This issue of Capital & Conflict comes from my friend Akhil Patel. He unpacks one of the favourite arguments of the Austrians. Not the Austrians generally, but the followers of the Austrian School of Economics, like me.
As you’ll see, it’s easy to interpret historical events to suite our preconceived ideas. Most schools of thought make this mistake. As Akhil puts it, “Do not be seduced by it. Or feel free to be, but do not let it guide your investment decisions.”
But the real treasure in Akhil’s work is the alternative it presents. Instead of using economic theory or macroeconomic analysis, Akhil begins with an observation: cycles are inherent in the economic system. And therefore predictable.
Using this idea, subscribers of Cycles, Trends and Forecasts invest to profit from the ups and downs of the various cycles fluctuating through markets around the world.
If you agree with his ideas, there’s no denying they’re a powerful ally in the investment world. So let’s see if Akhil can convince you..
Until next time,
Capital & Conflict
Beware the fatal conceit of the Austrians
Akhil Patel, Cycles, Trends and Forecasts
Few people today know or remember the depression that took place in the US between 1920 and 1921. The glamour and excesses of the Roaring Twenties has obscured it and the Great Depression eclipsed it in both length and legend.
But it’s important you understand what happened almost a century ago.
In the wake of the high inflation – and, for the US, the booming business – of the First World War, the recently created Federal Reserve set about bringing prices under control. Sean Keyes, writing for MoneyWeek magazine a few years ago, described it thus:
The various Federal Reserve banks raised interest rates by 244 basis points over the course of eight months, with rates peaking at 7% in June 1920.
The Fed’s aggressive tightening seems to have yanked the economy to a halt. Output peaked in January 1920 when the Fed raised rates by 1.25% – still the sharpest single rise in the entire history of the system. Employment and output fell slowly at first, then collapsed in the summer after the final rate rise in June 1920.
The word collapse is overused – but it’s entirely appropriate in this case. Production dropped by a third in just over a year. Wholesale prices more than halved. Indeed, the price collapse was probably the biggest the US has seen in its entire history. And the fall in output was second only to the Great Depression.
The severe deflation meant that interest rates were – in real terms – very high and made the servicing of debts crippling. Farmers and businessmen who had expanded to cash in on high prices and the commodities boom of the 1910s went bankrupt as prices and demand fell.
The fallacy of a common argument
Despite Keyes’s observation that the fall in output was second only to the Great Depression in American history, the US recovered rapidly. And it did so with minimal government intervention. The 1921 recovery also did not involve any deliberate action from the Fed other than bringing interest rates down again.
These points were included in a recent book by Jim Grant (of Grant’s Interest Rate Observer fame): The Forgotten Depression: 1921, the Crash That Cured Itself. Other “Austrian” economists (if you’re interested in the development of economic thought, you can read a good overview of their approach here) and analysts raise the same point. They view any government intervention as interfering and distorting the “natural” market.
But this is mostly an ideological argument which is not grounded (I use this pun deliberately) in the real world. The Austrians point to what happened in 1920-21 as the appropriate response to the 2008 crisis, instead of the government bailouts and Fed money printing that we actually got.
But this analogy is false. Do not be seduced by it. Or feel free to be, but do not let it guide your investment decisions.
You cannot compare the 1921 recession with the 2008 version (or the Great Depression of the 1930s). This is because the downturn of 1921 did not involve land values collapsing, and by extension the banks. What happened in 1920–21 is actually just like the downturn of 2002 in the US and the one we anticipate for the end of this decade or early part of next. In other words, the mid-cycle slowdown of the longer-term real estate cycle.
Hence the recovery after 1921 was much more likely to begin without requiring government assistance programmes, such as we saw after 2008, and without the Fed having to intervene as well (other than to reverse interest rate policy).
Why is this important?
I am not telling you this to score points or to lambast anyone’s deeply held beliefs about the monetary system.
The problem with ideology is that it is used to create seductive stories and explanations and then send you in certain directions with respect to decisions about your wealth.
