Do not respect their authority

“Then came the central bank response of lifting interest rates off of zero (and below zero), despite having declared the inflation to be “transitory.” It was not only that inflation was not transitory. The key fact is that central banks had no basis for declaring it transitory, nor any real understanding of why inflation was quiescent and then erupted violently. They tried to blame it all on the supply chain issues stemming from the pandemic, but ignoring the primary role of massive money printing, too-low interest rates and huge spending deficits was simply dishonest.

As for the prospects for monetary policy going forward, our overall judgment is that the central bankers will cause a recession in the global economy, during which (despite their current hawkish messaging) they will declare victory over inflation at the earliest possible moment (at whatever inflation rate coincides with that recession), and then gun the hell out of the global economy to restart it, hoping that it resumes growing without as much inflation as we have seen during this current cycle. It would be perfectly appropriate to call this “hope” a “big stretch.”

• Extract from Elliott Management’s Letter to Investors by Paul Singer, November 2022.

“The Federal Reserve – and central banks the world over – played a crucial role in making lockdowns possible and weaponizing the panic of politicians. As the lender of last resort and the provider of liquidity for the entire federal government, it removes normal fiscal restraint. It writes checks that cannot bounce to fuel governments in normal times but is always ready to make possible emergency spending too even if existing revenue and public consensus is otherwise absent.

“Starting with the $2.2 trillion CARES act of March 27, 2020, and continuing for a full year, Congress massively subsidized and hence funded and rewarded states that locked down, enabling stimulus payments to businesses and individuals amounting to some $10.4 trillion over two years. It was all funded by debt that the Federal Reserve added to its balance sheets, even while the Fed drove interest rates back to zero in the hope of avoiding economic collapse.

“In short, the lockdown was monetized with the printing press. Without a Fed, spending on that level would have destroyed the credit worthiness of the US. So yes, the Fed is wholly culpable in making the entire calamity possible and allowing for its continuation for two years and more. The results are as inevitable as the sunset: we now face the highest rates of inflation in forty years. Because central banks around the world collaborated in this operation, inflation is global too..

“Meanwhile, the rest of us are left with stagflation as far as the eye can see. What’s important at this point is to avoid the crack-up boom that can sometimes follow these kinds of policy disasters. We should count ourselves lucky if we somehow avoid that plus dodge the bullet of a full-scale financial crisis.”

• From ‘Maybe the Fed too was trolled’ by Jeffrey Tucker of the Brownstone Institute, 5^th November 2022.

Some investment truths are eternal. Here’s one from Warren Buffett, the most successful investor alive:

“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment.”

Buffett wrote that in an essay from May 1977, ‘How inflation swindles the equity investor’.

During great bull runs, equities seem invulnerable. FOMO – the fear of missing out – reigns supreme. A consensus builds that stocks are the only game in town. There’s often a superficial logic to the equity story. But it critically ignores one gigantic, contextual, elephant in the room: the future path of interest rates.

There is a warning from history. On 31 December, 1964, the Dow Jones Industrial Average stood at 874. On 31 December, 1981, it was 875. In Buffett’s words,

“I’m known as a long term investor and a patient guy, but that is not my idea of a big move.”

More than an entire decade for the US stock market was lost. Why? Back to Buffett, again.

“To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: the higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line..

… So there… lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.”

The problem with authority

A few years ago, this correspondent watched Craig Zobel’s 2012 thriller, ‘Compliance’. It made for uncomfortable viewing. In the film, based on real events, a fast food restaurant receives a call from someone claiming to be a police officer. The manager is informed that a female staff member has stolen money from a customer’s purse and must be detained.

Despite denying the crime the employee, a young girl, is held by her colleagues in the backroom. She protests her innocence to no avail. On the basis that she might be hiding the evidence, the “police officer” then instructs the manager to carry out a strip search. The film plays out as she and her gullible staff are manipulated by the caller through their desire to “help the police”. In the end, the employees realise that they have been tricked into committing crimes themselves.

