Homage to Ignorance
Will the price of oil go up or down next year?
The oil-importing economies want low-priced oil. The exporters need high-priced oil. But who will win?
Oil is the No. 1 commodity in the world. Its price changes everything.
Or… how about this…
What will be the rate of U.S. GDP growth?
Robust growth would give Ms. Yellen the room to maneuver as she needs. She could raise rates a quarter of a point or two… beginning this month… and claim to be doing the responsible thing.
But what direction will interest rates actually go? Up… or down?
That matters, too. If they go down… gold will probably go down with them. As will China… and lots of other things. The whole global financial system now depends on cheap credit.
Who knows the answers to these things? The Bonner & Partners team? Goldman’s top economists? The 300 Ph.D. economists at the Fed?
Much research has been done on the subject. It is conclusive, but only in the following sense: Someone may know what is coming down the pike, but you have no way of knowing who he is or what he knows. And whomever you take for your soothsayer, the odds are he’ll be wrong along with everyone else.
Trigger Warning: You may find much of the following material offensive. It concerns your intelligence – that is, the ability of your species, Homo sapiens, to separate fact from fiction… and plausible truth from total BS.
You may find, too, that I am belaboring something that is obvious: that we are not as smart as we think we are. But let’s keep an open mind… and belabor it a bit.
Where are we going with this? To Russia. But that is only as an illustration of how to use our newfound, critical knowledge – the realization that we don’t know what the hell is going on. In that respect, our crack research team will propose a new model portfolio – one that doesn’t rely on the pretense of knowledge.
Our Story So Far
Bringing new readers more fully into the picture… we’ve established that the world’s financial system runs on a very special kind of money. Catch up on the May issue of The Bill Bonner Letter here. It is not like the money the world used for most of our history. Instead, it is more like the money that it used occasionally and experimentally, and always unhappily.
Each time, it was hoped that the new money was different… that it opened up new possibilities for getting where we were going in a more carefree spirit. And each time, it turned out not to be true. The pattern was reliable. We ended up in a ditch.
Last month, we argued that – most likely – this current experiment will go the same way. Most things go the same way. Patterns tend to hold up. “This time” rarely is different.
Our money today is credit-based money, not asset-based money. It comes from the wrong side of the ledger.
You can see the stark difference by thinking about “negative interest rates.” Currently, $9 trillion in government debt (European and Japanese) trades below zero yield; that couldn’t happen without credit-based money.
If you want to get a positive yield by lending to the Japanese government, for example, you’ve got to go out 50 years.
The Japanese government is, effectively, bankrupt. It can only pay the interest on… or rollover… current debt by borrowing more. The government has become the world’s biggest… and most under-funded… pension fund.
It is clearly headed for bankruptcy in one form or another. And yet, you have to buy a bond with a maturity of 2066, or beyond, in order to get any return at all.
This is only possible because of the current credit-money system. The Japanese can keep rates ultralow, because they can create an almost infinite amount of this new credit money… and lend it to the government itself.
Currently, the Bank of Japan buys the equivalent of 100% of new Japanese government debt (funding deficits with pure “printing press” money). And it already owns 52% of the total outstanding.
Catching our breath…
In an honest monetary system, money represents real wealth. You work all your life. You save your money.
If you save 10% of your income during your working years, you are accumulating the fruits of 10% of your entire career. Honest money is based on… and depends for its value upon… real wealth that has already been produced.
A new book by William Goetzmann, Money Changes Everything, tells us what we already knew: that money is what made civilization possible.
Without money, you couldn’t do the kind of easy, win-win exchanges… stretching across rivers, oceans, national boundaries, languages, cultures… and importantly, across time.
Neither kind of money – asset based nor credit based – is actually “wealth” itself. It is just a claim on wealth.
Asset-based money is a claim on past wealth, the kind of money you earn by working. You get paid for something you’ve done… wealth you have produced.
It is the type of money the Bible anticipates. Adam and Eve, expelled from the Garden of Eden, would have to earn their daily bread “from the sweat of their brow.”
This type of money is typically backed by gold. There is no magic to gold. But it is limited. And it prevents the credit system from putting the cart before the horse, distributing money before the work of creating wealth has been done.
You can’t lend gold-backed money unless you have it to lend. And you won’t have it unless you or someone else created some wealth.
