“You’ve got to hate to make money!”
Unlike the conventional books we read about investment advice, Mark Spitznagel’s “The Dao of Capital” is wonderfully rich in variety. Actually, Spitznagel does not start talking about investments prior to chapter nine or page 227 of his 300 page-book. The overarching aim of the author is to give the reader “a way of thinking, of understanding the roundabout and the considerable strategic advantages to be gained along the patient, circuitous path” (p. 239). Therefore, he devotes a significant part of the book to the Austrian School of Economics and the lessons to be learned from its main proponents. The book is a homage to the school of thought that perceives the market as what it actually is: a dynamic process with all its nuances of complexity and uncertainty.
The book starts like a mantra with the following passage: “You’ve got to love to lose money, hate to make money, love to lose money, hate to make money…” (p. 1). Interestingly, Spitznagel himself memorized these words as a young trader in the futures market in Chicago. He was a pit trader working for the famous Everett Klipp at the Chicago Board of Trade. It was Klipp, his mentor, so to speak, from whom he has learned the aforementioned mantra, or “Klipp’s paradox”. It is a specific approach to investments with the following central lesson: “Rather than pursue the direct route of immediate gain, we will seek the difficult and roundabout route of immediate loss, an intermediate step which begets an advantage for greater potential gain.” (p. 1). However unconventional or counterintuitive this suggestion may seem to the reader at the outset of this fascinating book, Spitznagel delves into the foundation of his reasoning in the following eight chapters. He calls the underlying theory of his investment strategy the “roundabout approach”. Instead of just repeating the main Austrian tenets, Spitznagel creates “added value” for the reader that is, thanks to his practical background, peculiar to his book.
Rooted in Ancient China
As I said before, the roundabout approach does not seem very plausible but rather difficult to cognitively grasp at first. This means that investors have to overcome traits that are inherently humane (e.g. time inconsistency). However, according to Spitznagel, investors that follow his intertemporal investment approach are able to outperform others in the markets and thus to be very effective at achieving their goals. Investors are thereby benefiting from the insights of a theory that is grounded in ancient China.
The roundabout approach seems to have its origins in the Daoist thinking about life and war. The Daoist path (“dao”) emerged around 500 BC. Its main statement points out that the best path to anything lays through the opposite, or the “wuwei”. Spitznagel explains that “[o]ne gains by losing and loses by gaining; victory comes not from waging the one decisive battle, but from the roundabout approach of waiting and preparing now in order to gain a greater advantage later.” (p. 3). Spitznagel even uses analogies to Chinese martial art techniques in order to illustrate his roundabout approach. Like a combatant, one has to lure the opponent into emptiness and thereby destroy his balance to gain the position of advantage and thus eventually advance back in a decisive counterattack. A fight is, as it is written in the book ‘Laozi’, like a tree that breaks if it does not yield under the pressure of the wind. Hence, it is the opposite you have to do in order to achieve your personal goals.
Another very good metaphor for roundabout investing is the “conifer effect” (p. 43): Conifers carry pinecones that allow them to protect and spread their seeds in harsh climate conditions. Nevertheless, the growth rate of conifers in the early phase of life is much slower compared to its competitors in the forest. This is, however, a “conscious” result of evolution. In fact, conifers fall behind early on, because they are assembling their “assets”, which means that they are developing strong roots and thick bark, just to become very efficient in resource use and to enjoy often impressive life spans compared to its competing plants. Here, too, the intertemporal element is decisive for the success of conifers. Spitznagel, once more, emphasizes the importance of this two-step process: pursuing an intermediate step to achieve your ultimate goal.
