Russell Napier. Twenty One Lessons from Financial History for the Way We Live Now.

In assessing monetary policy, look at both the price of money (interest rates) and the quantity of money, because interest rates are like the accelerator pedal but the engine is the quantity of money; journalists and policymakers focus on rates but neglect the quantity, which is the only thing that actually affects nominal GDP growth.

“Interest rates constitute monetary policy. But interest rates are really like the accelerator in an automobile. But what makes an automobile go is not the accelerator, it's the engine. What you do with interest rates... is you try to change the quantity of money.”

Democracy is more suited to operation of capital controls than to free movement of capital, because when governments are elected to serve the people and capital can flow freely, capital arbitrages away the government's ability to deliver (e.g., threatening to leave if taxes rise), giving capital veto power over democracy.

“Democracy is more suited to the operation of capital controls than the free movement of capital... there is a a leverage that capital has against any form of government... arbitrage labor markets, arbitrage governments, arbitrage tax systems... It's a much better phrase. Arbitrage is what's happening. The base erosion profit sharing... is the beginning of governments beginning to fight back”

The FTC chair (Lina Khan) was appointed specifically because her doctoral thesis focused on how to break up Amazon, signaling government intent to aggressively enforce antitrust against large technology companies and large corporations generally.

“The lady who runs the FTC, you probably know uh her thesis, doctoral thesis, uh was on how to break up Amazon. So, they made her they made her head of the FTC.”

Monetary systems fail about every 30 years; the current systems in failure/transition are China's peg (likely to break), the euro (unsustainable), Japan's capital repatriation (coming), and potentially the dollar's reserve status, making these the second, third, and fourth largest economies' monetary systems unstable simultaneously.

“Monetary systems fail about every 30 years... I don't think China's going to peg its currency to the dollar... I don't think the euro is sustainable... Japan will have to start repatriating capital... These are the second, third, and fourth biggest economies in the world... we're living through a failure of all of them.”

Never buy emerging market equities if the exchange rate is overvalued because the central bank must then run a tight monetary policy to defend the peg, which depresses the stock market; history shows this: Taiwan 1989 (65x earnings), Hang Seng 1998 (<10x earnings), both due to exchange rate management making monetary policy too tight.

“Never buy an emerging market equities if the exchange rate is overvalued... If a country decides to target its exchange rate and it is overvalued, there are more sellers... that forces you to run a tighter monetary policy... there is a link between liquidity and the stock market... By the end of 1989, the Taiwanese stock market was on 65 times earnings. Uh the Hang Seng index got below 10 times earnings in in 1998”

Economists use purchasing power parity (PPP) to judge exchange rate over/undervaluation, but this is based on tradable goods prices only; in reality external accounts are dominated by capital flows, not goods flows, so you must assess whether the country is competitive on capital allocation, not just goods prices.

“Most economists will tell you... you work out the undervaluation of an of a exchange rate by looking at a PPP calculation... but it's really based upon differential prices and tradable goods... The world we live in, the external accounts are dominated by capital flows, not the flow of goods and services.”

The Chinese exchange rate is overvalued because the country runs a small current account surplus relative to GDP but is repelling capital at a ferocious rate (negative foreign direct investment inflows), meaning it is not competitive on capital flows, only on goods, suggesting currency is too strong.

“It looks really like the Chinese exchange rate is overvalued... it's not running a profoundly negative capital account deficit... at the minute China is repelling capital at a ferocious rate... foreigners are selling more direct investments in China faster than they're adding them”

The US stock market is expensive by any historical valuation measure (cyclically adjusted PE/Shiller PE or Q ratio), but there are many cheap stock markets globally, so if valuation ultimately drives returns, there are opportunities in global cheap stocks rather than focusing on expensive US indices.

“The US stock market, by any measure of its historical valuation, the one that we use... the cyclically adjusted PE or the Shiller PE... By any measure, it's expensive. But there are also lots of cheap stock markets in the world. So, there is an opportunity if ultimately what drives return is valuation, then there are things to buy.”

Straight-line extrapolation is the opiate of the people, not religion as Marx said; people extrapolate the past into the future as a source of certainty; at a time of great structural change, extrapolation is the most dangerous thing you can do.

“Extrapolation is the opiate of the people...Straight line extrapolation is the opiate of people. That's the certainty we all have. We extrapolate the past into the future. Now, I'm here to tell tell you about financial history. You would think, 'Well, this guy's going to be a big fan of extrapolating the past into the future.' Well, I'm not.”

