Ashton, What’s Wrong with Money?

Michael Ashton is trying to hasten the resurrection of monetarism before the economic world as we know it comes crashing down. In What’s Wrong with Money? The Biggest Bubble of All (Wiley, 2016) he begins with the notion of fiat currency, that there is nothing behind it “but trust that someone else will accept it at a reasonably predictable level in exchange for stuff we need.” But, he argues, “never before has that trust been so abused, and so stretched.” (p. xi)

Historically, there has been a “marked tendency” for fiat currencies to collapse. They have failed in one of three ways: “slowly, suddenly, or first slowly and then suddenly.” (p. 48) Money fails slowly when “lazy central banks add too much to the supply of money.” It shows up as “inflation creeping slowly higher.” Money fails suddenly “when a traumatic event has a dramatic impact on the society as a whole, and consumers and investors begin to question the survival of the system itself.” (p. 49) This failure is seen in hyperinflation. In the third case “inept or insouciant monetary policy can lead to creeping inflation, which gradually drags at the edges of commerce until it hits a level, a tipping point, where economic actors begin to question whether there is a light at the end of the tunnel after all. This is a common theme in developing countries and especially common in Latin America.” (p. 50)

Where are we, in the United States, now? “Our money is like a 1975 Ford Pinto that is still on the road today. The good news is that it has survived this long, and may well make it another few miles. The bad news is that it also might explode at any moment. We are defying the odds.” (p. 122) The massive expansion of aggregate reserves by the Federal Reserve has led to a “highly flexed economy and highly flexed markets. A break in this steel bar is almost assured.” (pp. 119-20) When it breaks, it will break to higher inflation. And inflation has long tails. Over the last century in the United States, inflation has been over 4 percent 31 percent of the time. And “once inflation exceeds 4 percent, historically about one-third of the time it will be above 10 percent!” (p. 120)

What is the solution to this problem, assuming that it is in fact a problem, that we’re heading toward potentially crippling inflation? Ashton suggests that “it is crucial that we restore to the Federal Reserve the ability to slow money growth by restricting required reserves.” (p. 126) And “while the Fed is making this adjustment, … they should work to keep medium-term interest rates low, not raise them, so that money velocity does not abruptly normalize. Interest rates should be normalized slowly, letting velocity rise gradually while money growth is pushed lower simultaneously. This would cause the yield curve to flatten substantially as tighter monetary conditions cause short-term interest rates in the United States to rise. Of course, in time the Fed should relinquish control of term rates altogether, and should also allow its balance sheet to shrink naturally. … But those decisions are years away.” (p. 127)

Ashton acknowledges that this course of action would entail dislocations in the economy and markets. But he believes it is the smarter trade-off.

In the third part of his book Ashton considers how to invest with inflation in mind. In finance there are only three miracles: thrift, compound interest, and rebalancing. Otherwise, the investor can add TIPS to his portfolio, using a liability-driven approach.

If a person expects a currency disaster, holding gold is not a satisfying answer. “In a calamity, perhaps everyone will suddenly accept gold coins in exchange for goods and services. But I cannot think of why they would. Gold is not inherently valuable to me. I cannot eat it or use it. I can wear it, but I suspect post-Armageddon bling has limited utility.” (p. 176)

The ultimate in Armageddon preparedness is to invest in human capital. Have skills to barter. And “prepare for the lean years by laying up stores of favors with friends.” (p. 177)

Butler et al., Adaptive Asset Allocation

The authors of Adaptive Asset Allocation: Dynamic Global Portfolios to Profit in Good Times—and Bad (Wiley, 2016)—Adam Butler, Michael Philbrick, and Rodrigo Gordillo— hail from ReSolve, a Toronto-based asset management firm. In 40 brief chapters they take the reader from some basic principles of investing and portfolio design to the research-based meat of the book: how to deal with the reality that “on every meaningful measure of market valuation, stocks are priced to deliver miserable returns over the next 15 to 20 years.” (p. 65)

