Vern’s angst…

  • Those famous four words…‘this time is different’
  • Why America matters
  • Why deflation is so persistent

Today is the Labour Day holiday in Victoria, so your editor is taking the day off. Whether it’s a ‘deserved’ day off is for your judgement.

So, unfortunately, we don’t have any markets info or market data in today’s Port Phillip Insider.

Instead, we’re reproducing an essay that I believe every Australian investor should read…and then re-read.

It’s from my colleague, Vern Gowdie.

Vern is a former financial planner. So from the outset, you may think he’s as mainstream and lacking in contrarian ideas as they come.

But the opposite is true…hence why Vern is a former financial planner.

After warning his clients at the time about the impending 2007 market crash, Vern realised that he could no longer operate effectively within the system.

He realised that the system was set up, not for his customers, but for the financial planning industry itself.

And on many occasions, Vern realised that regardless of how many times he tried to warn folks about the dangers within the financial system, they just didn’t want to hear it.

They were too interested in the latest hot investment idea, or the big new resources play.

Don’t get me wrong. I like a hot investment idea as much as the next speculator. But I also understand that as Vern likes to say, ‘the global financial system is a house of cards, ready to collapse.

Because of that, even the most bullish of investors should heed Vern’s warning. I know from chatting to him, it’s not a warning he issues lightly.

It’s not a warning he issues with any relish either.

In fact, I know Vern has had to do a lot of soul-searching to work out whether he really should ‘spill the beans’ on what’s really going on with the Australian and world economies.

That’s not because he’s a secretive kind of guy, or because he’s ashamed or embarrassed about his views…or even because he’s worried about what people will think of him.

No, it’s because he knows what he has to say will be a proverbial ‘punch in the face’ to the millions of Aussies who have no clue about what’s about to hit them.

Vern will reveal more tomorrow. But before then, it’s important that you read what follows. First published in his Gowdie Letter advisory five weeks ago, the following essay draws on Vern’s recent meeting with former US Federal Reserve chairman, Dr Alan Greenspan, and gives you an insight into the problems Vern believes are facing the world today.

I’ll be back with the normal Port Phillip Insider service tomorrow. Until then…



Very Few People Have Financial Intelligence

No one sees what we are seeing.

Are we blinded by our bias, or are they oblivious to what’s going on?

And so went a recent conversation with a good friend about the rise and rise of the US share market.

Are we missing something, or is it a case of being patient for the switch to be flicked from boom to bust?

To help rationalise this disconnect between what we think is a fait accompli and what the herd is doing, we draw inspiration from acclaimed psychologists, Kahneman & Tversky.

In their book On the Psychology of Prediction they wrote:

For if we can explain tomorrow what we cannot predict today, without any added information except the knowledge of the actual outcome, then this outcome must have been determined in advance and we should have been able to predict it.

The fact that we couldn’t, is taken as an indication of our limited intelligence rather than of the uncertainty that is in the world.

Based on the data we have, the outcome of this financially irresponsible experiment by a handful of central banker PhDs has been determined in advance. Record debt levels; downward wage pressures; historically high PEs; unfunded and unaffordable welfare promises; the sheer volume of boomer retirees; ultra-low interest rates; QE used to inflate asset prices; excessive corporate debt funding for buybacks and not for capital investment; too much supply and not enough demand.

The outcome is the system will collapse.

The lack of recognition of this actual outcome is an indication of limited intelligence…more specifically the fact that very few people possess financial intelligence.

When markets are running hot, how many people ask the question, ‘Why is this so?’

The majority simply accept that this is the way it is. Questions are rarely asked in boom times. No one wants to jinx the market.

The failure to recognise previous patterns of human nature is the reason history is doomed to repeat itself.

Those famous four words…‘this time is different’

It’s like most trends – at the beginning it’s driven by fundamentals; in the end, by speculation. It’s just like the old adage: “What the wise man does in the beginning, the fool does in the end.”

Warren Buffett

Actually, when people say ‘this time is different’ it proves it’s not different…because that’s what they always say to rationalise away the irrational behaviour of the mob.

The speculative end of the trend is evident in a recent article titled: ‘BAML Survey Of Asset Managers Says “Boom” Best Describes Market’.

Here’s an extract:

Major asset managers have been deploying cash. The BAML [Bank of America Merrill Lynch] Fund Manager Survey (FMS), released February 14 [2017], is a monthly survey of 200-250 primarily long-only investors.  The report showed that major asset managers have been deploying their dry powder, as cash holdings dipped to 4.9% from 5.1%.

The stock market is a buy, the BAML report noted, as cutting in cash holdings is supported by strong investor sentiment.

The ‘boom’ is supported bystrong investor sentiment’.

The following chart depicts the four stages of a bubble:

  1. Stealth: smart money buys in
  2. Awareness: the institutional money buys into the trend
  3. Mania: the public want a piece of the ‘easy money’ action
  4. Blow-off: watch out below

Greed and delusion — which manifest themselves in ‘this time is different’ assertions — is where I think we are at today.

chart image

Source: Hofstra University, New York
Click to enlarge

The predictability of human nature is what makes the phases of a bubble so easy to plot.

