The Fake Economy
The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Dec. 5, 2012. With permission, we're reproducing it here in an edited form.
"I'd rather be an optimist and a fool than a pessimist and right." -- Albert Einstein
Dear Fellow Fool Funds Shareholder:
A random question for you (one that contemplates your breaking federal law, so be forewarned):
Given enough time and ample resources, do you think you could create a reasonable facsimile of a $20 bill?
I'd wager that given modern printing capabilities, a reasonably diligent and determined individual could create a fool-some-of-the-people copy of a $20 bill.
If you manage to capture 99.5% of the features of a real Jackson, would you therefore suggest that this note is worth $19.90? Its value is limited to the cost of the materials that went into its creation -- probably $0.02. Build in the time value of the prison sentence you risk each time you pass a counterfeit bill and its implied value is ultimately negative.
But why would the value of two pieces of paper carrying similarly stamped or printed images be worth vastly different amounts? The answer is that money derives its value from its provenance.
Real or replica?
Lots of things have derived value. Take fine art, for example. In 2007, the famed Knoedler & Company art gallery in New York sold a Jackson Pollock painting for $17 million to Belgian hedge fund manager Pierre Lagrange. But late last year, Lagrange sued the gallery and its owner for selling him a forgery. Lagrange had art experts analyze the painting, who found that several of the paints used in the painting were not developed until after Pollock's death in 1956. If true, the painting that Lagrange bought probably isn't worth $1,700, much less $17 million.
At a bare minimum, the painting has to look an awful lot like a real Jackson Pollock, right? Yet any intrinsic beauty ultimately has no impact on its value. Shoot, with much in the arena of modern art, beauty, design, and even complexity are no longer relevant. The only thing that matters is the identity of the artist.
Once upon a time, a U.S. dollar represented a promise by the issuing bank that it would exchange the note for a proportional amount of a precious metal -- usually gold (The Coinage Act of 1792 defined a dollar as being worth 371.25 grains of silver, and gold to silver at 15:1). The bank note (i.e., a promissory note of debt by the bank) was the derivative -- the "money" was the metal itself. Fast forward to today, and the cluelessness in Washington, D.C., about what a dollar is becomes all the more baffling: It has been reduced to a political abstract, with its value now based solely on the authority of the issuer. This issuer (the Federal Reserve) has over the last decade used that authority to print and print and print more dollars.
This is the underlying philosophy of a zero interest rate policy. It should be obvious that our economy, and the global economy even, faces substantial headwinds. An accommodative fiscal policy is first and foremost a "trick" to convince citizens and companies into spending by penalizing savings. How has this worked out? I believe we have substantial evidence that low interest rates have failed to drive either investment or consumer spending, while forcing people who live off their interest income -- most notably, retirees -- to either accept a lower standard of living or to take on more investment risk.
Perhaps as a result, we see asset bubbles abound, particularly in the realm of bonds, where income-starved investors are pouring cash at the fastest rate in history. It is my opinion that much of this investment is being done with little regard either to credit or interest rate risks. I believe the end is nigh (though the cycle can take a much longer time than anyone expects): This month, Businessweek reported on large institutional investors who had shunned Treasuries as being too expensive now being compelled to buy them. With a fiscal cliff looming, even at sub-2% rates of interest, the overarching goal of many economic participants is the return of capital, not return on capital.
Destructive economic policies
It's my opinion that the zero interest rate policies and the profligacy of central banks in the U.S., Europe, and Japan are utterly destructive. At present, the American private sector has saved more than 8% of GDP, being paid interest rates that would ordinarily cause them to spend aggressively. The difference this time is that the private sector is still recovering from a massive debt overhang that caused the 2008 financial crisis. And when so many are choosing to pay down debt rather than invest or spend, aggregate economic demand will decrease. Since 2006, large percentages of the private economic participants in the U.S. have shifted from attempting to maximize profit to minimizing debt -- low interest rates be damned.
