Back in April, my good friend Charles Gave, Chairman of Gavekal, penned a short but brilliant piece in which he likened central bankers to a bunch of monkeys in a cage. In the unforgettable “Of Central Bankers, Monkeys and John Law,” he proceeded to run down the parallels between France’s 18th-century “Mississippi Bubble” and the situation in the Eurozone today.
Now Charles has given us a follow-up, titled “The Apex of Market Stupidity,” in which he regales us with a sardonic but spot-on recap of the sundry ways in which market participants and analysts have been witless over the years. And just last week, he says, we scrambled, clawed, and algoed our way to the very summit of market stupidity, when European markets were routed by the failure of ECB Chairman Mario Draghi to be sufficiently dovish.
Thus, Charles concludes, we now find ourselves in a world where “value in the financial markets is no longer a function of the discounted cash flow of future income, but instead is determined by the amount of money the central bank is printing, and especially by how much it intends to print in the coming months.”
This distortion of the basic tenets of investing is leaving otherwise rational market participants feeling like they are living in an alternate universe. Of course, reality will eventually reassert itself; but as Keynes famously said, “The markets can stay irrational longer than you can stay solvent.”
For today’s Outside the Box I bring you both of these pieces, which not only make for fun reading, as Charles is such a great writer, but will also help you understand a bit more about the psychology of the marketplace.
I want to offer a comment on Donald Trump’s latest contretemps – that we should not allow Muslims into this country for a period of time. That may be simply the most boneheaded, ill-conceived idea I have heard from a politician in my life, which is saying a lot, given Bernie Sanders’ recent suggestions for cutting carbon emissions by 80% by 2050, which is merely impossible without creating a multi-decade depression in the United States.
Aside from the Constitutional, ethical, and practical problems, closing the border to arbitrary groups, even temporarily, would cause enormous economic damage. Muslim-majority countries would certainly retaliate by barring Americans and/or Christians. The result could be a trade war at least as bad as that brought on by the old Smoot-Hawley tariffs, with people as the weapons and no resulting benefit to national security.
My associate Patrick Watson offered a very succinct thought on Twitter that is in the process of going viral (he is @PatrickW). Here’s a cut-and-paste of it:
Trump simply offers to ISIS and other Islamic terrorists a further rationale for their hatred of the West: “See, it’s just like we said. The West doesn’t just want to go after us; it wants to destroy all of Islam. They hate us, which is why we must fight back. Everything we do in our jihad is justified because of their actions.”
Whether or not their point of view makes sense to us is beside the point. They will take Trump’s words and talk about how well he is doing in the polls and say this is how most Americans feel. Forget the fact that this may be the most unconstitutional idea I have ever heard from a major candidate (has he read the First Amendment?), his proposal is simply offensive on so many levels. To characterize an entire major world religion as comprising nothing but extremists is just not right.
The United States was first settled by religious refugees, and more than a few of your and my ancestors came as refugees from religious persecution, poverty, or oppression by brutal governments. They were seeking freedom and opportunity. We are a land of immigrants and we have an immigration process, and we have never had a religious requirement as part of that process. That would be unconstitutional and decidedly un-American. And yes, I get that many Muslim states are not taking in refugees, and all the rest. That isn’t any excuse for America to be anything less than the beacon on the hill that we are supposed to be.
Okay, let me just say it right here (even though this is going to anger more than a few of you): Donald Trump is the only man in America who could get me to vote for Hillary Clinton. You have to understand that my distaste for the policies that Mrs. Clinton would institute is monumental. I can’t tell you how bad a continuation of the current political climate would be for this country. But to have a loose cannon like Donald Trump in the White House – a man who could say and do just about anything at any time, with no control of his ego – would be too much.
Think about it for a moment. He is president, and basically, no one gets to tell the president no if he really decides he’s right. Sometimes that has worked well for the country, and at other times it has been a disaster. Donald Trump looks like a walking, talking, shoot-from-the-mouth-with-my-latest-greatest-idea disaster to me.
Trump continually spouts so-called solutions, and when asked how he would accomplish them, he just says, in essence, “I’m Donald Trump. I’m a world-class negotiator. I can just go to the bargaining table and get what I want.” When he says that ISIS would cease to exist under his administration but then offers no realistic plan as to how he would accomplish that, he reveals himself for the egotistical fool that he is. He really has no notion of history or military context or the impact of geopolitical decisions.
