Investment spotlight: Be cautious

Investment spotlight: Be cautious

Janet Yellen of the Federal Reserve has finally done it – raising rates some seven years after the 2008 banking crisis.

So far this has not started the liquidity tightening so much feared in advance, but then the increase was so small, and rates remain so low, that nothing much seems to have changed in the world of finance.

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Indeed, whatever the original intentions of quantitative easing – the concept of trickle down value – this changed as central bankers realised it was not stimulating economic growth. Now it is much more about reducing relative currency values in the hope that this will encourage exporters and domestic manufacturers.

Either way, this will not help long-term pension savers or those desperate for a safe – but livable – return on their money. Fortunately for the politicians, stock markets remain high so the rich, at least, remain content.

Indeed, US markets have only ever sold at these valuations twice before – once in 1929 and a second time during 2000 and the tech boom.

This leaves most investors in a quandary. The alternatives for those with long-term savings to invest have traditionally been debt – especially that of developed countries such as the US and the UK – or equities with their promise of rising dividends. But the former is dangerous with such low yields, and the latter are at risk with current valuations.

The danger in outdated theories

The one thing that most investors should not do is to buy ‘structured products’, which few understand except for the higher yields promised. Mostly these are based on the Black-Scholes valuation of derivatives, a theory blown out of the water first by the bankruptcy of Long-Term Capital Management and then the 2008 mortgage derivative disaster.

Naturally, the investment bankers are reluctant to admit that ‘corporate finance’, to which they have devoted their university years and then their working lives, is professional nonsense. Black-Scholes assumed that there was ‘independent value’ in stock market indices, the interest rate, or assets. In the last case, the only objective reality is liquidity – a business either has it, or is bankrupt, regardless of the theory of ‘value’. This was the case with Michael Milken, Bernie Madoff, Jeff Skilling of Enron and, of course, the banks in 2008.

Corporate finance was born in the late 1940s. Until then it was accepted that investment management was a craft business with, like all other human activities, some who were good, some terrible and the majority just average. This was not good enough for hard-faced CEOs, asked to commit the enormous investment funds they were establishing to finance their employee pensions.

As always there were academics willing to create the necessary theories, especially with the help of the newly developed computer. Sufficient examination of past price movements, an imaginative explanation of why they took place, and all sorts of theories appeared that showed markets could be understood and so controlled. These became known as the ‘Efficient Market Hypothesis’ and pension fund management became an enormously profitable business; sadly for the pensioners, only the fees remained after the end of the Cold War and the return to normality in financial markets.