Investment Strategy

Keep the red flags flying high

It’s been revealed that left wing French president Francois Hollande has been paying US$10,000 a month to have a personal hairdresser. But it’s not just Hollande that has been using state resources to keep things well coiffed. The heavily manipulated stocks and bonds of developed countries continue to defy gravity. Bond markets are particularly insane, and come with a health warning. As we continue into the second half of the year, there are plenty of red flags flying.

On average, people with black or brown hair have around 100,000 hairs on their heads. But Monsieur Hollande, being an unpopular middle-aged man, has ever-thinning coverage over his cosseted cranium. Still, he probably has mistresses to impress.

We might suppose Hollande has around 80,000 active follicles remaining. Which means each individual strand is tended to – using French state funds – to the tune of US$1.50 a year. Some have dubbed him the “shampoo socialist”.

The leaked information about Hollande’s grooming habits may seem irrelevant. But it’s yet another reminder of how the pampered elites feather their nests with other people’s hard produced plumage.

In separate news, but along a similar theme, ex-head of the European Commission Jose Manuel Barroso has taken a role at US investment bank Goldman Sachs. It’s not just in the US that politicians float with ease from the powerful government sector into the lucrative private sector.

The EU’s previous bureaucrat-in-chief will advise Goldmans on the implications of “Brexit”, the UK’s departure from the European Union. No doubt he’ll get a fat pay cheque for access to his network of contacts, if not for his (lack of) financial prowess.

As for Britain itself, it now has a new prime minister called Theresa May. Inevitably there is much focus on her being a woman, and Britain’s second female leader after Margaret Thatcher (elected in 1979). It also makes her the latest woman to join the 70 or so elected female leaders of countries since 1960 (according to the Huffington Post).

Of course that’s not counting the various female queens of England, including Elizabeth I, (“bloody”) Mary, Anne, Victoria and Elizabeth II – although admittedly the current one has little real power.

In other words May’s gender is more or less irrelevant. Ability is what counts. She’s been quick to appoint her new ministers, and is clear that “Brexit means Brexit”.

That means – despite many bunches of sour grapes and clamouring for a second referendum by sore losers – Britain will certainly begin the process of extricating itself from the political union in Europe. All that remains are the details, which are likely to be devilish.

But enough of politicians. What about markets? We all need to keep a weary eye on the latest political shenanigans. But I’m sure that you’re more interested in what to do with your investments.

US stocks continue to defy gravity. At 2,168 the S&P 500 index is now hitting new record highs (just about). Despite weak earnings growth US stocks are trading at valuation levels rarely seen in their long history, since 1871.

In fact there were only two times when US stocks have been clearly more expensive. These were just before the Wall Street Crash of 1929, and in the late 1990s before the technology bubble burst in early 2000.

Other than that, US stocks trade at similar valuation multiples to those just ahead of the global financial crisis which started in 2007 – during the real estate and finance boom. These are hardly good omens for the future trajectory of US stocks. (For recent analysis of the risks in the overpriced US stock market see here, here, here and here.)

European stocks aren’t much better. Whereas the S&P 500 has a P/E of 25 – versus a long run median of 14.6 – the MSCI Europe index has a P/E of 20.

Europe surely is in worse shape than the USA in terms of long term fundamentals – including political uncertainty, big debts and an ageing population.

Europe surely is in worse shape than the USA in terms of long term fundamentals – including political uncertainty, big debts and an ageing population (see here). So it’s difficult to get excited about European stocks at these high levels. But ultra low interest rates and central bank money printing keep them elevated, at least for now.

Emerging market stocks surely look a better bet. The MSCI Emerging Markets index has a P/E of 13.8. Within that there are expensive markets, such as India (P/E 21), and Indonesia (P/E 19). But there are bargains too – most obviously Russia (P/E 7).

Given the choice, I’d clearly favour cheap emerging market stocks over expensive developed markets. But if developed markets crash I’d expect emerging market stocks to get dragged down too. That would just mean more buying opportunities, before they rebound.

And then there are bonds. More and more of these “investments” are now insane. Last week 50 year Swiss government bond yields plunged into negative territory.

Anyone prepared to lend for half a century at a negative interest rate would do better to buy a straight jacket and check into a padded cell. It simply makes no sense.


In “normal” times – that is every time except the last few years – bond investors have demanded a yield that’s a couple of percentage points above inflation. Otherwise what’s the point of taking the long term risk?

Nowadays, to get the same real (above inflation) return, a buyer of Swiss bonds would need 50 years of consumer prices falling by a couple of percent a year. In other words, perma-deflation.

Let’s see…if prices fall by 2% a year for 50 years they’d fall by 64% overall, with compounding. Today’s young university graduates in Zurich might pay 20 Swiss francs to enjoy a plate of wurst und rosti (sausage and fried potatoes). For bond investors to get a decent result, when those same graduates retire they’d only pay 7 francs for the same meal.

Does that sound likely? In a world with a growing population? Where many natural resources are getting harder to find and extract? Where billions of people in emerging markets are becoming wealthier and using more of those resources each year? Of course not.

It’s not just in Switzerland either. There’s now reckoned to be around US$13 trillion of debt trading with a negative yield. Of course this is hugely dangerous.

If a government can get paid to borrow money then it’s likely to accelerate the pace of borrowing.

If a government can get paid to borrow money then it’s likely to accelerate the pace of borrowing. Eventually the debt burden will become so great that confidence will collapse, bond yields will rise, and governments will suddenly find their budgets blown out of the water. If the debt burden is big enough, even low yields could add up to massive annual interest costs.


And it gets worse. Even companies are starting to get in on the game. The first corporate bond with a negative yield recently came to market.

Deutsche Bahn, a listed German railway company, just issued 350 million euros of zero-coupon five year bonds with a negative yield of 0.006%. In other words the bonds pay no interest, but buyers paid more to buy them than they will eventually be repaid in five year’s time. Actual German inflation is currently running at 0.3% a year.

This opens up a whole new world of freaky finance. A company can get paid to borrow. It can raise negative interest finance, park the cash in a zero yielding cash deposit or in short term government bonds and a positive return is guaranteed – with no risk to the company.

If this descent into negative yields carries on we’ll see companies loading up on debt and turning themselves into quasi hedge funds. Get paid to borrow, get paid to invest. Who needs to run a business? Who needs to invest in growth?

Sooner or later I’m sure that huge numbers of bond investors are going to suffer massive losses. That means distressed pension funds, mass hedge fund failures, and insurance companies pushed to the brink.

One day the developed country bond bubble is going to burst, and a huge financial crisis will ensue. It won’t be pretty, and it’s yet another reason to own gold – as crisis insurance.

In this crazy financial environment caution is the watchword. Government intervention in financial markets is something the Soviets would have been proud of.

I’m certainly no marxist, but I’ll keep a different kind of red flag flying high. The crash warning kind. These markets carry a big health warning.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.