The four measures, “derived from four distinct facets of financial markets,” are the Shiller PE, which focuses on the earnings statement; the Q ratio, which focuses on assets, or the balance sheet; market cap to GNP, which focuses on corporate value as a proportion of the size of the economy; and deviation from price (aka price residuals), which focuses on a statistical price series. (p. 69) Forecasts based on a model incorporating these measures are much more accurate than those based on the long-term average market return (“1.16 percent annualized return error from [the] model versus 5.55 percent using the long-term average”), “especially over long time horizons and near valuation extremes.” (p. 81)

Given the grim forecast of this model, which as of November 2014 calls for 15-year returns of -1.3%, what is an investor to do? The authors analyze three key portfolio parameters—volatility, correlation, and returns—and merge them with a fundamental understanding of structural diversification “to build optimal portfolios that adapt to ever-changing markets.” (p. 133) For instance, addressing the first parameter, the authors suggest that “when volatility is low, typically in the early and mid-stages of bull markets, [an investor] use leverage to increase volatility up to the target [e.g., 15% annualized]. Conversely, when volatility is high, typically in the early to mid-stages of a bear market, we hold a portion of funds in cash to decrease overall volatility.” (pp. 123-24)

Skipping over several key steps in the authors’ analysis, we reach the gorgeous equity curve of a portfolio that has a Sharpe ratio of 1.60, a maximum drawdown of 8.8%, volatility a stable 9.4%, and compound returns of 15.0%. One dollar invested in 1995 would have grown to $16.31 by the end of 2013. Although they don’t consider the portfolio management approach illustrated in this equity curve optimal (they provide even more impressive equity curves that result from “some minor engineering improvements to parameter estimates and more frequent rebalancing to better control risk”), they suggest that “it provides compelling evidence of the efficacy of an integrated adaptive asset allocation (AAA) framework.” (p. 141)

Any investor or financial advisor who is mathematically literate and has a platform for portfolio backtesting can use this book as a springboard for his own research. Even those with modest quantitative skills can essentially cut and paste some of its findings to improve their portfolio results. The gains could be substantial, many multiples the modest price of this book.

Taghizadegan et al., Austrian School for Investors

Mention the Austrian school of economics and many people flee instantly. Not only is it not mainstream, it is sometimes (quite unfairly) described as a cult. In the U.S. it is identified with the politicians and Fed bashers Ron and Rand Paul. In fact, Mark Spitznagel, whose book The Dao of Capital: Austrian Investing in a Distorted World I reviewed earlier, served as a senior economic adviser to Rand Paul’s presidential campaign. But, accept or reject its fundamental tenets (and some of those tenets actually warrant closer study than they usually get), the Austrian school’s emphasis on subjectivity and cyclicality could conceivably help inform investing decisions.

Austrian School for Investors: Austrian Investing between Inflation and Deflation by Rahim Taghizadegan, Ronald Stöferle, Mark Valek, and Heinz Blasnik is a translation from the German. Although not formally divided into two parts, the first half of the book describes the principles of the Austrian school. The second half extends them, albeit somewhat timidly, to investing in the usual sense of the term; more boldly, to investing writ large.

The authors admit they are not market timers. They also admit that investors who subscribe to Austrian economics tend to have a bearish bias, no matter what the market conditions may be. What they stress is asset allocation, and this on two levels.

First, they describe the “philosophical” portfolio. “Wealth is sustainably invested, if it is roughly distributed as follows: 30 percent in liquid hoards [cash and precious metals], 30 percent in capital (machines, tools, shares in companies, rented out real estate, …) 30 percent in durable consumer goods (owner-occupied real estate, art, high-value appliances…) and 10 percent in endowments (shares in enterprises for charitable, scientific, peace-promoting, cultural and environmental purposes).” (p. 241)