Spend as much time analyzing supply as you spend analyzing demand, because while demand is interesting and easy to fudge (GDP growth is just estimates), supply is hard to analyze and yet is crucial; most broker reports are 90% demand and near 0% supply analysis.

“Is spend as much time analyzing supply as you spend analyzing demand... People get very excited about demand... You can kind of fudge the number... But supply is really tricky... Supply rises from the dirt, and demand shines in the stars... If you're analyzing anything, to say, 'Okay, I get the supply side. Look at the broker's report. I guarantee it'll be 90% about demand.'”

The ratio of corporate profits to GDP is a mean-reverting series (Audi Dickey-Fuller test confirms this is one of the most mean-reverting series in economic history), meaning that after long periods of high corporate profit share, the ratio must return to historical norms, and the US is currently in the high end of that range.

“The ratio of corporate profits to GDP must mean revert in a free society... we can subject it to a statistical test called an Audi Dickey-Fuller test and discover that it is the most mean reverting series in economic history... And that's really important. The most important thing you can look at is a mean reverting series cuz it can tell you something about the future.”

When there is a structural turning point in history requiring system-level change, investors must make big leaps in asset allocation even when all competitors are playing by old rules, but this leap does not require owning risky assets per se—rather, owning non-risky assets in quantities that seem risky relative to what everyone else owns.

“When you come to that structural change, you have to make a big leap... not a big leap in owning risky assets. You don't have to own risky assets... You had to own gold, maybe commodity stocks... None of them, per se, in and of themselves would be considered risky, but you had to own them in incredibly risky quantities.”

If trade ties with China are severed or China severs ties with the developed world, this would be the biggest supply shock in global history, even larger than world wars, because of the massive amount of investment China has made since 1994 to increase not just domestic supply but global supply.

“If we were, and I think we will, and you'll have your own opinion, but if we were to sever our ties with China, or China was to sever our ties with us, this would be the biggest supply shock in global history... I would say world wars are pretty big supply shocks. But I think in many ways this one would be bigger, given this relationship we've had with China now really since 1994, and the massive amount of investment that China's done over that long period.”

Xi Jinping's future currency arrangement decision (float, dirty float, peg, or devaluation) will have impacts on all asset prices globally—property in Louisiana, bonds in America, and everything else—making it the single most important geopolitical decision for investors.

“There really isn't an asset price globally that isn't impacted in some way by this decision that will be made by Xi Jinping as to what his future currency arrangement is. Does it float? Is it a dirty float? Is it a peg? Is it a devaluation?”

The next 20 years will see governments adopting financial repression (the 1945-1979 model) to solve political problems: greening the economy, building China-independent supply chains, funding hot wars and potential future wars, because governments are tapped out on borrowing and aging populations leave them few options except to conscript savings from citizens.

“If you want to read any bit of financial history to guide you toward in the next 20 years, I think you need to read the period from 1945 to about 1979... We need to green the economy. We need to build supply chains... We are fighting a hot war... government are tapped out... Where are they going to get the money from? The answer is easy, from you.”

The modern world is slipping into a government-directed system where savings are being mobilized for public sector goods, which is radically different from the last 30 years, so running an asset allocation based on the last 30 years' rules would leave you in all the wrong places at all the wrong times.

“What I see when I see the modern world is I see a government day by day starting to mobilize your savings for public sector good... That couldn't be more different than the last 30 years. Imagine running an asset allocation based on the last 30 years and that happened. I mean, you'd be in all the wrong places at all the wrong times.”

Capital controls will gradually return not in the old sense of border searches, but in the new sense of restrictions on where you can deploy capital (e.g., restrictions on owning foreign debt), and Switzerland's historical prosperity is because it avoided the nationalistic capital controls of its neighbors.

“If what I said earlier is correct... the government ultimately ends up forcing people to own its own government bonds, that is a way to keep interest rates low. Well, that is a capital control... restricting the amount of debt that you can own outside of Switzerland... That is a form of restriction on the free movement of capital and that I think is coming back”

High nominal GDP growth is required to reduce debt-to-GDP ratios; governments need inflation to achieve this, and a central bank in control of a printing press can generate as much inflation as it wants; therefore inflation will return as a political target, not as an accidental failure of policy.

