Intrinsic Alpha Note – November 2013

“Investing should be more like watching paint dry or

watching grass grow. If you want excitement, take $800

and go to Las Vegas” - Paul Samuelson

“A Texan oil tycoon dies and goes to heaven. He is

greeted by St. Paul who informs him there is no space in

left in heaven. The tycoon asks to say hi to his old

buddies in heaven and shouts through the gates ‘Oil

found in hell!!’. A stampede ensues and heaven is left

empty, St. Paul says, ‘very clever, you can now enter

heaven’. The tycoon turns and replies, ‘you know, there

just might be some truth in that rumour’, and of course,

he goes to hell.” – paraphrased joke.

“They used to tank cod from Alaska all the way to China.

They'd keep them in vats in the ship. By the time the

codfish reached China, the flesh was mush and tasteless.

So this guy came up with the idea that if you put these

cods in these big vats, put some catfish in with them and

the catfish will keep the cod agile. And there are those

people who are catfish in life. And they keep you on your

toes. They keep you guessing, they keep you thinking,

they keep you fresh. And I thank god for the catfish

because we would be droll, boring and dull if we didn't

have somebody nipping at our fin.” – Vince Pierce,

Catfish 2010.

All roads lead to hell

I have not written in a few

months – largely because much

has not changed in the way of

fundamentals, although there

have been many changes. A

brief warning – this note is

lengthy and I recommend you

read it in a quiet place, perhaps your local pub or at

home with the comfort of a beverage.

Look at equities today. It is surreal that the analogue of

the 1995 bull-run leading into the era of Irrational

Exuberance has been echoed this year in the 2013 Bull

Run (Figure 1). I find myself asking whether people are

trying to go to hell? It seems that there was some truth in

the rumours, US equities have been a great investment

post 2008. Or could it be something more interesting is

taking place? I find myself asking whether the fixed

income bubble has resulted in the beginnings of an

equity bubble. Investors fearful of rising rates are

beginning to ignore how to value stocks – they forget you

need to discount future cashflows to equity. Rising rates

reduce this present value, but there is a feedback loop

inherent in the story – rates will only go up if the

economy is doing well, and of course, by “economy”

what we actually mean is the stock market. This is the

proverbial “central bank put option” also known as the

“insert Fed Chairman name here”-put.

Figure 1 data source The Bloomberg

Investors are asking for directions to hell, they haven’t

set off just yet. The important question to ask is when

exactly they will go to hell. If we extend the analogue we

get some potential indication and the truth of the matter

is – it looks like they can rest assured for quite some time

(Figure 2). Let me be clear, I believe we are at the start of

a new secular bull market in equities, a “once in a

lifetime” buying opportunity (or maybe 2008 was the

opportunity?). Buy now while stocks last.

Figure 2 data source The Bloomberg

Asset allocators today reason that equities are a hedge for

the Dollar (despite its trade-weighted strength since

2008), a hedge for monetary base expansion, a hedge for

inflation and a hedge against rising bond yields. US

stocks are all the rage these days, everyone is offering up

reasons to own equities. Of course the memory of 2007/08

Intrinsic Alpha Note – November 2013

has yet to be exorcised from participants’ minds – they

are being careful and there are many warnings out there

surrounding new nominal highs. It’s as though highs

have never been broken before. If you ask me, it is

precisely because people are asking the question of

whether stocks are overvalued that will push them

higher. History shows that it takes very little doubt in the

market’s psychology to force a crash. It is when everyone

is unprepared that we get crashes, not when we are all

hedged and diversified. We will see higher highs ahead –

risk on.

It is no coincidence that the long term log trendline in the

S&P 500 Index (also known as the Meridian) was

breached at the start of 2013 and the breach has been

sustained (Figure 3). The last time it was breached with

the same momentum was at the inception of the 1995

bull-run or the beginning of Greenspan’s Irrational

Exuberance.

Figure 3 data source The Bloomberg, rendering and annotations by Intrinsic Alpha

The gates of hell stay closed for now.