Here is an example of the sort of argument that can be concocted to explain what has happened in recent years:
- The Federal Reserve or Bank of England should not have intervened. Governments should have severely reduced the size of their budgets in response to the recession. They should have ignored the lessons of the Great Depression.
- Rather than allow the rate of savings to regulate interest rates they messed with it by printing money – trillions of pounds and dollars. In doing so they broke the monetary system.
- All of this “state” created money distorts the allocation of capital in the economy.
- Businesses feel that there is more money in the economy than there actually is (money that represents savings) and therefore have allocated capital to investment to serve demand that is not there. The result? A massive programme of “mal-investments” which will come back to haunt them in the coming crash.
- Then here the story diverges. For some, market investors have been blind to these problems (they haven’t read their Austrian economics textbooks) and have poured money into the stock market creating a massive bubble which will soon pop. High stock valuations support this view.
- The alternative story is that actually investors have seen through this and this is reflected in the fact most markets have gone nowhere over the last two decades. Take the FTSE 100, which is currently where it was in January 2000: 18 years and zero returns. Over the same period, the price of gold has quintupled. This means that the market is in fact wise to the scale at which capital has been misallocated and has delivered its verdict based upon the relative performance of these two assets.
Whichever version of the latter part of the story you believe, the investment advice is the same: you should be in cash or safe haven assets that store value – such as gold. Because the crash is coming – it has been coming for years in fact – and you need to be prepared.
Seductive isn’t it?
Let’s leave aside the fact that this view of money creation is wrong (I invite you to read my primer on this subject from last year – The secret life of banks). Let’s note in passing the deliberate selection of dates to show the relative outperformance of gold compared to the FTSE (the top of the dot com bubble vs. the bottom of the commodities cycle in 2000).
My key contention here is that understanding the land market will help you see the movement of the economy much better. Austrian economists, or any other economists for that matter, do not incorporate land, or the economic rent, into their models.
You know, however, that recovery from a land-induced bust requires action from the central bank. There is simply no way around it.
And if you know your history, you’ll understand that the recovery from a land bust takes time to happen: on average four years from the prior cyclical peak. And that once it does, the economic expansion will be sustained until the land speculation once again overwhelms other economic behaviour.
This pattern goes in cycles. It’s a long cycle and it happens over the course of years, not months. Once you know it, taking advantage of all the volatility will become easier to do.
You can also come to see which economic arguments are flawed and invest appropriately. For example, since 2009 until late 2016 I was positioned for a deflationary environment. During that same time many “Austrian” investors bought gold and other inflation hedges in response to the money creation from the central banks because they expected hyperinflation. And over that same period, the outperformance of the FTSE relative to gold has been enormous.
The time for protecting yourself from inflation is starting to arrive, right on cue. The past few years of waiting for it were wasted, I am afraid. Here’s what they don’t understand…
The US Fed needed to print more
The refrain over the past several years, since the Fed “QE” I, II and III, has generally been: “Never before has so much money and so much credit been created so quickly. It’s going to sink the dollar, ruin the US and cause economic mayhem, everywhere.”
But is this actually true: That so much money and credit was created so quickly?
Not according to Steve H Hanke, professor of Applied Economics at the Johns Hopkins University in Baltimore (he is also one of the very few economists who understands the land dimension and can spot the cyclical repeat). He had this to say (in 2015):
Even though the Fed has been pumping out State Money at a super-high rate since the crisis of 2009, it hasn’t been enough to offset the anemic supply of money produced by banks – Bank Money. Even after six years of pumping, State Money still only accounts for 21 percent
of the total money supply broadly measured. In consequence, the Divisia M4 money supply measure is growing on a year-over-year basis at a very low rate of only 1.7 percent.
You can read his entire piece here, and I suggest you do.
In fact, you could say the Fed did not actually print enough money. Banks were being forced to devote more of their balance sheets to holding more securities (in case of another bank run) instead of lending it out.
