.
What this means is that there is no hope for change through peaceful means. When change finally does come, it will be through violence. When the economic pain inflicted on the people reaches unbearable heights, law and order will break down, anarchy and chaos will ensue.
Looking at the ruins of our civilization will be a bitter reminder of what the great monetary tradition of the English-speaking countries, in ruling out irredeemable currency and mandating a metallic monetary standard, was designed to prevent.
EVERYONE IS WRONG, AGAIN – 1981 IN REVERSE, PART I: THE GREAT DIVIDE
This posting from iTulip.com president Eric Janszen appeared at the end of April. He posits we are in a mirror image of late 1981. Then no one believed inflation would ever end; today people are acting as if deflation will continue indefinitely. He thinks “everyone” is wrong today, as they were in 1981.
Chalk up a vote for the inflationist camp.
It is October 1981, the year IBM launched personal computer, air traffic controllers went on strike and were fired by President Reagan, and Israeli jets destroyed a nuclear plant in Iraq. The annual inflation rate in September was over 12%, a 30 year Treasury bond carried a constant maturity rate of 14.68%, and the Effective Fed Funds Rate hit 15.5% as the Paul Volcker Fed stood on the brake pedal, determined to crash the economy to cut off multiple simultaneous inflation channels – energy cost-push, supply shock, and the reckless monetary policy of the previous administration.
Thing is, no one believed it.
A risk-free government bond promised 14.68% interest for 30 years but no one wanted them. Gold traded between $432 and $453, or $1011 and $1063 in 2009 dollars, well below a peak of $850 – nearly $2000 2009 dollars – on January 21, 1980.
With perfect 20/20 hindsight we ask, what was going on the heads of investors then? That 30 year bond produced stellar after-inflation returns for decades, and on a risk-adjusted basis was the best investment of a generation.
No one wanted it.
Why did investors collectively not see that the inflation rate was destined to fall? Few believed that the U.S. government was serious about putting the economy through two massive recessions, earning the certain wrath of voters, in order to wring inflation expectations out of the economy. Fixed income investment professionals did not believe it, stock market investors did not believe it, and certainly the gold bugs did not believe it. Some held on for 20 years as gold went down, down, down.
Just about everyone expected the politicians to chicken out and let inflation go on forever.
The majority were wrong.
Today, the situation is a near perfect reverse of the situation investors faced in 1981. The annual inflation rate in March was a deflationary -1.7%, a 30-year Treasury bond carries a rate of 3.64%, the Effective Fed Funds Rate is close to 0%. Today just as few investors believe that central banks and governments are serious about, and capable of, halting deflation as expected the exact opposite of the same institutions 28 years ago – not this year, nor next year, nor in 10 years, or even 20.
The Great Divide
Humans extrapolate the recent past into the infinite future. But the history of transitions from inflation to deflation and back to inflation again is a story of discontinuous asset price responses to fiscal and monetary inputs.
The current deflation period D shares more in common with the early 1920s depression period A than The Great Depression period B and bears no similarity to the disinflation created by the Fed in the early 1980s period C. Neither The Great Depression nor the depression that followed the end of World War I were intended as the 1981 and 1983 recessions were. Note the very quick reversal of deflation in 1921, and also the sharp reversal in 1933 when the U.S. devalued the dollar 69% against gold.
Deflation expectations have over the past two quarters become so deeply embedded in investor’s minds that they now see a deflationary pricing environment persisting for decades, this despite the fact that only a year ago they could not shake the prospect of ever rising inflation, fed as it was by cost-push energy import prices, in turn driven by a weak dollar. Markets also expect central banks, as the economy climbs out of recession, to move quickly to respond to any sign of inflation with rate hikes before inflation price cycles set in.
In other words, the vast majority of investors believe that central banks and governments have so fine tuned fiscal stimulus and monetary policy that the economy can grow out of recession without significant inflation and also that our government is willing to risk sending the economy back into recession in order to halt inflation, if it re-emerges.
We think investors have it wrong again. Big time. We see a collective miscalculation as great as 1981, but in reverse.
We believe the current Fed and administration will embrace a nominal economic recovery, even if real growth is negative, that is, even at the cost of high inflation. ... The benchmark 10 year Treasury bond price is now overtly manipulated by Fed. But commodity markets generaly are not. So while the bond markets are now pricing in a real economic recovery with very slow growth and near zero inflation for the foreseeable future, commodity investors are pricing in negative real growth just ahead. Call it The Great Divide. ...
Our thesis since the middle of last year is that inflation will arise by late 2009 to early 2010 from three channels. One, a reduction in supply of raw, intermediate, and finished goods relative to demand due to the impact of the credit crunch on producers and retailers ... Two, the inevitable impact of excessive money growth with lag effects ... Three, a weakening dollar once global deleveraging ends ...
As the period of rising inflation arrives, the U.S. economy will appear to recover – and will in nominal terms, but not in real terms. The commodity markets are wise to this; unlike the 1981 period, the bond market investors are not. As the 1981 era, the equity markets are confused, not knowing whether to price in inflation or deflation, as the credit crunch reduces supply (inflationary), creates industry consolidation (inflationary), while weak demand weighs on earnings (deflationary). The cross-currents in our view weigh in favor of a general price inflation in coming quarters.