Military strategists, like the Prussian general von Clausewitz or the Chinese Sun Tzu, also deployed roundabout approaches for achieving their final battle goals. This strategic advantage is described by the Chinese word “shi”. In the words of the book ‘Sunzi’ (the art of war): “To win a hundred victories in a hundred battles is not the highest excellence; the highest excellence is to subdue the enemy’s army without fighting at all.” (p. 52). It is the commander, or the entrepreneur, that has to take all exterior elements into account and seek actively a position of optimal alignment before he moves into action. “Shi” is therefore about seeking first the positional advantage of the setup whereas, its antithesis, “li” goes immediately for the hit (this dichotomy is displayed in the world’s oldest board game “weiqi” or “go”). The reader, once more, encounters here the essential element of the roundabout approach, the temporal and teleological means-end framework, which will have become central to the Austrian theory of economics not until centuries later.
Economics as the science of human action
Acknowledging the quasi-a priori approach of Daoism Spitznagel becomes really concerned with methodology in the following chapters. How shall we conceive economic phenomena in the real world? Shall we rely purely on empirical findings or on universal principles? These are the questions that were fundamental to the founder of the Austrian School, Carl Menger, at the end of the nineteenth century. Menger’s “Principles of Economics”, still one of the greatest books in economics, which is available online at www.mises.org for free, stated that historical findings cannot help predict the future, whereas logical deduction based on what we know and observe can improve our explanations about the effects of human actions. Their methodological individualism led the Austrians, especially Menger, into the well-known “Methodenstreit” (method dispute) between the Berlin-based Historicists, who built their economic “theories” exclusively upon historical events in a positivist sense, and Carl Menger’s deductive approach that is based on certain universal economic laws. It is exactly this principle-based approach that makes the complex world around us easier to comprehend. In the words of Ludwig von Mises, the Austrians’ objective was “to put economic theory on a sound basis…” (p. 98), which yields rock-solid knowledge about economic processes. Put simply, economists need an antecedent theory to initially know which facts they are supposed to consider in their studies and to know how to interpret those facts. Therefore, interpretation of facts without a preexisting sound economic theory is impossible. The Austrian School of Economics does not object to empirical observation in a radical manner, however, its proponents suggest that there are certain a priori true assumptions (axioms) – thereby challenging the Popperian approach of falsifiability in science – that are derived from human actions and individual preferences and the laws of cause and effect, the teleological “means-ends framework”. Here, too, Spitznagel uses a quite intriguing metaphor: The metaphor of the caterpillar that “retains the means in resources today, which are the ingredients that will produce the purposeful ends of structures tomorrow [the butterfly].” (p. 88). It is, as we are going to see later on, the entrepreneur that assembles the productive (capital) means of the economy to the end that the preferences of the consumers are satisfied.
Menger’s – and independently from him Jevons’s and Walras’s – discovery also led to the marginal revolution and the theory of subjective value (which was subsequently supported by Eugen von Böhm-Bawerk, an Austrian economist of the second generation), thereby questioning objective value theories, such as the labor theory of value in Karl Marx’s “Das Kapital”. Since then, economic theory “knows” that it is the individual person’s preference, or need, i.e. someone’s subjective knowledge about the utility of a good – transitioning into demand of all market participants for a particular good – that determines the market price of that said good. All the age-old debates on the inexplicably high value (or price) of diamonds compared with water in Western Europe have been solved with the newly acquired knowledge. It is these subjective expectations and preferences of consumers and producers that make the study of economics a genuine social science, contrary to the unconstructive “physics envy” of modern neo-classical economics.
The fundamental role of time
What is fundamental to Austrian Economics is its emphasis on the role of time. As a consequence, and as we are going to see later on, time plays a major part in Spitznagel’s investment approach. Claude Frédéric Bastiat, an anti-protectionist Frenchman of the nineteenth century, understood the economy as a series of intertemporal exchanges. Governmental policies do not only bring along easily recognizable immediate effects (the “seen”) but rather a series of effects (the “unseen”) that can – and often – have unintended negative consequences. In the words of a later read, Henry Hazlitt’s “Economics in One Lesson”, one can find a single sentence that describes what economics is actually about: “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy.” (p. 19).