They continue, in what is essentially an inspirational manifesto: “We live in a time that is extremely unfavorable for the accumulation of wealth. However, we are still forced to make decisions against this backdrop of growing uncertainty. The best investment decisions can encompass an incredible range: 50,000 dollars in cash, which one can have at one’s disposal within a day when someone else needs to sell urgently, can be worth more than 1,000,000 dollars in shares; 1,000 dollars for a Chinese language course can be worth more than a life insurance policy; 100 dollars for software plus the time needed to learn how to operate it can be worth more than a property; coins buried a decade ago and forgotten can be worth more than a savings account filled to the brim. One needs to go through life with one’s eyes open, be active, full of zest for life, value-oriented and adopt a long-term perspective, while paying attention to liquidity, entrepreneurial opportunities, the quality of life and possible problems in one’s environment and the opportunities to fix them.” (pp. 242-43)

As for an actual portfolio, they adopt the “permanent portfolio” developed by Harry Browne, which allocates 25% each to gold, cash, stocks, and bonds. “The four economic scenarios that are covered in this manner are: inflationary growth (favorable for stocks and gold), disinflationary growth (favorable for stocks and bonds), deflationary stagnation (favorable for cash and bonds), inflationary stagnation (favorable for gold and cash).” (p. 251)

The reader who expects to find specific investing advice will be disappointed. This is more a meta-investing book than an investing book. But the reader may find a few ideas that will spark his imagination and, in the process, make him a better investor.

Napier, Anatomy of the Bear

Described as “a cult classic in the investment community,” Russell Napier’s Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms, first published in 2005, is now in its fourth edition, with a new foreword and preface (Harriman House, 2016).

Napier remains a bear. He believes that the run-up in the markets we have seen since 2009 is merely a bear market rally. The “inexorable pressure” from rising consumption in China and increasing retirement in the U.S. “augurs deflation and thus can unleash the force that will push equities to valuation levels associated with the bear market bottoms of 1921, 1932, 1949 and 1982.” (p. 13)

August 1921, July 1932, June 1949, and August 1982: four summer bottoms. What do they have in common? And what can we learn from them to steer ourselves through the next “big one,” whenever it may occur?

To study the nature of bear market bottoms, and how investors reacted to them, Napier analyzed “some 70,000 articles from the Wall Street Journal written in the two months either side of the four great bear market bottoms.” From his research he unearths “approaches that have worked in assessing when the bear is about to become the bull. What also emerges is an understanding of how similar the great four bear-market bottoms were, in turn leading us to a set of signals to guide investment strategy.” (p. 27)

As a measure of value Napier adopts Tobin’s q ratio, “the stock-market valuation of a company relative to the replacement value of its assets.” The four market bottoms in this book “are the only occasions when equities were at more than a 70% discount to replacement value.” (p. 29) The years 1921, 1932, 1949, and 1982, Napier claims, “also mark momentous change in American society. There was the birth of the consumer society (1921), the birth of big government (1932), the birth of the military-industrial complex (1949) and the rebirth of free markets (1982).” (p. 31)

Napier’s analysis often flies in the face of common wisdom. For instance, the popular myth that the stock market leads the economy by six to nine months is incorrect, at least for the four market bottoms analyzed in this book. “At these extreme times it seems the bottoms for the economy and the equity market were much closer together and the economy might have led the stock market.” This is an important finding since it “suggests the risk to investors at these extreme times may not be as great as often assumed. An investor need not buy equities on his forecast that the economy will start to improve in six-to-nine months. At the great bear market bottoms there is likely to be growing evidence the economy is already on the mend.” (pp. 253-54)

Whatever one’s view of what the next longer-term move in the market is likely to be—up or down—Napier’s history and analysis of major bear market bottoms is worth reading now, and tucking away for darker times.

Overholt, Ma, and Law, Renminbi Rising

Writing about China is fraught with dangers. The country is not known for its transparency, and its economy is evolving rapidly. And yet, as China becomes an increasingly accepted partner not only in global trade but in global financial markets as well, western policymakers, investors, and businessmen crave solid analysis. It is particularly important to understand the role of China’s currency in the global monetary system so that we don’t succumb to what Stanley Druckenmiller called, referring to Donald Trump’s erroneous claim that “China is manipulating their currency and holding it down,” “a kindergartner … view of economics.”

