Capitalism is Dead. Long Live Capitalism.

Friday’s effective nationalisation of the US Bond market is the end of capitalism as we know it. Guggenheim's Scott Minerd summed up exactly what the Fed has done with its actions:

The Fed has made it clear that it will not tolerate prudent and responsible investing.

Capitalism is dead.  Long live capitalism.

Recovery can now only be driven by investors returning to principles prudent investing and financial entrepreneurship.

This means genuine portfolio diversification combined with the flair of a venture capitalist in order to overcome the chronic shortage of hard assets by creating new ones. 

As investors rebuild robust portfolios a robust financial system also takes shape - one investment at a time.  I have called this rejuvenation process Robust Finance (RF).

The Tragedy of Centralised Control

If there is one lesson from the current situation it is the limitations of centralised control.  A virus did not shut down the world, governments did.  The present market crisis is equally the result of government action, this time their addiction to fiat money.  For the last 2,700 years the result of this addiction has always been the same – collapse of the economy and hyper-inflation.  

Remember how the Western Roman Empire debased its currency? It ended in 476 when the barbarian Odoacer deposed the final Western Roman Emperor Romulus.  In contrast the hard-money Eastern Roman Empire continued for another thousand years to 1453. (Nathan Lewis, Gold the Final Standard, page 30)

Who can still believe this time is different?  Can governments, the cause of catastrophe also be the solution?

The blame is not on governments per se.  I believe in government and the services such as roads, rubbish collection and mountain bike trails they provide.  But I believe in small government.  During their most prosperous periods in the 19th and early 20th centuries both Britain and the US had small government.  The issue with big government is the centralised system of dependencies they help create.

The Pyramid of Dependencies

Governments own fiat currency.  Their central banks wielded the two monetary tools a fiat system provides, interest rates and money supply.  Dependent upon the manipulation of these tools are commercial banks.  Banks and insurers are also dependent upon each other for their solvency through the derivatives they trade between themselves.  Finally, at the bottom of the dependence hierarchy are corporations, small businesses and individuals in serfdom to the system through debt.  It is this centralised system of dependencies that has no future.

Dependency Pyramid

Bill Gates and those who depend on the fiat system for their livelihood will disagree.  They are like Russians who still mourn the demise of the communist regime.  Or children who feel secure with an authoritarian parent no matter how bad the parent’s behaviour.  Bill and those like him will call for more authoritarian measures such as global vaccination and a paperless one world currency.  Centralised control is what they know and love.  The currency of control is fear.

Greater centralisation and greater dependency can only lead to more of what we have today. Dependency is anathema to the prudent investor.  Apart from the destruction of the moral and social fabric of society, the financial risks are simply too great.  Centralisation and dependency are not consistent with long term return on capital.  As Bob Rodriguez details ominously,

With the events of the past three weeks, the perversion and conversion to a dystopian capital market and economic system is virtually complete.

As for me, with the Fed's announcement of unlimited QE and its “will buy or support almost anything,” along with the pending passage of a $2-2.5 trillion stimulus package, this is the end of the capital markets as we have known them.

Over the last few decades what has changed are not the principles of sound investing but the increasing dependencies within the fiat system.

These dependencies can be traced back to loss of fiscal discipline when the world exited the gold standard in 1971 or to the rise of derivatives in the 1990’s which bound the solvency of banks and insurers to each other.  The growing indebtedness of individuals, corporations and nations has exacerbated the issue.

Graph of total global debt

The robust and indeed only viable solution for investors is to return to the basics: nurture a diversified portfolio of assets of independent value outside the fiat system. 

A Return to Hard Assets

The prudent investor adapts to the changed landscape in order to ensure genuine portfolio diversification.  Those who still believe a mix of bonds and equities represent a diversified portfolio live in the distant past.  Most of these assets are bound to the fate of the fiat system through debt.  Obviously any asset that depends upon the fiat system cannot provide diversity away from that system.

