Do you remember the scene in the Wizard of Oz where Toto tugs at the bottom of the curtain, revealing that the Great Wizard is really just a little old man who had tricked people all along? How did this little old man get away with it for so long? And how were so many people duped?
In fact this dynamic of deception plays out in real life with a high level of frequency.
Consider the Ponzi scheme, named for Charles Ponzi, who promised high returns to his investors. As it turned out, he was paying out his early clients with money given to him by new investors. People believed the returns were based on investments that Ponzi had made. They told their friends about their stratospheric returns, which drew in yet more investors. But it was all a fraud.
Though the scheme was named after Mr. Ponzi, he was likely not the first one to come up with the idea. Nor was he the last one to implement it. A more recent example was Bernie Madoff, whose scheme ran for decades until it was uncovered in December of 2008. The only reason that Madoff’s scheme was revealed was because he confessed to his sons, saying that it was all a big lie. The estimated amount that Madoff stole from his clients ranges from $18 billion to $65 billion. He is currently serving a life sentence, but has petitioned President Trump to reduce it.
In 2010 I personally came across another Ponzi scheme while I was working in the Caribbean. A Jamaican investor claimed he could make 10% per month for his clients. His investment of choice was trading foreign exchange. At the time the Managing Director of the bank I worked for approached me to see if I could rationalize a way to make that kind of return in the F/X markets – my answer was simple “no”. The man fled Jamaica for the Turks and Caicos, where I was working, and within a few months the FBI was knocking on his door and taking him into custody.
Similar schemes work in other industries, but unfortunately finance lends itself well because of its complexity. On a basic level math is simple and must add up. If it doesn’t add up, then it doesn’t work. That should be the point at which the investor walks away.
But there are times in the investment world where the math gets complicated quickly. Eyes cloud over, and the investor is lost in a maze. But it works.
It works for 2 reasons – 1) because the math is sound, even though it is complex, and 2) because we have faith in the person showing it to us. The second piece is more important, and can really drive home the success of the investment. Without that important element of faith, nothing happens.
And so we move to the current environment.
The economy looks healthy, unemployment is at historic lows, and the stock market is breaking into record territory every couple of weeks. Things look good. It’s all built on good fundamentals. Sort of.
In 2018 at this time the Fed had been raising interest rates attempting to cool the economy, while in 2019 the Fed was nervously lowering rates with fears of a recession. The result being that interest rates are now quite low, with very little room to drop any further in the event of a recession.
Most people follow all of this on the periphery. Rate changes affect their mortgages, whether to lock in or not. Or whether to borrow more to buy a new car, or expand the business. But the actual mechanics of tinkering with interest rates are left to the financial wizards in the Fed, the Bank of Canada, the Bank of England, etc.
There are a lot of smart people out there who are involved in making these decisions for us. We put our faith in them, primarily because the math is too complex but we know these are very smart people and figure it must make sense to those folks. It is in fact, part skill and part deception.
Our faith in the system collapsed in 2008 when Lehman Brothers was allowed to go under. But our faith was gradually restored when Quantitative Easing, and its sibling QE2 were implemented. It doesn’t really matter to us what was done, what mattered more was that programs were devised, and implemented – and that smart, important people stood behind them along the way. We had confidence in the people, and the programs worked. It could have been part financial wizardry and part deception, but the faith in the process made it work.
But even the Wizard of Oz needed some tools to work his deception. Now with interest rates at near record lows, actual tools are scarce in the event of a real recession. As the former Governor of the Reserve Bank of India, Raghuram Rajan, recently said “Part of the magic of central banking is to pretend you have a bazooka behind your back.”
In this climate, we would do well to include a few tools of our devising in our investment portfolios with the notion that this time the deception might not work.