Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

October 2011

YouTube rules the world. Although it is the locus for much of the drivel making its way around the internet, the video service has developed into a force for shaping opinion and promoting change, as its role in revealing the viciousness of certain regimes in the Arab world and in exposing the hypocrisy of politicians elsewhere attests. In September the video of a BBC interview with “an independent trader”—individuals who trade stocks and other financial instruments for their own account—made the rounds and caused something of a stir. The “independent trader” flatly states that another financial meltdown is unavoidable because “Goldman Sachs rules the world.” He believes that governments, despite their powers, are unequal to the task of avoiding financial and economic collapse. Bombast aside, the clip was notable for its insights into a trader’s world view, the amorality of which shocked the interviewer and, undoubtedly, many viewers as well. It was clear that making money from price moves is his paramount objective, with little regard for underlying fundamentals. Nor does he care about the success or failure of economic rescue efforts, the outcome of which does not matter as long as he can take advantage of the markets’ reaction through his trading strategies. He “dreams of recession” because of the opportunity it would create for traders like himself. Intrigued, we reviewed the trader’s website where we learned of his admiration for Jesse Livermore, one of the greatest speculators of the early 1900s, who made a large fortune in the Great Crash of 1929. What our trader failed to mention was that Livermore made and lost many fortunes and ended up committing suicide.

Role models aside, the YouTube trader’s behavior and mindset exemplify what traders as a whole are all about. There is nothing inherently evil in their activities; nevertheless, it is a shame that they should devote their talents to skimming short-term profits in securities, an activity whose socially redeeming value is claimed to lie in “providing liquidity” to financial markets. As Buffett colleague Charles Munger said during the depths of the market collapse in early 2009, society would be better off if such people “drove taxi cabs” for a living. It is worth noting that at around the same time the video appeared, a study was released which showed that traders shared many psychological traits with psychopaths.

The spectacle of an obscure financial operative pontificating on YouTube was just a momentary distraction from the real drama unfolding in the global economy and financial markets. The Europeans are wrestling with a debt crisis that threatens to doom many of their banks, undo their currency union, and drag down the world economy. In the U.S., political dysfunctionality nearly caused the government to default on its debt payments (it did succeed in prompting a U.S. debt rating downgrade from S&P). Countries in financial straits that are trying to sell their bonds to raise cash have looked to China with its trillions in foreign exchange reserves, but the Chinese have made it clear they are not interested in bailing out the rest of the world (in fact, they may have to bail out their own banks as their most recent economic stimulus efforts have caused bad loans to balloon).

Meanwhile, leave it to bankers to bite the hand that feeds them; after benefitting from taxpayer assistance during the crisis, they are balking at new rules requiring more capital to cushion the impact of any future financial meltdown. Additionally, they “went ballistic” over European proposals to impose a modest “Tobin tax” on financial transactions, claiming it would bring down the economy, cut employment, and end banking as we know it. Such unreconstructed talk brings to mind Milton Friedman’s cure for business organizations that get themselves in trouble: “let them fail.” Banks may be too big and important to be allowed to fail, but if bankers themselves had to face the possibility of suffering the consequences of bad decision-making, it could put a real brake on irresponsible banking practices.

Adding to the woes besetting markets, Chinese manufacturing fell for the third month, and fears are growing that a property market collapse may be in the works. German retail sales dropped, and European inflation rose more than expected. Japan’s economy was weaker than usual. Unemployment in the U.S. shows little improvement, housing remains depressed, and the economy appears to be slowing again. Unsurprisingly, global stock markets had their worse quarter since 2008, with one global index losing about 17% for the period. U.S. stocks reacted negatively to all the bad news, dropping about 14%. Commodities, which have been a reliable source of gains this year, fell heavily; prices for everything from crude oil to gold, silver, and copper dropped. Even the so-called “rare earths,” whose prices had boomed due to scarcity, fell as manufacturers found alternative materials that worked just as well. The only thing that seemed to rise in value were U.S. treasury securities, as interest rates fell to levels not seen in decades, in spite of the ratings downgrade. (Mortgage rates, which track those of treasuries, dropped to record lows.)

