HedgeTalk: Lessons from “Government Decrees”

By: Johan Rosenberg, Chairman

NYT Oct 9, 1982 - “Prime Minister Olof Palme today ordered a 16 percent devaluation of the Swedish krona and a general price freeze as part of an austerity policy for his new administration. The devaluation, together with other proposed measures to strengthen industry, is designed to make Swedish exports less expensive and thus more competitive, and to provide more jobs at home. The new value of the krona is about 13 cents.” I was 14 years old, held Swedish krona, was living in the USA, and was totally confounded. How could something like a currency be worth something one day and the next day be worth less, by “government decree”? Really? It was senseless and unnatural to me. Ten years later in 1992 I got beat up again. Sweden experienced a financial crisis as a result of a housing bubble similar to what the US experienced in 2008. Swedish banks failed and I experienced yet another devaluation of the krona. These events left me black and blue and with little faith in the Swedish krona/economy. However, coming out of the 1992 financial crisis Sweden somehow miraculously transformed itself to one of the most durable economies. I missed the run up because I would not get involved in something that was seemingly so illogical. So now in 2020 I propose that the “inherent value” of the finite asset base never changed in March/April of this year, though this was - and still is - up for debate. In this context, inherent value is the value that can be ascribed to an unlevered green and blue space rock (earth). What happens on the surface of the space rock and its inhabitants is subject to, from a macro perspective, minor and irrelevant fluctuations of metabolism. The inhabitants of the space rock however believed that up to 3% of the population (240MM), could rapidly perish. That hasn’t happened. I am not using the traditional definition of “intrinsic value” embedded in fundamental analysis as pioneered by Benjamin Graham which relies in part on P/E multiples. Prior to US federal stimulus and the reopening of China, the world was stuck in global uncertainty, and thus experienced a 30% decline in major equity indices. To restore confidence and hope the Federal Government distributed stimulus dollars to help subside the population’s anxiety, help them sustain their households, and create some feel-good endorphins. Move over Timothy Leary, Jay has topped your accomplishments 10x. But what has changed by “government decree” is the representational seashell system used to account for the parts comprising of the finite whole. USD has been effectively redenominated, and the redenomination has been accomplished/distributed through stimulus and new Federal TARP. Therefore, the amount of USD required to purchase parts of the finite whole has risen commensurately. Yes, USD has been devalued - but so has every other major currency. Net-net, nothing has changed in terms of relative value and the wealth of nations. The speed of stimulus mimicking had to happen so no-one was left behind in the scuffle-shuffle. Could this be the “reason” in the “no rhyme nor reason” riddle of the S&P 500? I would say that is why, in a redenominated world, everybody believes in the valuation inflation that comes with devaluation of the currency. The data used for many economic graphs are in the old denomination and the new redenomination simultaneously. The before or after are not on the same base scale. One side has to be recalibrated to account for the redenomination. Without a recalibration, V rally looks senseless and inflates the recovery. Without recalibrating it looks like the top line indices have nearly recovered. They haven’t yet, but with time they will. Adjust for the redenomination and I suspect the charts will look more logical. When the new and bigger redenominated M2 filters through the economy and is redistributed through products and services, net imbalances will be counted as losses and earnings. If consumption has been inherently and permanently altered, winners and losers will be identified. To help describe winners and losers in this market there is the concept of an upper and lower arm K recovery. As opposed to a V shaped recovery, upper and lower arm K recovery is a recovery where some companies go up (upper arm K) and some companies go down (lower arm K). The market is repricing the upper arm of the K automatically and quickly based in future upper arm K earnings, while the lower arm K companies are stuck perpetually in the lower arm. Little is going to change in the lower arm. I predict upper arm K’s will be just fine as upper arm K earners, and unexpected relatively wealthy unemployment check collectors, will overindulge and create upper arm K future earnings after this artificially induced COVID-19 fast. Upper arm K products and services will rapidly inflate and earnings will be fine. These companies will be defined as “COVID proof”. When I see this happen, I will then be able to go back to Graham’s way of thinking regarding value investing. I’m trying to resolve my 1982 frustration, what Swedish monetary policy makers understood then, and what I didn’t understand. Does this line of reasoning work? If you agree with this then cash is trash, and aside from the bond/gold barbell, strong consideration needs to be given to upper arm K companies. Alas, I think I have again missed another run up because I have to understand before I act. But if there is a rally left to happen when a full accounting of the redenomination has occurred, perhaps there will be an opportunity to get the last of it. Aside from another lockdown, I should not be that worried about another giant cliff drop, as long as I’ve put in some portfolio defenses/insurance (i.e. hedges).