Debt- or credit-backed money is different. It has a different relationship with time. It can be created by the credit system at will, not as an expression of wealth that has been earned and saved… but as an expression of optimism about the future. It is a bet that your borrower will earn the money (or rob a bank) to be able to pay it back.
Asset-backed money is an all-cash deal. Credit-backed money is a leveraged buyout.
You get the idea.
Each type of money has advantages. Gold- (or other asset-) backed money limits “policy” responses to crises… and restricts “demand” to real demand – rather than credit-induced phony demand.
Activist economists don’t have tools to work with; they can’t “stimulate” the economy.
Over many centuries of experimentation, it was discovered that credit-backed, future-focused money systems were dangerous and unstable. Unlike asset-backed money, they are vulnerable to the credit cycle. Asset-backed money goes up in value in a credit crisis; credit-backed money goes away.
In a gold-backed system, the amount of money in circulation is naturally and automatically connected to the amount of real wealth in the economy.
A credit-backed money system is different. It relies on public officials to manage it wisely, using rules and regulations to prevent the supply of credit from becoming overabundant.
This assumes that officials can tell how much credit is enough (which they can’t)… and that they have the strength of character and institutional disciplines to control it (which they don’t).
Again, the historical judgment is unanimous: Public officials do not make good guardians of a nation’s money.
The outlier is today’s monetary system. It has been around since 1971. That makes it the longest experiment with “paper” money ever. Most people have already rendered a verdict: This time IS different, they say.
My advice: Withhold judgment until a full credit cycle has been completed.
The Goal of an Economy
If an economy could be said to have a goal, it must be to increase the well-being (the wealth) of the people in it.
And yet, despite an increase of credit-money at more than twice the rate of GDP growth, 95% of American men have actually lost real income over the last 46 years. Today, they earn nearly 5% less than they did in 1970.
And a new study from the Levy Institute tells us the U.S. has suffered FOUR LOST DECADES since the new money system was put in place in 1971. For 9 out of 10 Americans, earnings growth ended in the early ‘70s.
How is this possible?
As we showed last month, a society gets richer by saving its money (building capital) and investing it wisely. But it is the scarcity of capital – not the abundance of it – that is the key. Scarcity gives capital value and causes it to be used wisely, on projects that increase the economy’s real wealth.
If the amount of savings appears to be infinite, capital tends to be squandered on consumption, stock buybacks, student loans, wars… etc., etc. This leads to less real capital investment, fewer productivity increases, and lower wages.
Debt is the flip side of credit; you lend… your borrower has debt. And the more debt there is in the system, the more you need robust growth to service it.
So you see… the whole system is self-correcting after all. Credit, credit everywhere, but hardly a drop has gone into the kind of capital investments that actually raise productivity and wages.
Debt increases, and then the burden of debt itself decreases the means to pay the debt back, which ultimately (we’re still waiting!) results in a credit crisis… debt defaults… asset-price collapses… and more.
And now, with so much debt outstanding, the private sector is pretty much tapped out. It is no longer creditworthy. It cannot take on any substantial new debt.
That leaves only one borrower still standing – government. Alas, government is probably the worst investor of all. Very rarely – and then only by accident – does government spending produce any positive return on investment, and it is practically never enough to justify the risk and expense.
As government takes over the role of major borrower and primary capital allocator, growth slows further… then goes negative… and the economy collapses.
There… now, you have the background on what our credit-money system has wrought and why it is doomed to catastrophic failure.
Prepare for the Worst
We caution new readers… Don’t ask your financial planner or your brother-in-law about this. They will not know what you are talking about.
Most people are not even aware that there is such a thing as a credit-money system… or that there is any difference between a dollar today and a dollar in 1965.
Even fewer will realize that the whole system could collapse when the credit cycle turns…
… with disastrous consequences for a heavily indebted economy.
In a credit crisis, creditors stop lending. “Money” vanishes.
That’s why we began our introductory letter to this service with a scene at an ATM. When a severe credit crisis hits – like the one in 2008, only worse – there will be no money in those machines. Those machines cannot be restocked easily… because the money – real, physical money – doesn’t exist.
The difference between asset-backed money and credit-backed money is like the difference between living in a house that you own and living in a house with a 100% mortgage.
It could be the very same house. Identical in every way. But under stress, it behaves in an entirely different way.
