The growth of the U.S.'s bigger and broader productive economy has been stunted by bad policies and bank bailouts benefiting rent-seeking financiers siphoning off an outsized percentage of the nation's gross domestic product (GDP). Rent-seeking companies lobby Congress for subsidies for activities that do not benefit society. Moreover, beneficiaries of Congressional largesse damaged society by engaging in control fraud, wherein parasites damage their own financial firm from within while earning huge bonuses. William K. Black coined the term "control fraud." As a regulator during the 1980′s S&L crisis, he helped initiate over 1,000 felony indictments. Yet the much larger 2008 crisis produced zero felony indictments.
The financial services industry has grown like an algae bloom with the help of taxpayer bailouts and ongoing subsidies, all of which increase our debt. According to a study by Harvard professors David Scharfstein and Robin Greenwood, in 1950 the financial industry accounted for only 2.8 percent of GDP; in 1980 it accounted for 4.8 percent of GDP; and in 2007, it accounted for 7.9 percent of GDP. In 2011, the Commerce Department reported the financial sector accounted for 8.4 percent of GDP, and represented 30 percent of corporate profits.
If proceeds of U.S. debt had been invested for roads, high speed railroads, new industries, cheap energy, airports, and to fund scientific research, the debt would self-liquidate. But the bailouts came with a huge component of dead-end financing designed to let bankers suck rents from the financial system. The Fed monetizes debt through asset purchases and has been filling gaping holes in bank balance sheets.
Buffett, Bailouts, and Hyperaggressive Monetary Policy
Warren Buffett, CEO of Berkshire Hathaway and one of the most successful investors in world history, riffed gold in his 2012 shareholder letter. Yet he acknowledged: "the dollar has fallen a staggering 86 percent in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time." Buffett didn't mention that most of the weakness in the dollar occurred after Nixon took the dollar off the gold standard in 1971.
Buffett claimed that for most people, gold is only a fear trade and that people afraid of every other asset run to gold and hope the "ranks of the fearful will grow." Based on my observations, Buffett's notion does not represent diversified investors.
Buffett may or may not be right about gold, but he has a reason to be biased. He's the beneficiary of massive post-crisis bailouts and the Fed's hyperaggressive monetary policy the past five years. If U.S. taxpayers hadn't bailed out many of the stocks in his portfolio (US Bancorp, Bank of America, American Express, Goldman Sachs, Wells Fargo), his performance would have suffered, and he wasn't alone.
Shares of Lehman were worthless. Bear Stearns' shares (now part of JPMorgan Chase) and Merrill Lynch's (now part of Bank of America) plummeted along with the shares of Freddie Mac, Fannie Mae, Citigroup, MBIA, Ambac, AIG, and many more.
Savvy investors like Buffett are ever mindful that the financial system hasn't dealt with its problems. Investors are looking for diversified temporary stores of values--and that may include gold and U.S. Treasuries.
Temporary Liquid Stores of Value: Gold and T-Bills
Buffett claimed gold, a non-productive asset, is in a bubble. Perhaps both gold and U.S. Treasuries are in a bubble, and they are both non-productive assets, but they both have financial utility. Buffett keeps his powder dry by investing a working level of $20 billion in U.S. Treasuries--and never less than $10 billion--for liquidity. The same aggressive zero interest rate policy (ZIRP) that has destroyed safe savings and encouraged investors to buy riskier assets (thus benefiting Buffett's stock portfolio) has resulted in a negative real return for U.S. Treasuries. But Buffett invests in treasuries for the same reason other diversified investors invest in some gold: because he believes it is a prudent strategy.
Many reasonable diversified investors, including Ray Dalio of Bridgewater, the largest money management firm in the world, own a portion of their diversified holdings in gold. Gold doesn't pose credit or counterparty risk, and unlike many U.S. stocks, it has never been worth zero. Gold isn't viewed as an alternative to productive assets; rather investment in gold is another way to diversify.
