If the economy is growing at a mere 2 per cent [seven
years after the Financial Crisis], surely it is time to
conclude the Fed’s medicine is not healing the real
economy. At the same time, the risk taking that the Fed
is encouraging … will prove increasingly dangerous.(1)
– Financial Times(1)
If markets ever lose their faith in central bankers
– and it has been shaken recently [by the SNB] –
the reversal could be sharp.
– Wall Street Journal(2)
[The SNB’s decision] is symptomatic of the whole mirage
of stability that the developed-world central banks have
sought to foster in the post-crisis era starting to unravel
in a rather disorderly fashion.
In my recent posts I’ve been discussing the possibility that investor confidence in central bankers could collapse and the likelihood that any such a collapse would produce dire consequences. Along the way I’ve gone into a lot of nitty-gritty detail about the nuances of how central banks work, both in the Big Leagues of the Fed, the ECB and the BOJ, and in the Minor Leagues of the Swiss National Bank and the Danmarks Nationalbank.
But you don’t need to know anything about monetary policy, geopolitics, macroeconomics, or capital markets to understand why confidence in central bankers is likely to collapse. All you need to know is that when someone possesses absolute power – as central bankers do in all the post-industrial democracies – they will absolutely abuse it. Central bankers think of themselves as gods(4), but in fact they are no more than modern-day Icari whose hubris has led them to wander far too close to an atomic heat source.
These posts have naturally occasioned many inquiries about how investors might protect themselves from the consequences of collapsing confidence in central banker policies. As my readers have possibly noticed (this being my 115th post), I’m better at pointing out problems than I am at articulating solutions to them. That said, here’s how I would go about analyzing the conundrum.
First, it’s important to remember that it’s not my intent in this blog to make predictions. My job, as I see it, is to examine consensus opinion and to deconstruct it when (a) it seems wrongheaded and (b) the consequences of its wrongheadedness seem serious. Am I predicting that the stock and bond markets will soon collapse? No. Do I think it could happen for the reasons I’ve suggested? Yes.
Second, the possibility of a collapse in confidence is a subspecies of the broader question of how investors might protect themselves against tail events.(5) And this is a complex problem for many reasons. First, tail events are, by definition, rare, and therefore investors who insist on always protecting themselves will, over an investment lifetime, lose much more on the cost of protection than they will save on the occasional market crises they avoid.
But tail events are also not as rare they should be, statistically speaking.(6) This is because capital markets are not analogous to subatomic particles blithely going about their random ways certain that a lethal collision with a weakly interacting massive particle (a WIMP) is vanishingly unlikely to happen. No, markets are made up of human beings who, on occasion, can be counted on to do things that are surpassingly stupid – like develop absolute confidence in the wisdom of central bankers.
If, despite all these cavils, investors wish to protect their portfolios against a collapse of confidence, several possible preventive actions come to mind, as follows:
Bitcoins. Since my readership tends to trend, uh, fossilish, stocking up on bitcoins probably won’t be widely appealing. In addition to a certain libertarian bent, bitcoins have long been championed by the hapless Winklevi twins,(7) which seems reason enough to run in the other direction. On the other hand, the great thing about bitcoins for our purposes today is that they are largely unmanipulable by central bankers.
Gold. I’ve never owned gold as an investment, but I know many ultra-wealthy families who each control vast amounts of physical gold. You can argue with them all day (believe me, I’ve been there) about the foolishness of owning gold as an investment or even as a hedge: gold yields nothing; it’s expensive to store; it’s expensive to insure; it can be confiscated by greedy governments; it doesn’t always hedge against the things you’d want it to hedge against; and if push came to shove and you really, really needed it, could you get it or would you need to spend it all hiring a private army to keep other people from taking it away from you? All that said, I notice that families who own gold sleep a little sounder than families who don’t.
Portfolio hedges. As prices become more and more elevated, some investors hedge their portfolios against a major collapse by using out-of-the-money, long-dated options. The problem with this strategy, especially for investors unused to it, is that when the options expire worthless you are unhedged unless you buy more, which is a little like continuing to bang your head against the wall in the hope that it will stop hurting.
Capital preservation-oriented investing. This isn’t specifically a strategy to protect against a feared tail event, it’s a strategy for lifelong success in the investment world for wealthy families. Capital preservation strategies make sense because, for people who are already rich, the extreme outcomes of aggressive investing are asymmetrical. On the one hand, you get even richer – nice. On the other hand, you go broke – worse than not nice. Capital preservation begins by thinking first about risk and only second about return. Thus, when prices are at historic lows, risk will also be low and we will want to be at the upper bounds of our exposure to risk assets. As prices approach historic highs, we will want to move toward – but never below – the lower bounds of our exposure to risk assets. When markets are being brazenly manipulated by central bankers, the central problem is that we can’t know what fair pricing is, and therefore risk is high, and therefore we will want to be cautious. This capital preservation strategy will cause us to lag Fed-hyped markets on the way up, but it will save our bacon when/if those markets collapse.(8)
(1) 2/14-15/15, p. 11
(2) 2/9/15, p. C6
(3) 1/21/15, quoting Marc Ostwald.
(4) Former head of the IMF, Dominique Strauss-Kahn, on why he didn’t know that prostitutes frequented his sex parties: “I was busy saving the world.” (By the way, DSK, my invitation to these parties seems to have been lost in the mail.)
(5) As opposed to so-called “Black Swans,” that is, events that are unanticipatable.
(6) As I pointed out in Creative Capital, on Black Monday in 1987 the stock market plunged 23%, an event that, statistically speaking, would have been unlikely to happen “had the life of the universe been repeated one billion times.” Page 81.
(7) So-dubbed by Mark Zuckerberg, in case you missed the movie.
(8) Note the symmetry of the outcomes under a capital preservation investment strategy. If markets don’t collapse, all that happens is that we’re still rich. If markets collapse, all that happens is that we’re still rich.
Next up: Am I Charlie?
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.