We know that we’re watching a fictional event. These are actors playing their respective roles. But although the premise itself sounds ludicrous, it is convincingly staged. In fact, the events depicted in ‘Compliance’ are not purely fictitious… instead they’re based on 70 similar incidents that took place across North America.

The film’s message is that many of us automatically and even unthinkingly surrender to authority. It’s not malice that makes the (innocent) girl’s co-workers humiliate her. They do it because they think they’re following the legitimate orders of a police officer. As to why that officer can’t come to the restaurant: let’s just say he is very persuasive.

It was the poet Coleridge who coined the phrase “the willing suspension of disbelief”. If an artist can infuse his work with enough humanity – and the appearance of truth – we, the audience, will buy into the illusion. We’ll put our scepticism on hold.

That is the power of authority. We can’t help but draw parallels with the investment world… where the most successful players never cease to question the received wisdom.

‘Compliance’ follows two even more notorious US experiments in human psychology that we find ghoulishly relevant to our current global predicament..

1) The Stanford Prison Experiment

The Stanford Prison Experiment took place at Stanford University, California, in August 1971. 24 male students were assigned roles as either prisoner or guard in a mock prison in the basement of the university’s psychology department.

Psychology professor Philip Zimbardo was setting out to test the hypothesis that the main cause of abuse in prisons was the psychological make-up of the prisoners and their wardens. The ‘guards’ were equipped with wooden batons and mirrored sunglasses to prevent direct eye contact. The ‘prisoners’ were arrested at their homes, fingerprinted, then had their mug shots taken.

Order lasted for precisely one day. On day two, prisoners in one cell blockaded the door and refused to follow the guards’ instructions.

Then after 36 hours, one prisoner started to “act crazy, to scream, to curse, to go into a rage that seemed out of control.” When the experimenters realised he wasn’t acting, he was released.

Guards soon resorted to physical punishment. Sanitary conditions quickly deteriorated too, with guards refusing to allow prisoners to urinate or defecate anywhere but a bucket in their cell. Some prisoners had their mattresses removed; others were stripped naked as punishment.

The experiment then spiralled into more abuse, hunger strikes, and solitary confinement. After just six days, it was abandoned. One third of the guards were determined to have displayed “genuine sadistic tendencies”. Many of the prisoners were traumatised.

The Stanford Prison Experiment is widely regarded as having demonstrated the malign power of unchecked authority.

2) The Milgram Experiments

Equally notorious was the series of experiments run by Yale psychologist Stanley Milgram in 1961. You may have seen video footage of the original Milgram tests, or recreations of them. Each involved three participants. Two of them – the one coordinating the experiment, and the so-called ‘learner’, were “in” on the experiment. The third, the supposed ‘teacher’, was the unwitting subject of it.

So, the teacher began by reading a list of word pairs to the learner. Then they would read the first word of each pair again, and four possible ways to complete it. The learner would press a button to indicate his response.

If the answer was incorrect, the teacher would be instructed to deliver an electric shock to the learner. Each wrong answer increased the voltage by 15 volts. (Incidentally, in one version of the experiment, the learner would mention to the teacher that he or she suffered from a heart condition.)

The ‘teacher’ participants believed the shocks were real. They weren’t. The ‘learners’ were all actors, the electric shocks faked. But that didn’t stop 65 per cent of the participants in Milgram’s first experiment administering the final massive 450-volt dose. Every time any teacher was hesitant to continue delivering (and enhancing) the shocks, he was told by the experimenter:

1. Please continue.
2. The experiment requires that you continue.
3. It is absolutely essential that you continue.
4. You have no other choice, you must go on.

If a teacher still wanted to stop after receiving all of these verbal cues, the experiment was halted. Otherwise, it was halted only after the learner had received the maximum 450-volt shock three times in a row.

