World
Global Strategy
Popular Delusions
Knowing what you don’t know: random thoughts on value, volatility and inflation
Dylan Grice
(44) 20 7762 5872
dylan.grice@sgcib.com
IMPORTANT: PLEASE READ
DISCLOSURES AND DISCLAIMERS
BEGINNING ON PAGE 9
www.sgresearch.socgen.com
12 November 2009
Although few predicted it, we “know” the Berlin Wall was destined to fall with hindsight. Yet
when it did, it was triggered by events which were unpredictable even with the same
hindsight. Our governments look insolvent. Historically this has caused inflation and funding
crises. But as with predicting the demise of communism in the East, who knows when? With
government bonds overvalued and inflation expectations “generous” it feels wrong that risk
assets and volatility trade around their historical averages.
Q “The corrupt and brutal regime of President Ceausescu of Romania was infamous across
the world. His ferocious government had run the country emphatically for many years,
crushing any signs of dissent ruthlessly. In November 1989 he was re-elected President for
another five years as his supporters at Party Conference gave him forty standing ovations.
Q On December 21st the President, disturbed by a small uprising in the western city of
Timisoara in support of a Protestant Clergyman, was persuaded to address the public rally in
Bucharest.
Q One solitary man in the crowd, Nica Leon, sick to death with Ceausescu and the dreadful
circumstances he created for everyone started shouting in favour of the revolutionaries in
Timisoara. The crowd around him, obedient to the last, thought that when he shouted out
“long live Timisoara!” it was some new political slogan.
Q They started chanting it too. It was only when he called, “Down with Ceausescu!” that
they realized something wasn’t quite right. Terrified, they tried to force themselves away
from him, dropping the banners they had been carrying. In the crush the wooden batons on
which the banners were held began to snap underfoot and women started screaming. The
ensuing panic sounded like booing.
Q The unthinkable was happening. Ceausescu stood there on his balcony, ludicrously frozen
in uncertainty, his mouth opening and shutting. Even the official camera shook with fright.
Then the head of security walked swiftly across the balcony towards him and whispered,
“They’re getting in”. It was clearly audible on the open microphone and was broadcast over
the whole country on live national radio.
Q This was the start of the revolution. Within a week Ceausescu was dead”.
Jon Snow of the BBC, quoted in “Wall and Piece” by Banksy
 Popular Delusions

Inevitable randomness
Watching some of the documentaries over the weekend marking the 20th anniversary of the
fall of the Berlin Wall, I found myself marvelling over and over at the extent to which arguably
predictable events can have unequivocally random triggers. I say arguably predictable
because, although most commentators were completely caught out by the sudden demise of
hitherto steadfast communist regimes, a minority understood exactly why they would one day
fall. But no one could possibly have known when.

Proving that economists don’t have a monopoly on cringeworthy predictions, Ceausescu

famously said weeks before he was toppled that democratic reforms would occur in Romania
only when pears grew on apple trees. Presumably he attached a probability of zero to the
existence of a Nica Leon.

The Berlin Wall itself might even have come down by accident. An announcement on easing
restrictions on East Germans’ travelling to West Germany was botched by politburo
spokesman Gunter Schabowski, who seems not to have properly read his brief. Not knowing
when the new policy was to come into effect, and pressed by the foreign media during a live
broadcast to give a date, he blurted out “immediately, without delay”. Minutes later a
newsreader at ARD in West Germany broadcast that “This 9th of November is an historic day.
East Germany has announced that, starting immediately, its borders are open to everyone!”

Of course that wasn’t the new policy, and it wasn’t supposed to be effective immediately. But
by then it was too late. The broadcast had been picked up all over East Germany and, within
hours, check points across the border were crowded with hundreds of thousands of
deliriously ecstatic East Germans celebrating their new-found freedom.

Why is this relevant? Consider the following chart summarising market valuations. The red
marks show where we are currently in terms of standard deviations from the historic mean
and the lines show the historical ranges.