People want to go to hell

What we are witnessing is the largest attempted reflation

amidst a severe deleveraging since the 1930’s US

deleveraging. It took 12 years for US real GDP per capita

to recover to its long-term growth trend. We’ve only had

6 years since the 2007 credit crisis and as you can see,

Bernanke and co. handled this deleveraging rather well –

we are only 7% below trend whilst at the peak of the

1930’s episode, US real GDP per capita stood at 38%

below trend.

Figure 4 data source http://www.measuringworth.com/, calculations by Intrinsic Alpha

The pace of growth of real GDP is naturally increasing

i.e. real GDP should grow exponentially over time. The

main reason for this that gaining some knowledge

(technological advancement) helps us gain more

knowledge later. Despite this, it is early to presume the

worst is over, but there are some signs and we are on the

way to closing the gap via re-leveraging and reflation.

For one the US household debt service payments as a

percentage of disposable incomes has fallen to 1980’s

levels – the US consumer has deleveraged (Figure 5).

There is now far more capacity for consumers to take on

additional debt, which is what drives strong upswings in

real GDP.

It’s the credit – stupid!

In the West, we can count on people to spend, spend,

spend with what they don’t have.

Figure 5 data source Federal Reserve Bank of St. Louis

Credit spends just like money – note to self.

The banking system has also been aggressively de-

leveraged via the Fed’s Quantitative Easing injections.

Intrinsic Alpha Note – November 2013

Figure 6 data source Federal Reserve Bank of St Louis, calculations by Intrinsic Alpha

I have constructed a measure of the total money stock for

the US based on the Fed’s methodology for M3 and taken

the ratio of this to the St. Louis Source Base (base money)

in Figure 6. This provides a neat measure of how much

the monetary base has been leveraged up versus the

monetary base. As is clear – this ratio has been on the

steady rise from a level of 6 times in 1959, all the way up

to 16 times. The system is roughly 4 times less leveraged

than before. The banking system’s function is to short the

monetary base (money created by the Fed) and lend this

money out via credit. Banks create money (credit) as they

can make greater loans than actual money held through

fractional reserve lending. Of course if you default the

mafia bank has a right to your property – the vig interest

rate is what you pay for the privilege. When this money

short is called on i.e. the banks get stopped out leading to

a shortage of reserve currency i.e. US Dollars. This is

what happened in 2008.

Anther take on prices

The price level is where the quantity of money available

meets the supply of goods, services and financial assets

(“stuff”). It is my view that the supply of money versus

stuff is what drives the absolute price level i.e. inflation,

however the composition of inflation (goods, services

and financial asset inflation) is driven by something a

little more sinister – the inherent leverage in the banking

system and wider economy. What we call “money” these

days is also a matter of subjectivity. In practice, credit is

money, because credit spends just like money when it’s

created. Remember, banks and financial institutions

create credit through their ability to leverage the

monetary base.

Figure 7 data source Federal Reserve Bank of St Louis, calculations by Intrinsic Alpha

Figure 7 shows how upon abandoning the gold standard,

the US incurred bouts of increasing leverage coupled

with highly infrequent periods where services inflation

was lower than goods inflation. The green areas show

that falling leverage coincides with lower services

inflation than goods inflation – the services sector

benefits from credit and easy money.

Increasing the ratio of manufactured money (credit

currency via bank-created credit) drives services and

financial asset inflation up at a faster rate than goods

inflation. This is because the services based sectors of the

economy demand the same value in real terms for their

output. Doctors and accountants notice the prices of

goods & services rising and want to maintain their

purchasing power, so raise their fees by more than

inflation. Commodity producers (and manufacturers of

goods) on the other hand are on a negative terms of trade

versus the services sector – they are buying services at a

mark-up to inflation (ultimately, the pecking order for

terms of trade is Services>Goods>Commodities sectors).

