The Bear’s Lair: Under funny money, we’re all living in Vegas

“True investing is not the same as gambling” said Isabella Kaminska in the Financial Times recently. Yet in today’s world, I’m damned if I can spot the difference. Bonds are a one-way bet to losses, the stock market is at levels it should not have reached until 2075, London real estate is at levels it should never have reached at all, and only crypto-currencies appear to offer sound long-term value. Whatever the differences were between investing and gambling, they have disappeared. That reality has unpleasant implications for our future.

Traditionally, investment involved securing a relatively assured and steady income, together with some prospect of capital gain. The wealthy held the bulk of their net worth in farm land, the crops or rent on which fluctuated from year to year, but as population and wealth increased, could be expected to follow a gently upward trend in value. There were risks of income declining or even of a loss in an atypical year, but provided the landowner kept some liquidity, these risks could be made up in subsequent years. The big risks, of a war that erupted locally or of a famine that devastated population, were ones one could neither hedge against nor wanted to gamble with.

Starting around 1700, two additional types of investment came along at opposite ends of the risk spectrum. At one end, innovations such as the Bank of England made government bonds truly risk free, enabling people to put their money where there was no risk of income fluctuation and no risk of default. Incomes could decline as bonds were refinanced at lower rates, but that risk was alleviated by the marvelous invention of 3% Consols in 1751.

Through Sampson Gideon’s invention, people could lend to the government at a 5% running yield in wartime by buying Consols at 60% of par. That gave them an investment that was almost completely safe from being refinanced at a lower interest rate, since when peace returned the bonds would simply return to par (they were eventually refinanced at 2½%, but not until 1888 – 137 years is a decent run, and ample for us mere mortals.)

Sophisticated investors and financiers made nice capital gains on the recoveries in Consols prices after major wars, especially that after 1815, but for the ordinary retail investor Consols provided an investment that was less risky than land, had zero management costs, and gave a yield that did not fluctuate, unlike land which depended on harvests and the solvency of tenants.

Ordinary investors quickly demanded government bonds, but they mostly rejected the other major investment innovation of the early 18th century, corporate equities. The South Sea Bubble of 1720 allowed sharp traders like Gideon to make their first fortunes and lucky ministers like Sir Robert Walpole to increase theirs, but it horrified the investing public to the extent that the Bubble Act of 1720 was immediately passed to prevent the incorporation of any new companies except by Royal charter. An immense literature of vilification was produced around the Bubble, asserting that stock investment was pure gambling, with the Exchange consisting of disreputable stock jobbers rather than the better established and better-connected people who ran the West End gaming clubs.

The Bubble Act was in force until repealed in 1826 and successfully prevented any significant stock market bubbles during that century, at the cost of possibly delaying the Industrial Revolution by half a century or so. Large entrepreneurial ventures like the Bridgewater Canal during that period had to be exceptionally aristocratically sponsored – in that case by the Duke of Bridgewater – and major corporations like Wedgewood and Boulton and Watt were forced to remain privately held.

Only in the 1820s, as investors were successfully proving they could also lose huge amounts of money on South American bonds, did stock investment begin to come back into fashion. Mrs. Harriet Arbuthnot, a very shrewd diarist married to a junior minister, tells of her successful speculation in shares of the Liverpool and Manchester Railway, which she correctly saw as the economic future, but bemoaned that her husband would not let her speculate in South American bonds.

As often happens, the husband knew best and saved them from major loss. Both shares and bonds were issued in those days on a 10% paid basis, with the other 90% to be subscribed a year or two later; while the £900 required to pay up the Liverpool and Manchester was affordable and money well spent on a highly lucrative investment, a series of similar demands to pay up on defaulting South American bonds could have destroyed the Arbuthnots’ fairly modest finances.

