Do you have a licence for your Minsky ?

Chaos theory, which went properly global with the success of the film Jurassic Park, studies the behaviour of dynamic systems that are highly sensitive to initial conditions. Within a chaotic system, tiny changes in initial conditions lead to wildly divergent outcomes at that system’s extremities. Within any chaotic system, short term prediction may yield certain benefits, but long term prediction is essentially impossible.

Chaos theory can be applied to a variety of disciplines, among them weather and climate. When snow settles on a snow mass, at a certain point, under certain conditions, that mass will shift from a stable equilibrium – safety – to an unstable equilibrium – the risk of an avalanche. But it is impossible to predict with any precision which snowflake will trigger the avalanche. The same holds for dropping grains of sand onto a table. For some time, the sand pile will remain stable. At a certain point in time, it will shift to being unstable. One single grain of sand then has the capacity to shift the entire sand pile over. But we cannot predict in advance which grain that will be.

The film Jurassic Park, adapted from Michael Crighton’s novel, brought chaos theory into the popular realm. A wealthy scientist, John Hammond (Richard Attenborough), using DNA derived from fossilised mosquitoes, decides to recreate dinosaurs on a remote island. But once brought back to life, won’t they breed ? No, says Hammond. All the dinosaurs on the island are engineered to be female, by way of chromosome control. Dr Ian Malcolm, played by Jeff Goldblum, has been brought along to assess the project. His assessment is sceptical to the point of hostility:

.. the kind of control you’re attempting is not possible. If there’s one thing the history of evolution has taught us, it’s that life will not be contained. Life breaks free. It expands to new territories. It crashes through barriers. Painfully, maybe even.. dangerously..

I’m simply saying that life.. finds a way.

Life – nature – does indeed find a way. Malcolm survives into the inevitable sequel, and gets to be (justifiably) sceptical and hostile all over again. One of his companions is overwhelmed at the spectacle of the CGI dinosaurs. His response:

Oh yeah. [Facetiously] Oooh ! Aaah ! That’s how it always starts. Then later there’s running and, um, screaming..

Jurassic Park is, of course, fiction.

That central banks exist, and that their ongoing grim mission creep continues to metastasise uncontrollably, on the other hand, is fact. And it is fact that for decades they have been attempting to impose artificial constraints on market prices.

Since the global financial crisis, the financial markets have been a battleground between the forces of deflation and inflation. Deflation represents the free market. A free market wants to reset the game, and clear all the redundant pieces from the table. Inflation represents the State, and its economic agents, the central banks, whose notional independence from the State may be unlikely to survive this ongoing crisis. The State ‘merely’ wants to perpetuate itself, and is somewhat indifferent to the costs incurred to its citizenry in the process.

After years of seemingly endless stimulus and overly easy monetary conditions, the wheels are finally starting to fall off an increasingly rickety capital markets bandwagon. Weakened by rising bond yields and inappropriate corporate behaviour, the centre is not holding any more. Last month, for example, began with the collapse of a fraudulent Anglo-Australian financial services company, and ended with the collapse of an overleveraged family office with tendencies toward the sillier extremes of hedge fundery.

In his latest commentary, analyst and truth bomber Doug Noland cites the work of the economist Hyman Minsky:

Minsky’s “financial instability hypothesis” models three categories of debt structures: Sound “hedge finance” – where “cash flows are expected to exceed the cash flow commitments on liabilities for every period.” Less sound “speculative finance” – where cash flows, although inadequate to fully service debt in the short-run, are generally sufficient over the longer-term. And unsound “Ponzi finance” – “cash flows from assets in the near-term fall short of cash payment commitments” and only with some future “bonanza” will cash flows ever be sufficient to service debts and provide any realistic hope of generating profits.

Importantly, “a ‘Ponzi’ finance unit must expand its debt load to meet its financial obligations.” New money and credit in abundance are a necessity for perpetuating the scheme. The greater the ratio of speculative and Ponzi finance, the greater the fragility of the financial sector to rising interest rates and/or other shocks. Ponzi financed assets, in particular, are highly sensitive to both changing perceptions and higher interest rates. Traditionally, higher rates are problematic as debt service costs rise at the same time the present value of future cash flows drops. Quoting Minsky, “The rise in long term interest rates and the decline in expected profits play particular havoc with Ponzi units, for the present value of the hoped for future bonanza falls sharply.”

Minsky: “It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system… Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”

Minsky witnessed a lot, but he surely never imagined an environment of zero rates and endless trillions of Fed monetization, and how such a backdrop – the perpetual “bonanza” – would extend the “deviation amplifying” Ponzi phase. The Archegos fiasco had me this week sharpening my focus on Minskian analysis..

We have long advised investors to enjoy the party, but to dance near the door. We elect to dance on. We have and recommend no meaningful exposure to bonds whatsoever. We do make selective use of the least risky (i.e. marvellously inexpensive) high quality and powerfully cash-flow generative listed companies, not least in Asian markets (though we have no exposure to China, and probably never will); we like well risk-managed systematic trend-following funds that offer the potential to benefit in falling as well as rising markets; and we maintain plenty of exposure to real asset-linked value companies operating profitably amidst the world’s commodity markets.

We think, in short, that ‘the State’ will win. That means inflation. Which means, in turn, that many investors will lose.

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.