In an economic cycle, wealth is directed towards the

services sector (in particular the banking sector) because

they are the first to experience the up-thrust in

purchasing power due to additional manufactured

money i.e. bankers get paid bonuses before businesses

can extract benefits of borrowing before consumers are

given more credit to spend and before financial assets

rise in value. This makes talented university graduates in

Engineering suddenly realise they wanted to become

investment bankers from birth instead of

engineers…money (or inflation) talks.

Intrinsic Alpha Note – November 2013

Figure 8 data source Federal Reserve Bank of St Louis, calculations by Intrinsic Alpha

So the balance of inflation between the goods and

services sectors is not really a balance at all – in this

system it pays to be part of services. Figure 8 shows

services CPI increasing significantly more than goods

and commodities CPI over time – there have only been 5

brief periods since 1959 (none lasting more than 2 years)

where average services inflation has been lower than

goods inflation.

But what about the price level?

In 2007/8 the “-flation” debate centred around whether

all that central bank “money printing” would cause

hyperinflation or whether it was insufficient and we

would slip back into deflation. Everyone was screaming

inflation because of all that money printing!!!! It must be

said that the high inflation scenario was far more

consensual as people looked towards the most recent

data points of the US stagflation in the 1970/80’s. It

wasn’t so difficult to imagine inflation rising quickly,

what with the Chinese economy still growing at 9% p.a.

and commodity prices at all-time highs – people are

victims of the availability bias and valence. The de-

coupling theory prompted investors to think that the

emerging markets would prop-up global inflation

despite a deflating West. They were wrong.

Investor expectations have shifted and most would now

agree we are dangerously close to deflation. Just last

week (ending Friday 8 November 2013), the latest

Eurozone CPI print was published and this confirmed

Mr Market’s view of deflation, 0.7% YoY and Mario

Draghi cut the Eurozone overnight rate by 25bps to

25bps.

Figure 9 data source www.tradingeconomics.com

The US is no prize turkey either with the most recent CPI

figure coming in at 1.2%

Figure 10 data source www.tradingeconomics.com

Have the central banks forgotten their targets?

There is room for more inflation but Mr Market wants to

look the other way. The BofA Merrill Lynch July Fund

Manager Survey polls 238 hedge funds around the world

responsible for a combined $643 billion in assets under

management on various topics. The results for what

these guys consider the biggest tail risk are shown in

Figure 11 So inflation is firmly last in the list. They are

more preoccupied with pontificating on China and its

manufactured nominal GDP numbers and whether it will

be able to sustain its demand for commodities.

Figure 11 data source BofA Merrill Lynch Global Investment Research

Intrinsic Alpha Note – November 2013

What you will commonly hear is that there is a fine

balance in the printing presses – printing a bit more

money than needed will create inflation extremely

quickly, a kind of leverage effect. I don’t buy this. The

reason we haven’t seen high inflation is because the devil

is in the detail.

Figure 12 data source Federal Reserve Bank of St. Louis, calculations by Intrinsic Alpha (right axis in $ Millions, left axis in percentage) Figure 12 shows how the amount of money defined as

M3 + Commercial Bank Credit (that is Fed M3 pre 2006

and my measure of M3 post 2006 – see appendix for how

well these compare) has increased substantially since

2009 but this has not lead to dramatic increases in the

CPI. There is one other important observation from the

chart. It is clear that changes in CPI and changes in

money are weakly correlated (42% correlation over the

period above with a 1 month lag) – my previous assertion

that the stock of money drives inflation requires a caveat.

It is not the stock of money in isolation that describes

inflation. To believe that is to believe that there is no

supply and demand for money. The more accurate

description should read, the stock of money combined with

its percolation through the economy is what drives changes in

price level. This raises another question – where is all that

manufactured money? We will find the answer in the

Fed’s excess reserves and how these are handled.

Figure 13 data source Federal Reserve Bank of St. Louis

Four decades ago, Milton Friedman recommended that

central banks pay interest to depository institutions on

the reserves they are required to hold against their

deposit liabilities. This proposal was intended to improve

monetary policy by making it easier to hit short-term

interest rate targets. The Fed was given this authority in

2008.