In Renminbi Rising: A New Global Monetary System Emerges (Wiley, 2016) William H. Overholt, Guonan Ma, and Cheung Kwok Law present a carefully documented analysis of the burgeoning role of the RMB in the world economy. (And they finished their book before the IMF decided to include the RMB in its special drawing rights basket, which further elevates the importance of the Chinese currency.)

The authors discuss, among other things, the economic and institutional foundations for the rise of the RMB, whether the Chinese bond market can support a potentially global RMB, the waxing and waning of the Chinese stock and banking markets, the liquidity of the RMB, the spreading global network for RMB trade, businesses uses of the RMB, and the RMB as a reserve currency. They illustrate their points with numerous charts and graphs.

Renminbi Rising is valuable not only for its meticulous research but also for its investigation of alternative scenarios. It’s a must read for anyone who wants to understand China’s place in the world’s financial system.

Seides, So You Want to Start a Hedge Fund

Ted Seides is best known for the 10-year (2008-2017), $1 million bet he made on behalf of Protégé Partners with Warren Buffett. Buffett put his money in Vanguard’s Admiral shares; Protégé, in five hedge funds of funds. As of February 2015, seven years into the wager, Vanguard’s S&P 500 index fund was up 63.5%; the hedge funds, an estimated 19.6%.

In an unconnected move, Seides left Protégé, where he was president and co-CIO for 14 years, following five years in the Yale University Investments Office. His self-described “free agency” status presumably gave him ample time to write. The result: So You Want to Start a Hedge Fund: Lessons for Managers and Allocators (Wiley, 2016).

The book, though small in format and only about 200 pages in length, is packed with information, including case studies. Seides knows whereof he speaks. In his role at Protégé he was involved in both sides of the hedge fund world, manager and allocator, because the firm “invests in small and specialized hedge funds on an arm’s-length and seed basis.” The author “worked actively with each of Protégé’s 40 seed managers.”

This book is not a step-by-step manual; it is rather, as the subtitle says, a series of lessons. Seides warns, for instance, against a co-portfolio manager construct, calling it a recipe for failure. “Better-structured investment organizations have slightly unequal investment leaders, where one portfolio manager drives the car, and the other second-guesses his directions.” (p. 77)

He explores the tug of war between flexibility and style drift. “Changing a strategy to evolve with the times,” he notes, “is a riskier proposition for the manager’s business. If his opportunism proves successful straight away, he may earn the right to be flexible for the long term. But if the shift fails to perform in the short term, the manager may lose some clients even if he is ultimately right on the stance.” (p. 108)

Illustrative of Murphy’s Law, Seides claims, “the best performance month in a manager’s career inevitably comes the month before his launch. There’s no reason why this happens, but it seems to occur with alarming frequency.” (p. 150)

For every hedge fund that folds there are probably half a dozen young Turks who think they can succeed. Reading Seides’s book may well be one of the best early investments they can make.

Conti-Brown, The Power and Independence of the Federal Reserve

Protocol is important in Washington, a way of determining whether bureaucrats are “pale and distant stars, lost in a Milky Way of obscure officialdom” or whether they “swim in the luminous ether close to the sun.” The members of the early Federal Reserve Board were relegated to the Milky Way. They, said the keepers of the official protocol at the State Department, “would sit in line with the other independent commissions in chronological order of their legislative creation. That meant that the board would follow the Smithsonian Institution, the Pan-American Union, the Interstate Commerce Commission, and the Civil Service Commission.” This solution didn’t satisfy the “status-conscious members of the board,” and so the question was taken to President Wilson who, when pressed, said: “Well, they might come right after the fire department.” (pp. 40-41)

Peter Conti-Brown, in The Power and Independence of the Federal Reserve (Princeton University Press, 2016), recounts how “an institutional backwater gasping for recognition … became an institutional juggernaut that occupied a space apart from the rest of the government” (p. 41) and analyzes what it is that the Fed, “one of the most organizationally complex entities in the federal government,” (p. 8) actually does.