Nothing to see here: current valuations in historical context – (std deviations from average)

-2

-4

-6
S&P500 (1881-now ) Bonds (1881-now ) Credit (1921-now ) Volatility (1900-now )

Source: SG Global Strategy

2 12 November 2009
 Popular Delusions

At first glance it seems there’s nothing to get excited about. Risk assets – equities and credit –
are on the expensive side of their historical ranges, though hardly egregiously so. But two
things stand out: volatility is right on its average and government bonds are expensive.

Neurological tricks and equity volatility

This subdued volatility makes me nervous. Bloomberg’s Betty Liu interviewing Warren Buffet in
early March remarked that analysts were complaining they couldn’t value their companies in
this “new environment” because no one had any idea what the future held. Even CEOs
wouldn’t give forecasts because they had no visibility for the rest 2009 or even beyond. Buffet
replied with typical candour:

“Betty, we didn’t have any visibility in 2006 either, we just thought we did … people say “Oh,
the future’s too uncertain now” … Well the future was uncertain then, or in 2007 too, they just
didn’t know it was uncertain.” 1

This is a fundamental truth. The future is always uncertain. Only the extent of our self-
deception changes over time. Nicolas Taleb has famously explained why and how we live with
this delusion and how our cognitive system overrides the role of the random. The Nica Leons
and Gunter Shabowskis of the world are airbrushed out because their existence poses
intractable questions. Indeed, the natural state of the mind is to see order even where there is
none, a happy delusional equilibrium tricking us into seeing what can’t be seen.

109 years of variant delusion – DJIA daily volatility

80%

70%

60%

50%

40%

30%

20%

10%

0%
1900 1909 1918 1927 1936 1945 1954 1963 1972 1981 1990 1999 2008

Source: SG Global Strategy

And if equity volatility is a proxy for market visibility, then current equity volatility at its historical
average suggests we are in such a delusional equilibrium right now. And thanks to Taleb’s
insights, which teach us that this delusional equilibrium is merely a neurological sleight of hand
and not based on anything fundamentally true, the current confidence exhibited by the
“average” level of equity volatility today isn’t based on anything fundamentally true either. It’s
based on the tricks of our collective minds.

1
Interview with Bloomberg’s Betty Liu recorded on 5 & 6 March 2009

12 November 2009 3
 Popular Delusions

Events which are unexpected enough to disturb the delusional equilibrium must happen,
because truth outs eventually. Sometimes the unexpected is worth savouring: the Berlin Wall
fell; Nelson Mandela was released. Sometimes they’re not: the Asian economies weren’t tigers,
and the sub-prime crisis wasn’t contained.

Yet these surprises are the events which create opportunity. CEOs refusing to forecast,
analysts complaining they have no visibility, risk appetites declining across asset classes and
equity vol “spiking,” like some sort of collective mental breakdown, is the least risky time to
invest. The illusion of predictability is shattered, and the reality of uncertainty temporarily fairly
priced. Temporarily because we know that our brains are hardwired to reassert the delusional
equilibrium.

The next chart shows valuations in November of last year and March of this. On each occasion
volatility was historically high. With the collapse of Lehman (November) and concern that
governments were about to go bust (March) the market then knew that it didn’t know. Volatility
more closely reflected the reality that we never know what’s around the corner and risk prices
reflected the emotional discomfort such realisation causes. It was a good time to be active. In
November credit was cheap while in March equities were a bit cheap.

Today volatility is low/average. We’ve forgotten that we don’t know. We’ve once again found
our happy, delusional equilibrium which allows us to pretend our world is ordered. It’s fun and
it’s comfortable, but it’s not the time to be making aggressive bets.