This new policy is especially important now that the Fed

has been holding more than $1 trillion dollars in total

reserves from depository institutions for the past three

years (Figure 13). Total reserve balances held at the Fed

include required reserves and any excess reserves that

depository institutions choose to hold on top of the

required reserves.

Under the 2006 Act, Federal Reserve Banks were directed

to: “pay interest on required reserve balances (that is,

balances held to satisfy depository institutions’ reserve

requirements) and on excess balances (balances held in

excess of required reserve balances and clearing

balances)”.

In 2007, required reserves averaged $43 billion, while

excess reserves averaged only $1.9 billion. This

relationship was typical for the past 50 years when the

Fed did not pay interest on reserves with only two

exceptions. Those occurred when the Fed provided

unusual levels of reserves to depository institutions in

September 2001 following the terrorist attacks and in

August 2007 at the onset of the global financial crisis.

Other than those two months, excess reserves were less

than 10% of total reserve holdings, because depository

institutions had an incentive to minimize noninterest-

bearing excess reserves held at the Fed. In other words,

banks are not incentivised to lend out their reserves

when they earn interest on them by keeping deposits at

the Fed. Who would have thought?

Once the Fed was authorized to pay interest on reserves,

the relationship between the levels of required reserves

and excess reserves changed dramatically. For example,

required reserves averaged almost $100 billion during

the first six months of 2012, while excess reserves

averaged $1.5 trillion!

The reason for paying interest on excess reserves is to

maintain the target for the Fed funds rate which is the

rate that banks lend and borrow balances held at the Fed

Intrinsic Alpha Note – November 2013

(reserves) with each other. The Fed sets the target rate in

line with Monetary policy and uses Open Market

Operations to influence the supply of money via asset

purchases (the resulting balances on bank balances

ending up at the Fed as excess reserves) and the interest

rate on deposits to influence the demand for such

deposits. It’s great for the Fed, because the interest rate

lever is another tool it can use to increase or reduce the

amount of these reserves entering the real economy and

hence inflation.

Better the devil you know than the one you don’t

I’m going to be quite clear and direct at this juncture. If

the Fed stops paying interest on these deposits, banks will have

a greater incentive to extend credit to the economy. This will be

inflationary. But of course for this to happen, the demand

for credit needs to be there as well – people have to take

the loans they are offered. Now that the consumer and

companies are ready to re-lever, I say game on.

"Gold is the money of kings; silver is the money of

gentlemen; barter is the money of peasants; but debt is

the money of slaves.”

Is the common phrase. Does this need to be amended to

include, “and Bitcoin will be the money of the Digital

Generation”?

“Altfiat” (alternative to fiat currency) is something the

common man in the streets understands, people have

become distrustful of their governments and central

banks. You don’t need to stretch your imagination much

to conceptualise why, the 99% are angry that the 1% now

command a significantly disproportionate share of global

income and wealth (Figure 14).

Figure 14 source: Thomas Piketty and Emmanuel Saez, "Income Inequality in the United States, 1913-1998," Quarterly Journal of

Economics, 118(1), 2003. See more at: http://inequality.org/income-inequality/

Figure 15 source: Economic Policy Institute, The State of Working America 2011, "Wealth Holdings Remain Unequal in Good and Bad Times." - See more at: http://inequality.org/wealth-inequality/#sthash.2haLtrub.dpuf The rich should understand and sympathise with the

common man in the street for being a bit disgruntled.

The truth is, inequality alone is insufficient to build

mistrust in a nation’s fiat currency. It’s what happened in

2007/8 that was the catalyst, however the storm has been

brewing for quite some time as the US Dollar has lost

most of its purchasing power over time via inflation and

devaluation relative to trading partner currencies. Major

central banks globally took it upon themselves to save

their credit-fuelled financial systems from insolvency by

injecting taxpayer money into their banking systems.

