C&B Notes

Where to From Here?

We recently wrote a short piece discussing the current happenings in the broader markets.  The recent price volatility has not changed much yet for U.S. equities, but the drawdown of global equities — when combined with the depreciation of other currencies against the dollars — has made a select few of these businesses more compelling investment opportunities.

Thoughts (But No Predictions) About the Current Environment

At a Daily Journal annual meeting in Los Angeles earlier this year, Charlie Munger — the 91-year-old Vice Chairman of Berkshire Hathaway — shared his opinion on the investment landscape when asked about negative interest rates in Europe and persistently low rates in the United States:

This has basically never happened before in my whole life.  I can remember 1½ percent rates.  It certainly surprised all the economists.  It surprised the people who created the life insurance industry in Japan, who basically all went broke because they guaranteed to pay a 3% interest rate.  I think everybody’s been surprised by it, including all the people who are in the economics profession who kind of pretend they knew it all along.  But I think practically everybody was flabbergasted.  I was flabbergasted when they went low; when they went negative in Europe — I’m really flabbergasted.  How can I be an expert in something I never even thought about that seems so unlikely? It’s new territory….

I think something so strange and so important is likely to have consequences.  I think it’s highly likely that the people who confidently think they know the consequences — none of whom predicted this — now they know what’s going to happen next?  Again, the witch doctors.  You ask me what’s going to happen?  Hell, I don’t know what’s going to happen.  I regard it all as very weird.  If interest rates go to zero and all the governments in the world print money like crazy and prices go down — of course I’m confused.  Anybody who is intelligent who is not confused doesn’t understand the situation very well.  If you find it puzzling, your brain is working correctly.

The table below reflects the nominal return an investor can earn by purchasing a 10-year sovereign bond and holding it until maturity.  The impact of various interventions made by central bankers the world over remains clear in these figures:


These rates of return (and, by extension, their prices), and the manipulation that has brought them to and kept them at historical lows, are so critical because they set the market for financial assets.  In particular, U.S. Treasuries and German Bunds represent the “risk free” rate of return in dollars and euro, respectively.  The intrinsic value of all asset classes relies on the prevailing opportunity cost, and over the next decade market participants are currently requiring a risk free rate of return of just over 2% in dollars and merely 1% in euro.  So what rate of return should investors reasonably expect to make in stocks, real estate, private equity, venture capital, timber, etc. during this same time period?  Markets generally price opportunity cost fairly efficiently — prices of assets will be bid to levels such that risk-adjusted returns across asset classes converge.  Accordingly, the primary effect of major central bank policy to keep “risk free” rates artificially low has been to drive financial asset prices to new highs.  Future returns from an asset are inversely correlated with the price paid for it, so this induced appreciation has reduced future investment returns. 


To further the confusion, current yield curves for a number of sovereign buyers reflect negative real rates of return (nominal interest rates minus expected inflation).  We are certain that the world has a positive time preference for money.  That is, people must be compensated to defer consumption, and this preference for current consumption requires real interest rates to be positive.  While in a truly deflationary environment nominal interest rates can be negative, real interest rates must revert to positive in the long run.  At some point the disjunction between a positive time preference and negative real rates must be resolved.  History suggests that the resolution of this disjunction is likely to be painful, but we offer no expectations about the timing of such a resolution.  In addition and perhaps most importantly, the rates of return currently offered by nearly every asset class are inadequate if risk-free, real interest rates revert to positive.  So, the inducement of low interest rates is doing much more (and worse) than just compressing future returns as discussed above — it is putting investors at risk of permanently impairing their capital as they bid up prices of financial assets.

For the first time in quite some while, there is a real discussion about raising interest rates in the U.S.  Perhaps this has been the catalyst for the recent bout of volatility in the broader equity markets and for the meaningful drop in lots of global stock prices during August (or perhaps not — who knows?).  Maybe this is the beginning of the resolution of the aforementioned disjunction, or maybe it was simply a dip on the way to higher equity prices.  Trying to time the market is a fool’s errand, no matter how urgent an investor feels about the need to do something when the pressure increases and the yelling on the mid-day CNBC show grows louder.  The reality is that for a long-term, patient investor a decrease in the prices of assets and an increase in the price volatility that often accompanies these moves are allies.  As explored above, the rate of return of an asset is inversely related to its price; that is, as the asset’s price goes up, its future rate of return falls.  But when prices gap down, an investor has opportunities to buy cash-producing assets at more attractive levels that promise better returns to its owners and less risk of permanent losses of capital along the way.  Now, this contrarian mindset is far from an easy discipline to maintain when markets are gyrating, and humans have all manners of adapted behaviors that try to stymie this approach.  In fact, economic cycles and financial asset bubbles are, in part, a product of these human inadequacies.  But, when coupled with the decisiveness needed to act in a chaotic market environment, an opportunistic posture that is sensitive of and disciplined to price is the way to compound capital at above average rates of return over long periods of time.

Yogi Berra