November 2008 valuations March 2009 valuations

8 8

6 6

4 4

2 2

0 0

-2 -2

-4 -4

-6 -6
US St ocks Bonds Cr edit Volat ilit y US St ocks Bonds Cr edit Volat ilit y

Source: SG Global Strategy

The mispricing of long-term inflation risk

One event which might some day cause such a vol spike is a repricing of inflation risk in the
bond market. I’ve written in detail about the historical relationship between fiscal strain and
inflation. Although inflation is widely considered a monetary phenomenon, past episodes of
runaway inflation – from ancient Rome to modern day Zimbabwe - have generally had as their
root cause a government unable to pay its bills. They have been fiscally generated. 2

Some have argued that fiscal scare stories shouldn’t be taken seriously because government
debt to GDP remains at manageable levels even after the gargantuan fiscal stimuli. And, if the
true measure of government liabilities were represented by the red bars below (on balance
sheet government debt), then I’d agree. But they’re not. Our governments account for
pensions and health promises in a way which no company would ever get past its auditor, on

2
See “Inflation is Always and Everywhere a Fiscal Phenomenon”, Popular Delusions 09/10/09

4 12 November 2009
 Popular Delusions

a current period flows basis. A more accurate actuarial estimate of capitalised net liabilities
has been done by Gokhale, with his results shown as the grey bars.

Are our governments solvent?

Official Net Debt, % GDP * To tal net liabilities (o n and o ff balance sheet), % GDP **

750%

500%

250%

0%
Germany Spain France Italy UK EU US
* 2010 OECD pro jectio ns
** 2005 estimates o f to tal Fiscal Imbalance
Source: SG Global Strategy, OECD, Gokhale (2009)

I don’t see how our governments can pay these liabilities. EU and US net liabilities add up to
around $135tr alone. 3 That’s four times the capitalization of Datastream’s World equity index
of about $36tr, and forty times the cost of the 2008 financial crisis.

Our governments appear to be insolvent. They’re liquid, so they can stay afloat the way the
Detroit auto companies did for years despite being insolvent. But unlike the Detroit auto
companies, our governments’ debt doesn’t trade at distressed prices and as an effective
option on finding an escape from impending bankruptcy.

I think they should. Such liabilities have historically crippled governments (and economies, and
companies, and anyone else for that matter). And although governments usually default via
inflation, our governments are short real goods and services (e.g. earnings-linked pensions,
health care), which they won’t be able to inflate away. This means there will ultimately be even
more pressure to inflate away whatever they can.

That’s not to say there’s anything inevitable about inflation as an outcome. Retirement ages
and taxes will certainly rise, entitlements will be cut and this will lower the burden. Gokhale
suggests that in the absence of any policy changes an increase in government saving of 8%
of GDP into perpetuity would restore balance.

But this implies some very tough decisions, and our governments haven’t demonstrated such
toughness in a long time. With a 30y implied rate of just 2.4% the bond market seems to be
backing them. It’s surely worth looking at ways to take the other side of that bet?

3
As far as I’m aware, Gokhale hasn’t done any calculations for Japan but they’re in the same boat

12 November 2009 5
 Popular Delusions

Trust your government! 30y inflation breakevens show no concern over government insolvency
3.5

2.5

1.5

0.5

0
05/2002 05/2003 05/2004 05/2005 05/2006 05/2007 05/2008 05/2009

Source: Bloomberg

If you’re still not convinced, consider the following chart showing the distribution of US
inflation rates in recent decades. Inflation has averaged 3.7% since 1951 when the Fed
discontinued its bond yield fixings. True, this includes the inflationary 1970s. But if we exclude
that period and calculate the average inflation rate from 1982 to the present (the “Great
Moderation”), we find that it has averaged just over 3% in this time. So 30y inflation
expectations are currently pricing in an even more benign inflationary environment than during
the central banking’s golden age.

30y inflation breakevens show no concern over government insolvency: distribution of post
WW2 US headline inflation rates

100

90
Implied 30y average inflatio n "Great M o deratio n" average inflatio n rate
80

70
P o st WW2 average inflatio n rate
60

50

40

30

20

10

0
-2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Source: SG Macro Strategy

If inflation is mispriced, so is everything else

Risk assets exist in the orbit of “risk free” assets, so this isn’t just a bond market problem. It’s
true that equities look cheap if we anchor around the last twenty five years or so. The

6 12 November 2009
 Popular Delusions

following chart shows the Shiller PE for the S&P500, alongside the US market’s median price-
to-book, is at the low end of its range. Equity valuations might be considered “unchallenging.”

