149

23rd August, 1928

PERSONAL AND CONFIDENTIAL

My dear P.M.,

The recent booms and 'shake-outs' on the London, New York and Brussels Stock Exchanges, occurring at a time when reinvestment has become a personal problem, has led me lately in odd moments to make some little study of investment conditions to-day. I don't know that I am much further ahead in coming to decisions than I was six months ago, although I have a certain amount more knowledge. In fact, as someone has said, I am possibly not wiser but only better informed.

An individual has to decide on his investment policy for himself as regards the degree of diversification that he considers sound, (1) as between countries, (2) as between industries and (3) as between the various classes of securities, ordinary shares and fixed interest bearing scrip.

This is exactly what a sound Investment Trust Company does and it looks at first sight as if the problem is solved for one by buying their ordinary shares and preferred stock. But the same thing has occurred to many other people and the result is that the securities of the best trust companies with reliable and capable Boards and management are closely held and so expensive and difficult to acquire. There are plenty of new and untried Trust Companies, but one is rather giving a blank cheque to unknown people in investing in them.

And in addition a reasoned attack has been made in this last year on (what one had previously taken on trust) the soundness and desirability of good fixed interest bearing securities. E. L.

Smith, the President of the Investment Managers Company in America, and a man called Raynes, Secretary of the Legal and General Assurance Company in England, have both made and published researches into the relative desirability of a well diversified selection of ordinary shares as compared with debentures. The American took examples in endless array of comparisons over the last sixty years, and the Englishman in less detail and over a shorter period. Both come to conclusions in favour of ordinary shares.

I have read most of the publications in the above regard. Very briefly the argument for a well-diversified list of ordinary shares as against Debentures is as follows. Fixed interest bearing securities, however unimpeachable the security, are titles to a fixed money income and to the return of a fixed number of units of currency at the end of a period which is usually long. They are, therefore, subject to the risk of currency depreciation and to a quite separate risk of fluctuation in capital value owing to changes in the ruling rate of interest. Ordinary shares are completely free from these two risks, but have individually a very much greater risk in that the business or the particular firm whose shares are held may be a declining one. The diversification of the list is, therefore, designed as an actuarial protection against the risks of individual shares. The advantages which Ordinary shares have as giving an interest in the equity of prosperity generally follow independently and there is an additional point in their favour arising out of the practice of most industrial companies of distributing in dividends only a part of the profits earned and of accumulating the other part in the form of expansion or of other investments. This other part thus accumulates for the benefit of the equity holder by a process of compound interest.

Reviewing my personal position, I have lost considerably more through fixed interest bearing loans than through ordinary shares.

That the war was responsible for this does not detract from the argument. My experience includes low interest Victorian interminable loans and Melbourne and Metropolitan Board of Works 4% Debentures with twenty-five years yet to run before maturity.

Also worse than either, I recently sold a lot of French war loan at less than 20% of what my Father paid for it. The German 'rentier' had of course an infinitely more bitter experience in that he lost everything from holding what were considered in pre- war Germany absolutely gilt-edged securities.

However, like most other arguments for an extreme bouleversement of one's old ideas, one is very loath to accept it as a whole and to act on it. Having surveyed all the arguments I am inclined to greater caution than ever all round, I am more than ever against long term loans and completely against interminable loans. And I am prepared to have a greater proportion of ordinary shares as compared with fixed interest scrip than I was before.

But having gone this far, then comes the practical difficulty. Is the present the right time to make investments in the ordinary shares of companies in either Australia or England or America? I barged into this problem and had talks to bankers, brokers, economists, and having listened to dissertations on the Bank rate, inflation of Stock Exchange values, and many other problems, I came out the other end with the general impression that a depression of ordinary share prices was probable in the next six or nine months and that one would do well to hold off for that time at least.

And I may say in passing that the economists are sharply divided into two camps in this country as to the wisdom of the Bank of England and the Federal Reserve System 'butting in' to the extent they do in attempting to control affairs by their gold reserves and the bank rate alterations. But it is quite beyond me to follow, much less decide which side is liable to be right.

It seems to me that the conflicting economic theories of J. M.

