Three Things I Think I Think – Stopping the Next Crash Edition

Here are some things I Think I am thinking about:

1.  Hillary Clinton has a plan to stop the next crash.  Here’s an op-ed over on Bloomberg View by Hillary Clinton about reforming Wall Street.  It’s titled “My Plan to Prevent the Next Crash”.  It’s basically a whole bunch of reforms that Hillary wants to slap on Wall Street.  Some of it makes a lot of sense (like the part about ensuring that executives can’t leave an imploding firm with a golden parachute) and some of it is excessive (like the “risk fee” on large banks who rely on short-term funding).  But the part that irks me is this idea that regulation can always stop the next crisis.  This just sounds like political pandering.

With Bernie Sanders hot on her heels I have to wonder if Hillary isn’t pivoting a bit here with some populist rhetoric.  By attacking “bankers” (whatever that means, I mean, “banker” is a pretty general term) she is striking a cord with her base voters.  It’s an extremist and unrealistic view that goes over well with likely voters.  But make no mistake here – no amount of regulation is going to stop the next crisis.  And here’s why.  Because the crisis wasn’t “caused” by a lack of regulation.  Yes, it was exacerbated by a lack of regulation, but it wasn’t caused by a lack of regulation.  The root cause of the financial crisis was a housing bubble in which lenders relaxed lending standards (as they always do late in market cycles) and made poor risk management decisions about who to lend money to.  Combine this with speculative home buyers and you got the housing bubble.  Add on the securitization in the financial sector, a bit of fraud and you had a very fragile house of cards….

The thing is, bubbles are part of markets.  Markets are driven by inherently irrational and uninformed participants. We don’t make perfect decisions about the future and at times we do very silly things. Further, corporations are always finding ways to game government regulations.  And since government is slow to act the corporations are often one step ahead. So, unless the government can stop us all from engaging in the markets then I am afraid there will be bubbles in the future.  This doesn’t mean we shouldn’t have common sense regulations in place, but we shouldn’t fall for populist rhetoric about the idea that government officials can fend off the next financial crisis.

2.   Why Do People Invest in Hedge Funds?  Ben Carlson has a good piece on his site explaining why people invest in hedge funds even if there’s so much research out there showing that they’re usually just high fee versions of index funds.  Unfortunately for hedge funds, the evidence isn’t getting any better as recent performance seems to keep lagging even a basic 60/40 (hedge funds have underperformed a balanced index since 2002).

But there’s a certain irony in the recent performance relative to a 60/40.  As interest rates decline and stock valuations remain elevated investors are concerned that a balanced portfolio like a 60/40 won’t perform well in the future.  And I agree with this idea.  In fact, the math is pretty simple.  That 40% of the 60/40 is guaranteed to do worse in the next 30 years than it has in the last 30 years (because rates are so low).  And given the high historical valuations of stocks it wouldn’t be surprising if stocks do worse than many people are used to.  But even if they perform well (perhaps due to high equity risk premiums) then you’re just getting a leveraged version of the old 60/40 which means that the risk profile of a 60/40 is much riskier than many investors are comfortable with.  In any case, a 60/40 isn’t nearly as attractive as it once was.

Investors have reacted to this environment by allocating assets to managers who are differentiating themselves from your cookie cutter indexing strategies.  Unfortunately, by paying such high fees it’s very unlikely that they’re getting a better return.  And that’s the kicker here.  If the aggregate markets are generating something like a 6-7% return in the coming 10 years (2.5% on bonds and 10% on stocks) then paying 2 & 20 in fees means you’re barely going to generate a real return there.  So, the fee structure, like most active strategies, remains far too onerous.  In a world with lower or more volatile future returns you shouldn’t be paying high fees.  In fact, you should be doing everything in your power to guarantee higher returns by paying lower fees.

3.  Is Gold a Good Inflation Hedge?  Here’s an interesting new paper on gold and its inflation fighting capabilities.  The authors conclude that gold can serve as a reasonable inflation hedge.  My view here is pretty simple.  Gold is not a currency in the modern monetary system.  It is just another commodity. It is a cost input in the capital structure and something that people like to wear so they look fancy.  It might have some use as “money”, but it’s a very poor form of money because it’s not widely accepted as a medium of exchange and it requires a wheelbarrow to transport.

Further, when we’re looking for purchasing power protection in a FINANCIAL ASSET portfolio which one would we rather own – the cost input in the capital structure or the instrument which is attached to the cost input PLUS a markup?  In other words, owning stock not only gives you a hedge against the cost inputs in the capital structure, but stocks give you an embedded premium (the profit premium).

As I’ve noted in the past, the risk adjusted returns on gold are abysmal. Since gold is a major cost input in the capital structure we should expect that gold will tend to rise in value with the rate of inflation.  The problem, however, is that gold prices, like all commodities, tend to be much more volatile than stocks.  Since 1970 gold has had a standard deviation of 29 relative to just 18 for stocks.  A diversified portfolio of commodities has had a standard deviation of 21.  So you are better off diversifying into commodities if you must.

Of course, if we want to diversify all of our assets then owning some nonfinancial assets isn’t irrational.  Then again, when it comes to real assets most of us have a pretty healthy holding there via real estate in the first place.  So, while gold might serve as a fine inflation hedge I don’t think it’s a necessary inflation hedge to hold in a portfolio.  There are plenty of other (far less volatile) ways to hedge against inflation risk than having direct exposure to gold.