If you own it, you can live in your house through a financial calamity… It is real wealth. It doesn’t go away simply because asset prices get marked down.
The mortgaged house, on the other hand, quickly becomes a liability. The price goes down, but the mortgage does not.
Millions of people lived through this nightmare just eight years ago. Their asset – the equity they had in the house – disappeared. Many ended up with nothing… and nowhere to live.
The likelihood of another sharp credit contraction à la 2008, only worse, seems high. We’re prepared for it in three ways:
- We have high levels of cash in our investment portfolios. (My own allocation is currently one-third cash.)
- We have at least a month’s worth of living expenses covered by keeping real, hard, paper cash at home.
- We have large quantities of gold. (My own portfolio allocation is one-third to gold.)
As for stocks, we lean toward those that we won’t mind owning for a long period… even through a significant bear market.
But what if we’re wrong?
And what if we could find a way of investing in stocks that didn’t require us to be right about the future?
The Russian Bull
“The spring of 2000 ushered in the first peaceful and democratic transition of Russian power in a thousand years,” explains our colleague, researcher Chad Champion.
Chad was given the unpromising task of doing battle with ignorance. He was asked to understand what was really going on in Russia… and take a guess about where its stocks were headed. It was going to be an uphill fight; our money was on ignorance. (His full report is included at the end of this issue.)
Chad took up his sword and shield and began by studying the career of Vladimir Putin:
He was basically unknown in Russia prior to his presidential candidacy. Up to then, he had always operated behind the scenes.
Washington, D.C. insiders didn’t even have Putin on their list of potential candidates to succeed Boris Yeltsin.
His public support skyrocketed from 2% to 50% in the five months from August to December of 1999. And he never looked back.
Was he a liberal or a throwback to Stalin? A Communist or a market reformer?
No one knew.
But he made one thing clear to the Russian people… He wanted to establish a “dictatorship of law.” He wanted “clear and fair rules of the game” after the turbulence of the 1990s.
Giving Chad a little artillery support is Gleb Pavlovsky, writing in last month’s Foreign Affairs magazine. He notes that for all the hooting and tooting about Putin’s dictatorial regime, the actual forms of government in America and Russia are more similar than different.
America has its open elections… its checks and balances in Washington… and its constitution. Russia has plenty of these things, too – on paper. But in both countries, real control of the government lies in the hands of a privileged elite.
In America, the collusion between cronies and government is known as the Deep State.
In Russia, real power is in the hands of a small, unelected elite, too. There, it is called the Sistema.
Sistema combines the idea that the state should enjoy unlimited access to all national resources, public or private, with a kind of permanent state of emergency in which every level of society – businesses, social and ethnic groups, powerful clans, and even criminal gangs – is drafted into solving what the Kremlin labels “urgent state problems”…
Sistema is flexible, but there is one constant: a ruling team that protects its grip on power. The electoral system in Russia is well-developed and highly sophisticated. It is also completely useless. Elections are separated from the process of endowing the state with power; they amount to nothing more than an expensive ritual.
In our daily Diary entries, too, we have described how the “foxes” (using the term suggested by the great Italian economist Vilfredo Pareto) get control of a government and use it for their own purposes.
Coming into focus is a different view of Vladimir Putin. He is not a relic of a discarded age. Instead, he is an early model of the type of politician now emerging all over the world – the “strong man” who promises to keep the foxes under control… Marine Le Pen in France, Rodrigo “The Punisher” Duterte in the Philippines, Norbert Hofer in Austria, Abdel Fattah al-Sisi in Egypt, Recep Erdogan in Turkey, and either Donald Trump or Hillary Clinton in the U.S., both of whom seem to be angling for the strong man position.
The “strong man” leader seems to appeal to people when it becomes obvious that democratic institutions are not able to protect voters from the elite. Mr. Putin, like Mr. Trump, is an example of the “tyrant,” the “strong man” leader who emerged in Ancient Greece as democracy degenerated into dictatorship.
Under Putin, Sistema has become a method for making deals among businesses, powerful players, and the people. Business has not taken over the state, nor vice versa. The two have merged in a union of total and seamless corruption.
Mr. Putin’s approach – and his appeal – was demonstrated in his handling of the Chechnya crisis in the late ’90s.
“We will wipe out the terrorists wherever we find them. If we find them in the toilet, then that’s where we’ll do it,” Putin said.
