quarterly client briefing - | prerequisite capital management...2020/01/10 · [in addition to the...

www.prerequisite.com.au Copyright © 2020 Prerequisite Capital Pty Ltd, Australia. All rights reserved. Past performance is not indicative of future results. Prerequisite Capital Pty Ltd (ABN 42 621 110 736) is an Authorised Representative of First Mutual Australia Pty Ltd (ABN 42 154 012 085), AFSL 423710

10th Jan 2020 // Quarterly Client BRIEFING

Dear Valued Client,

Frequently Asked Questions…

In discussions with clients, certain topics often come

up. This Letter will provide perspectives regarding

these recurring discussions…

• Pg. 1 – What underpins a currency? What is it fundamentally?

• Pg. 2 – Should I own physical gold?

• Pg. 3 – How do the Analysis Tools fare historically? (i.e. 1929 & 1987 share market peaks?)

• Pg. 5 – How do Prerequisite’s Tools compare to Martin Armstrong’s capital flow models?

• Pg. 7 – How do you navigate a zero or even negative interest rate environment?

• Pg. 8 – Going beyond headlines to a ‘systems’ perspective on assessing liquidity conditions.

(i.e. the significance of the Repo dramas over the last 3-4 months)

What underpins a currency? What is it fundamentally?

The ultimate form of currency is productive output/enterprise… the abundance and increase in

useful goods & services is what defines our standard of living and largely underpins the demand

for a currency that is redeemable in future productive output. This requires:

1. A willing, educated and industrious people, that are

2. Situated within a stable, just and predictable rule of law that values life and values just

contracts (and is able to effectively enforce such). ‘Do all you have agreed to do. Do not

encroach on any person or their property’ (R. Maybury).

3. With market mechanisms intact so resources can be properly allocated, including the

redistribution of resources from poor stewards to good stewards.

…these things give rise to improving living standards in a society and preserve the inherent

demand for the society’s currency. If there is integrity to a contract with trust being maintained

at the core of the governmental/legal system, there is integrity to a fiat currency. In such a

society/system, ‘fiat’ (i.e. “by decree”) has both force and value… and so the fiat currency also

will have value. If ‘by fiat’ they can take your life or take your stuff, then ‘fiat’ still has power,

and you need to be very careful in how you interact with such… if government utilises ‘fiat’

heavy-handedly and arbitrarily, then clearly their power is not likely to prove very sustainable

nor desirable, the living standards in that society will strain and their currency threatened.

When these things erode or fail, so too does the currency… the currency inflation (or the loss

of confidence in the currency) being a symptom of the above, not the cause.

Clearly this is only the beginning of a discussion about currency (& where inflation stems from),

you can find a more detailed first-principles explanation in PCS Reports 11, 12 & especially 27.

Simplistically, the ultimate currency hedge in a semi-functional system is ownership of

productive enterprise (i.e. businesses) that produces useful, unique & valuable goods and

services that can be sold for whatever ‘currency’ form one would desire. The ultimate currency

hedge in a system that is losing the above attributes is Gold (or some other ‘real’ thing of value),

something that is not predicated upon ‘fiat’ nor is anybody’s liability.

“Men are disturbed not by things, but by the

view which they take of them.” …Epictetus, 55-135 AD

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product’s future performance.

www.prerequisite.com.au


Should I own physical Gold?

When Clients ask us this question, we usually suggest they consider a very ‘small’ physical gold

holding on the basis of an ‘insurance’ principle (i.e. you hope that you’ll never need it in your

lifetime, but it is put aside as insurance against some drastically negative ‘low-probability’

possible outcomes).

However, holding physical gold in some sort of jurisdictionally diversified manner can be more

complicated than it first appears. For example, the possession and use of gold can be

‘complicated’ in an environment where the value of life and the integrity of a contract has been

dissolved or is becoming unreliable (see some of what we discussed on the previous page under

‘What underpins a currency’).

You will own your vaulted gold on the basis that a contract will be honoured (i.e. the same or a

similar underpinning as your fiat currency).

Your claim on some gold in a vault is predicated upon a contract having integrity &

enforceability both now and into the future. A banking and financial system exists (as does

most of our modern world) because a contract has both consequence and value in the context

of an effective judicial & policing system.

