A Terrible Misconception: Capital is "Money"

Something is Very Wrong...

Written by Adam English
Posted November 5, 2013

This weekend, a discussion spurred me to uncover something great.

Unfortunately, that great thing is about something terrible.

After some lightsaber duels with my six-year-old nephew in his Darth Vader Halloween costume, I retired to the couch to watch the Raven's game and catch up with my cousin, who works for a major investing firm. On these occasions, we inevitably talk shop for a bit. Normally, it is akin to small talk about the weather; sometimes it is far more informative.

My cousin told me that his job is getting more and more stressful. With the Dow and S&P 500 setting all-time highs, his clients are desperately chasing after gains that have come and gone.

But the markets are juiced and are being hyped. They are running on cheap loans and share buy-backs funded by credit. Market performance isn't pegged to company growth as much as it is pegged to the flow of cheap money flooding in from QE and Fed policies.

Yet even as he and his colleagues are trying to give some sound advice, he has an obligation to do what they want — and keep their savings pouring into a bloated, hollow bull market.

They know something is very wrong in the economy. And they know from firsthand experience how it can and will burn their clients, unless they carefully limit their investments to companies with real value.

The problem is it is so darn difficult to define. Neither of us can put a finger on it, even though we are on the same page and it was obviously staring us right in the face.

Apparently, we're not the only people with this problem...

Eloquently Defined

When I got to the office yesterday, the conversation was still lingering in my mind. As it happens, I stumbled upon an article from Dylan Grice later in the day that touches on the root of the problem.

Grice worked for Societe Generale's Global Strategy Alternative Views team before leaving to join Edelweiss Holdings, a private investment company. In the Edelweiss Journal, he discusses how there seems to be a widespread misunderstanding of what "capital" truly is...

 

The term is used interchangeably with the term "money" by central bankers, economists, and businessmen, but here are some of Grice's key points about this error (emphasis mine):

... This is a fundamental error of thought. Capital is not money. One is scarce, the other is infinite. And we might not have thought anything of this sloppy language had we not been talking to an economist a few days earlier who feared for the future of euro.

The situation remained grave, he said, and there was surely no alternative than for the ECB eventually to "print more capital"...

... Capital comes from savings, and the policy of cheap credit with its inflation of time preference has encouraged spending, not saving. Scarce capital is growing ever scarcer.

One day, the price of capital will reflect its underlying scarcity, because one day it must. But in the meantime we think very carefully about the capital requirements of the businesses we own, growing increasingly wary of those which depend on artificially cheap "financial capital" for their survival. We note in passing that physical gold bullion is the oldest and purest capital there is...

... Success in the long run requires that thought and action be fully independent from the false ideas of the herd. Yet today's language of inflation embeds so many of these false ideas that the full rottenness of what passes for financial thinking today is obscured. One increasingly reads of capital stewards complaining that things seem more difficult today. We think it's because they are. We are also increasingly mindful of conversations with friends, family and colleagues that reveal a widespread perception that something is very wrong, though people can't quite put their finger on what it is. As we have just argued, we think the answer is that the inflation of credit has driven an inflation of asset prices, which has driven an inflation of future expectations, which has driven an inflation of time preference... and that while the consequences of these various inflations are profound, the new language of inflation which it has spawned is shallow.

Therefore, not only is there insufficient capital to ensure future prosperity and insufficient realism to deal with the future this implies, there is insufficient linguistic precision for most people to articulate the problem let alone understand it. And when language itself becomes so grotesquely distorted, how does one go about substituting the customers' unattainable hopes and expectations of never-ending growth with the need for principled and honest action?

Grice is spot-on here, and I doubt you or I could find anyone that can put it better. Even my cousin and I, with our experience in investing and economic issues, struggled to wrap the proper language around the issue.

He and his colleagues consistently cannot bring their clients to the realization of what is going on, in spite of all the evidence of the problem being covered in the business section of every news service and publication.

Even central bankers and economists don't know, don't remember, or simply don't care about this critical distinction. 

The Dilemma

I'm not normally one to lump all the blame on one person or thing, especially in financial markets. There are just far too many variables and players contributing to justify a single scapegoat.

For this, though, there is no doubt that the Fed deserves a lion's share of the blame.

It clearly believes it is genuinely creating capital to stimulate the economy. Its easing programs created the credit bubble through easy money. It managed to rig the system so this easy money was considered on par with actual capital, spurring asset price jumps in turn...

The headlines this created heralded the resulting highs in indices as proof that the Fed's engineered recovery was a success.

Since the capital versus money confusion is nearly universal, everything appears fine on the surface. Future expectations surged, along with a desire for immediate results from investments.

Instead of talking about delayed inflationary forces and distortion of the monetary base, traders and the mainstream media worked under the false belief that there has been actual and meaningful growth and capital creation.

The entire situation creates a terrible dilemma for all of us: We know that the market is unsustainable, that the dollar is going to become profoundly weaker in the future, and companies that are using easy money to create the illusion of capital growth will see their stock prices drop... yet we want and need to invest for our future.

Thankfully, we do have some options.

As Grice points out, gold is a great choice. Silver is as well, in my informed opinion.

However, as Jimmy pointed out yesterday, we must diversify to protect ourselves. Depending on precious metals that are often manipulated by institutional traders alone is foolish. Inevitably, it seems like we have to hold our noses and get into bonds or equities and expose ourselves to the bubbles and risks in the distorted markets.

 The Right Way to Do It

If you do your research and make careful decisions, you do not have to overly expose yourself to the risks the Fed has created. Although they have become harder to find, there are plenty of unappreciated companies that are not being pumped up by ballooning debt and that aren't on the radar of hype-crazed investors.

We're starting to see proof of it, too...

Of the U.S. funds run by active managers, 57% are beating their benchmark indices this year, according to fund-tracker Morningstar. That is the best overall performance for the industry since 2009 — and well above the 37% of all funds beating the market.

Implied correlations — a measure of how closely the performance of individual stocks mirrors that of the index itself — have fallen to their lowest since October 2007 after peaking in 2011. Instead of the returns of most stocks clumping close to the index returns, there is a much broader spread on how individual stocks perform.

Fund managers are turning their focus to well-run companies that have sustainable advantages and may hold their value during a downturn. (That is what my cousin and some of his more altruistic colleagues are trying to convince their clients to do.)

Even the people who are completely gung-ho about equities know something is wrong, and they're starting to get very picky about the companies they invest in...

As the "recovery" ages and the flaws of it become more and more apparent to investors chasing gains, the companies that created the illusion of value purely on credit will be punished, along with anyone left holding their shares.

The only hope for individual investors is to find the few promising companies that are far from the headlines and invisible to the herd. It won't be easy, but it is becoming the safest way to protect yourself in the stock market.

If you are interested in learning more, I suggest you add Dylan Grice's articles to your reading list. They can be found through the Edelweiss Journal webpage

Take care,

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Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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