Chad explains why it wasn’t the communist hardliners who elected Putin.
During this period [the late ’90s], Russian politics consisted of two parties – Democrats and Communists.
Each enjoyed the support of about 20-30% of the Russian populace. This left a huge group of the electorate in the middle.
The “independents” were skeptical of both parties. And according to Dr. Peter Rutland – a Russian affairs expert and author – they “preferred strong, pragmatic leaders at the national and regional levels.”
Gaining the support of the middle ground formed the basis of Putin’s election strategy. It may not be obvious, but in Russian politics, Putin is a centrist.
Interestingly, his rise to power was similar in ways to Donald Trump’s. According to Dr. Rutland, “Putin had no need of the debates and TV spots; he was getting all the free coverage he needed on network news.”
The news covered him spending a night in a submarine with Russian sailors.
Another report showed him taking live calls from voters.
And the best media coverage of all came from a documentary on his life – The Unknown Putin – which portrayed him as someone everyday people could relate to.
When it came to his policies, Putin never got into details. According to Dr. Rutland, “His only promise was that there would be no promises… it was very important for Putin’s image that he not be seen as inhabiting the same existence as the other candidates.”
This helped him gain control of the oligarchs – he wasn’t promising anything to them, either. And his popular support would give him the power he needed to confront them.
The game was now being played on his terms.
When it comes to investing in Russia, Chad continues:
Most of the risk of investing in Russia today is seen as political risk. And Putin is a big factor in that.
Facts and “Facts”
Chad may be right about Russia. But we are looking for a way to invest that doesn’t depend on being right.
You may remember 2008 and $150 oil. Oil had been going up with such conviction that a theory – a narrative – arose to explain it. “Peak Oil.”
It seemed so obvious, so irrefutable, that it was widely regarded as fact. Contradicting it put you beyond the pale – like a climate change denier today.
Oil use was going up. China was booming. And the cheap, ready, available oil had been pumped already. Case closed.
But then, just as the world became resigned to paying $150 for a barrel of oil, the frackers – financed with the cheapest funding in two generations – struck oil! And then all hell broke loose.
The oil industry had gotten used to high prices. Suddenly, it found its revenue cut in half… and then cut in half again. Russia reeled. Petrobras collapsed. And the prostitutes were said to be packing up their skimpy skirts and clearing out of the oil patch.
Then a whole new set of theories and fact-ish ideas emerged.
The first among them came from analysts and pundits who were looking on the bright side. The bright side was that a lower oil price would be good for the economy.
Energy was the No. 1 cost for many businesses and households all over the world. If the price of oil were to fall from $150 to $100… consumers and businesses would have an extra $50 per barrel for spending – a “stimulus” that should put growth back in high gear.
The IMF, for example, calculated that each $20 cut in the price of oil would result in a 0.5% boost for the world economy. On those numbers, the $100 oil price drop we now live with should have resulted in an addition to GDP of 2.5%, or about $2 trillion worldwide.
Only 12 months ago, analysts were calling for global growth of 3.5% in 2016 – thanks to a lower cost for energy.
Of course, it didn’t happen. It turned out – as should have been obvious all along – that the producers had bills to pay, too.
When their income dropped, so did their spending. They had to cut back on their exploration projects, and in the case of big, national producers, such as Saudi Arabia, they had to curtail other development and investment projects, too. Now, world GDP growth is estimated at 2.5% for this year.
Nor did consumers take all their energy savings and rush to Walmart. Instead, under the pressure of debt, and wage stagnation, they increased their savings rate.
You can see, too, how pernicious the Fed’s zero interest rate policy turned out to be. The effect (which may or may not have been intentional) was to transfer trillions from savers to borrowers… and particularly to Wall Street and Washington.
ZIRP boosted asset prices… but left retirees, and those planning to retire, in need of more savings. They have to save more, for longer, to realize the same retirement income. As I’ve reported in the Diary, more people over the age of 65 are working today than ever before.
Typically, people save as they approach retirement. Then, they dis-save – putting saved resources back into the income stream – after they retire. As more people remain longer in their retirement-preparation years, America comes to look more and more like Europe and Japan.
Meanwhile, the facts and theories kept coming. Amy Myers Jaffe of the University of California, Davis proposed a reason why oil was not only cheap now… but why it would stay cheap for a long, long time: a “technology revolution.”
