財經觀察 2034 --- Debt, Doubt, and Disease in the Markets

Debt, Doubt, and Disease in the Markets by Tim Price

“I respect faith, but doubt is what gets you an education.”

- Wilson Mizner

You come to realise just how vulnerable the modern world is to sudden distress when you play Dark Realms Studios' Pandemic 2. The game has you in the role of a contagious disease and you gain points by spreading infection (which, of course, meets the accusation of appearing tasteless, but the game predates the current outbreak of Swine Flu by at least a year). Throughout the game, aircraft gently scud across the globe and ships slowly track across the oceans; their freight may or may not be deadly. Our convenience of modern transport comes at a price.

An infectious outbreak is the perfect metaphor for the storm that has raged across markets over the past two years. For disease, read credit. For plague carriers, read banks. And, in their turn, homeowners, and investors. Very few of us were immune. In the words of Warren Buffett at last weekend's annual shareholder meeting of Berkshire Hathaway, “I think that virtually everybody associated with the financial world contributed to [the crisis]. Some of it stemmed from greed, some from stupidity, some from people saying the other guy was doing it.”

But having collectively lost our minds, we can now at least return to sanity, one by one. And now that the equity markets have enjoyed a bouncy resurgence over recent weeks, there is a growing conviction that the storm has abated. But the disease may well be merely in remission. Bankruptcies and default rates will continue to rise, along with the unemployment numbers. Consumer spending will continue to fall across much of the Anglo-Saxon economy, as it must, to allow fragile personal balance sheets to be rebuilt. The private sector has retreated; only the state has expanded, swelled by the involuntary future liabilities of taxpayers. Having spent decades attempting to roll back monopolistic practices, Big Government, as the supposed saviour of the banking system, now enjoys almost God-like power over industry. Whether businesses survive or fail during this recession will be a function not of the market but of whether government wants them to. That is not an economy that most entrepreneurs will want to play much part in, and it throws the bear market rally into a sharp and uncomfortable focus.

The collapse of the so-called Great Moderation, in which both economic growth and inflation appeared to have become recalibrated into a state of permanently low volatility, has led to an era of Huge Uncertainty. A collapsing Empire of Debt has become, in turn, an Empire of Doubt. Does the western world turn into 1990s Japan? Does the colossal fiscal and monetary stimulus ultimately emerge as inflation or is it dwarfed by the scale of capital market losses and ongoing deleveraging? Now that bonds have outperformed stocks over a forty year period, do we back the deflationary momentum behind debt instruments or do we prepare for the mean reversion pendulum to swing back in favour of equities and risk assets? Perhaps the most shocking outcome of the banking crisis in 2008 was the more or less complete failure of portfolio diversification (at least aside from cash and high quality government debt). But should a one year outlier require us to tear up the modern portfolio rulebook?

Warren Buffett also pointed out that all four candidates to replace him as Chief Investment Officer at Berkshire Hathaway (BRK.A) failed to beat the 38% decline of the S&P 500 Index during 2008; his colleague Charlie Munger added that almost every investment manager “that I regard as intelligent and disciplined and has a record of past success, they all got creamed last year.”

Eric Beinhocker in The Origin of Wealth (Harvard Business School Press, 2006) does a particularly fine job of nailing the fundamental inadequacies of Traditional Economics. He points out that the influential economist Léon Walras borrowed for economics, inappropriately, a number of theories from the domains of mathematics and physics. A key prediction of Traditional Economics, for example, is that the economy as a whole must at some point reach equilibrium – a prediction made by both the general equilibrium theory of microeconomics as well as by standard macroeconomics. So how long does it take for the economy to reach equilibrium?

In the 1970s, the Yale economist Herbert Scarf determined that the time to equilibrium scales exponentially with the number of products and services in the economy to the power of four. The intuition behind this relationship is straightforward: the more products and services, the longer it takes for all the prices and quantities to adjust.. if we optimistically assume that every decision in the economy is made at the speed of the world‟s fastest supercomputer (currently IBM's Blue Gene, at 70.72 trillion floating-point calculations per second), then using Scarf‟s result, it would take a mere 4.5 quintillion years (4.5 x 1018) for the economy to reach general equilibrium after each exogenous shock. Given that shocks from factors such as technological change, political uncertainty, weather and changes in consumer tastes buffet the economy every second, and the universe is only about 12 billion years old (1.2 x 1010), this clearly presents a problem.

The essential problem of Traditional Economics is that it assumes a largely closed system of, in Beinhocker's words, incredibly smart people but in unbelievably simple worlds. The reality, as modern commentators tend to agree, is that the economy is closer to being a complex, adaptive, dynamic system – not unlike a living organic being, vulnerable to illnesses and other sudden exogenous outbreaks. Notwithstanding the huge uncertainties facing today's investor, we believe that a number of key investment approaches still warrant consideration. First of all, that a genuinely diversified portfolio across disparate asset classes has value. (Sheltering in cash alone, for example, works in deflation but is catastrophically useless in a high inflationary environment.) In equities, we have long favoured the defensive use of measures such as the Altman Z Score to help screen for those businesses most likely to survive through a recession of indeterminate severity and length – our objective here not being to beat the equity market but simply to generate a positive return. By avoiding the worst losses incurred by the broader market, an incidental benefit over the long run might nevertheless be market-beating returns.

In debt markets, we see some attraction in high quality corporate issues (and much less in government debt given supply concerns) but superior returns from even more defensive sovereign borrowers of equivalent or superior creditworthiness. In a world overrun by fast-printed fiat currency bereft of inherent value, let alone a world where financial uncertainty dominates, we still see merit in the scarcity and safe haven characteristics (and alternative currency attributes) of gold and silver. A combination of such investments affords a degree of genuine hedging, as opposed to the leveraged speculative activity of former proprietary traders at investment banks now cut loose from the flow trade and customer front-running activities back at the corporate mothership.

Fundamentally, it makes sense to own up to our lack of complete foresight and conviction. From an economic and investment perspective, a realistic assessment of the limitations of our knowledge may be helpful. Overconfidence – in economic modelling or financial forecasting or the sustainability and durability of previous market relationships – is unlikely to be of much advantage. In the words of Francis Bacon,

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