Fra Evergreen Gavekal: Markets are on alert in a week that could see more great insights from the gods of central banking on high. Investors seem a little spooked with the MSCI emerging markets index off 4% in the last eight trading days, while CURRENCY volatility has picked up as the US dollar has strengthened. And yet despite these minor ructions, there remains a deeper sense of calm. It is the sort of quiescence born of insiders’ knowledge that the nature of financial markets has changed, and in a way that favors them.

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In the past, MONEY sat at the center of the economic system. When MONEY was created, it moved slowly through the real economy toward the fringes where assets were located. Too much money caused a bull MARKET; too little and we got the reverse. Now asset prices sit at the center of the system and MONEY is relegated to the periphery. Every right-minded person knows the main role of a central bank is to create sufficient money to stop asset prices going down, because if this can be achieved then a little of that elixir may just flow into the real economy and create growth.

Indeed, talk to a central banker, preferably a retired one, and they will admit that they have one long term goal which is to stop asset prices from going down the following week. This is because so much debt is linked to these assets that should prices start to fall then the mother of all margin calls would materialize. Most central BANKERS have read Irving Fisher’s great 1934 tome The Debt Deflation Theory of Great Depressions and they don’t want something similar starting on their watch.

To achieve the desired results, central banks have bought bucket loads of government BONDS, on the simple idea that if the anchor rate was pulled down, then all rates would follow including the discount rate used to value long-dated assets, and thus the value of the said assets would go up. In the case of equities, the particular traits of investors in these markets has meant that central bankers could play a more indirect role.

Today, most MONEY managers can be described as having five core beliefs, or at least operating principles:

  1. it is not certain that central banks can control asset prices forever and it could end in tears;
  2. I am one of the few investors smart enough to understand this;
  3. most other money managers are dumb enough (especially the INDEXERS) to believe that central banks really can control asset prices
  4. so despite being very smart, and knowing better, I have to keep BUYING SHARES, but
  5. because I am very smart, I will see ahead of the others when the time is right to get out, and in any case I have some very good risk control systems which will kick in and prevent me suffering too huge a loss.

The astute reader will have recognized a sophisticated version of the prisoner’s dilemma taken from game theory; i.e., the system continues to work so long as nobody breaks the rules. However, to escape the dilemma in good shape, it is necessary to be the first one to break the rules.

The implicit reasoning in this assumption is that if the investor cannot be first out then they can at least be second or third.

However, such a stance rests upon two key assumptions that are less than rock solid.

  • The money manager in question has the insight or the algorithms to get out of the MARKET in good time, and this early warning system will be different from the system used by rivals. We saw this proposition tested in 1987 and the results were not pretty. When the sell notices all kick in at the same time, there will be no exit.
  • Markets will remain open and will be tradable. I recall that in October 1987 that the Hong Kong STOCK MARKET simply closed its doors for four days and when it did re-open prices were not the same.


In short, it may make sense to stay INVESTED, but we have reached a point where protection against an untidy denouement to the present MARKET phase should be built into the construction of a portfolio. It is not enough to rely on a protection that will be executed in response to price signals.

In constructing what Nassim Taleb would call a “non-fragile” portfolio my simple recommendation would be to remain long US BONDS and short-dated dim sum bonds. Those wanting to maintain an equity component to the portfolio should stick with Asian and US shares.

It should be noted that a 50/50 portfolio of long-dated US treasuries and short-dated dim sum bonds has outperformed the S&P 500 since November 2013 by a solid 4%, and with much lower volatility. When a very defensive portfolio starts to outperform the best STOCK MARKET in the world, it is seldom good news.

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