Absent the reliable rule of law… Gold only works in the absence of excessive risks to your life

and property (i.e. can you operate in an environment where contracts could potentially mean

little, which in extreme means that you have a gun and are prepared to use it to enforce your

claims over property?).

Historically over the last few hundred years, this is why for example Switzerland was a popular

destination for physical gold ‘insurance holdings’ for families (& crooks) around the world… the

Swiss political & legal system was reasonably independent, resilient, uncorrupted and reliable

– contracts would be honoured. Conditions in your own domestic jurisdiction could deteriorate

to the point where you lose everything, but you know that you can still access your claims on

your gold in Switzerland and that the legal (‘fiat’) system in Switzerland would still likely have

the integrity to honour such claims.

However, given present trends and likely developments in most Developed Countries around

the world, such assumptions of reliable/predictable rule of law conditions may hinder access to

any privately (jurisdictionally diversified) holdings of gold. Increasingly the rule of law

underpinnings of most countries are being eroded, giving rise to an increasing need for a long-

term gold hedge, but such countries still have significant power to ‘by fiat’ (i.e. by decree)

change laws or impose punitive taxation in an increasingly arbitrary manner – rendering the

practical utility of a vaulted gold holding ‘complicated’ in the very least. If you are not worried

about the integrity of the contracts you are depending upon (to secure your claims on the

vaulted gold), then some physical gold makes sense as it is nobody’s liability and will hedge

currency inflation.

Desperate (underfunded) governments have a tendency to hunt down or expropriate assets (by

a change in law, by tax or by inflation), especially if the nature of a particular asset is perceived

by them to be a threat to their own currency – which in times of trouble is what gold may

become. Furthermore, technology & international taxation agreements are giving rise to an

incredibly transparent world with regards to asset ownership – gone are the days where you

could privately own assets without having to declare them and get away with it (not that we

would ever recommend doing this)… everything is traceable.

We own Precious Metals within our Portfolios, but these holdings don’t have the characteristics

required for a jurisdictionally diversified physical ‘insurance’ holding. This is something clients

should pursue separate to their Prerequisite Capital allocation should they be so inclined.



How do the Analysis Tools fare historically? (i.e. 1929 & 1987 share market peaks?)

[In addition to the below, we would recommend reviewing our Quarterly Client Briefing dated

25th Apr 2018 for further historical review of this period of time]

No tools are ‘perfect’ but our tools

definitely are ‘useful’. Individually they

are incomplete, collectively they paint a

more three-dimensional picture of what

is happening.

Leading up to the 1929 peak we can see

the strong liquidity conditions

underpinning it – we can also see the

over speculative condition and the

distribution occurring by the Patient

money crowd. It’s also interesting how

fast the liquidity fell away without

recovery when the market cracked at

the end of 1929.

(For a brief explanation of these money

flow tools, click here for a presentation)

The raft of major liquidity turning point

signals that the market relentlessly

progressed through indicated the

strength on the way up, that would be

reversed on the way down.

Our % Probability of a ‘trending

environment’ was at circa 20% for the

end of 1929 (note that this indicator is

pushed forward in time by 1yr, so this

reading was given at the end of 1928),

which means an 80% probability of

sideways/choppy market conditions at

the end of 1929 – given this was coming

on the backend of a decade-long self-

referencing momentum trade that went

to extremes, any lack of reinforcement

(i.e. correction) would threaten the

reflexive dynamic.

BUYING

SELLING

Speculative Money Flow

DJIA

Marginal Allocation of

‘Patient’ Capital

Accumulating

Distributing

Underlying Liquidity Movement (‘Emergent’ System Money Flows)


DJIA

Structural Momentum (3yr)

DJIA

Aggressive Trend definition

Strategic Trend definition

Major Signal: consensus/critical mass condition

(see 5th Apr 2019 Quarterly Letter for explanation)

http://www.prerequisite.com.au/wp-content/uploads/2019/08/00-Money-Flow-Tools-OVERVIEW.pdf

http://www.prerequisite.com.au/wp-content/uploads/2019/04/2019-04-05-Quarterly-Client-BRIEFING.pdf



Leading up to the 1987 peak we

saw underlying liquidity starting to

wane, not confirming the

successive peaks in price. This

occurred amidst an over-

speculative condition with Patient

money strongly distributing into

the rise.