Like most Regency ladies, Mrs. Arbuthnot liked a flutter, and investment in shares or indeed South American bonds at that time was pure gambling, as it had been in 1720. There were no reliable accounts or auditors, and no prospectus requirements – so quite a successful bond issue was made in 1822 for Poyais, a non-existent country whose bonds were made plausible to potential investors by an eloquent description of the non-existent cathedral in its equally non-existent capital.

The repeal of the Bubble Act, the gradual increase in the number of stable publicly traded companies, and the advent of the railways caused a gradual reappraisal of the value of equity investment. Share valuations remained low, and investment was made mostly for the dividends available, which exceeded the yields on government bonds, but especially after the 1862 Companies Act share investment was no longer gambling, although it still appealed only to a modest segment of people at the top end of the income distribution.

In the United States, similarly, the advent from the 1850s of good business information and bond and share appraisal systems made share investment more popular, and from the merger boom of the 1890s onwards capital gains became an investment objective as well as income. Then again, the United States had no Consols. Bond investors in the Civil War were refinanced when peace returned so missed out on Consols’ post-war gains, but on the other hand they enjoyed a gain in the value of their money from the abolition of greenbacks and the return to the Gold Standard.

Investment changed fundamentally when Britain and the United States moved to fiat money in the 1930s (the post-war Bretton Woods gold standard was a sham). Bonds were no longer secure against inflation, and experience in Britain in 1945-75 showed that Consols were now not safe but financially suicidal. Even index-linked bonds, when they appeared after 1980, suffered from governments fiddling with the price index; they were not the equivalent of Gold Standard bonds.

Meanwhile, equities became much more popular, as their dividends kept up with inflation and their stock prices showed at least some signs of doing so. As a young embryo banker, I was taught that solid equities were almost completely safe provided you held them for long enough. From the 1980s onwards, bonds also became viable investments again, and not simply a way of throwing away your money.

The era of over-expansionary monetary policy since 1995 and particularly the era of funny money since 2008 have changed all that. Long-term government bonds barely yield more than inflation, and carry a huge price risk of loss if interest rates rise. Corporate bonds are also far too tightly priced, with substantial credit risks given the appalling state of most blue-chip balance sheets.

As for equities, it must be likely that in real terms their prices are are currently far above the average of the period 2025-2075, and they may even be above the maximum of that period. Hence the overwhelming probability for investors in U.S. equities is for substantial long-term losses. Yes, I suppose if loss is certain it isn’t technically gambling, though lengthy occupation of a table in Las Vegas will produce the same result. Emerging market equities are less overpriced and hence a better bet, but the 1990s’ assurances that most emerging market governments would remain committed to private property rights, become gradually richer and allow investors to make money, seem a long way away now.

And then there are crypto-currencies, the investment that Ms. Kaminska despises – she has said so frequently this year, deterring FT readers from major profit opportunities – and believes are mere gambling. I would argue the opposite. Yes, crypto-currencies are imaginary, and almost certainly a bubble. However, ever since the world’s governments took away the secrecy of Swiss bank accounts around 2010 the world’s rich have needed a foolproof way of hiding their assets from greedy governments, and crypto-currencies, or at least those with full anonymity, seem an admirable means of doing this. Thus crypto-currencies are likely to grow until they become a meaningful competitor to fiat money and to gold, even if they endure some bubbles and crashes along the way.

However, gold’s market capitalization is about $8 trillion and US dollar M1 is $3.5 trillion, Hence there is a very long way for fiat currencies to grow from their current $250 billion market capitalization before they reach their potential. Investing in something with perhaps a 10-fold growth potential — that’s not gambling, that’s sound long-term wealth maximization.

The difference between investing and gambling is quite simple. You are investing, not gambling, if you rationally believe that you will achieve a real long-term profit from your activity (and yes, I accept that card counting in blackjack is a form of investing, until the casino throws you out on the street.) You cannot rationally believe that today when investing in government bonds, corporate bonds or U.S. equities (emerging markets equities are arguable) any more than you can believe it when playing the slots in Vegas. Maybe, just maybe, crypto-currencies are the last true investment remaining.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)