As investors, we have mixed feelings about all the “red-screen” days we have experienced for several months. No one likes to see portfolio values shrink, but such events must be faced with equanimity, as the inevitable consequence of owning public businesses whose shares trade in markets that are occasionally wracked by emotion. On the other hand, we have a few things in common with the “independent trader” of YouTube fame. While we do not share his disdain for government interventions or his seeming indifference to the suffering caused by financial turmoil and economic downturns, our duty to clients requires us to take advantage of opportunities wherever and however that may appear. People make mistakes, and if some of them find they are in need of ready cash we will be there to supply it to the extent we can, in return for securities at discounted prices.

Inflation and Reality

A remarkable image: two billion Reichsmark for a postage stamp. The Financial Times recently ran an article on the deep roots of financial probity among Germans, illustrated with a picture of three postage stamps from the 1920s. In the aftermath of the Great War and exacerbated by poor economic and fiscal policies, Weimar Germany suffered an extraordinary inflation of its currency in the early 1920s—at its peak, the Mark lost value at a monthly percentage rate of 3.25 x 106 (a very large number). The results were devastating. A vast transfer of wealth from creditors to debtors took place as debts were repaid with nearly worthless money. Families and businesses were wiped out. It was an experience the German people have never forgotten and, given the country’s subsequent history, have no desire to see repeated. Germany, to the frustration of some of its neighbors, is very reluctant to go along with the more aggressive proposals to deal with the EU debt crisis for fear of surrendering control of monetary policy to those who don’t share their financial rectitude.

The German experience provides a revealing backdrop for a discussion of U.S. inflation, or more specifically, fears of future inflation stoked by the government’s fiscal and monetary policies since the beginning of the financial crisis in 2007. To some, the programs undertaken to shore up the banking system and prevent a deep recession from getting worse seem radical. This may be because the numbers are very large—trillions have been added to the Federal Reserve’s balance sheet, and to the national debt—but so is the modern economy. While a lot of the hysteria is nothing more than political posturing, the underlying issues are serious and warrant some attention.

In the Spring of 1980, inflation in the U.S. peaked at about 15% annualized, a minuscule rate when compared with the great German inflation, but a serious figure nonetheless (even a 2% rate can eat into a surprising amount of purchasing power in just a few years). It took a Federal-Reserve-engineered recession and high interest rates and unemployment to squelch an amount of currency debasement that Americans found unnerving. Bond prices had been declining for at least a decade prior to inflation’s highwater mark, indicating borrowers’ growing fears of falling purchasing power as reflected in higher yields. The Federal Reserve essentially fast-forwarded that process by inducing a collapse in bond prices, resulting in a sharp rise in yields, that “broke the back” of inflation in the early 1980s.

The current situation is, in some ways, a mirror image of the one reigning at the beginning of the Volcker era at the Fed over thirty years ago. Inflation is modest at less than the 2% generally assumed to be the Federal Reserve’s “target” rate. The prices for many commodities have risen sharply in recent years, producing an inflationary “feel” for most consumers, but measured inflation (which makes allowances for volatile commodity prices) has remained under control. Demand for goods in the economy is slack, there is excess productive capacity, and money supply growth is low—all of which indicate a rather benign environment for prices. Bond prices have generally been rising for three decades, indicating that the “inflation premium” being demanded by fixed-income investors has fallen as the rate of inflation slowed during the period. In its bid to stimulate economic activity the Fed has sped up this trend, producing bond yields that are at or near record lows.

Those possessing a contrarian bent might see danger lurking in the current situation. Just as low bond prices (and high interest rates) in the early 1980s foreshadowed a thirty-year period of declining rates and inflation, today’s ultra-low interest rates and muted inflation expectations may indicate a risk for something unpleasant going forward. We sympathize with such concerns, but it is important to recall that the financial system contains its own antidote to higher inflation—the bond market. A fall in bond prices and a corresponding rise in interest rates in response to rising consumer prices would slow the economy and reduce inflationary pressures. Given the growth in size and importance of the bond markets over the last 30 years, this reaction to rising inflation could have a greater impact than previously. Current fiscal and monetary policies may be running the risk of future inflation, but the countervailing market forces would impose limits. Consequently, as investors we are less concerned about inflation than we are about a potential decline in bonds, as their current levels are clearly unsustainable. Given the large amount of “flight-to-safety” capital flowing into bonds, ours is a “contrarian” stance which we believe to be rooted in the cautious assessment of risk and reward that duty to clients requires, as opposed to the markets’ emotional response to daily events.

 

Dennis Butler, MBA, CFA