Major liquidity turning point signals

basically nailed the peaks (&

ultimate peak).

Like in 1929, our % Probability of a

‘trending environment’ was at circa

30% for 1987 (note that this

indicator is pushed forward in time

by 1yr, so this reading was given in

1986), which means a 70%

probability of sideways/choppy

market conditions in 1987 – given

this was coming on the backend of

a significant multi-year self-

referencing momentum trade that

went to extremes, any lack of

reinforcement (i.e. correction)

would threaten the reflexive

dynamic.

BUYING

SELLING


DJIA

Marginal Allocation of ‘Patient’ Capital

Accumulating

Distributing



DJIA

Structural

Momentum (3yr)

DJIA

Aggressive Trend definition

Strategic Trend definition

Major Signal: consensus/critical mass condition

(see 5th Apr 2019 Quarterly Letter for explanation)

http://www.prerequisite.com.au/wp-content/uploads/2019/04/2019-04-05-Quarterly-Client-BRIEFING.pdf



How do Prerequisite’s tools compare to Martin Armstrong’s capital flow models?

It is surprising how often we have this question come up from clients. We consider

Armstrong to be an exceptional analyst. But quite frankly, having explored Armstrong’s

publicly available materials quite extensively on the subject, we are still none-the-wiser as

to the practical realities underpinning how he measures capital flows… he tends to be quite

opaque when it comes to detail on his methods, which is understandable.

Over many years we have evolved several approaches (starting from a first principles basis

that we have explained in some of our PCS Reports) to solve for different analysis issues. In

recent years since we have become aware of Martin Armstrong, we have been quite

surprised at how often we end up with similar conclusions to him around capital flows but

arriving at such from probably quite different processes.

For example, recently he commented upon an instance relating to the lead-up of the Gulf

War with the accompanying chart…

“[To] clarify, in the Gulf War the USA was the aggressor

and thus the capital flows moved away from the dollar.” …Martin Armstrong, 5th Jan 2020 ‘Capital Flow Analysis’

(www.armstrongeconomics.com)

From our perspective we can see the

setup to the capital movement

Armstrong references – we can also

see the corresponding dynamic

wherein you ‘buy the rumour & sell

the fact’ to the actual Gulf War.

So although we don’t really know how

Armstrong does it, we do have

methodologies that account for these

things on a forward-looking & real-

time basis… we have sought over the

years to operationalise principles &

concepts into data-driven models,

making our analysis less ‘opinion’ or

perception driven, and more objective

and data-driven.

“Without data you’re just a person

with an opinion.” ...W. Edwards Deming

BUYING

SELLING


EUR/USD

Marginal Allocation of ‘Patient’ Capital

Accumulating

Distributing





Armstrong also frequently will talk about Currency Pegs and the issues around them (i.e.

they always ultimately fail) – for example in December of 2012 at his conference he

presciently anticipated the EUR/CHF peg to break…

“At the Berlin World Economic Conference I delivered the same forecast we gave to

the Swiss – the EURO/SWISS PEG COULD NOT HOLD. Indeed, its lasted

about Pi 3.14 years before the pressure really built and 3.3 years it cracked.” …Martin Armstrong, 17th Jan 2015 ‘The Euro/Swiss Has Been Warning

The Peg Could Not Hold’ (www.armstrongeconomics.com)

But what does this look like in practical reality? Well, in not really understanding how he

does it, this is one of our ‘least bad’ ways to track such things in real time…

“You always need a map even in markets. How can you figure out where you are going if

(1) you do not know where you have been and (2) you do not know where you are right now?.” …Martin Armstrong, 17th Jan 2015 ‘The Euro/Swiss Has Been Warning

The Peg Could Not Hold’ (www.armstrongeconomics.com)

In summary, we don’t really know how Armstrong does what he does – however we have

found immense practical utility in our solutions (that have been born out of necessity and a

rigorous dive into the first-principle underpinnings of various phenomena in the world)… at

times what we do and what he is talking about do seem to correspond, and at other times

they don’t.