Conti-Brown, a lawyer by training and now on the faculty of the Wharton School, masterfully meshes accounts of Fed functions with leading personalities who perform(ed) those functions. For instance, he describes the roles of staff economists and lawyers within the Federal Reserve System, invoking by way of illustration “two senior staffers who have exercised enormous influence over policy making” (p. 86) at the Fed. Highlighting their relative importance, the salaries of senior staffers are higher than those of the governors, including the Fed chair.

The Federal Reserve Banks, which owe their existence to “a compromise long past that few understand and fewer can explain,” (p. 104) are constitutionally troublesome. Private corporations with stockholders (private commercial banks like Wells Fargo), over time they have become more like “public regulatory institutions.” Conti-Brown argues that “despite their near political invincibility,” the continued presence of the Reserve Banks, “in the form they are in, is one of the most important, least studied, and least defensible features of the governance of the Federal Reserve System.” (p. 126)

Throughout his book Conti-Brown advances arguments—“about law’s limited role in defining the boundaries between the Fed and the politicians, about the influence of ideology on technocracy, about the efforts of insiders and outsiders to dictate Fed policy” (p. 240)—to show how much personalities and, by extension, the appointment and removal process, matter at the Fed.

He suggests that the best kinds of reforms simplify the Fed’s governance, ensuring that “we know who is pulling which levers of Fed power, when.” (p. 241) He rejects two micromanaging proposals for reform—to audit the Fed and to subject the Fed to a default monetary policy rule (the Taylor Rule). With regard to the second proposal, Conti-Brown argues: “The better approach would be to focus on the more flexible appointment process. Perhaps the Taylor Rule is exactly the right approach to monetary policy. If that’s the case, … don’t amend the Federal Reserve Act; appoint John Taylor to the FOMC.” (p. 265)

As for the prevailing views of Fed independence, Conti-Brown contends that they are “insufficiently comprehensive to tell us much of anything about the Fed, its structure, and its functions.” Challenging these views “has required illustrating in three and four and five dimensions the contested spaces where the Federal Reserve makes its policies, separate and together with other actors inside and outside the government, by using technical skill and making value judgments, under legal and practical authority.” (p. 269) Conti-Brown may not have written the definitive book about the Fed, but he has successfully described it in a way that defies stick-figure characterization.

Duhigg, Smarter Faster Better

Charles Duhigg, a Pulitzer Prize-winning reporter for The New York Times, made a real name for himself with his 2012 book The Power of Habit. He has now turned his attention to the question of productivity in Smarter Faster Better: The Secrets of Being Productive in Life and Business (Random House, 2016).

As expected, the book is well written and fast paced, with lengthy illustrative stories. Although he draws on “hundreds of interviews, papers, and studies,” Duhigg doesn’t get bogged down in social science jargon. For instance, my favorite chapter, on decision making, begins: “The dealer looks at Annie Duke and waits for her to say something. There is a pile of chips worth $450,000 in the middle of the table and nine of the world’s best poker players—all men, except for Annie—impatiently waiting for her to bet.” (p. 133) And the chapter ends: “Anyone can learn to make better decisions. … No one is right every time. But with practice, we can learn how to influence the probability that our fortune-telling comes true.” (p. 155)

In eight chapters Duhigg writes about motivation, teams, focus, goal setting, managing others, decision making, innovation, and absorbing data.

We learn that “subversive” residents of nursing homes—those who “made choices that rebelled against the rigid schedules, set menus, and strict rules that the nursing homes tried to force upon them”—flourished while the obedient residents experienced rapid physical and mental declines. Their “subversive” choices convinced them that they were in control. They endowed their actions with larger meaning. (pp. 31-33)

We learn that committing to (or being forced to commit to) “stretch goals”—ambitious, seemingly out-of-reach objectives—“can spark outsized jumps in innovation and productivity.” (p. 103) At least they can spark these jumps if they are paired with SMART goals—goals that are specific, measurable, achievable, realistic, and have a timeline.