Better technology is compressing the price of oil from both sides. On the supply side, it is getting easier and cheaper to coax the goo out of the earth’s many nooks and crannies. And on the demand side, energy-saving technology is getting better and cheaper all the time.
Add to this last point that “climate change” seems to light a fire (if we can use that expression) under the whole alternative energy industry. Many people think they are doing a public service by not using oil… or by switching to other forms of energy.
This theory led to a further worry in the energy world, that billions and billions worth of assets would be “stranded” and worthless – like an archipelago of adult bookstores just as the internet brought porn right into the bedroom.
The fear of ending up with unsellable oil in the ground is supposed to motivate giant oil companies and oil-rich nations such as Saudi Arabia to “get it while the getting’s good,” pumping and selling as much oil as possible before the world decides it doesn’t need it anymore. All this pumping, of course, would drive the price down further, and keep it down.
There was also the geopolitical/debt angle. Almost all the world’s countries are in debt, some more than others. And among them are oil producers who rely on energy sales to pay their bills. Back when a few giant producers could maintain a stable and rising market, debtors and creditors knew what to expect.
The new arrangement is much less sure. Producers can’t afford to wait. They have to produce and sell. Otherwise, prices may be lower… and their credit may be cut off.
But against this wall of reasons why energy producers were doomed, the price of oil rose. It has almost doubled so far this year.
And from here… where it goes is anyone’s guess.
We draw two lessons:
One… nobody knows anything.
Two… up, down, and up again is still the general look of things.
What is the best way to invest, when the most learned analysts and most obvious explanations turn out to be wrong? The familiar pattern gives us a hint. In particular, it leads us to Russia…
Take a look at the top chart above…
Here, we see the pattern that has become so familiar:
Boom/bust… bull/bear… up/down… As you can see, two years ago, Russia’s market was squeezed… between collapsing oil and commodity prices and economic sanctions.
The black line is the daily price of the MSCI Russian Stock Market Index. It is currently trading at 495. That’s only 70% off its 2008 high. And its price to earnings ratio is 8 – which is near its average since 2000. Prior to the financial crisis in 2008, it reached a high of 16.
Chad reports that Russia is cheap today because of the economic sanctions imposed after it annexed Crimea during the Ukrainian crisis:
The sanctions – imposed by the West – eliminate state-owned businesses’ access to Western financial markets. And they prevent oil and military technology exports to Russia.
Commodities, defense, and banking make up almost 90% of sector weighting in the MSCI Russia Index.
And he tells us that another reason why Russian stocks are so cheap is the price of oil and commodities:
According to the World Bank, oil and commodities make up almost 20% of Russia’s GDP.
The chart above shows Brent crude oil prices – the price benchmark for oil worldwide. As you can see, oil prices have been crushed over the past two years.
The top two holdings in the MSCI Russia Index are Gazprom and Lukoil, two of the world’s largest oil and gas producers. These two companies make up 36% of the index.
[See more on Gazprom in Chad’s full report in the Appendix to this issue.]
That much is fact. Now comes the guesswork and quasi-facts. Chad looks ahead:
As you saw in the chart above, the Russian market is down close to levels not seen since the 2008 financial crisis. And when the stock market of a major global player gets this cheap, it’s time to get interested.
Russia fell hard during the collapse in oil prices. The economic sanctions have made doing business even more difficult.
But this isn’t a country struggling like it did after the Soviet Union collapsed. In many ways, Russia is more stable under Vladimir Putin. Russian fiscal policies are more robust now than they were in the 1990s. It has some of the largest global businesses. And it’s a bigger player on the world stage. Putin is making deals with China, India, Iran, and Saudi Arabia.
That sounds like a strong U.S. foreign and economic policy. But it’s modern-day Russian policy. And Russia’s market is getting ready for a big move. Here’s why…
Oil prices are improving. As you can see from the price of Brent, they’re up over 70% from the February low.
As I mentioned earlier, oil and commodities make up almost 20% of Russia’s GDP.
So, this is a huge catalyst for the Russian market.
What about the political risk?
The thought is this: As long as the geopolitical rhetoric between the West and Russia continues to improve, the market will heat up.