Böhm-Bawerk considered economics to be inextricably linked with time. It was Böhm-Bawerk that established a comprehensive theory of capital in 1930. He viewed the production of capital as a temporal process that has to be dynamically adjusted to the changing conditions by the foresighted entrepreneur. The roundabout production (“Produktionsumweg”), meaning the sacrifice of capital and time for greater later consumption, our Chinese “shi”, creates the prosperity that allows us to live the lives we do today. The direct way, the “li”, however, only allows for smaller contributions to our wealth. More circuitous processes of production mean a higher standard of living. It was Böhm-Bawerk, too, who already took the robust humane “bias for the present” into account, which is today’s concept of hyperbolic discounting in behavioral finance. Time, therefore, is a highly subjective factor. This is the inherent “humanness” that Spitznagel wants the readers to overcome, or to “evolutionary adapt” to, by following the “dao of capital”. While pointing out mistakes we usually make, Spitznagel criticizes that Wall Street’s focus is entirely on the present as well. In fact, “time inconsistency is the source of much conventional wisdom on Wall Street, from momentum investing to the merits of monetary policy.” (p. 162). Furthermore, traders get rewarded for ignoring roundabout investing while acting as if there is no future is perfectly rational on Wall Street. Nassim Taleb describes them as lacking “skin in the game”.
The market is a dynamic and cybernetic process
Another important insight that the Austrians have conveyed to us is that savings, which lead to more goods of higher order (e.g. better tools, more efficient manufacturing facilities), as a result of increasing roundabout production, are the real driver of sustainable growth and, ultimately, the cause of civilization. Genuine savings are steered by market interest rates, which are the result of the supply and demand side. Böhm-Bawerk viewed interest as the cost of time that accounts for the natural propensity of humans to prefer money, or capital, sooner rather than later. Interest also depicts the price that decides on the “return and the prudence of making an investment.” (p. 116). In other words, you succeed with your investment decisions only if you outperform the natural market interest rate. Opportunity costs, another concept from an Austrian, Friedrich von Wieser, are therefore the objective way of determining the true economic costs of capital production, respectively of the investment of money.
Lower market interest rates indicate a higher savings rate, as the result of consumers’ low time preferences. Under such circumstances, entrepreneurs invest in more roundabout production processes, as they are encouraged by lower borrowing rates. The epitome of this Austrian concept was Henry Ford, who deployed a tremendous amount of time in order to save huge amounts of time at later production stages. Roundabout production not only helps the economy but it is also profitable for the owners of the deployed capital. Successful entrepreneurs are keen on seeking “false prices” in the market. Market processes subsequently provide for the rebalancing of resources, from the least profitable to the most profitable entrepreneurs, without ever reaching a static point during this process. False prices are thus eliminated through the “alertness” of successful capitalists, according to Israel Kirzner. Instead of being consumed, capital is reinvested and newly accumulated, whereby the whole economy progresses. The important role of entrepreneurism in Austrian theory is striking in this regard. An entrepreneur is, in the words of Mises, a speculator who is “eager to utilize his opinion about the future structure of the market for business operations promising profits” (p. 188). The entrepreneur is the protagonist of the “grand homeostatic process” (p. 188) of markets. He, or she, is the one who drives the market’s engine, while searching, discovering, trying and failing.
Furthermore, Spitznagel looks into market processes from a cybernetic standpoint. Cybernetics is the science of control and communication within a system, such as a forest of conifers or capital markets. A cybernetic system achieves “balance through internal governance and guidance, which depend upon the system’s own ability to internally communicate and react to changing conditions due to the interactions of a variety of players” (p. 203). The market is not a perfect process (none of the Austrians claims the opposite); indeed, market prices are often inconsistent with what one might expect from the findings in the literature on efficient capital markets. Errors do occur and resources are allocated inefficiently. Attempts to intervene in cybernetic systems may, however, end in paradoxical and adverse effects that are beyond the rationale of the intervention. “Instead of order and balance there is distortion that leads, ultimately, to destruction,” says Spitznagel (p. 204). The market is, as Friedrich August von Hayek put it, a “spontaneous order”. What seems, at first, disorganized and arbitrary is a thoroughly purposeful and working entity – order is the paradoxical outcome of perceived disorder. Locally dispersed knowledge about consumers’ preferences, supply shortages and abundances finds through the universal price system its way to the market participants. Prices contain Bastiat’s “unseen” information; information that enables producers and consumers to be part of and benefit from the market economy in the first place – unlike centrally planned economies. Without information, particularly negative feedback (e.g. company losses, bankruptcies, payment defaults), systems like the market economy would not work properly. Market participants would not (and would not need) to adapt to new circumstances, thereby correcting the antecedent errors of the system, if its negative feedback loop was suppressed by interventionism. The “evolutionary” process of the market would eventually come to a halt. Here, too, it is the entrepreneurs, who penetrate into the “jungle” of prices and goods as they compete against each other. However, as Hayek stated, interventions can – at best – serve to postpone the negative feedback mechanisms, just to eventually end up in the most negative feedback of all – the crash.