The unanswered question is how long it will take the central banks and governments to break the back of deflation. They are trying as hard as they can.
A subsequent post by Janszen, “Deflation fare thee well – Part I,” follows up on his inflation-will-soon-return theory.
HOW QUICKLY COULD THE DOLLAR COLLAPSE?
The world may be ready and perhaps even resigned to the dollar’s collapse; what few seem to be imagining, however, is how very quickly the collapse could run its course around the world.
Rick Ackerman, Bob Prechtor, Mish Shedlock and others are approximately aligned on a scerario of a deflation lasting long enough to bankrupt all those hoping to be bailed out by inflation, and then – perhaps – a hyperinflation/U.S. dollar collapse. Let us say this comes to pass and you are “prepared.” What could mess up one’s best laid plans?
Here Ackerman explores the idea that the hyperinflation could come on so fast that everyone is effectively blindsided, even those who “saw it coming.” With memories of last fall’s markets crash still fresh, we can well imagine such a scenario. The best strategy is to not try to call market tops and bottoms, and consider that you might be wrong anyway.
We popped up on the “wrong” side of the inflation/deflation argument here the other day with a hyperinflation scenario that seems to us not just possible but likely. Although we hold fast to a prediction that deflation is going to run its course, throwing tens of millions of Americans into bankruptcy, before relief comes to debtors, we are persuaded that at some point well down the road the U.S. will throw the switch to hyperinflate. Even so, we believe that the attendant collapse of the dollar will play out far more quickly than the collapse of the German mark during the Weimar hyperinflation of 1922-23. So swiftly will this occur, in our opinion, that the hyperinflationary spike will begin and end in mere weeks, leaving deflationary to dominate both before (as it continues to do now) and long after.
A contributor to the Rick’s Picks forum, Ed M,, disagreed – mainly, he said, because there is no precedent for so swift a collapse of a sovereign currency. We present his argument below, followed by our response, but also some interesting thoughts of Ed’s concerning barter.
Here is Ed:
“The idea that a hyperinflation would come and go in a few days or weeks has no precedent, and, as such I give it little credence. However, the question for those owning [precious metals] concerning what to ‘transfer’ one’s ‘profits’ into, is very relevant. Furthermore, there is the issue of taxes on what could be, at least nominally, outsized profits. So, while leaving the question of what to buy momentarily behind, let me offer that arranging some sort of barter might be the way forward for [precious-metal] holders.
“Choices of what to purchase will be more or less the same in future as they are today, but in what will likely be a chaotic environment, some items will be, for a variety of reasons, difficult to acquire expeditiously and economically.
“But here are some of the choices that, depending on where one resides, and what connections one has, may be possible. Each choice has obvious advantages and disadvantages having to do with relative liquidity, availability, perceived value, maintenance costs, taxes, ‘fungibility,’ etc.
“I haven’t done much research on this question yet, but I imagine that bartering [precious metals] for raw gemstones might be worthwhile.”
- Raw Land
- Food Stuffs
- Developed Property – commercial and/or residential
- Precious gemstones
- Objets d’art
- ‘Services’ unspecified
- Other commodities
- Heavy equipment
- Businesses unspecified
History Rarely Repeats
When we try to guess how long it will take for the dollar to collapse, why should precedent matter? History almost never repeats itself in a way that can be clearly foreseen and easily predicted. There is always a twist, and in this case the speed of the collapse is exactly what we might expect to undo even those who profess to be “ready”. Bear in mind that the dollar is already a fundamentally valueless IOU, not money, and it is therefore only mere perceptions that need change to make this so in practice. That could happen – globally – in the space of time it takes to air the evening news.
Moreover, it is not the reichsmark or Zimbabwean dollar that we are talking about, but a currency in which nearly everyone on the planet has a crucial stake either directly or indirectly. Under the circumstances, and given the lightning speed at which news travels these days, it is not difficult to imagine how a global run on the dollar might become unstoppable in mere hours.
The world may be ready and perhaps even resigned to the dollar’s collapse; what few seem to be imagining, however, is how very quickly the collapse could run its course around the world – as quickly, even, as a run on a single bank.
WHAT YOU SHOULD KNOW WHEN HIRING A FINANCIAL ADVISOR
Clients and advisors are on the move. If you are hiring or firing a pro, here is what to consider.
Some basic and good advice from Forbes on choosing a professional financial advisor. Everyone is confronted with the basic principal-agent problem here: If you hire an agent, how do you get him/her to act in your best interests? The incentive structure matters. Everyone is aware of the broker who “churns” client accounts to earn trading commissions, contrary to the clients’ interests. But the fee-only compensation scheme can be expensive; and as has been amply observed, once assets are under management the tendency is for advisors to play it conservatively to avoid losing the assets – which means going with the consensus flow. Better to fail conventionally, the thinking goes, than to risk failing unconventionally, even if the later is the truly prudent strategy.