A new U.S. president could improve foreign relations with Russia. And even end the sanctions. This isn’t a long shot bet, either…
Donald Trump’s foreign policy advisor, Carter Page, worked as a banker for Merrill Lynch in Moscow. And he is an investor in Gazprom. He has described the U.S. relationship with Russia as “trapped in a Cold War mindset.” He is also on the record as calling Putin a “strong leader.” And then you have Trump, who said, “I think I would have a very good relationship with Putin.”
Hillary has taken a tough stance on Russia on the campaign trail. But she was the one Obama tasked to “reset” Russian relations and ease tensions back in 2008.
Her husband Bill Clinton told then-British Prime Minister Tony Blair, “Putin has enormous potential… I think he’s very smart and thoughtful. I think we can do a lot of good with him.”
So, is it time to buy Russia?
I’ll come back to that in a moment. First, we have some more belaboring to do.
The Cost of Ignorance
I’ve been wrong about many things in my life. But I’m making progress. I’ve learned to expect to be wrong… and to make forecasts carefully… always weighing the costs of error.
The real risk with any forecast is not just the risk of being wrong itself. If I think the sun will shine tomorrow… and it rains… how much harm is done? A picnic spoiled, perhaps.
But suppose I say to myself, “I’ll go into the woods and collect mushrooms. They’re perfectly safe.” The upside is obvious. But the cost of being wrong is large.
In order to find the real risk, you need to multiply the probability of being wrong by the damage you will suffer if you are.
Asset allocation, not stock selection, is the key to investment success.
Putting all (or most) of your eggs in one basket can be the way to make a lot of money. Typically, not all markets will go up at the same time. So, you want as much of your money in the rising market as possible.
Let us say you believe the U.S. stock market is going to be the big winner this year. If you are right, you will want to take advantage of it. You will want to make a big allocation to U.S. stocks.
You may choose, for example, to buy 10 prominent stocks on Wall Street. As we have pointed out again and again, which stocks you choose is less likely to have a big effect on your wealth than the decision to invest in a given market.
The exceptional risk comes from concentrating your money in the U.S. stock market. But since that is also the way to make exceptional profits (concentrating money in the one market that is most likely to rise), it is worth thinking a bit about how the risk can be reduced.
In other words, despite the persuasiveness of Chad’s argument, the future of Russia is the kind of “knowledge” that we don’t have.
We have no way of measuring the probabilities of the oil price going up or of sanctions being eased, so let’s focus on the risk of being wrong.
How can we get the advantage of concentrating our investments in a few big-off positions and still reduce the risk of loss? By letting the most powerful force in the financial world – Reversion to the Mean (R2tM) – work for us. That way, we don’t have to be right about the future; we just have to be right about the past.
Being wrong about the future is no sin. After all, there are millions of possible futures… but only one that actually happens. The odds that you’ll be right about it, in any detail, are very small.
You may be right, however, about the general pattern. While each day is totally new, every 24 hours has many features similar to the day before it. The pattern repeats itself… sunrise… sunset… over and over.
If you say, “this time it’s different,” you are likely to be wrong about that. Still, night follows day, just like it always does.
What pattern can we count on in Russia? What past can we look at in order to avoid having to count on our specific knowledge of the future?
Bigger and Longer Is Better
I’ve written a lot about the most powerful and reliable force in the investment world… a kind of “Magnetic North” of finance… guiding us to reliable profits. It is reversion to the mean. You can read my issue on it (including a special appendix on mean reversion by the research team) in the February 2016 issue of The Bill Bonner Letter.
The idea is simple. Things get out of whack from time to time. When they get out of whack, there seems to be a strong gravitational pull that brings them back into whack, back to earth, back to “normal,” back to a well-established mean.
After all, in order for there to be a normal, things have to return to it after they have gone astray. Otherwise, trees really would grow to the sky.
The important thing is that this phenomenon is investable. Not always. Not everywhere. But sometimes.
An individual company follows a familiar pattern. It begins. It grows, but never to the sky. Instead, it dies. If you look at a chart and you see it has a mean stock price of $10, and it is currently selling at $5, you might be tempted to buy. “I’m going to make $5 when this reverts to the mean,” you will tell yourself.
But the problem with individual companies is that they all die. The mean position for a company, as for a person, is horizontal.
Every human will spend more time dead than alive. Companies are no different. When a person gets to be over 70, and you notice a decline, gambling on a reversion to the mean (the person becoming as he was when he was 35) is probably a bad bet. As for a company, when its time has come, the only new chapter it writes is Chapter 11.