Stocks historically cheap?

45
40
35
30
25
20
15
10
5 Shiller PE Median PB
0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: SG Macro Strategy, Shiller, Factset

But the next chart shows how misleading narrow historical framing can be. During the 20th
century, the ultra-low valuations have occurred when inflation wasn’t under control.
Low/stable inflation regimes, which I’ve loosely defined as occurring during the 1920s, the
1950s to the early/mid 1960s and the 1980s to the present, have seen considerably higher
Shiller multiples than inflationary regimes. The average multiple during inflationary regimes has
been 12.2x. During price stability it has been 19x.

Shiller PE shifts during inflation regimes

50 Price St abilit y 4

45
3.5
Price St abilit y Price St abilit y
40

35 3

30
2.5

25
2
20

15 1.5

10
1
5
WW1 inf lat ion WW2 Inf lat ion 60s inf lat ionary pressure eplodes in t he 70s ????
0 0.5
1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001
Shiller PE M edian PB

Source: Shiller, Factset, SG Macro Strategy

12 November 2009 7
 Popular Delusions

When will inflation become a problem?!

For all my emphasis on long-term inflation there is no sign at all of cyclical inflation pressure.
So when will this inflationary maelstrom visit us? When will our governments wake up to find
the capital markets closed to them? When will they be forced to fund their working capital
requirements with the printing presses? What will trigger this crisis?

The truth is I don’t know. Maybe it won’t happen for another ten years, by which time the
Hospital Insurance trust fund assets will probably have been run down, leaving it reliant on
current government revenues for funding. 4

Or maybe the trigger will be Japan. The domestic savers who have been the biggest buyers of
JGB are now retiring and running down their assets (the Japanese saving ratio is now almost
zero). Doesn’t this mean there are now no buyers of JGBs? Such a funding crisis could easily
force the government to pay its bills with printed money. It might even cause contagion across
developed bond markets as everyone realises we’re all in the same boat.

The oil markets could be a source of volatility too. While the biggest single source of
improvement in the US current account deficit has been lower oil prices, the Guardian
reported on Tuesday that an IEA whistleblower said the US applied pressure on them to inflate
their potential reserve estimates because revealing the true state of the energy markets’
supply potential would cause panic buying. So maybe Matt Simmons is right. Maybe Saudi oil
production has peaked and we face a looming energy shortage worse than that of the 1970s.
Maybe this will morph into a funding crisis for the US government.

Maybe it will be none of the above. Maybe a spiritual descendent of Gunter Shabowski, the
politburo spokesman who accidentally brought down the Berlin Wall and exposed the
unsustainability of the communist model, will do the same thing for our governments’ fiscal
positions. A stray comment at a press briefing might be erroneously interpreted as meaning
China wants to sell all its Treasury holdings, and this might set in train an irreversible cascade
of financial panic.

I wish I knew. But I don’t. What I do know is that, like Eastern Europe before the fall of the
Berlin Wall, our governments’ current actions are inconsistent with long-run stability. I know
that not being able to predict the crisis trigger doesn’t mean there isn’t a crisis trigger.

I know that with human nature being what it is, people assume that because outcomes such
as government funding crises and runaway inflation haven’t troubled developed markets for
many decades, they can’t ever happen again. And I know that with volatility at these levels the
market is much more confident in its ability to predict what lies in the future than I am.

So while there are some interesting micro exceptions, (I’ve written about agriculture in recent
weeks and will write about others shortly) from a purely top-down perspective I just can’t get
excited about the reward being offered for the risks we face.

4
See the “2009 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal
Supplementary Medical Insurance Trust Fund” page 16

8 12 November 2009
 Popular Delusions

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