Besides our robust innate desire for immediacy it is modern monetary policy that urges investors not to pursue a real capitalistic approach, as Spitznagel stresses. Central banks’ monetary policy, especially through reducing interest rates (even below the lower-zero bound), stimulates credit expansion by commercial banks and therefore causes massive market distortions, such as malinvestments or artificially driven up asset prices.
Spitznagel on artificial booms and busts
Spitznagel uses the “Misesian Stationarity Index” (MS index) as a central tool for making investment decisions. A diverging MS index can be viewed, according to the author, as quasi-proof of distortion away from “stationarity”. In a stationary economy, “there are no aggregate profits or losses” (p. 182). In other words, in the aggregate, the return and replacement costs of capital are balanced. A MS index of 1 is a sign for an undistorted market. The MS index is thus similar to the well-known Tobin’s Q ratio that is total value of the stock market divided by total corporate net worth (at replacement cost). Central banks are the antagonists of a free market economy. They are legally appointed to reduce interest rates if markets show signs of weakness, even though it ultimately contradicts a genuine, savings-induced drop of interest rates as a consequence of consumers’ declining time preferences.
This is where Mises’ Austrian Business Cycle Theory (ABCT) gets in. Central banks’ policy of increasing liquidity supply leads to the temporary and illusory prosperity of all market participants. Even entrepreneurs that have failed to generate returns above the market interest rate might now seem to do business profitably (MS index >1). Some projects that previously seemed clearly unprofitable might appear profitable and realizable because the underlying calculation mechanism has changed. Price inflation might ensue, as a result of the expansion of the monetary base. This development is usually politically opportunistic, especially in periods of high unemployment, however, it reduces the capital stock of an economy in the long run. It is thus of no help to a sustainable base of employment. Moreover, the intervention even destroys wealth after reversion (through deflation) to the starting point as it was before the artificial boom. Mises called this phenomenon “capital consumption”. In his book, Spitznagel analyzes the recent recession and the monetary countermeasures that were embraced during the crisis. He comes to a deadly conclusion: “Thus there is a hyperfocus on – and even addiction to – the yields of stocks and other risky and high-duration securities (a ‘maturity-mismatch’); there is an irrepressible allure to the steep yield curve. What was supposed to create patient, roundabout investors instead creates the opposite: punters in highly speculative ‘carry trades’.” (p. 195-196). A current example of this is Deutsche Bank’s massive holdings of derivatives on its balance sheet.
Spitznagel goes a step further and integrates the concept of hyperbolic discounting into Mises’s theory of capital consumption. According to this, investors are increasingly focused on the near future. This is hardly the result that the G20’s politicians hoped for after the global financial crisis. Although price inflation has not taken off so far, the author stresses that the artificial boom has nevertheless degraded the capital stock because it has (and will) become less roundabout. By contrast, Austrian analysis usually points at the “malinvestments” in projects that are not too less circuitous but rather “too roundabout” (p. 198) relative to the low amount of genuine savings. In this regard, Spitznagel offers a slightly distinct view than many Austrians before him. This is a decisive point regarding the recent crisis, not merely for people that are interested in understanding the detrimental repercussions of monetary policies.
