The Thin Blue Line

‘It’s a fine line between clever and stupid’ – Nigel Tuffnel, Spinal Tap.

Past few days we’ve been deep in country. No mobile signal, no wifi connection. The family manned the whisky tombola at the local fair. One thing I noticed – some people would look at the stand, and if you said nothing, they’d walk on by. But engage them, and they’d buy a ticket every time. Even if, after you explained that the prize was a bottle of whisky and they said they didn’t like whisky, they’d still want to buy a ticket.

It suggests that people susceptible are incredibly suggestible, and that once their mind is made up, they find it very hard to change course. Even if it becomes obvious that the pay-off from what they’re doing has disappeared.

So I picked up a book from the bookstall. Someone had donated a box of business and market books. I’d read a lot of them already. But I hadn’t read ‘The Downwave – surviving the second great depression’ by Robert Beckman. On the cover blurb we have ‘The Downwave is likely to change all aspects of society as we know it. From fashion and entertainment, to the political and spiritual, staggering changes lie ahead’. ‘Everything indicates that the second great depression is starting. Property prices are already falling in real terms, unemployment continues to grow. Businesses are collapsing. Today, few people are not feeling the effects.’ ‘Beckman foresees further banking crises, financial panic, and calamities of desperate proportions’.

What is great about this book is that Beckman didn’t just publish it this week (like the series started on Monday in the FT) – a full year into the credit crunch. No, Beckman was early. He published the book in 1983.

Now it’s worth comparing Beckman’s work with another book that came out around the same time; ‘Is inflation over, are you ready’ by Kiril Sokoloff – who currently runs 13d – far and away the best market letter of the past five years.

Beckman’s book starts with an exposition of the long wave – the 50-60 year Kondratieff cycles of prices, unemployment, wars and political change. Most of the book is about these cycles. Now, I find these sorts of things engaging. Even if Kondratieff offered little in the way of explanation for these cycles. Kondratieff was a quant – he mainly nailed the data. But what struck me about Beckman’s book was that there was nothing scientific in it at all. In 1983, we’d seen three 50-60 year Kondratieff cycles. Predicting a fourth wasn’t like forecasting the sun to rise in the East. There was little about when to follow, and when to fade, the prevailing mood – or what the prevailing mood really was. There was nothing about the evils of inflation, its impact on valuation, on profitability, economic volatility, or underlying business profitability. We were headed for a great deflation, said Beckman – so sell your house, sell your stocks, buy bonds – and do nothing until 1990 (when it would be time to buy stocks again).

Now it’s easy to criticise something with hindsight that was proved wrong. But that’s no reason not to do it.

I think the main problem with the Beckman book was that he stated that the Kondratieff wave had turned, but he didn’t explain why he thought it had turned, or how reliable these turns were in predicting stock prices. Like so much pseudoscience – it’s unprovable, and undeniable, until it’s too late. For you, and for your capital.

The same sort of pseudoscience stalks the debate on climate change. Remember – most of the climate change debate is about the forecasts. But the models the climate change gurus use are neither reproducible (the basic tenet of science) – nor are they starting point consistent (ie they can’t explain the current situation, let alone the recent past). Nigel Lawson’s ‘An Appeal to Reason – a cool look at global warming’ is an excellent account of the current debate.

The Sokoloff book is a different kettle of fish altogether. It started off as a contrary conversation, between Sokoloff and his co-author, one day as they were walking through Central Park in 1982. They discussed, against a backdrop of 12% inflation and 15% rates, what would be the contrary thing to do. Kiril said – mortgage your house to buy stocks. They both packed up laughing. It was ludicrous. But it was right.

There are two things that Sokoloff identified. First – the inflation theme was long in the tooth. It was deeply consensus. But politicians were beginning to turn against inflation. Second, inflation is pernicious for businesses. Businesses can’t measure their cost of capital, they have no earnings certainty. They see their ratings crushed. So, if it was right, and the world was turning away from inflation, the reduction in inflation would paper over a lot of cracks. The payoff from stocks and from zeros (zero coupon bonds) would be enormous.

Now, it may be a fine line between clever and stupid, but the title of this post refers to a documentary about a miscarriage of justice. It’s a great film, and the line itself comes from a police officer – referring to the police as the thin blue line, between a society in order and one in anarchy. That apparently justified the shocking actions of the police in this case. A similar line is taken by the environmental lobby. It doesn’t matter if we misrepresent facts, fabricate data, or downright lie. Climate change is the greatest ever threat to our planet, so all action is justified to achieve our goal.

My own position is very different. I believe that the greatest threat to our existence comes from political solutions to society’s problems – solutions that show diminishing returns. Returns far lower than the cost of capital. Solutions that, in other words, destroy value. In ‘The collapse of complex societies’, Joseph Tainter creates a matrix of explanations for collapse – and finds that diminishing political returns is the most convincing. And there’s no doubt that the returns of something like the Kyoto agreement – a trillion dollars for half a degree in 20 years time (according to the models, that is)– are well below the cost of capital. In what may be the greatest irony of modern times, those self-ordained protectors of our planet, the environmentalists, may be the ones most at risk of destroying it.

Which brings me neatly back to the market. There is plenty of scope for an ironic outcome from here. With the papers screeching of the credit crunch, the housing bust that will last 30 years, telling us ‘not to bank on cheap oil’ (all from Monday’s FT), we know that sentiment is still extreme.

What I look for at times like these is dissonance. There was a cracker in the weekend paper. ‘BA, down 30% this year, announces 90% fall in profits, reduction in routes.’ That’s all well and good. But BA is also 35% up from when I bought it last month.

When sentiment has gone this far, and when positioning has followed it, the payoff from a reversal can be very large.

But in my view, this is not just an issue of opportunity. I think there is gathering evidence that the tide has turned. I think an end to inflation – however temporary – is the most likely outcome here.

We have seen the non-oil current account deficit in the US collapse. And now oil is off the top, the oil deficit will shrink as well. We are seeing a profound reduction in the banking multiplier. China and India have entered cyclical downturns. We have seen the CRB Rind index of non-traded commodities – the index least susceptible to financial speculation – and an excellent long lead on inflation - fall a third from its peak. We have seen cement prices in the US crack lower. And the markets are certainly beginning to sniff it out. My fund has hit a new high as I write; up 52% from the Mid-February start.

Inflation is ending. Are you ready?