Milgram’s experiment started three months after the trial of the German Nazi war criminal Adolf Eichmann began in Jerusalem. Milgram set out to answer the question: could it be that Eichmann, and those like him, were simply “obeying orders” ?

In the Milgram experiment, the bogeyman authority figure was not a senior army officer. It was just a man in a white coat.. armed only with a clipboard.

Obedience and the system

Summarising his experiment, Milgram wrote:

“I set up a simple experiment at Yale University to test how much pain an ordinary citizen would inflict on another person simply because he was ordered to by an experimental scientist.

“Stark authority was pitted against the subjects’ strongest moral imperatives against hurting others, and, with the subjects’ ears ringing with the screams of the victims, authority won more often than not.

“The extreme willingness of adults to go to almost any lengths on the command of an authority constitutes the chief finding of the study and the fact most urgently demanding explanation.

“Ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process”.

Milgram’s results are hardly unique. The table below shows the average compliance level to the maximum voltage (450 volts) from a number of studies. University ethics boards (rightly) outlawed Milgram-style experiments in the late 1980s, so no other modern studies are available.

Study                         Country               Percentage obedient to the highest level of shock

Milgram                     USA                           62.5%

Rosenham                  USA                          85%

Ancona & Pareyson    Italy                           85%

Mantell                      Germany                   85%

Kilham & Mann           Australia                    40%

Burley, McGuinness    UK                            50%

Shanab, Yahya            Jordan                       62%

Miranda et al              Spain                         90%

Schurz                       Austria                     80%

Meeus, Raaijmakers    Holland                     92%

Source: Smith and Bond (1994), James Montier

But what does all this mean for investment?

For Craig Zobel in ‘Compliance’, authority was an unseen policeman. For Philip Zimbardo at Stanford, authority was a prison guard. For Stanley Milgram, authority was a man in a white coat.

For us, authority in the investment world is primarily encapsulated in the form of the US Federal Reserve. In fact, it’s any central bank and its staff. And they are all just as susceptible to the corruption of power as the participants in the studies listed above. The individuals working at central banks may well be normal and well-intentioned. But they operate within a perverse system, which does the world a great deal of damage.

Western central banks are dangerous for a number of reasons.

1. Quantitative easing

The QE programmes they have pushed so aggressively have distorted relative prices across all asset types. They have only delayed the inevitable deleveraging – which now appears to be starting in earnest.

2. Artificially low rates

Having driven policy rates down to zero, they have forced investors to chase yield. That means exposing themselves to higher degrees of risk than they might have otherwise. That’s because cash deposits have, until comparatively recently, been eliminated as a viable investment choice.

3. Kicking the can down the road

In pumping up the money supply (and their balance sheets), they have set the scene for a potentially dangerous inflationary mess further down the line. That mess is now before us.

4. A false sense of security

Many investors accept that the central banks know what they are doing. Even that “they have everyone’s back”, or what used to be known as the “Greenspan put” – supporting equity markets – is alive and well.

Don’t fight the Fed

In the markets, there’s a simple rule of thumb: don’t fight the Fed.

Given its almost unlimited monetary firepower, it has never made sense to bet against Fed policy. But that was before the Fed and its international peers went “all-in” with quantitative easing. Now the West’s central bankers have an existential problem: their influence over markets only works while investors believe that that influence still holds.

The Fed is now faced with a market that craves a “pivot”. It probably won’t be disappointed. But be careful what you wish for; the loss of credibility that will accompany any Fed pivot could give rise to explosive effects in asset markets.

So be afraid, and very afraid, of rising interest rates. But be even more afraid of the technocrats who claim to be in charge of the situation.

Is there a risk, then, that the “ordinary people, simply doing their jobs, and without any particular hostility on their part, can become agents in a terrible destructive process”?

The last three years, in more than one setting, would certainly appear to suggest so.

………….

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Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: info@pricevaluepartners.com

Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.