I loved a Zero Hedge excerpt of Hugh Hendry’s letter to investors. Brilliant. Risk-on vs Risk-off, as the crucial choice in finance right now. I have carefully selected a few paragraphs.
“There are times when an investor has no choice but to behave as though he believes in things that don’t necessarily exist. For us (Eclectica), that means being willing to be long risk assets, in the full knowledge of two things: that those assets may have no qualitative support; and second, that this is all going to end painfully. The good news (for him), is that mankind clearly has the ability to suspend rational judgment long and often. …
What is one to do with such a situation? In my view there are really only two responses.”
The bearish response.-
“Remember the film The Matrix? Morpheus offered Neo the choice of two pills -blue, to forget about the Matrix, and continue to live in the world of illusion, or red, to live in the painful world of reality… (Some) as the “enlightened”, chose red, and so are convinced that they understand everything which has become illusory about today’s markets. Their truth is Austrian economics. They know that today’s central bankers are spinning a falsehood of recovery; they steadfastly refuse to be suckered in by the euphoria of a monetary boom; and they are convinced that they will therefore be spared the consequences of the inevitable crash.”
The bullish proposition.-
“I (Hugh Hendry) have long thought of myself as one of the enlightened… I still believe that the attempt by central bankers to prevent the private sector from deleveraging via a non-stop parade of asset price bubbles will end in tears. But I no longer think that anyone can say when (so he says he has taken the blue pill). Look back on the last five years and I think that it is indisputable that mass injections of loose monetary policy have both fuelled asset prices and staved off further crisis. I am also absolutely persuaded that the global economy remains so fragile that modern monetary interventions are likely to persist, if not accelerate. They will therefore continue to overwhelm all qualitative factors in determining the course for stock prices in the year ahead.”
I am impressed with the clarity of thought underpinning the argument. As I would most likely do, after a representation of “La sonnambula” by María Callas, I can hardly temper the impulse to shout ¡¡¡¡ BRAVO !!!!!! And yet, I fully disagree with his judgment.
First. I have always said that mathematics has been rightly quoted as introducing not only “rigor”, but also “mortis”, in economics. I do not agree that we have to optimize the expected return on our portfolio, regardless of the shape of the bell curve representing the “normal distribution” of possible returns. Fat tails have to be considered when deciding. And tails denote morbid obesity right now. When I have to jeopardize the return of my capital (to a substantial degree), in order to enhance the return on my capital, I always leave the game. Invariably. Above a certain level, expected losses or gains, outweigh each other naturally in a normal distribution, but they don’t in my book of vital choices.
Second. The “blue pill” might be the right option, but I will never, ever, go for it. As Emiliano Zapata once said, “It is better to die on your feet than to live on your knees.” There is more to life than optimizing your well-being or survival options. Call me a Jesuit if you want, but I will always go for the red one. Serfdom to principles comes before serfdom to debt or performance. I respect other points of view.
Third. I loved his reasoning, but there is a clear inconsistency in it. If he asserts that it is not possible to say when the asset price bubbles will end in tears, how come he can be certain about the outlook for the year ahead. If you don’t know when, it could be a decade down the road, but it could also be tomorrow.
Fourth. I think he is not picking the best option for his clients (because his brainless clients are mostly unaware of this subtlety), but for himself. He needs performance to subsist in the industry, so he puts performance first, and all the other considerations behind. He is honest about it, a lot more than others who try to sell biased analysis of the underlying reality in order to sustain their businesses. Admittedly, he gives his customers what they want: performance at all costs.
So despite the harmony in our diagnosis, I think the only consistent policy available is to stand aside, because -agreed- you do not know when the meltdown is going to happen. And use patience (the new cool word in fedspeak). If you are a man, in the meantime you can enjoy playing with your nothing box. If you are female, do as James Montier suggests, listen to Winnie the Pooh, and do nothing!
My financial survival is highly more unlikely than his. In essence, our divergence is all about a well known aphorism: “the end (performance) justifies the means (the blue pill)”. To me, increasingly, it is the other way around, and “the means (the red pill) justify the end (a period of underperformance)”. As a rule, I am sure no end justifies the means. All my sympathy for Hendry nevertheless. He may be right, and he sure does not deceive his customers. You have to credit him with clear risk disclosure in this scripts.