And now that I have offended a substantial number of my readers and probably even lost a few, I had better hit the send button before I get into even deeper trouble. Have a great week, and take comfort in the fact that 80% of Republicans haven’t decided who they will vote for, so that means Donald Trump is getting 25% of the 20% who have a favorite. I have to admit that I’m firmly undecided but would be happy with any one of five or six of them. They are probably not the same five or six you would choose, but I bet there would be some overlap.
Your trying to figure out what’s driving both politics and markets analyst,
John Mauldin, Editor
Outside the Box
Of Central Bankers, Monkeys, and John Law
By Charles Gave
April 17, 2015
A revealing experiment involved monkeys being placed in a cage with a pile of nuts stashed on an upper level. Their efforts to snaffle the food caused them to be doused in water, blasted with a siren and startled by an electric shock. After a number of attempts the monkeys gave up. Later, a second group of monkeys were introduced—the new entrants made a beeline for the goodies, but were quickly beaten back by the chastened first group of monkeys. Finally, this first group were removed from the cage and replaced by a fresh contingent. The new monkeys immediately made a dash for the nuts, but were beaten back by the second group; i.e., those who had never experienced the cold water, siren or shocks.
It does not take a wild imagination to see a parallel between our monkeys and central bankers. For generations central bankers were cowed by their inflation-scarred colleagues and accepted that the top of the cage was off limits. But then a rebel monkey, erh central banker, emerged in the shape of Alan Greenspan. As the gorilla in the pack he persuaded the rest that the fruits at the top of the cage may not be forbidden. The result of this “bravery” in economic policymaking has been two huge financial crises.
The funny thing is that the general public remains grateful to the central bankers since their “new-fangled” actions to “save” the world economy appear to be working. For the most part our monetary guardians have escaped responsibility for the crashes, with popular ire focusing instead on “nasty” commercial bankers. The concern must be that few experiments (certainly in economics) are “new”, except for those which ignore history. And, of course, to quote philosopher George Santayana “Those who cannot remember the past are condemned to repeat it”.
History has thrown up multiple attempts to create wealth by printing money from the Song Dynasty in China to renaissance era Italian bankers, through revolutionaries in France and their Assignat notes, to the more recent case of Zimbabwe. However, one of the most revealing cases took place in the early 18th century when France was ruled by the boy king Louis XV and power was exercised by his uncle, the Regent.
Heroes and villains
Enter John Law who presented the Regent with a simple solution to the kingdom’s straitened financial situation: the government would grant a client company “La Compagnie des Indes Orientales” (CIO) a monopoly to conduct international trade between France and French colonies in the new world. Later CIO would become Banque Royale as its notes were to be guaranteed by the crown. Law would arrange for shares in CIO to be sold to the public, allowing payment to be made using the discounted French rente at full value, rather than its discounted market price. The price of the shares, and also that of the rente, went through the roof, which we have come to recognize as the usual response to a quantitative easing program. Since the run lasted quite a while, it led to a remarkable boom, centered on the Palais Royal in Paris and the luxury industries.
At this point, Cantillon joins the story. He was an astute financial operator who, sensing an opportunity, decided to move to Paris. He quickly had three key insights:
- No new wealth was being created in France; rather there was just a massive increase in the monetary value ascribed to older assets. In fact France was getting less, rather than more competitive. He went short the French currency and long the British pound, a trade which eventually made him a ton of money.
- The main beneficiaries of the artificial wealth being created were those cronies closest to the Banque Royale which had been granted the trade monopoly. This phenomenon was later called the “Cantillon effect”.
- The system could work only as long as nobody asked to be repaid in real money, at that time gold.
When Cantillon started to see great French aristocrats (those close to the Banque Royal such as Prince de Conti) selling their shares against gold he opened up a large short position, and made out like an (Irish) bandit. When the system imploded, he was sued for both shorting the French currency and also being short the shares of the colonial monopolist. He won, as at that time the courts in France were genuinely independent.
Fortunately, he committed his analysis to paper in the book “Traite sur la nature du commerce” which is a must-read for anyone interested in financial speculation. Schumpeter spoke highly of Cantillon, who was probably the first economist to clearly distinguish wealth from money. He recognized the distinction between asset prices rising due to an economy becoming more productive rather than as a result of a massive expansion of the supply of credit. In the second case, the value of money is going down versus the price of assets, which is a form of inflation.