This is from the article that accompanied the above graph (emphasis mine):

Bubbles can be very damaging, especially for those who arrived late with the hope of getting something for nothing. Even if they are inflationary events, the outcome of a bubble’s blow off is very deflationary as large quantities of capital vanish in the wave of bankruptcies and financial defaults they trigger. Historically, they tended to be far in-between, but between 1995 and 2008 three bubbles took place back-to-back; the stock market (deflated in 2000), real estate (deflated in 2006) and commodities (deflated in 2008).

Tearing up large chunks of capital is deflationary for one simple reason…people have less to spend. Which is why the Fed and other central banks had to flood the markets with liquidity after 2008/09. They were trying to create Bernanke’s theoretical ‘wealth effect’.

Given that the world is already wrestling with deflationary forces — cheap labour, excess productive capacity and the increasing uptake of automation — the next market crash could take us into a depression.

The article notes that historically, bubbles tended to be few and far between.

Their tempo increased after 1995.

Greenspan, Bernanke and Yellen have proven to be serial bubble blowers. When confronted with the natural ebb and flow forces of a market, the Fed’s programmed response is to ‘prime the pumps’.

Giving rise to the next (bigger and more damaging) bubble.

chart image

Source: Quantitas Capital
Click to enlarge

The reality is, asset prices cannot permanently outgrow underlying economic activity.

Facilitating easy access to an abundance of cheap money can and does cause a deviation from the economy. However, the deviation is temporary, not permanent.

The orange line (US GDP) eventually exerts a gravitational pull on asset prices (blue line).

When the bubble cycle makes a full rotation, those who hoped to get something for nothing will find out the hard way that this time is not different.

Why America matters

People ask me why I spend so much time looking at the US markets and economy. Why not spend more time on analysing Australia?

My approach to investing is more macro than micro. I am a lousy stock picker — as are a lot of professional fund managers. But at least I admit it.

If we can get the big trends reasonably right, then we can participate in the wave up and avoid the inevitable crash.

You’ll never pick the bottom or the top. The aim is to invest somewhere in the ‘Stealth’ phase and exit in the ‘Mania’ phase.

It’s a given that you’ll enter a little late and leave too early, but no one ever went broke taking a profit.

Successful investing is about making a considered risk versus reward assessment.

When markets are in the ‘stealth’ phase they represent a low risk/high reward proposition. In the ‘mania’ phase there is a distinct and fundamentally important reversal in market characteristics — high risk/low reward. As the ‘mania’ phase continues, the market dynamics become extremely high risk/negative reward.

Yet, the majority read the signs differently. In their mind the market is signalling ‘no risk/really high reward’ in the mania phase and ‘high risk/no return’ in the stealth phase.

Identifying trends and making judgement calls is how I manage my money.

The following graphic on who’s who in the global economic zoo, shows you why we have to take notice of the 600lb gorilla on the other side of the Pacific Ocean.

If you look closely, on the bottom right (around 4 o’clock on the chart) you’ll see Australia…at 1.8% of the global economy. 

In the scheme of things, we do not matter.

chart image

Source: Visual Capitalist
Click to enlarge

If something goes awry in the US, China or one of the big four in Europe, we’re caught in the downdraft.

Given the interconnectivity resulting from globalisation, it’s not hard to see why dominoes falling in one part of the world will eventually reach our shores.

The Western world and China dominate the global economy.

Each one of these major players is grappling with the same problems, to varying degrees.

Massive debt overhang; demographic issues (less births, more retirees); low wage growth; youth unemployment, and rising levels of lower and middle class unrest.

The global economy is more fragile than most people think.

All it takes is for one significant piece of this economic puzzle to experience a contraction, and we have a world of trouble.

Watching what’s happening beyond our shores is like an over-the-horizon radar…hoping to spot a problem in advance and take the necessary precautions to protect our capital.

When the US share market falls 50, 60 or 70%, the All Ords will play follow the leader.

Why deflation is so persistent

The US economy is 70% consumption.

With average US household income stuck in a time warp — not buying any more than it did in the 1970s — the fight for the US consumer dollar is intense.

The rise and rise of Amazon, at the expense of traditional retailers, is evident in the following graphic.

The American consumer (as well as the Aussie, UK and European consumer) is looking to make their dollar/pound/euro stretch further by turning to online suppliers.

The destruction in shareholder value of the major retailers over the past decade is breathtaking. Sears is down 96%. JC Penney is down 86%.

A decade ago these were not penny dreadful stocks. They were retailing institutions.

Even the giant Walmart has only managed to stay static.

chart image

Source: Visual Capitalist
Click to enlarge

Amazon is coming to Australia, and the same level of creative destruction is likely to happen to our major retailers. There will be a knock on effect to yields from Real Estate Investment Trusts (REITs) with large exposures to shopping centres.

The deflationary trend of online consumption is only going to embed itself into the system, as the negative loop of retail closures, staff lay-offs, the reduction in penalty rates and lower yields on REITs force more and more people to seek more ‘bang for their buck’.

Mix in the deflationary effect of an asset bubble bursting, and we have the very real potential to experience a Greater Depression.

To quote another famous Buffett truism, ‘Be fearful when others are greedy and greedy when others are fearful.

I fear that most people are completely unaware of the unsustainable pressures building within the global economy.

Thanks to history, we know the outcome — the ‘wealth effect’ asset bubble will burst. The economic fallout will be far worse than 2008/09, and social unrest will escalate.

Now is a time to be fearful. Remain cautious. And unlike the US investment institutions, keep your powder dry.

Vern Gowdie