Wednesday, December 4, 2013

Mauldin & Tepper, Code Red

Extraordinary measures for extraordinary circumstances. But have the central banks overplayed their hands? How, and how quickly, will they be able to scale back their operations? As you might surmise from the book’s title—Code Red: How to Protect Your Savings from the Coming Crisis, John Mauldin and Jonathan Tepper are skeptics.

A little more than half of this book is devoted to explaining (and decrying) current policies. The book is written in laymen’s terms. The authors have, as they say, “written Code Red with cab drivers in mind.” (p. 251) Well, that may be a bit of a stretch. But the prose is engaging, so even if you’re familiar with its macroeconomic themes it’s a good, sometimes ghoulishly funny read.

Then comes chapter eight, entitled “What Will Happen When It All Goes Wrong.” “In theory,” the authors write, “the Fed could reverse its Code Red policies in a second. However, the problems with undoing Code Red policies are all political and practical, not technical.” (p. 210) They foresee a scenario in which the Fed becomes technically insolvent as its starts to wind down its Code Red policies; in fact, they “pretty much guarantee” this outcome. (p. 214) The Fed is leveraged some 59-to-1, having borrowed more than $3.24 trillion and with only $55 billion of equity. Since it pays out its net income every year to the U.S. Treasury, it has no built-up equity. Hence the prediction of a technical insolvency. But, the authors ask rhetorically, “if the Fed is borrowing money from the government and not the other way around, how long do you think the Fed could keep its independence?” (p. 215)

They also suggest that the Fed will be forced to pay ever higher rates of interest on the large excess reserves banks are holding. These banks will then lend out the money again, multiplying it 10 times. “Money growth would surge and create very high levels of inflation.” (p. 220)

How should an investor manage through the bubbles, booms, and busts that central banks create? Enter the investor’s old friend, diversification. The chapter on diversification is introduced with a great quotation from Ray Dalio: “He who lives by the crystal ball will eat shattered glass,” perhaps written in connection with Bridgewater’s All-Weather funds. The authors recommend that the investor build his own all-weather portfolio. To help the investor along, they include a chapter on “commodities, gold, and other real assets.”

If as the Fed unwinds its portfolio the investor is confronted with an inflationary environment, he should own stock in companies that have pricing power. These are companies that have, in Warren Buffett ‘s words, moats around them. Types of moats are: intangible assets, the network effect, low-cost producer, high switching costs, and efficient scale. Taking just one example to illustrate each kind of moat, we have: Disney, MasterCard, Walmart, Oracle, and pipelines.

Mauldin is, as he writes, “long on humanity but short government,” (p. 340) a bias that’s evident throughout the book. Despite this bias (or, others would argue, because of it) Code Red is a worthwhile read.

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