We don’t always agree with Armstrong’s conclusions, but we can frequently appreciate why

he thinks the way he does. He is both an interesting person and an exceptional analyst. We

find it intriguing how often his name will come up in discussions among a subset of our

clients.

EUR/CHF

Inflows...

Outflows...

Net Money Flows

(Emergent + Speculative)




How do you navigate a zero or even negative interest rate environment?

[Excerpted from Aug-2019 PCS 040 Report…]

One of the consequences of killing bond markets (i.e. taking yields to near zero or even negative where

the only bid increasingly is being Government driven/mandated) is that the stock of ‘high quality

assets’ in the world shrinks even more rapidly. This means any remaining high quality assets (i.e.

basically anything that is productive, somewhat resilient and has an earnings or cash flow return-

stream above zero) becomes increasingly scarcer & more valuable (up to a point).

Government policy is likely to not just kill sovereign bond markets, but next in line will be non-

sovereign fixed income (so the credit spreads might not actually widen past a point, but actually

tighten to near zero as Central Banks target non-sovereign fixed income securities)… potentially after

this equity markets (& MMT type ‘monetised fiscal policy’) will be targeted in a last act of desperation.

Somewhere along the line however, confidence in the currency issued by the government will collapse.

We ‘suspect’ the USA will be among the last in line to progress down this path relative to the rest of

the world (we’ve written about this quite a bit in the past). Obviously, Japan and Europe are well

progressed along these lines – China too but in a different form.

In a zero-yielding world, ‘everything’ essentially becomes ‘commodity-like’ (as commodities have no

yield and in fact a negative yield by the time you’ve factored in logistics, storage and insurance etc).

For example, a zero or negative yielding sovereign bond is essentially now a ‘commodity’… the only

difference being is that it’s almost impossible for a commodity to go to zero ‘value’ (or price) whereas

if confidence collapses in the denominating currency then a sovereign bond most definitely can go to

‘zero’ price.

When ‘everything’ is commodity-like… when bonds, fixed income securities and even most equities

have minimal to no yield (especially if it’s been driven by hyperactive fiscal/monetary/regulatory

policies), then it’s not a ‘valuation’ paradigm you need, but rather you need more of a merchant-type

trading philosophy to guide your portfolio operations – you need to focus more on capital/money

flows and positioning in order to harvest the natural swings in market prices driven by the underlying

behaviours of participants. Such swings won’t always make sense to a traditional analysis paradigm,

it’s likely going to be best to dispassionately view each ‘asset class’ category as simply ‘categories of

inventories’ that you may or may not wish to hold at different times depending upon how capital is

behaving, where the money is flowing (& why), and how participants are positioned. A more detached

and objective approach to markets will be even more valuable than usual.

The unsustainable indebtedness issues in most countries will see their policy makers

eventually turn their ‘banking system’ issues into ‘currency’ issues, i.e. policy actions that will

ultimately cause a loss of confidence in their currency and/or capital flight.

Valuation multiples are an ‘effect’, whereas Capital Flows are the ‘cause’ (when

capital concentrates into an asset class or a security, valuations are naturally bid

up, when it disperses valuations fall). Investors are trained in ‘Valuation’

methodologies but Capital Flows & Liquidity remain a blind spot for most.

From a market analysis perspective, the solution is to treat every market as if it

were a commodity or currency. For example, a currency market analysis

framework tends to elevate things such as money flows, participant positioning,

market structure and relative return prospect type analysis approaches.

From a Portfolio Construction perspective, the solution will be to take very seriously resiliency

concepts (not just the myopic focus on ‘efficiency’, especially in portfolio construction that is

optimised to the last 50 years of experience), in addition to the fact that all assets and markets

map to three factors – growth, inflation and capital flows…. – see our 14th Jul 2019 Quarterly

Letter for a discussion of these things.

“...focus on the movement of

liquidity… most people in the

market are looking for

earnings and conventional

measures. It’s liquidity that

moves markets.”

…Stanley Druckenmiller



Going beyond headlines to a ‘systems’ perspective on assessing liquidity conditions.