The recent drama over a possible technical default of U.S. debt, cast doubt on the liquidity of T-Bills, and reignited concern about the dollar's reserve currency status. The most shocking development was this: "HKFE Clearing Corporation, part of Hong Kong Exchanges and Clearing, increased the haircut on US Treasury bills from 1 percent to 3 percent for maturities of less than one year." The Commodity Futures Trading Commission is considering a regulation that could double liquidity facility costs; clearinghouses may have to back Treasuries pledged as collateral with bank credit lines. The CFTC claims that in a crisis, it may take too long, up to a day, to liquidate Treasuries. Yet Congress foolishly refuses to rule out the future possibility of a technical default. Perhaps Warren Buffett should diversify Berkshire Hathaway's liquid investments even more.
Central Banks: Global Printing Destroyed Money Standards
There is no longer a stable currency benchmark for the largest economies in the world: the United States, the Eurozone, China, Japan, or any other country. Relative value is a rapidly moving target. No one can adequately track it.
Central banks still use gold as a form of money. Dr. Mario Draghi, President of the European Central Bank, is the former governor of the Bank of Italy, the fourth largest owner of gold in the world. Draghi stated:
I never thought it wise to sell it, because for central banks this is a reserve of safety; it's viewed by the country as such. In the case of non-dollar countries, it gives you a fairly good protection against fluctuations of the dollar. So there are several reasons, risk diversification, and so on...the experience of some central banks that have liquidated the whole stock of gold about ten years ago, was not considered to be terribly successful from a purely money viewpoint.
Dr. Draghi suggests some gold ownership is a prudent strategy at a time when global currencies have become unmoored.
Trouble is Opportunity
The world population is approaching 7 billion. Every day we wake up hungry, and we all have needs. We will have trouble. Liars, thieves, and bullies will always be with us. But so will productive people and productive assets to supply growing needs. There will always be opportunities for sound investments.
It is in everyone's interest to keep the production-to-corruption ratio as high as possible. Our leaders failed us, but the human will for survival may result in a push to rebalance the scales.
Those of us who have lived through tremendous upheaval know that people don't want cash, gold, or other liquid assets for their own sake. These are simply a means of storing value so that you can invest in productive assets at a reasonable price.
What Is a Reasonable Price?
The late John Templeton (1912-2008) was one of the greatest investors of all time. He used guidelines that suggest many global stocks are currently overpriced by historic measures and are located in countries with high debt to GDP ratios. They are a "Templeton sell." Before he evaluated country risk, however, he looked at individual companies. He looked for companies with low debt and growth in net earnings per share.
Templeton sought profits after deducting expenses and taxes. He also looked for a good price as indicated by relatively low price-to-earnings (P/E) ratios, relatively low price-to-earnings-growth (PEG) ratios, strong dividends, and relatively low price-to-book values. For blue chips that meant a P/E ratio of 12 or less, dividend yields of more than 4 percent, prices of 1.2 times book value and a price to earnings growth ratio of less than one.
When stocks became overvalued in Templeton's estimation, he sold them. He remarked that he never bought a stock at its lows and never sold at the highs. He was one of the earliest western investors in Japan and sold when he believed the Japanese stock market was overvalued. The Japanese stock market became a bubble that continued to expand until it exploded.
Templeton didn't get out at the highs, because he didn't want to stay invested in a stock bubble. He was happy to hold cash as a temporary liquid store of value, if he couldn't find an investment 50 percent better than what he was selling. This wasn't his only strategy, but it was one of his several successful strategies.
Bubbles versus Reasonably Priced Productive Assets
Most global stocks appear overvalued. Many stocks in the S&P 500 (Standard and Poor's) look like a "Templeton sell," and the index overall has a trailing 12-month P/E ratio of 18.4 according to the Wall Street Journal's market data center.
This is why John Templeton avoided indexes and performed his own analysis. One defense against bubbles is to selectively invest in productive assets when they can be purchased at reasonable prices. When assets are overpriced, investors can choose a store of value.
This article was excerpted from "How Hidden Bank Risks Drive Investors to Productive Assets, U.S. Treasuries, and Gold" published yesterday at The Financial Report.
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