Genuine portfolio diversification is achieved through assets valued in themselves and not dependent on the institutions of the fiat system for that value to be realised.  In other words hard assets. 

The prudent investor returns to hard assets to ensure a diversified portfolio.  She takes advantage of the flood of new fiat money provided by central banks to exit fiat-dependent assets.  Before the cash generated inflates she invests in hard assets.

Hard assets include precious metals, property, non-collateralised digital currencies such as Bitcoin, Litecoin and Monero as well as equities and their bonds where cash flow is high and borrowing is low/nil.

Roadblocks to Hard Asset Accumulation

While sound in principle a return to hard assets raises two issues.  First hard assets do not necessarily generate good returns. As a prudent investor the Harvard Endowment Fund after the 2008 Financial Crisis diversified into natural resources including farms in Australia and forests in Romania and Ecuador.  The investments performed poorly leading to a billion dollar write down.  Gold has been the foundation of hard money for millennia precisely because its value remains stable.  Gold prices do not so much go up as fiat currencies devalue.

Second, there is a chronic shortage of hard assets.  For example production of physical gold increases supply around 2% a year.  ICPM Group estimates gold accounted for 0.52% of global financial assets in 2019.  The disconnect between the price of paper gold and physical bullion reflects this scarcity. Like lifeboats on the Titanic there are simply not enough hard assets to go around. 

Unleashing the Entrepreneurial Spirit

The prudent investor responds to this need for hard assets with sound return potential by becoming entrepreneurial and creating their own.  This is not as difficult as it may seem.  For example:

  • The invention of the distributed ledger (blockchain) in 2009 enables asset ownership to be recorded without dependence on a centralised authority. 
  • Non-collateralised digital assets have been created without the need of mandate from a third party authority.  The market capitalisation of assets such as Bitcoin, Litecoin and Dogecoin demonstrates the ability of investors to generate their own assets with zero linkage to the fiat system.

Rules of Hard Asset Creation

A fundamental requirement of creating new hard assets is that they have independent value.  If they are collateralised by linking their value to the value of another asset dependencies emerge.  This non-collateralised requirement means that new assets must start life illiquid.  Liquidity needs to be nurtured by encouraging adoption.

Fortunately for the prudent investor growing illiquid assets to liquidity is exactly what Venture Capitalists have been doing for decades.  Their business model of multiple investments, patience and active involvement is proven.  According to Cambridge Associates VCs have been the best performing asset class over the last 20 years.  Prudent investors take the VC model and instead of applying it to start-up companies they build new assets.

Building New Hard Assets

As an example of new asset creation I developed an asset classed called Self-Managed Investments (SMIs).  A form of digital hedge fund, SMIs have zero exposure the fiat system yet because of their no-fee structure offer investors better returns than the traditional 2 + 20 hedge fund model.  The template is freely available for investors to use in their own asset-creation endeavours. 

Bitcoin Enhanced Asset Performance
Returns from the Bitcoin Enhanced Algorithm over its first two years compared to Bitcoin source:

The first SMI is a long/short Bitcoin strategy called Bitcoin Enhanced.  Over the last 2 years the trading algorithm as demonstrated a 75% return (37% p.a.).  The asset is currently in the illiquidity stage.  In keeping with the venture capital model where early investors experience the greatest capital efficiency, the first tokens are being sold at a steep discount to maximise potential upside with least capital outlay.  As scarcity helps to drive demand the total supply of tokens is hard-capped at 4 million. 

RF is Happening Now

The world demand for physical gold and the creation of SMIs like Bitcoin Enhanced are just some ways RF is already under way.  A mailing list helps investors keep up with developments including the launch of new assets.  You immediately notice how decentralised the process is.  Investors, large and small, adapt to the changing landscape and refocus their intent on providing for themselves the best risk-adjusted returns. The process requires no central planning, no co-ordination, no new laws and best of all, no one-world anything.