In other words, all the money printing that took place did not make up for all the money destroyed in the downturn. We cannot emphasise this point enough. The Fed printing money is NOT the problem: the collapse of the money supply, caused by the credit (created against land values for the most part) being wiped out in the downturn and not replaced by new bank lending, was.
The situation was worse in Europe, as Professor Hanke showed. This is why the eurozone took much longer to recover than the US or the UK.
This situation has now come to an end, as it does every real estate cycle, as interest rates are lifted back to “normal”. This is around 8 to 9 o’clock on our property clock.
Money and credit do matter. But land value matters even more.
The alternative to seductive stories
Back to why this is important for your investments. Let’s take a look at the FTSE 100 since 2000. As you can see, the dashed line shows that the index is currently where it was at the peak in 2000, at around 7,000.
Remember, if you think that central banks have broken the monetary system, you’re going to be looking at this chart, at the fact that the FTSE has gone “nowhere” for two decades, and see weakness; possibly preparing for it to go much lower, but certainly to underperform other assets such as gold.
Since 2000, the index approached the dashed line at the real estate cycle peak in 2007; it then briefly broke through in 2015, before doing so decisively in 2017.
Here is what you need to know about this chart.
Markets butting up against highs over a long period of time are rare events. And when they break up they run for years and years. So market history tells us.
Let’s take a look at the Dow Jones between 1930 and 1950. In 1950 the Dow was at around 213, which was where it had been in 1930. Then it broke through and never looked back.
It ran and ran. It reached a peak at around 1000 in 1966: two decades of going nowhere followed by a 500% gain in around 16 years.
W.D. Gann said this, in his Truth of the Stock Tape, about stocks that test highs over a number of years (emphasis added):
When stocks establish certain levels of accumulation or distribution over a longer number of months or years and then cross them it is almost a sure sign that they are going to new high or low levels before they meet with resistance again…
When a stock advances…into new territory or to prices which it has not reached for months or years, it shows that the force or driving power is working in that direction. It is the same principle as any other force which has been restrained and breaks out. Water may be held back by a dam, but if it breaks through the dam, you would know that it would continue downward until it reached another dam, or some obstruction or resistance which would stop it. Therefore it is important to watch old levels of stocks. The longer the time that elapses between the breaking into new territory, the greater the move you can expect…
Following the peak of 1000 around 1966, the Dow stalled at this level for many years. It touched this level in 1969, 1973, 1976/77 and 1980. Each time it reached those highs but failed to break through. In late 1979, BusinessWeek magazine ran an issue with the title “The Death of Equities”, so gloomy was the outlook then.
But after 16 years of going nowhere, the Dow finally broke through 1,000 in 1982.
After doing so it ran up for another 18 years, before peaking at around 11,000 in 2000. 16 years of going nowhere and then 18 years delivering a 1,100% gain.
Are you starting to see a pattern?
In my view, the conclusion you should be drawing from the chart of the FTSE is exactly the opposite to the one I paraphrased earlier.
Be prepared for the FTSE to go much higher. Much much higher. Obviously it will not be all in a straight line and there will be volatility along the way (as in past examples of market breakouts). During that period we will have to contend with the mid-cycle slowdown and perhaps the peak of the real estate cycle.
Incidentally, the market ructions of the past couple of months have brought prices back down to previous highs. If these hold, that is a strong set-up. And, if you’re interested in time cycles, note that this was exactly 180 months from the market lows in March 2003 (for an introduction to the idea of time cycles, and the significance of this time count, please review this newsletter).
So now you have both a price point of support and a time point of support for this set-up. I will discuss both of these points in more detail in future newsletters.
I am sometimes asked: what if I am wrong about cycles and these patterns? That’s a big question. I will be the first to admit that it could well happen. But what this type of analysis throws up are very clear time and price points at which you will know this definitively and you can respond accordingly.
I want you to be wary of ideology masquerading as investment strategy. All you need to do is to understand the land cycle and learn your market history.
And the rest will take care of itself.
Editor, Cycles, Trends and Forecasts