The same is less true for whole industries. By focusing on industries or sectors, rather than on specific companies, you eliminate some of the particularities – the lifecycles of individual companies – but you still have the particularities of the industry to worry about.
In 1900, there were people who earned their living by sweeping the horse manure off the cross walks (“cross sweepers” they were called). But, “this time really was different” for them when the first horseless carriages appeared on the streets of Manhattan.
There are two ways to reduce the particularities that might sink your investment: time and size.
The longer the period of the investment, the less chance that you will be whacked by an unusual, drawdown year.
You can also reduce the impact of any single company or single industry by having a lot of them. Buy an entire market (or a market index) and you eliminate the chance of getting an outlier stock. Hold it over a long, long time… and you eliminate the chance of an outlier year.
In both cases, you are simply increasing the number of data points, so the mean is more reliable.
But then, if you invest in “everything” for “all the time,” you also give up the chance of positive outliers as well as negative ones.
Which takes us back to the political risk in Russia. When I say “Russia,” I mean the entire Russian stock market, or a proxy for it, such as the Market Vector Russia ETF Trust (RSX).
Occasionally, a whole economy experiences a “this time it IS different moment.” That happened to Russia in 1917. When the Bolsheviki took over, investors lost 100% of their money. They were shut out of the market for the next seven decades.
But revolutions are rare. And unpredictable. Most often, national markets do have means… and they do regress to them.
Our research team has been studying the issue. They have done their usual excellent work in showing how R2tM can be used to deliver profits, with no need to guess about what is going on in the world. Oil? Interest rates? Growth rates? Fed policy? You don’t have to be right about them.
The quasi-facts… the sort-of facts… the B.S… they don’t have to matter. You just have to invest in markets that are big enough and for long enough to eliminate the unpleasant particularities. But you also want to be in the markets that are most likely to go up.
The Bargain of the Century
“The bargain of the century” is what legendary investor Mark Mobius – Templeton Emerging Markets chairman – calls the Russian stock market. Perhaps it is.
“We use four factors when trying to determine if R2tM will work for us,” Chad tells us. “Now, all four factors are shifting in Russia’s favor.”
Here’s Chad again with the short version…
The farther away prices shift from normal value, the more time it takes to revert back to normal. Russia has been selling far below book value for several years now.
Things are improving as oil prices stabilize. And Russian businesses are learning how to operate under economic sanctions. It’s just a matter of time before these companies show a profit… even while operating under sanctions.
- Asset Class
Different asset classes have different cycles. We’re seeing the oil cycle play out right now. Oil prices have fallen 60% since their peak in 2014. And there have been 64 bankruptcies in the oil and gas industry so far.
Many investors believe oil hit bottom in January. And prices have shot up 76% since then.
With oil prices playing such a key role in Russia’s GDP, any increase in oil prices bodes well for the Russian market.
The fundamentals of an economy change over time. This is especially true for an economy that’s really only 25 years old.
The Russian economy was weak after the dissolution of the Soviet Union. It opened up its markets in the mid-’90s and became the next hot emerging market investment… which ended in the Russian financial crisis in 1998.
The Russian government continues to bolster financial market infrastructure. According to The Economist, “The central bank is recapitalizing well-managed banks and compensating Russians with savings in bad ones.”
The central bank has shut down risky banks (almost 20% of all Russian banks).
And it has increased exchange rate flexibility, allowing its currency to fluctuate more against other currencies.
Humans are herd animals. We like to be where it’s comfortable and safe.
In terms of the stock market, that typically means buying high and selling low.
Contrarian investors break out of the herd. They do exactly the opposite of what everyone else is doing.
Behavioral finance tells us “economic actors are not rational.” Right now, economic actors – the herd – are avoiding Russia simply because it’s cheap. To the majority of investors, Russia is just too risky.
Which gives you the opportunity to buy low… and sell high when the herd comes back.
And Chad again, telling us that Russia has outperformed the S&P 500 over the past 20 years:
That’s right. Russia has outperformed the S&P 500 – and the MSCI Emerging Markets Index, and the MSCI World Index – over the past 20 years.
Sounds unbelievable, right? If so, how could it be so cheap?