Smarter Faster Better is not as focused as The Power of Habit and probably won’t be hailed as a breakthrough book (though my predictions have been known to be wrong), but it has much better story lines. All in all, it’s a great read.

Cohen and DeLong, Concrete Economics

Stephen S. Cohen and J. Bradford DeLong have written an engrossing, sweeping history of the American economy as seen through the lens of a single hypothesis: that “in successful economies, economic policy has been pragmatic, not ideological. It has been concrete, not abstract.” And it has been the product of intelligent design, implemented by government and “brought to life, expanded, and transformed in unforeseeable ways by entrepreneurial activity and energy.”

Concrete Economics: How the Government Reshapes the Economy through Entrepreneurs (Harvard Business Review Press, 2016) traces the determinants of what was a vibrant American economy—until the latest redesign, beginning in the 1980s. “Yes, there was an ‘invisible hand’ and enormous entrepreneurial innovation and energy. But the invisible hand was repeatedly lifted at the elbow by government and re-placed in a new position from where it could go on to perform its magic.”

According to widely accepted folk wisdom about American economic history, “America is and has always been Jeffersonian. It is and has been a small-government laissez-faire country, exalting its pioneers, its entrepreneurs, and its small businesses, and deeply distrustful of any sort of ‘interference’ by the government in the economy.”

This folk wisdom is wrong, the authors argue. Starting with Alexander Hamilton, the brilliant early architect of the American economy, the government adopted policies to promote industry, commerce, and banking. In administration after administration, the government embraced a high-tariff policy to distort markets in America’s favor, to protect its infant industries. It later took the lead in creating the transcontinental railroads and “even engaged in social design on a big scale” when it “sold off millions of acres” to homesteaders. During Teddy Roosevelt’s administration it made some pragmatic corrections to the economy, busting trusts and establishing the income tax “to address the outrageous concentration of wealth of the first Gilded Age.” The New Deal engaged in pragmatic experimentalism to get the economy back on track. Eisenhower preserved the New Deal, launched huge housing and highway programs, financed the large-scale development of research universities, and supported the development of new technologies. “This was a big-time exercise in hands-on direction, in deliberate winner-picking, and it was a very big winner for the United States.”

“And,” the authors continue, “American government did not accept ideological handcuffs. When push came to economic shove, the US government even deliberately devalued the dollar in the interest of national economic prosperity. It did so more than once, each party taking a crack: under FDR, under Nixon, and under Reagan. America used all the tools: infrastructure development, tariff protection, direct picking and promoting of winners, exchange rate devaluation, and, during the first Reagan administration, a return to selective protectionism through naked import quotas in the form of ‘voluntary’ export restraints.”

By the 1980s, however, as the U.S. tried to shift its economy into ever-higher-value activities, ostensibly pursuing the same strategy as Eisenhower and his successors (where “government tolerated a slow shift out of garments, toys, luggage, shoes, and luxury goods and vigorously moved to shift into advanced technologies—commercial aviation, semiconductors, and computers”), the shift was misguided. The direction was selected not pragmatically but ideologically, and presented not concretely but abstractly. The economy turned toward the processing of real estate transactions, the processing of health-care insurance claims, and especially into finance. These new industries “produced nothing (or exceedingly little) of value, serving at the end mostly to redistribute income to the top.”

It’s high time for another redesign, the authors contend, which is a policy task as well as a task for economists. The authors “do not propose the content of such a redesign, complete with dubious numerical targets. That is not how it happened in the successful American past.” But they do suggest one change: to “push thinking and talking and proposing about what we should do about our economy into concrete terms. Insist that proposed shifts be couched so as to be image-able, as in, ‘This is the kind of thing we will get.’”