This audacious attempt to monetize asset prices by printing money resulted in ruin for the French middle class, which had sold its weak but solvent French rente against worthless shares. What followed was a collapse in the credit sphere followed by a great deflation. The lesson is that a huge inflation in asset prices is seldom followed by inflation in retail prices; rather once asset prices start deflating what usually follows is a deflation in retail prices (see “The Debt Deflation Theory Of Great Depressions” by Irving Fisher).
The stability of the system was predicated on the guarantee that French government bonds could, if asked, be repaid in gold, and the same for the shares in CIO. At the peak of the “Mississippi Bubble” the Banque Royale had 4mn francs in its vault and outstanding notes totaling more than 100mn francs. So when the consummate insider, Prince de Conti, started to convert his positions for gold, the system began to collapse. Within a year the CIO share price had fallen by more than 80%. From start to finish, the episode lasted a little more than three years.
Why I am recounting this old story? Because we are at it again. Simply replace the French rente with current Italian or Spanish Bonds; the Regent with Francois Hollande; John Law with Mario Draghi and it is clear that very little has changed. My hope is that most of our clients will end up following Cantillon rather than face the predicament of France’s ruined middle class at such time that latter day Prince de Contis cash out.
In the current system, gold is being replaced by the willingness of Germans to keep accumulating financial assets issued by the rest of Europe, which will never be repaid. The ratio that exorcised Cantillon was the value of the gold stock / the value of engagements; the modern equivalent may be the net external balance of Germany vs the rest of Europe with Angela Merkel or the Bundestag playing the Prince de Conti.
And what has Mario Draghi, in the role of John Law, done to prolong the agony? He has manipulated the cost of money by increasing the quantity of money, or, at least, promised to do so in the hope that speculators front run the ECB. They have, of course, duly obliged. And what happened during the Mississipi Bubble is now unfolding in our time. The increase in the quantity of money in itself cannot lead to an increase in wealth. For confirmation, consider the case of Italy as shown in the chart below.
The blue line is the ratio between the Italian and the German industrial production indices. From 1960 to 2000, Italian industrial output grew faster than its German equivalent by 48%. However, since 2002, the Italian measure has declined 40% versus that in Germany. As a result, the Italian stock market, which outperformed the German market between 1970 and 2002 by a robust 250% (in common currency terms) has, since 2002, underperformed by 60% (red line, right scale). I have few doubts that a modern day Cantillon would have been short the Italian stock market versus the German one at least since 2002.
Indeed, it is clear that wealth creation in Italy has effectively stopped, as shown by the fact that since 2000 the economy has spent three quarters of its time in recession. Indeed, measured in absolute terms, industrial production today is 25% below where it was in 2000.
Of course, the only sensible approach for a heavily indebted country which has seen growth disappear would be to devalue its currency. Since that option was off the table due to the strictures of the euro system, the bond markets, from 2008 onwards started to play the default game. By 2012, spreads had opened to such an extent that it should have been obvious that the euro was doomed (see bottom pane of the chart above).
At this point “Derivative Draghi” did his worst and promised to do “whatever it takes”. The bond markets understood this as a promise that the ECB would buy Italian, Spanish and Portuguese government bonds. As a result, yields promptly collapsed. But, and this is a big but, the Italian economy kept shrinking and the German economy kept expanding. If the policy had succeeded, one would have expected the expression of the relative return-on-investment in the two economies (namely the ratio between the two stock markets indices) to change direction.
So what should the savvy investor do? Remember Richard Cantillon and do not trust John Law. Stay short the Italian stock market versus the German one (equivalent to CIO stock in 1717). Remain short the German bond market versus the US (equivalent to being short the French currency vs. the British one in 1717).
The Apex Of Market Stupidity
By Charles Gave
December 8, 2015
In some 40 years of watching financial markets, my dominant emotion has been a mixture of curiosity, amusement and despair. It seems the stock market must have been invented to make the maximum number of people miserable for the greatest possible amount of time. The bond market, meanwhile, has just one goal in life: to make economists’ forecasts for interest rates look even more silly than their other predictions.