“We need high nominal GDP growth if we're going to bring down this debt to GDP. It's a political target and those who think that inflation will stop it uh I think are just straightforward wrong.”

The most dangerous form of speculation is the search for yield, because when real returns fall below acceptable levels, investors are forced to chase higher returns, which means taking on risk they don't understand; the longer rates stay low, the more risk accumulates somewhere in the system.

“The most dangerous form of speculation is the search for yield... with your savings you won't accept a 2% annual return... people don't accept it and they go out looking for higher returns. And that's the world we just lived in... they take much higher risk.”

The appropriate safe real yield is 5% (hardwired into human psychology via Jane Austen's novels featuring 5% gilt yields), and people will pursue that aggressively even if it requires extreme risk-taking; when rates are below 5%, people systematically take on too much risk, as evidenced by pension fund holders cashing in and buying Portuguese vineyards yielding 5%.

“If you read a lot of literature... Jane Austen in particular, Jane Austen was very keen to find a man with lots of government bonds yielding 5%... There's this number that keeps cropping up, 5%... it's kind of hardwired into us... All my friends who cashed in their defined benefit pension schemes, they all own Portuguese vineyards. Why? Well, they yield 5% and we're only getting 1% in the bank.”

Tourism is the best real-world indicator of exchange rate valuation: expensive tourists at a location signal a strong currency; Napier observes French and Italian tourists at Rockefeller Center, suggesting their currencies are weak and should be shorted; this works because real people with real money vote with their feet differently than economists with models.

“Tourism is the best guide... when I go to the Rockefeller Center, all I do is I stand there... you listen to see what language people are talking and then you short the currency... when I go, it's all I mean when I go, it's French and Italian that I hear at the Rockefeller Center these days.”

The real danger for investors from populism depends entirely on the strength of the constitution and rule of law; in countries without rule of law, you don't truly own equity rights to assets or cash flows, so avoid investing in China and Russia; the US constitution is exceptionally strong and will win over any president.

“The real danger for investors from populism depends on the strength of the constitution and the rule of law... When you're trying to find and invest today... first and foremost, find somewhere where you believe in the rule of law... my own personal view is the American constitution is exceptionally strong and regardless who comes along, the constitution will win”

Always look at what principals (real individuals with their own money) are doing rather than what agents (asset managers with other people's money) are doing, because principals make better decisions; locals choosing to move capital out of a country are the canary in the coal mine for currency weakness or overvaluation.

“If you find yourself in a in a in a country where that's happening, the locals are right and the foreigners are wrong... If you get a chance between looking at the decision of an agent and a principal, always check what the principal is doing because it's their money and they tend to make better decisions.”

Never think about anything else when you should be thinking about incentives—understanding incentives is the key to forecasting outcomes because economics assumes all are motivated by getting richer, but actually people are motivated by diverse incentives like status, career advancement, or altruism, and unless you discover the actual incentive you cannot forecast the outcome.

“Never ever think about anything else when you should be thinking about incentives... unless you discover what the incentive is, you can't forecast the outcome. That's what Munger said, and I think he's right.”

High equity valuations fall slowly (not quickly) when the surprise is a decline in growth or persistent inflation; two historical examples are 1901-1921 and 1966-1982 (16+ years), contrasting with 1929-1932 (collapse); the slow decline occurs because inflation takes longer to threaten solvency than economic collapse.

“High equity valuations fall slowly when the surprise is decline in US equity valuations. 1901 to 1921, 1966 to 1982. It takes that long... economic collapse threatens the solvency of corporations instantly. Inflation takes a longer time to threaten the solvency of corporations and that's why it's a long slow decline.”

Never trust a forecast with a decimal point because it falsely shows confidence in the future and represents selling of one's own intelligence; the 'tyranny of the decimal point' obscures the fact that all forecasts are really stories, just dressed up in equations.

“Never trust a forecast with a decimal point... The tyranny of the decimal point was allowed to get in the way of understanding... the problem with that decimal point is it shows a degree of confidence in the future which is overconfidence... She's only got stories told through a decimal point. And it's the precision of the story which is dangerous.”

Always buy equities below 10 times CAPE (cyclically adjusted PE) unless the future holds communism, war, or surrender of monetary independence with an overvalued exchange rate, because at low valuations equity returns are certain except for these three catastrophic scenarios.