Such artificial booms must inevitably be followed by a crash. The economy, overall, regresses because of net capital consumption. The downturn is not exclusively destructive, but “must be viewed as a catharsis, a cleansing process – an agent of creative destruction” (p. 208), what seems to be part of the cybernetic self-control and self-regulation taking over again. A similar story could be perceived in Yellowstone National Park in 1988, when nearly one-third of the park burned or suffered fire damage. Paradoxically, the root cause for the huge fire was actually fire suppression. No cleaning process, i.e. small blazes in the case of Yellowstone NP, had been allowed to happen before 1988. In other words, a distortive state had been upheld before the forests and pastures could have returned to a more natural state. The same is basically true for the economy: “Investment cannot exceed savings any more than seeding in the forest can exceed land, nutrients, water, and sunlight…” (p. 211). Governments and central banks undermine the cybernetic processes of markets, the homeostasis, by “short-circuiting the governors and adaptive teleological processes” (p. 211). Many false prices are thereby maintained, resources are not allowed to be freed up and to be used more efficiently and appropriately by more alert entrepreneurs. However, government agencies are lawfully entitled to manipulate prices, such as interest rates as the price for money and, eventually, the price for time. Under such circumstances, entrepreneurial accounting and foresight, especially in the field of roundabout production, are perpetually skewed. Prices, for instance about the available savings, cannot convey proper information; they eventually lose their signaling function. Those manipulations happen as a manifestation of what Hayek terms as the “pretense of knowledge”, which is a social phenomenon that makes the people in our central (money) planning bureaus spuriously believe to know what the “uniform” time preference of all market participants is. It does not need much wisdom to see that this is absolutely ludicrous, whether from an empirical point of view or from a normative-philosophical.
Lessons from the book
Austrians would try to avoid the preceding boom altogether by adhering to sound money, such as a market-based gold standard. Hence, a homeostatic crash of greater dimension does not need to follow. We know undisputedly that the reality differs from this idealistic image though. Armed with the knowledge that market distortion is not merely a negative byproduct of economic growth but rather an exclusively monetary phenomenon, Spitznagel equips us with investment advice:
A central lesson from the first part of the book is that markets are not perfect but they are perpetually correcting, and that is why they never achieve the purely artificial state of rest. In fact, there would be no liquidity in the market if all investors knew everything (therefore the assumption of perfect rationality is highly exaggerated by the proponents of modern economics) and uncertainty was merely a crisis phenomenon. Furthermore, any market exchange “must be perceived as mutually beneficial to both parties” (p. 25) if markets are not distorted by interventionist regimes. The fact is, nevertheless, that we live in a highly distortive market environment. We also know that distortions are limited to a temporary disruption. While waiting for the homeostatic forces to set in, we also know that marginal investment schemes look better than they would under natural conditions. Capital is furthermore caught in the present, roundabout production is thwarted. “It only stands to reason that the stock market should inevitably fall […] as investors are routed into immediate liquidation altogether; […]” (p. 230). Despite this intimidating environment, Spitznagel advises the reader to occupy a strategic position of advantage, and “exploit these otherwise unexpected booms and busts.” (p. 230).
What is the entry point for roundabout investors?