Over the years I have often observed how most market participants are able to concentrate on only one set of information at a time. For example, in the 1970s, the only data release that mattered was the consumer price index. In the days leading up to the CPI’s publication, everybody dropped all other considerations to speculate feverishly about what the number might be. And then following the release, they would spend the next week or two commenting sagely on what the number actually had been. Eventually Milton Friedman convinced the Federal Reserve (and from there the markets) that there was some kind of relationship between the money supply and the CPI. So everyone stopped looking at the CPI, and instead started to focus on the publication every Thursday evening of M1 (or was it M2?). Inevitably each week would see an immediate rash of commentary on these arcane matters from the leading specialists at the time, Dr. Doom and Dr. Gloom.
This gave way to a period in which the US dollar went through the roof on the covering of short positions established during the era of the minister of silly walks in the 1970s. For a few years, the only thing that mattered was the spread between the three-month T-bill yield and the three-month rate on dollar deposits in London (an indication of the shortage of dollars outside the US). The beauty of this one was that the scribblers on Wall Street could comment on it twice a day or more, which of course had no discernible impact on reality, except for the destruction of the forests needed to print so much waffle.
That era came to an end in 1985 with the Plaza Accord. At that point the Fed, under the wise guidance of Paul Volcker—my favorite central banker of all time, probably because he was the only one without a PhD in economics, which may well explain his success—decided it was going to follow a type of Wicksellian rule-based policy under which short rates were kept closely in line with the rate of GDP growth. Of course, this meant the Fed paid little attention to the vagaries of the financial markets, so there was very little to comment on. The result of policymakers’ lack of interest in financial markets was that from 1985 to 2000 the US enjoyed a long period of rising economic growth, low inflation, low unemployment and high productivity; a period dubbed “the great moderation”. The trouble was that no one was able to make any money trading on inside information provided by the politicians and central bankers. As an advertisement for Smith Barney put it at the time: “We are making money the old way. We earn it.”
Naturally, that wouldn’t do at all. After nearly 20 years of economic success, the US budget was in surplus, the pension funds were over-funded, and the “consultants” in Washington were on the verge of bankruptcy, having nothing to say. Clearly something had to be done, and it was: policy shifted to accommodate Wall Street, with forward guidance, negative real rates, the privatization of money, and a lack of regulation. This allowed Wall Street to make money, but it created nightmares elsewhere through the ever-successful euthanasia of the dreadful rentier.
Still, the shift to an economy driven by the decisions of central bankers meant the market commentators were back in business in a big way. For the last 12 years, the only thing that has mattered has been to know whether or not the chairman of the Federal Reserve has had a good night’s sleep. Similarly in Europe, the dysfunctional euro, created by a bunch of incompetent politicians and Eurocrats, bred drama after drama. Since nobody wanted to admit it was a failure, the most important man in Europe became the president of the European Central Bank.
In the last week, we have reached what is surely the apex of this stupidity. A bunch of algo traders programmed their computers expecting “Derivative Draghi” to be extremely dovish, as any proper Italian central banker should be. I am not sure I understand why, but some traders obviously decided that he had not been dovish enough. European stock markets plunged by -4%, while the euro went up by roughly the same amount in the space of a few minutes. What that means is simple: value in the financial markets is no longer a function of the discounted cash flow of future income, but instead is determined by the amount of money the central bank is printing, and especially by how much it intends to print in the coming months. So we are in a world where I can postulate the following economic and financial law: variations in the value of assets are a function of the expected changes in the quantity of money printed by the central bank. To put it in a format that today’s economists understand:
Δ (VA) = x * Δ (M),
where VA is the value of assets and M is the monetary increase.
What we are seeing is in fact in one of the stupidest possible applications of the Cantillon effect, whereby those who are closest to the money-printing, i.e. the financial markets, are the biggest beneficiaries of that printing. This is exactly what happened in 1720 in France during the Mississippi Bubble inflated by John Law. The end results were not pretty (see “Of Central Bankers, Monkeys And John Law” [above]).
What I find most hilarious is that some serious commentators have been pontificating at considerable length about what the market’s participants think. These days, some 70% of market orders are generated by computers, and many of the rest by indexers. And computers do not think. They simply calculate at light speed, which allows them to react to short term movements in market prices as they were programmed to do. And since they are all programmed the same way, the result is some big short term market moves. In essence, these computers act as machines that allow market participants to stop thinking. As a result, I cannot remember a time when less thinking has ever been done in the financial markets, which is why I find today’s financial markets infinitely boring.
We are swimming in an ocean of ignorance, just like France in 1720. It seems all the painful economics lessons learned over the last 300 years have been forgotten. I suppose that means we will just have to wait for another Adam Smith to appear. La vie est un éternel recommencement...