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?

Pin-up

Marilyn is an unlikely pin-up. Marilyn von Savant that is. She writes a syndicated agony aunt column in the US, which she’s done since 1986. But her real claim to fame was that she was for many years recognised in the Guinness book of records as having the highest IQ ever recorded – 242.

Leonard Modinow tells a story about her in ‘The Drunkard’s Walk’ – a fantastically engaging book on randomness and probability. Anyway, one of her readers asked about the Monty Hall problem. In the game show, there are three doors. Behind one a car, behind the other two; goats. The contestant guesses a door, then Monty, knowing what’s behind all the doors, opens one of the other doors to reveal a goat. The contestant is then asked – stick with your current door, or switch to the other closed door.

So are you best served sticking or switching to win the car? Marilyn said switch. There followed a storm of protest, from the public and from maths professors alike. 92% disagreed with her (either saying it makes no difference, or stick). But Marilyn was right.

Why? Because the chance of not picking the car first go, and instead picking a goat, is 2/3. Then, when the other goat is eliminated, the chance of picking the car if you switch is 1. So you have a 2/3 chance of winning the car if you switch. But a 1/3 chance of winning the car if you stick.

What is amazing about this is how simple, yet unintuitive it is. Even Paul Erdos, the preeminent mathematician of his day, got it wrong.

Now one thing I like about global macro is its ability to generate counterintuitive results. Why the dollar likely goes up, and US stocks likely outperform when the US falls into recession - that’s a classic – but unfortunately now pretty widely known.

But here’s a new one; I think Hungary, an oil importer, will collapse if oil prices continue to fall. And I’m betting that oil prices continue to fall.

Why? Well, it’s precisely the reason that Hungary hasn’t collapsed yet (the forint recently hit new highs against the dollar and Euro). Now I’ve been negative on banks with Eastern European exposure for a year – and I’ve made some good money. But the forint hasn’t cracked and a lot of people have asked me why. Especially during the latest bout of risk aversion from mid-May through to mid-July.

The answer is petrodollar reflows. Oil’s move from $100/bbl to $145/bbl from April through June racked up the oil exporters’ reserves. And those reserves flowed through European banks into emerging Europe.

And heaven knows Hungary needed them. Its current account deficit stands at 17% of GDP. It gets nine percentage points of financing from FDI, and another six from remittances from Hungarian workers in Spain and Italy in particular. The remittances are likely slowing fast (remittances to Mexico have collapsed over the past year) – as the Spanish housing market collapses, and as Italy slides back into the doldrums. So Hungary sure needs the capital.

Johannes Wiegand has just written a paper for the IMF comparing the current funding in emerging Europe with events leading up to the Latin American debt crisis. He’s used BIS data on bank flows to measure petrodollar outflows into bank deposits, and then he’s looked to see where the banks have then lent (he’s used a bunch of complex correlation analysis to get there, and as I’m not prepared to rework his many equations on such a sunny day, I’m going to have to take it on trust that he’s done it right).

And what he comes up with is that;

First, petrodollar reflows into bank deposits are significant – accounting for around a quarter of oil exporter surpluses.

Second, Russia, Libya, Nigeria and Angola have put a lot more on deposit than the Middle East.

Third, most of it has gone into European based banks.

Fourth, those European banks have funnelled over half of their resulting emerging market loans to Eastern Europe.

So the danger for Hungary is that a sharp slowdown in deposits at European banks will lead to a similar sharp slowdown in lending to Hungary. Something the broader process of restricting loan growth across Europe will reinforce. And this just at the point that remittances from the rest of Europe to Hungary will likely collapse.

Now, the problem with this process is that it will become self-reinforcing. Downward pressure on the forint will lower the value of the bank assets in local currency, and reduce the ability of Hungarian borrowers to pay interest. Falling real estate prices will do the same. The banks will become more and more unable and unwilling to lend. Consumers in Hungary with Euro or Swissie denominated mortgages – the majority of them – will see their incomes squeezed.

This is fantastically toxic. And it happens because oil goes down. Just as the Latin American debt crisis did, and despite the fact that Hungary has seen no great resources boost. And this just at the point investors might be thinking ‘well, Hungary survived the May-July sell-off, maybe it’s robust after all’.

My own view is that we will get a full blown crisis in Hungary over the next 18 months. And that falling oil and a rising dollar will precipitate it. I am currently long the dollar against the forint. Further down the track, should equities rally as I expect and shorts in these names get squeezed, I will use the opportunity to return to my short positions in the banks with Hungarian and broader emerging European exposure.

I’m heading down to the New Forest with the family for the coming month, so my posts will likely become a little less frequent. But, I hope, the ‘end of inflation’ theme will remain the same. It’s working so far, and the fund hit a new high watermark for the year today, up 46%.