Full text of contrarian investor Simon Mikhailovich’s talk: Safeguarding Your Money in Uncertain Times at TEDxWilmington event.
Listen to the MP3 Audio here: Safeguarding Your Money in Uncertain Times by Simon Mikhailovich
Simon Mikhailovich – Contrarian investor
Famous American journalist H. L. Mencken once said:
Whenever you hear somebody say, it’s not about the money, it’s about the money.
So my topic today is definitely about the money. And it’s about how to protect your money during these uncertain times.
Now, why do I say these are uncertain times? The last 35 years, I’ve seen tremendous innovations in many areas. We’ve seen technological revolution in technology, in computer science, in health sciences, in telecommunications, we’ve also seen a technological revolution in finance.
But unlike those other areas where I think the technological advances have been extremely positive, a lot of technological innovations in finance have been pretty dangerous, and I think pose catastrophic risks.
Now humans have been dealing with catastrophic risks since the dawn of civilization. 2500 years ago, Pericles, who was an Athenian politician, and a general said that the key was not to predict the future, but to prepare for it.
But clearly, if you were to prepare for the future, you have to have some understanding as to what kind of risks you’re trying to manage. Let me give you an example.
Everybody intuitively understands that tangible assets are subject to catastrophic risks, and the way… fires, thefts, floods, and so forth. And the way we deal with those risks is through insurance. So we insure our homes, we insure our cars, we insure our furniture.
Now you may be interested to know that tangible assets only represent 25% of household net worth in the United States. 75% is in financial assets. But nobody seems to have an idea to insure financial assets against loss, which they cannot afford to lose, of course.
SO WHY IS THAT? Well, if there’s one thing we learn from history is that people don’t learn anything from history. People learn from personal experience.
Well, first of all, let me tell you a little bit of my personal experience, so you have some ideas as to where I’m coming from with this.
I grew up in the Soviet Union. I emigrated with my family when I was 19. One of the reasons we immigrated was because we saw the facts for what they were and we realized that the Soviet economic and political systems were unsustainable. It was a very expensive decision.
We came to the United States as stateless refugees, we had to abandon or give up our citizenship. And we were allowed to take $100 a person in a suitcase. And so that’s how we arrived there. That was my first brush with catastrophic financial risks.
I worked my way through college, I worked my way through business school, and I became an investor and I’ve been doing it for the past 32 years. 15 of those 32 years I’ve been involved in credit derivatives, structured credit, a lot of the new technologies that were squarely behind the crisis of 2008.
So fortunately, my partners and I were able to see that being in the business we saw this coming and we profited from that crisis. But unfortunately, I’m seeing a lot of the same problems.
And in fact, I think the problems that I see now in the same areas that were problems before, are much greater. So before I share some of these facts that I’m referring to, let’s just do a little bit of financial math. You don’t need to know anything other than what I’m about to tell you.
All financial assets are valued based on something called discounted cash flow model, DCF, discounted cash flow formula. And this formula operates in a way where one of the major inputs is interest rate. And the way it works is when the interest rates go down, asset prices go up. Asset prices, meaning cash flow producing assets: stocks, bonds, commercial real estate, go up. So rates down, values up, rates up, values go down.
So just keep that in mind as we continue to talk.
So what has been the personal experience of investors in the west for the past 35 years? This is a picture of U.S. interest rates, it’s been a one way ride. Interest rates have gone from 20% to virtually zero. And the asset prices, of course, because when rates go down, asset prices go up. And the asset prices have continued to go up.
Yes, there have been crisis along the way. But over time, prices keep going up. So you can see that this has been a one way street.
If we take a step back for a minute, and look at a broader historical perspective, you will see, this has been an incredibly unusual period of time. This is that less steep decline in the dark area, all the way at the edge of the chart.
You can also see the red line which shows that the rates today are lower than they have ever been in history. And go back to the formula I just gave you: If the rates are as low as they’ve ever been in history, that means that the values of financial assets are as high as they’ve ever been in history.
Now that’s interesting, because when I went to business school and when they were teaching me how to be a good investor, the first thing they told me is you’re supposed to buy low and sell high.
Well, it seems like what we’re doing here is the other way around. We’re buying high and hoping that it’s going to go much higher. Well, that in history… historical record of that kind of thing is that’s how you go broke. That’s not how you become wealthy.
Now, you can also see that low interest rates have spurred the growth in debt. And these two lines that you’re looking at is the growth of debt and the growth of stock prices, S&P 500. And you can see they’re perfectly matched. As debt increased, as leverage increased, so have the prices. It’s clear why: cheap debt, people borrow money, they buy securities, demand for securities increases, and the prices go up.
But there’s a bit of a problem. And the problem is that the lower line there in blue is the growth of American economy. And the red line is the growth of American debts.
Now in mathematics, whenever you see a line that goes like this, it’s called exponential function and the historical and mathematical record for exponential functions is that they always end in a bust. Now, maybe this time is different. But history is pretty clear. It’s a 100% certainty in the past that those types of events always end badly.
What you’re looking now are the global debts for this century since 2000. So if 2000 crisis was about there being way too much debt, we have 50% more debt in the world today… 50%, over $200 trillion of debt.
In the United States, government debt has doubled since the last crisis. Corporate debt has doubled since the last crisis, and personal debt which declined because of the mortgage defaults after the crisis has just… I just read in the paper that it has reached a new all-time high. So we have fully recovered and we’re off to the races again.
Now, before I go further, everybody hears about trillions, their eyes glaze over and people don’t have a sense for how much that is. Let me give you a little bit of example of what we’re talking about here.