As I wrote to you on October 19, 2017, Edward Chancellor and I met soon after I read his prescient and literarily superb book, Devil Take the Hindmost: A History of Financial Speculation (2000). We have stayed in regular touch, including attending a Berkshire Hathaway annual meeting together. This is his fifth appearance as guest writer. Just yesterday he sent me the following fable from Breakingviews which, with his permission, I am posting as it captures the zeitgeist of the times like few others are able to do.
Alice was tired of studying for the CFA exams, the figures in the spreadsheet were blurry, she laid her head on the desk…
Her first day at Tweedle Asset Management was going to be a busy one. She was escorted around the offices by a young staffer named, Otto. Their first visit was to the bond team. Fixed income was Alice’s keenest interest.
“Do you hold bonds for income?” she eagerly asked. Everyone laughed. “Are you dreaming?” the desk head replied rudely. “The coupon is subtracted from the principal, not paid out. If it’s income you want, you should we take out a Danish mortgage, they pay very well. Or sell short Swissies.”
“But why own a bond, if it doesn’t pay interest?” replied Alice who’d read her Homer and Sylla* assiduously.
“As long as yields continue declining, even at negative rates we hold bonds for capital gains. If you want dividends, go ask the equity folks.”
“I see,” said Alice doubtfully, hoping that stock-market investors would prove more sensible. At least, they valued investments by discounting future income streams. But on opening a door marked “Fundamental Active Equity,” she came across an empty trading floor.
“Oh, we closed down that team last month – they’d been underperforming for decades,” said Otto.
“What was their problem – did they buy overpriced stocks?” Alice asked, keen to show off her knowledge of Fama and French**.
“That’s exactly what they didn’t do!” replied Otto scornfully. “They stuck with value, and as everybody knows value sucks. If you want to outperform, you’ve got to show your FANGs.”
This didn’t sound quite right to Alice, who wondered how Otto ever passed the CFA exams.
“If you’ve sacked all your fundamental investors, who manages your equity portfolios?”
“Nobody, exactly. All the money is passively invested in index funds. As they say, ‘if you can’t beat the market, at least you can replicate it.’”
“But that means nobody is assessing the stocks’ fair value. It sounds like the market’s on autopilot,” she commented.
“Forget about equities, Alice,” Otto advised kindly, “that’s no longer where the action is. If you want to meet real investors, go visit the VC team.” So, a week later, Alice pushed through the swing doors to enter Tweedle’s fancy offices in Menlo Park. Everything was just as Alice had imagined, complete with bean bags and free candy-vending machines.
“What type of companies do you invest in?” asked Alice of the young VC, named Anna, who showed her around.
“We invest in unicorns,” replied Anna smartly.
“That must be difficult, because unicorns are mythical creatures,” Alice joked.
“Well, there are hundreds of unicorns in Silicon Valley – a unicorn is just a company with a fabulous valuation. Still, the business side of affairs is pretty mythical,” she added with a smirk.
“What do you mean?” asked Alice, more dumbfounded than ever.
“Well, most unicorns are just black boxes. If you open the box, it turns out to be empty.”
“That doesn’t sound like a very wise investment,” said Alice primly.
“True enough, but they make very good speculations. Besides our aim isn’t to find companies that do anything useful or will ever make a profit. No, we look to get in at an early funding stage and exit at the IPO. That’s where the real money is made.”
A few days later, Alice spent the day with the private equity team, Tweedle’s highest-compensated employees.
“How do you add value?” she asked to get the conversation going.
“There are only three things you need to know about private equity: leverage, leverage and leverage,” replied a slick young man in a bespoke Savile Row suit. “Our business is financial engineering.”
“But isn’t it risky to load companies with too much debt?” asked Alice whose vague understanding of Modigliani-Miller*** taught her that you can’t create value just by adding debt.
“Oh, all the risk is carried by the creditors – we stuff them with covenant-lite loans, payment-in-kind bonds, and the like. They’ll take any dreck for the tiniest slither of income. And when the proverbial hits the fan, we refinance.”
“Everything seems so strange,” Alice thought to herself. “I don’t think I’m cut out to be an investor, after all. Perhaps I’d enjoy economics research more.”
That’s how she came to find herself knocking on the door of Dr. Oirob, head of Tweedie’s monetary and economics department.
“The highly abnormal is becoming uncomfortably normal,” intoned the doctor, trim beard and bespectacled with a shrewd, playful look on his face. “Interest rates have been pushed down to unimaginable levels. There is something vaguely troubling when the unthinkable becomes routine.”
“At last, here’s someone I understand,” Alice mused, slipping into an empty chair.
“Central banks have stepped through a mirror,” continued Oirob excitedly. “They used to struggle to control inflation. Now they can’t push it up. They used to oppose wage increases, now they urge them on. It’s the same with fiscal expansion. We were taught that inflation was monetary, and that economic activity was real, but now it seems that inflation is real and what we thought was “real” turns out to be purely financial. Everything is upside down.”
Alice now wondered whether she understood any of this. To change the subject she asked,
“Isn’t Modern Monetary Theory the cure to all our problems?”
Alice really was au courant with the latest trends in economics.
“Why those snake-oil peddlers,” replied the sage, showing an irascible side, “would have us believe six impossible things before breakfast – government debt doesn’t matter, deficits are the cure not the problem, governments don’t have to raise taxes or issue bonds, they can just print money, blah, blah. It’s the most complete nonsense!”
“Here’s the root of the problem.” Oirob*** continued, his eyes burning intensely, “For two decades or more, central banks have played around with interest rates, pushing them lower and lower. They meant well but didn’t understand they were messing with the price of time. If you set the clock – the tempo of capitalism – to run backwards the normal order of things breaks down: companies turn into zombies, herds of unicorns appear, investment discipline disappears. Wealth becomes virtual. Inequality is unleashed. Society melts down, markets melt up…”
At this point, Alice opened her eyes. Her face glowing in the reflection of the monitor. It had all been a dream, a most wonderful dream. Now, it was back to dull reality. She clicked on the Reuters website to see if anything had happened while she slept. Nothing remarkable, it seemed, just a story about a new strain of the cold virus spreading in central China.
* Homer and Sylla: a reference to Sidney Homer and Richard Sylla’s History of Interest Rates.
** Fama and French: finance professors Eugene Fama and Kenneth French demonstrated that historically expensive stocks (high price-earnings ratio) have performed badly relative to “value” stocks (low price-earnings ratio).
*** Modigliani-Miller: an academic theorem which holds that the value of a company is not affected by changes in its capital structure (i.e. that leverage doesn’t create value).
**** Dr Oirob is based largely on Dr Claudio Borio, an economist at the Bank for International Settlements, who has warned vainly for the past decade about excesses of monetary policies. Borio’s name is spelled backwards.