The right kind of profit and stable money

In a boom everyone’s clever.  Everyone talks about how well their stock portfolios are doing and how they’re just making a killing flipping property, or how much money their private equity team is making or how good their return on investment has been.  In these times people often talk at dinner parties about the virtues of taking big risks, leveraging yourself up to the hilt, speculating on this stock or that stock, and just generally getting on the party bus before it leaves town.

These parties always end. 

We’re currently in the middle of another one by the way.  You can tell by the talk going around.  “If you didn’t buy stocks in March where were you man?”  “You have to have equity exposure or else you’ll miss out.”  “If you’re still sitting in cash you are wasting such a big opportunity right now.”

Good luck with that.  I prefer staying sober.

As Nouriel Roubini wrote in the FT this week,

“Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble.”

All this euphoria stems from quite a simple problem.  If the permissive cause of a boom is excessive money and credit creation by the central bank, then the active cause is a complete misunderstanding of profits.

What is your motivation if you think euphoric capital gain constitutes profit?  Profits are never easily made.  People work hard for profits, they invest hard for profits, they take sensible risk for profits, and they’re patient for profits.  Buying a stock and selling it for more than you paid is not profit, it’s luck.  Sure you might have been good at predicting what hundreds of thousand of other people in the market might do, but in truth very few are even good at this.

In reality, when all is said and done, selling a stock for more than you paid is speculative luck, not profit.  Buying a stock and earning dividend yield on it… now that’s profit.

Sensible investors don’t care about a rising market and don’t worry about missing the party.  That party ends in tears for most.  Instead, sensible investors buy a stock at a good price because they believe in the long term prospects of the company.  They hold their share for a long time, don’t fret about erratic fluctuation in the price, earn dividend flow, and liquidate their assets later in life or pass it on as an income generating inheritance.

Unfortunately, there are very few sensible investors about, almost none in fact. 

I can’t believe the advice thrown out on the radio and TV these days by talking heads who claim to be investment/market gurus.  Even more disconcerting though are the investment philosophies of some of our most well respected financial institutions and pension funds.

I was participating in an asset allocation strategy session the other day with an investment committee for an established institution with considerable funds under management.  It was agreed that the current rally in stocks was not fundamentally justified and was mainly the result of the massive monetary stimulus which has provided the means for speculative carry trade activity to run rife in the global equity space.

I suggested to the team that a prudent approach would be to ignore the rally and focus on long term value investing in companies that are expected to pay solid dividends over many years.  The idea was to keep new exposure to stocks limited as the market got overheated.

The response was that they could not afford to miss the current rally because all the other funds were taking part in it and therefore would show better returns to their members.  Funds that had missed the rally, they said, would lose contributions as people shifted across to the funds who had been partying, so they would have to also jump into equities to mitigate the risk of losing contributions and enduring a diminishing capital base.

This mindset is the very anatomy of a crash, and the crux of market volatility.  The herd is so fearful of missing out on speculative luck that all end up floundering in the crash.  Everyone long the market in this environment is also huddled up close to the exit door, so when it’s cool to sell then everyone bails.  More Roubini…

“But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.”

What a truly sad state of affairs.  The markets need a fundamental re-evaluation of what real profits are and investors need to come to the realisation that educated gambling is different from true investing. 

Very importantly, the central banks need to play their crucial role in all of this: stop creating the mountains of excess credit and liquidity that fund all this irresponsible activity.  Ludwig von Mises noted astutely that a bubble is fuelled by excess liquidity provided by the central bank and that the resultant crash must necessarily been in proportion to the size of the bubble that preceded it.  In his article Roubini finally notes,

“This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”

When money is dear, investors are far more cautious and bubbles are far less likely to develop and grow to dangerous sizes.  When money is cheap and printed out of thin air, bubbles can proliferate unchecked almost everywhere.  Cheap money is basically the fuel that feeds the gambling fire, and the inflation it creates also generates the incentive to take bigger risks in the search of ‘real returns’ which are nothing more than false profits.

What we need in our markets is not more regulation but stable money and a rethink on what constitutes profit. 

That’s freedom.