“Always buy equities below 10 times cape unless the future holds communism, war, or surrender of monetary independence with an overvalued exchange rate. So if price is what you pay and value is what you get, sometimes they're just so cheap that you buy them and you go away and you know it's going to be okay.”

Xi Jinping's incentives and decisions matter more than anything else for global financial markets, because he controls an economy between a command and market system where he controls interest rates, the quantity of money, and exchange rates simultaneously—but this is impossible, so he will eventually have to choose which one to let go.

“There is one person in the world whose incentives matter for us and change everything, and his name is Xi Jinping... He controls the banking system. He controls interest rates. He controls exchange rate. These things are profoundly important... it really isn't possible to control everything. And at some stage you have to choose what you want to control.”

The world has adapted to the fixed point between the first and second largest economies (China-US), and if that arrangement breaks, there is a big structural change; yet fund managers are asking only 'Will China invade Taiwan?' rather than 'What does the China-US monetary arrangement change mean for interest rates, inflation, and asset prices?'

“We all know there's a geopolitical change coming between China and the developed world. No one's really asking, 'What does it mean for the global the monetary system?'... We're just saying, 'Will China invade Taiwan?' That's the only question that most fund managers seem to want to ask me about China... but there are more profound things going on in this shift.”

Chinese overproduction has destroyed returns in many industries, so if a trade fracture occurs, old 'sunset industries' like shipbuilding that have been unprofitable under Chinese competition could experience a comeback, as evidenced by Mitsubishi Heavy Industries share price up 150% year-on-year.

“Could be very good for the steel industry outside of China. The Chinese overproduction has destroyed returns of many industries. And if we find ourselves in a position now there was a fracture between China and the rest of the world, many of these old industries, often called sunset industries, could be on a comeback. Shipbuilding... If you think that's all pie-in-the-sky, then you might want to wonder why the share price of Mitsubishi Heavy Industries is up 150% year on year.”

Pepper's Law states that when something is going up and looks unsustainable, you use all your analytical power to estimate when it will stop, and then double that period and subtract a month—this is more accurate than any other method for timing when irrational exuberance ends.

“Use every analytical power that you have to assess when it's going to stop... and then double that period and take off a month. And that's Pepper's Law.”

Mussolini was famous for making trains run on time—walking into an uncertain world and promising certainty, and delivering it; finance is similar: people sell certainty through precision (decimal points) in uncertain times, and this is dangerous because it tempts people to believe false certainty rather than reason under uncertainty.

“Remember Mussolini. Why was Mussolini famous? He made the trains run on time. What he did is he walked into a world full of uncertainty and promised certainty and delivered it. That's what happens in finance. We live in uncertain times...The person who's going to sell is the person who walks in the room and say, 'You know all this uncertainty? I have an answer to two decimal places.'”

In an inflationary scenario, equities are desirable, especially cheap international value stocks that started at low valuations and can't compress further, and they produced positive real returns even in the 1966-1982 inflationary bear market.

“If it holds inflation, I think equities are where you want to be. Not the S&P 500, but there are stock markets all around the world on relatively low valuations... In that period from 1966 to '82, value stocks did okay. I mean not brilliantly, but they produced positive real returns because they started cheaply.”

The main challenge with mean-reverting series is they can't tell you the timeframe over which reversion will occur, so even though profit margins must eventually fall, they may do so over decades rather than years, and this uncertainty is more valuable than it might appear because it affects where to deploy capital.

“Unfortunately, it can't tell you anything about the future necessarily in the time frame you want in that you want that information. This is the problem.”

Money is almost always in disequilibrium and will remain so; the biggest disequilibriums occur when the state fixes prices (e.g., managed exchange rates) and private capital arbitrages against the fixed price, creating imbalances and opportunities for profit.

“Money is almost always in disequilibrium. At least I hope it's always in disequilibrium, or else how are we going to make any money?... The biggest disequilibriums come when the state tries to fix the price of something. Private capital arbitrages it. Imbalances build up.”

Current indicators suggest we haven't yet reached the supply-of-securities surge (IPO boom) that typically marks the final stage of a bubble, so Pepper's Law suggests current exuberance will run longer than analytical assessment alone would suggest.

“There's some things that aren't there yet, really. I mean, I'm Boris might contradict me, but I don't think we've got a huge flood of IPOs coming out yet. And usually these, you know, great big surges pull forth supply, the supply of securities, and that hasn't come yet. So, probably it's going to run for a bit longer than you think it it can run.”