For the first six months of 2001, our average account declined -1.61%.
“Excess production capacity has emerged recently”
“Slowing growth abroad”
“Manufacturing production has been cut back sharply”
“Lower consumer confidence”
“Rising uncertainty about the business outlook”
“Backup in inventories”
“Persistent erosion in current and expected profitability”
”High energy prices sapping…purchasing power”
These are just a smattering of the reasons the Federal Reserve Board has put forward for lowering interest rates six times in six months. They have not yet blamed horrid age spots, ring around the collar or the ghastly play of the New York Mets for any of their easing actions. On the other hand, there are still six months left in the year, and almost four points between here and zero in the fed funds rate. If the members of the Open Market Committee were kindergartners who had broken the prized aquarium of a briefly absent teacher, they would be unlikely to have put forth a greater number of improbable reasons for their transgressions. The Fed has cut rates because the stock market has been weak across the board, with one notable wing collapsing entirely. All the explanations listed above are charming balderdash; a collapsing market in over the counter stocks has alarmed the Fed, and spurred historically vigorous money creation. Yet this still begs the question, what does it mean that the authorities have gone to such great and clumsy lengths to hide the real cause of their aggressive actions?
America has fallen into a stock market standard of monetary policy. We say “fallen” into because no one would have planned it this way. The gold standard had an elaborate theory behind it as well as a set of rigid rules. Monetarism had a Noble Prize winner behind it as well as a set of flexible rules, since nobody knew which money supply was the one that should count. Yet we still had a general set of rules for what to do next, and it seemed to accord pretty much with what was going on in the business world outside the monetary temple. The authorities today raise and lower interest rates based on whether they approve of the level of stock prices, and then use whatever economic statistic is currently lying closest to hand to justify their actions.
We are at the moment the beneficiaries of the new standard, since we own a collection of businesses with very stable, and indeed growing cash flows, that are worth more today as the gravity of interest rates grows weaker and weaker. As a matter of working policy, we are not disposed to look gift horses in the mouth. However, as public policy the new standard is not a good idea, because it contains the seeds of a virulent inflation that needs only slightly different conditions to grow faster than Jack’s beanstalk. We know that worrying about inflation is out of fashion. Every day, whenever you tune into StockMarket TV, some talking head can be heard announcing some weak economic indicator or crummy business result, and then instantly pronouncing this as proof that the Federal Reserve must cut interest rates some more. Slow growth must mean no inflation, doesn’t it?
Well, no, it doesn’t. This country saw marvelous growth in the 1990’s with low inflation, and anemic growth in the 1970’s with alarming inflation, and these facts never seemed to make a dent in the thinking of a good number of people in power both on Wall Street and in government. Even today, Argentina, Brazil, Indonesia and a number of third world countries are seeing devaluations and currency debasement on an appalling scale, and most of their growth rates are not positive, let alone overheated. When awkward facts cannot make theory budge, reputations crumble.
To quote J.M. Keynes, “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” Alan Greenspan is in thrall to an idea of A.W. Phillips, first drawn elegantly in his famous curve, that inflation will not break out in an economy with gathering unemployment. To his credit, long before his death in 1975, Phillips said that if he had known what they were going to do with his curve, he would never have drawn it. Thirty years on, Greenspan seems not to have gotten word. He trots out the Phillips curve at every Congressional appearance. That this is so wrongheaded is likely to have an unpleasant side effect. Inflation is the result of printing too much money. It can come even when business conditions are weak. And a glance at any monetary aggregate will show that money is growing either rapidly, or explosively.
We make an issue of the likely re-appearance of inflation, sooner rather than later, and stronger rather than milder, because the world is looking in the wrong direction. When we began this business twenty-one years ago, financial quotes were hard to come by, but the corrosive effects of inflation on wealth were on everyone’s minds. The two decades have seen a complete triumph of knowledge over wisdom. Now ordinary civilians seem to know every tick in every financial market, yet prices of all sorts of real world goods march higher, even in a near recession, and alarm no one. So this might be a good moment to remind us all what our initial goals were when we started out. Twenty years ago we said that through time, we wanted to compound money at a rate six to eight percentage points greater than inflation. We were artful enough not to explain which “inflation rate” we meant, because we knew the sheer instability of the process of inflating guaranteed there would be wide disparities between individual measures of inflation. But the point survives that inflation can erode your wealth permanently, while quotational loss, in the short term, is more annoying than it is impoverishing.
If this sentiment seems deeply ironic coming from us, we are aware of it. After all, we have emphasized time out of mind how important it is never to take big losses. Indeed, the results of the last year and a half are likely to be precisely the reason you hired us. The market has collapsed and we have lost only very modest amounts of money. Our aversion to permanent losses is at least as much arithmetic as it is temperamental. The nature of compound interest dictates our fetish for safety.
As long time readers know, we are slaves to the parable of the dull and the rakish money manager. Imagine two competing investment firms; the first is dull as dishwater, and earns fifteen percent a year for ten years running. Now imagine a second much more venturesome shop down the street making twenty percent in eight years, it doesn’t matter which eight, and losing twenty percent in two years. The mind’s eye pictures the two outcomes being roughly the same. In fact, the first fellow will be 47% ahead of his more enterprising colleague. Our plucky lad with the poorer clientele will, however, have a much larger money management business, since he had bragging rights for 80% of the time. So long as people chase short-term performance, this will be the bane of our business. As we have watched the anemic inflows into mutual funds this year, down two-thirds and more from what they were at the top, we have had occasion to remember our parable.
Getting this balance right-guarding your money from the depredations of inflation, while never taking too great a chance with it- is what we think we excel at. We are also aware of our limitations. Sometime in the next few years there is likely to be something to replace the internet for zany investment excess. This is not in the nature of a prediction, but an observation that with this much money creation, something always pops up. We hope we see it coming, but realistically we doubt it. One way or the other though, we are very much aware that at the height of the last frenzy we got virtually no phone calls from clients urging us to participate in it. We are deeply grateful for that, as the nature of the client base has a large but unheralded role to play in any investment manager’s results.
Sincerely,
Edwin A. Levy
Michael J. Harkins