Forbes also suggests agreeing in advance on a target asset allocation and benchmarks for evaluating performance. We suggest thinking this through more deeply than the concept of benchmarking suggests. First of all, the benchmarking discussion in the “Six Impossible Things Before Breakfast” posting above informs us that the standard capitalization-weighted indexes such as the ubiquitous Standard & Poor’s 500 only make sense if the market is efficient – a bad assumption. Outperforming some benchmark is not even a good objective. John Templeton’s criterion quoted above is simple and good: “The aim of investment is maximum real returns after tax.”
More fundamentally still, you should honestly assess your financial needs and your appetite for risk. If leaving everything in short duration bonds supports a nice lifestyle, why speculate in financial assets? “Investing” is not saving. For most people the utility from a financial gain is less than the disutility of an equivalent loss. To use the phrase we have coined: Don’t risk cake for the chance to win some icing.
Finally, as is pointed out, to avoid a Madoff style debacle make sure your money is handled through a custodial or brokerage account in your name at a separate firm if you hire a small firm or follow your former big-firm advisor going out on his or her own.
Luanne Roth of Cary, North Carolina, bought $400,000 of a complex, Wachovia-underwritten Allstate bond that lost 75% of its value. She says her Wachovia broker billed it as almost as safe as cash, and while she does not blame him personally, she has filed an arbitration claim against the bank. As a former tech company finance chief, Roth, 55, could handle her own investments. But she spends her time doing volunteer work and says of investing: “I don’t want that to dominate my life.” So she has hired a new pro, a neighbor who recommends mostly low-cost index funds, charges her a fee and takes no commissions from product sellers. “I know where he lives,” she jokes.
The market for financial advice is in turmoil. Unhappy clients are dumping and suing their pros; brokers and advisors are switching firms in large numbers (in the first six months of the year 11% of those working at Wall Street firms left, according to Discovery Database); and Washington is considering new rules that could bar advisors from selling their own firms’ products, as Roth says her broker did. (Wachovia, now part of Wells Fargo, declines comment.)
If you are looking to hire or fire an advisor, or trying to decide whether to follow your pro to a new firm, here are some pointers.
Consider doing it yourself.
The Internet and new products make it easier than ever to be your own money manager, but it takes some time and (with today’s market volatility) confidence. You can build a diversified portfolio using low-cost mutual funds and ETFs and then track and adjust your asset allocations using online services such as Financialengines.com. Or you might get help from your fund company. Fidelity Investments emphasizes its online asset allocation and planning tools. Both Vanguard Group and T. Rowe Price offer free advice from human planners if you bring in $100,000 in new funds or have $500,000 invested.
Benchmark your pro.
If you hire an advisor, agree in advance on not only a target asset allocation but also benchmarks for evaluating performance. For example, your small-company stocks might be measured against the Russell 2000. What if you have not set benchmarks but want a quick read on how your advisor has been doing? Norman Pappous, a laid-off Merrill Lynch financial advisor, offers EvaluateMyAdvisor.com. Provide three years of back statements, and for $500 he will choose benchmarks and evaluate your returns. In half the assessments done so far, he says, a client could have equaled (or beaten) the advisor’s performance with a low-cost mix of exchange-traded funds.
Decide how you want to pay.
Pay commissions and you might give the broker an incentive to steer you to expensive or dubious products. That fact is a marketing point for investment advisors who charge fees only, calculated by the hour or as a percentage of assets under management. “Most of what the Wall Street firms have is proprietary stuff, so you already know there are higher expense ratios built in there,” says Mary Malgoire, a fee-only advisor in Bethesda, Maryland. While they typically use low-cost mutual funds, fee-only advisors themselves do not come cheap. Malgoire’s firm charges 1% a year of all investment assets up to $1 million, 0.8% of the next $3 million and 0.35% on the rest.
Traditional Wall Street firms like Bank of America’s Merrill Lynch or Morgan Stanley Smith Barney will also happily charge you a percentage of assets – as much as 3% for “wrap accounts” that usually include trading costs. “This is a terrible deal for investors,” insists Edward Siedle, a financial fraud investigator from Ocean Ridge, Florida. That is true for those who trade infrequently, or have small accounts charged the highest percentage fee, but not always for wealthier clients. For example, clients with more than $2 million invested can get fees below 1% of assets from Morgan Stanley.
If you want access to the products of a big firm (e.g., initial public offerings, trust services and securities denominated in a foreign currency), appreciate stock picking ideas and have the confidence to say no, then using a traditional broker who works on commission can also make sense.
Watch who has your money.
If you hire a small firm – or follow your big-firm advisor going out on his own – make sure your money is handled through a custodial or brokerage account in your name at a separate firm. This will not save you from bad advice, but it does provide protection from old-fashioned embezzlement or a Madoff-style scam. Many small advisory firms use Charles Schwab & Co., TD Ameritrade or Fidelity Investments as custodians. Average investors should be wary of any mingling of separate clients’ funds – except in an SEC-registered mutual fund.
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