Further, I suspect that many economic participants view central banks' accommodative policies as signaling extraordinary levels of macroeconomic risk. Why would the Japanese central bank have a near-zero interest rate policy unless the economy were not on the verge of collapse? Unfortunately, in countries where short-term political interests trump sound economic policies over the longer term, the easiest decision there is to make is to attempt to trick people into feeling wealthier by attempting to lift asset prices. Federal Reserve Chairman Ben Bernanke has expressed confidence that people will spend more if they feel wealthier "because their 401(k) looks better or for whatever reason their house is worth more..." At some point, people can no longer be convinced, and the damage to the national budget will be done.
Super easy access to capital has the potential to generate particularly destructive unintended consequences, an outcome easily observed via the destruction of the housing market. And yet the Federal Reserve's policy is, essentially, to punish savers for preserving their capital. Is there any wonder that companies are preserving capital? The very existence of near-zero interest rates signals that the Federal Reserve believes the American economy is still in a crisis!
Businesses offer a lesson that our politicians have no real incentive to remember. In an economic system, all other interests are subordinated to what happens with invested capital. A business can offer a great product, treat its employees handsomely, be utterly beloved and do an enormous amount of commerce, and struggle to survive, or completely fail, because it could not generate a return on capital (see LivingSocial for a perfect example of a struggling company). It is the only absolute in business. Companies routinely succeed despite putting out mediocre products (cable companies), mistreating employees (fulfillment companies), and doing a low volume of business (pager companies), but the market is ruthless toward companies that destroy capital.
Our investing strategy
Sounds dire, right? Well, it is. In the lifetime of Fool Funds, we have operated under a constant threat of massive macroeconomic risks, and we will continue to do so. During this time, Americans have abandoned the stock market in droves, in no small part because they fear the volatility and potential for loss of capital (the same factor that causes people to save). We also observe this in the substantial, nearly constant move of capital out of equity mutual funds and into either bond funds or into index-linked exchange-traded funds.
Both of these moves, in my opinion, are markers of investors making decisions based more on macroeconomic themes and less on individual security analysis. This is also observable in security correlations. Between 1900 and 2010, there were only 12 days in which 490 of the S&P 500 stocks moved the same direction, according to Bianco Research. But in 2011, there were 15 days -- including August 8, 2011, which was the first day in history that all 500 stocks moved the same direction (down).
These factors cause us to behave in two distinct ways (ones we hope that you will share with us): First, we do not pay attention to the short-term movements in the stock market, since they are generally functions of investors' fear or greed. Second, while each of our portfolios has benchmarks, we tend to ignore them from a security selection process, and especially from a sector/geographic allocation perspective.
Because of the historically high level of correlation across all asset classes, it is possible/probable that our idiosyncratic portfolios will produce highly, uh, syncratic returns over periods of time. Of the 23 countries in our benchmark for our global portfolio, for example, we have no exposure to 12 of them; and we own securities in 13 countries where the index has no exposure.
Ultimately, we like equities over the long term because they tend to be inflation-resistant (corporate earnings tend to move in the same direction as inflation), and they capture the benefit of the economic growth of the world's most dynamic companies. And while the news in many countries has not been good, it is an historical occurrence that bad news and cheap equity prices tend to go hand in hand.
I've noted in the past that we do not agree with the academic view that security volatility is the most appropriate definition of risk. Rather than shun volatility, we seek to take advantage of it. One of the themes around which we have deployed substantial assets in all three portfolios (to a degree) is the rise of the consumer in developing economies around the globe. Our investments in companies like Shimano (Japan), Yum! Brands (U.S.), Natus Medical (U.S.), and Odontoprev (Brazil) are all based upon a similar theme: their exposure to major growth drivers in developing markets. But when you invest in securities that trade in smaller, less liquid markets (or simply in less liquid securities) you almost by definition expose yourself to heightened levels of volatility for the simple reason that it takes relatively smaller levels of flows of funds to cause them to move. And in a world where more and more investing is done on macroeconomic themes, we believe that such gusseting creates opportunities in the form of mispriced stocks.
Editor's note: Bill Mann is not able to engage in discussion on the boards or in the comments section below. Bill does not own shares of any companies mentioned.
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The article The Fake Economy originally appeared on Fool.com.