This Quantitative Easing put a fast end to the pain (for

some) of deleveraging in the West – a condition brought

about due to Western economies reaching the tipping

point of where their debt service obligations

overwhelmed growth in incomes. The credit cycle should

have reversed – irresponsible banks should have

collapsed, property values should have halved, equities

should have lost 50%, prices should have fallen and the

system should have found its natural clearing level – just

like in any market. Instead our leaders decided to avert

disaster (and US experience of the 1930’s deleveraging)

and aggressively de-leveraged banks (via reserve

injections and TARP funds) until they could then extend

further credit into their economies and repeat the cycle.

Of course, you can’t pull off the greatest financial rescue

in living memory (or ever) of financial institutions.

People have realised that the fiat currency in their

pockets is not a store of value – it is only a means of

transacting between market participants. A Dollar in

your pocket today is worth less tomorrow because of

Intrinsic Alpha Note – November 2013

inflation, or more accurately, an increased supply of

money relative to the things we buy with that money.

People are gradually opening their eyes to the fact that

popular measures of inflation like the CPI are not

representative of true inflation – instead these have been

massaged towards stability over time.

So what about bitcoin? My views on this can be

summarised as:

• It is a commodity, not a currency – it has

nowhere near any credibility as a medium of

exchange. Fiat is far more dominant and this will

not change – sorry.

• Fiat is issued under law – bitcoin is not. Should

bitcoin pose a credible threat to this status quo,

the authorities will simply make it illegal. Don’t

tell me people will use it anyway. They won’t

because their taxes and wages will be payable in

fiat.

• Supply is not limited – there are many altfiat

crypto-currencies in circulation today. Why not

keep supplying alternatives and make them all

worthless?

• The widespread use of bitcoin today is to

primarily facilitate money laundering, trade in

illicit goods and speculation. That is not a

currency.

• It is far too volatile to be used as a credible

transaction mechanism. I know the dollars in my

pocket do not have a 100% volatility over a day.

Sure they lose value over time relative to stuff,

but this is far slower than bitcoin.

• Bubbles usually reach their peaks when the

fundamentals reinforce the trend. For bitcoin this

has just started.

The truth is, a lot of hype has been created around altfiat.

You can’t blame people – they are angry. They want to

stick it to the bankers. Imagine how upset they will be

when they lose everything on bitcoin. Let’s all pull our

heads from out of the sand and get back to work. Any

asset with no cashflows cannot be valued apart from the

only credible asset in a catastrophe scenario - gold and

other “intelligent metals”.

I have decided to include a brief summary of my main

exposures as part of this series. Full transparency.

As is clear, I am long the over-indebted West, short the

Yen, long inflation with a partial hedge against short

term volatility via a small albeit convex fixed income

allocation. Overall direct Emerging Market exposure has

been kept low but is well maintained via UK equity

exposure. You will notice a long position in Greek stocks

– needless to say I am of the view this represents the

most convex position in the portfolio aside from the

value stock. You will also notice no gold or silver – my

reasoning is that these are undergoing consolidation as

real rates rise. All rates exposure has been maintained

towards the short end of the curve. Hardly any cash to

care about – remember, a dollar today is worth less

tomorrow, real assets all the way.

Exposure % Allocation

1 Eurostoxx 50 Equal Weighted TR Index 15.80%

2 Odey Opus Hedge Fund 14.10%

3 S&P 500 TR Index (USD) 11.40%

4 FTSE 250 TR Index 10.10%

5 S&P US Dividend Aristocrats TR Index 6.90%

6 Value Stock Position (Esure Group) 6.40%

7 DB X-trackers MSCI Japan Index (GBP) 6.00%

8 Lyxor MSCI Greece (USD) 6.00%

9 iShares UK Property UCITS ETF 6.00%

10 FTSE 100 TR Index ETF 5.40%

11 Ossiam Risk-weighted Commodity ex-grains ETF 3.70%

12 DB X-trackers iBoxx Global Inflation-Linked TR Index (GBP) 3.50%

13 DB X-trackers iBoxx £ Gilts Total Return Index 2.30%

14 iShares £ Corporate Bond 1-5yr UCITS ETF 2.20%

15 Cash 0.20%