We analyzed stock returns of the S&P 500, the MSCI Emerging Markets Index, the MSCI World Index, and the MSCI Russian Index going back to 1995 (when the MSCI Russian Index data started in Bloomberg).
We compared returns across five areas:
1. Average return
2. Annual growth rate
4. Largest Decline (1 yr.)
5. Total return (from 1995-2015)
Here are the results…
As you can see from the table, Russia’s annual growth rate was 9% – that’s 50% higher than the S&P 500.
And its total return of 462% was double that of the S&P 500.
A $10,000 investment in Russia in 1995 would have turned into $56,213 by 2015. The same investment in the S&P 500 would have turned into $33,185.
The MSCI Emerging Markets and World Index returns are even worse compared to Russia. These indexes include countries like Brazil, India, and China.
But investing in Russia involves risk. To measure risk, we looked at what Wall Street types call “volatility” – how far the price has moved away from its long-run average. You can see just how risky Russia is compared to the other indexes.
In short, investing in Russia has meant taking on a lot more risk. But as you can see, it has also meant much greater returns.
Right now, Russia is far away from its long-run average. Which is why we agree with Mark Mobius that it is the “bargain of the century.”
The R2tM Portfolio
But what if Russia turns out to be an outlier? What if we’re wrong about oil, sanctions, and Putin? How can we protect ourselves from that risk… and still get R2tM (reversion to the mean) working for us?
Our researchers/analysts are already on the case.
Nick Rokke explains:
Meb Faber found that countries with stock market declines over 80% would rebound an average of 120% over the next three years.
And if you ever find a U.S. sector that has declined over 80%, history says to buy it. This doesn’t happen often, but when it does, these sectors rise an average of 170% the next three years.
And that’s not all… Meb also found that countries with stock markets that declined three years in a row bounced back with a vengeance. In that fourth year, the stock market as a whole rose an average of 30%.
Why is this important? Because the Russian stock market was down each of the last three years. Right now, it is down 75% from its peak in 2011. This rubber band is stretched and ready to return to equilibrium.
Russia’s CAPE ratio (the average P/E ratio, adjusted for inflation over the last 10 years) is 4.9. Whenever international stocks have a CAPE below 7, the average 1-year return is 31%.
Russia’s price to book (PB) ratio (compares the price of the stock to the value of assets) is among the lowest in the world. Stocks with the lowest PB ratios outperform the average stock by 1.4%
Russia’s dividend yield (dividend divided by share price) is among the highest in the world. Stocks with the highest dividend yield outperform the average stock by 3%.
Russia looks like a value investor’s dream. With its checkered past and current uncertainty, it is a textbook contrarian play – just the kind that investors like Doug Casey, who has made fortunes in far flung corners of the world, look for.
This is the basis of our new model portfolio (see table on the below). We combine value measures like the CAPE ratio, PB ratio, and dividend yield and find the best countries to buy.
And based on this analysis, Russia is at the top of our list.
But what we’re interested in now is what else is on the list. What we want to do is spread our R2tM bet over several markets, so we get the benefit of mean reversion without exposing our entire investment to the particularities of the Russian market.
Instead of investing in a single market, we take a group of national markets, as dissimilar as possible, but all extremely cheap. This would give us more “data points,” making it more likely that we wouldn’t get stuck in an outlier.
Here’s how this portfolio looks, as of May 2016 (see the table below):
As you can see, the next three cheapest markets by our measures are Spain, Italy, and Poland. All of these countries have ETFs that only own companies from each country. Once again, Russia’s ETF symbol is RSX. Spain is EWP, Italy is EWI, Poland is EPOL.
These countries all have individual problems to work through. Spain might split into two countries. Italy has major debt concerns. Poland is suffering as its two biggest trading partners – Russia and the Eurozone – have stagnant economies.
Where does the U.S. rank in our scale? As the fourth most expensive country in the world. Only Mexico, Ireland, and the Philippines are more expensive.
Our R2tM Portfolio is our homage to ignorance. It doesn’t depend on any specific knowledge or guesswork about the future. Nor is it aimed at particular events or opportunities.
It is more like pointing William Tell in the right direction than trying to guide the arrow.
This portfolio depends only on knowing that, over the long-term, there are certain patterns that repeat themselves, no matter what we think.
Markets tend to go up… down… and up again. That is not likely to change. We just have to give ourselves enough time and space to let it happen again.
May 25, 2016