Through loose monetary policy only the stock market is reliably affected. Actual physical investment by monetarily blowing up asset prices happens quite rarely, contrary to the intentions of central bankers. The Austrian business cycle is therefore adequately reflected in the oscillation of the stock market, persistently correcting inflationary departures from stationarity. On each period of distortion, as Spitznagel shows based on data, follows a severe stock market crash. Well, what should investors do? The simplest strategy would be to buy when the MS index is low (<1) and sell when it is high (>1). Spitznagel calls this the “Basic Misesian investment strategy” – a common (contrarian) investment strategy among professionals. Looking at the data, the Misesian investment strategy would have outperformed the stock market by more than two percentage points per year. There is “great beauty and effectiveness in our simplicity” (p. 237). However, it is an exceedingly roundabout way to invest someone’s money. It takes, on average, several years of underperformance in order to achieve the outperformance. It painfully sacrifices immediate profits when stock markets start booming again. Only a few investors are psychologically and economically capable to strictly continue to pursue their strategy when others are earning immediate profits. Basically, it means to “stay out of the market for long periods of time when distortion is running high” (p. 239), and to hold cash (or bonds) in order to position ourselves for better investment opportunities at a later point in time. Our time preference for immediacy is further magnified when monetary floodgates are wide-open and peer-group and business pressures are high. This misleads us to following the direct path many times instead of pursuing the approach of ‘shi’. A practical problem that arises from the roundabout approach is the near-continuous high of the MS index (>1) since the 1980s. In order words, during the last thirty-five years, there have not been many entry points for roundabout investors who want to follow the basic Misesian investment strategy.
Spitznagel employs, however, two further approaches at his investment companies:
(1.) The first is tail hedging an equity portfolio, using extremely far out-of-the money put options to an underlying stock index (like the S&P Composite Index). Thus, in a high distortion environment there is a “third choice between owning stocks and cash” (p. 247). Additionally, tail hedging, the “means”, provides the «pocket money» needed for the time when the MS index is low again, the “end”. Because of its apparent relation to monetary policy, Spitznagel refers to tail hedging strategies as “central bank hedging”, or better “Austrian Investing I” (p. 249). This is for obvious reasons no practical strategy for occasional roundabout investors.
(2.) Austrian Investing II is not directly based on the assumption of distortion but rather focusing on highly productive capital. The most productive capital is also the most roundabout, and, as Spitznagel says, “[t]he most profitable capital structures will tend to be very roundabout as well.” (p. 255). Picking the right stocks is therefore the main task of the roundabout investor. Spitznagel uses two calculation methods for this specific purpose: He calculates the return on invested capital (ROIC), which is the division of a company’s EBIT by its invested capital (which was necessary to generate that return). This calculation task is to find highly roundabout, productive firms, i.e. the ones with a high ROIC that results from the reinvestment of foregone profits. Spitznagel does not stop here. He also applies a second formula, the “Faustmann ratio” (depicting the market capitalization), which, in order to bring forth underpriced company stocks, has to be low. Through using both approaches in combination Spitznagel attains very good results. Contrary to the popular saying that “stocks follow their earnings” (p. 267), investments, paying attention to the suggested approach, see their EBITs take a temporary turn for the worse only to bring in high returns after all.
Finally, to improve his positional advantage, Spitznagel simultaneously applies Austrian Investing I as well as Austrian Investing II in practice – “a cohesive whole of intertemporal opportunism” (p. 269). It is no wonder that Benjamin Graham’s value-investing strategies are reminiscent of Austrian strategies. However, it is only the Austrian approach that “provides a logical and sound basis for understanding the why” (p. 274), namely the edge of the Böhm-Bawerkian roundabout capital production process.
Throughout his book, Spitznagel does not avoid direct confrontation with the arguments of the greatest economists. He shows argumentatively why the Austrian School offers better explanations for the boom and bust phenomena than, to name but a few of the famous examples in the book, John Maynard Keynes (“animal spirits”), Hyman Minsky (“run up leverage”), Robert Shiller (“irrational exuberance”), or even Nassim Taleb (“black swan”). Behavioral biases, such as herding, and black swans are imperfect explanations for the regular occurrence of stock market phenomena that are perfectly foreseeable and expected events, as the author concludes. Since having the right theory at hand, Mark Spitznagel’s “Dao of Capital” gives an extremely useful tool to investors that are eager to use its roundabout investment approach in a world full of monetary distortions.
So, in future, let us pick up a conifer cone whenever we see one!
The Dao of Capital. Austrian Investing in a Distorted World (Wiley Press, 2013). By Mark Spitznagel. Foreword by Ron Paul.
This article was first published on the website of Global Gold in September 2015. For the present publication the article has been revised.
Fabio Andreotti, Board member Hayek Club Zurich