(i.e. the significance of the Repo dramas over the last 3-4 months)

On the 15th of October we dedicated an entire 21-page PCS Report (043) to a first-principles

education piece on the topic of ‘Liquidity’ (presenting also a lot of the practical ways we

measure it). Within it, we noted…

Over the last couple of months it became clear that we needed to more specifically educate around

this topic as when we issued our PCS 040 Report on the 13th of August 2019, observing (among

other things) that:

“…when we step back and look at near term liquidity conditions in the world (see next

page for dashboard) we are somewhat surprised to find a reasonably resilient picture”

This catalysed a flood of questions from clients over the last two months as the popular narrative

and headlines in the world were that we were in the midst of a low-level liquidity crisis – especially

with everyone citing the events in the Repo markets as an indication of this. (By the way, don’t

forget that we’re in an inverted yield curve environment, and one of the many implications as

explained in our PCS 012 Report is; “…an inverted yield curve typically represents an expansion

of investment & bank liquidity in excess of available real-savings in the economy... When an

expansion has exhausted available savings, because of the banking system’s practice of borrowing

short and lending long, the banking system & the economy becomes hyper-dependent upon

obtaining short-term liquidity (in absence of available real-savings…”, so strains showing in short

term funding markets are par for the course in such a setting.)

“Just listen to your patient; he is telling you the diagnosis.”

… Sir William Osler (1849–1919) – widely considered to be one of the greatest physicians and diagnosticians of all time –

In stepping back, and looking across the broader global system with regards to Liquidity, we do

not see similar stresses or strains across the broader set of polarities that are important to the

provision and functioning of Liquidity. The Repo markets, although an important sub-system in

the broader liquidity system, it is not of material concern for the moment.

In assessing global liquidity (or liquidity within a region) it is essential you take a systems

view rather than an isolated view of a ‘subsystem’ (like Repo for example). This means

stepping back and assessing the broader array of core drivers and symptoms in order to

triangulate what is really going on.

13th Aug

15th Oct

S&P500 Bank Index

World MSCI Bank Index



“…systems thinking is based on the fundamental shift of perception from the world as a machine to the

world as a living system.”

“Systems thinking is a framework that is based on the belief that the component parts of a system can

best be understood in the context of relationships with each other and with other systems, rather than in

isolation. The only way to fully understand why a problem or element occurs and persists is to

understand the part in relation to the whole.”

…Capra, F. (1996) The web of life: a new scientific understanding of living systems

(1st Anchor Books ed). New York: Anchor Books. p. 30

“The approach of systems thinking is fundamentally different from that of traditional forms of analysis.

Traditional analysis focuses on the separating the individual pieces of what is being studied; in fact, the

word “analysis” actually comes from the root meaning “to break into constituent parts.” Systems

thinking, in contrast, focuses on how the thing being studied interacts with the other constituents of the

system – a set of elements that interact to produce behaviour – of which it is part.

“This means that instead of isolating smaller and smaller parts of the system being studied, systems

thinking works by expanding its view to take into account larger and larger numbers of interactions as

an issue is being studied. This results in sometimes strikingly different conclusions than those generated

by traditional forms of analysis, especially when what is being studied is dynamically complex or has a

great deal of feedback from other sources, internal or external.”

…Daniel Aronson (www.thinking.net)

What is happening in Repo markets is significant, but it is simply the latest manifestation of

broader structural issues that have been plaguing global banking and financial systems for

years (that we’ve also been writing about for years). These sorts of Repo concerns and issues

will increasingly be the norm rather than the exception, but there will be seasons where

conditions find some respite. The key will be to measure and map the different contributors

to global liquidity, and to take a systems view in terms of how it all fits together and functions

as a whole (see PCS 043 for further details on how we do this and what this looks like).

As always, please feel free to contact us should you have any questions about your portfolios

or the conditions unfolding in the world.

Kind regards,

Daniel & Darren

Contact Information:

Daniel J. Want (Director)

[email protected]

Darren A. Brind (Director)

[email protected]

phone. +61 498 671 505

Prerequisite Capital Pty Ltd (ABN 42 621

110 736) is an Authorised Representative

of First Mutual Australia Pty Ltd (ABN 42

154 012 085), AFSL 423710

a PO Box 144 Morningside QLD 4170

http://en.wikipedia.org/wiki/Component

http://en.wikipedia.org/wiki/System



Calculated on Daily NAV

quarterly client briefing - | prerequisite capital management...2020/01/10 · [in addition to the...

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