Keynes [1] (Cambridge School), Gregory [2] (London School) and others are of no more than academic interest to the ordinary person. They hinge in the main, I gather, on whether it is right and proper for the Bank of England, the Federal Reserve System and the Reichsbank to try and exert a smoothing influence on the financial see-saw in their respective countries and even on international finance. Their theories extend in some cases to the expression of a doubt as to whether or not the gold standard is the word of high heaven.

But as a matter of practical business, whatever certain schools of economists may think, I take it that the existing practice will continue as regards the gold standard and as regards the control by Central Banks. So that apart from learning from the Economists the basic proven facts of economics and finance, one can with little risk afford to ignore their fancies.

I had hoped that one could have supposed that the main index to tendencies would be crystallised in the Bank rates in the various countries, but apparently this is not so. Unfortunately, or perhaps fortunately, gold will not move from London to New York simply because the Bank rate is 4 1/2% in London and 5% in New York. The difference in rates attracts floating balances, but unless the process continues on a large scale the purchase of dollars with sterling will not necessarily push the exchanges beyond the gold point. If, however, the movement is long continued, the exchange will be pushed against London and gold will move. But there is apparently a considerable 'lag'. And the situation may well be affected by 'invisible' factors, such as American tourist expenditure, etc., which may quietly readjust matters so that the exchange is not affected at all.

However, in spite of all this, the difference in Bank Rates that individual countries may impose on themselves to check their domestic financial position may cause gold to move. This brings about the situation that the Central Bank in the country losing gold may be forced to raise its Bank rate if they attach importance to preventing the loss of gold going further. One of Keynes' points has apparently always been that the British gold reserve is in this way very much at the mercy of the financial policy of foreign countries, especially that of the United States.

But without going to the extent of raising the Bank Rate, the Central Banks have another weapon in their armouries, which I gather they always use first. That is the sale of their own securities in their own country in order to absorb as much loose money as they can that otherwise would be attracted abroad by the higher rate there existing.

During the last twelve months the United States have lost about 100,000,000 worth of gold or about a third of their net imports of gold since 1921. In order to check this drain away of gold, the Federal Reserve Banks have sold securities hard in an effort to mop up as much as possible of the available loose money, but they have failed to affect the position much by so doing. They have at the same time been obliged to use their other and more potent weapon, the Bank Rate, and this has been raised in: half per cent stages from 3 1/2% in August 1927 to 5% in this current month. The Bank rate could of course have been used more harshly, but they did not want to affect adversely the genuine demand for credit by legitimate business. But it is apparently impossible to distinguish satisfactorily between genuine business demands for credit and credit wanted for Stock Exchange operations. The result was that they were not able to stop a greatly increased volume of credit flowing into the hands of Stock Exchange operators, and a Stock Exchange Boom resulted.

The position has apparently been checked by the last increase in the American Bank Rate.

The whole of this big question of correlating the domestic financial policies of this country and the United States with each other and with those of the other countries of the world is of course the preoccupation of the Governor of the Bank of England and the Governor of the Federal Reserve Board at their periodical meetings.

This may all seem to be wandering rather far afield from the question of investment that I set out to discuss, but it represents fairly exactly the way I have been led on from what appeared at first sight to be a fairly simple problem into what was for me an adventure into the wheels of the economic and financial machine. Getting back again on to the rails on which I began, the line of thought of those who hold that prices of securities will probably come down is as follows. Leading Stocks in England and America, even after the recent slump on the Stock Exchanges in London and New York, are roughly on a basis of a yield of under 5%. There is overinvestment on certain major lines.

The Bank rate is 4 1/2% in London and 5% in New York. While the upward trend in securities was current and was fostered by the gambling wave, operators were profitably occupied by borrowing at just above the Bank rate and using the money to take up securities for the chance of capital appreciation. Now that the rise is checked, they find themselves holding these securities which yield only round about the Bank rate. They are now faced with the risk of a fall in prices and consequent capital loss. More than this normal risk is presented by the apparent determination of the controlling banks to stop the inflation of Stock Exchange credit by the operation of a high and higher bank rate. The theory is that operators will be forced to sell their securities to pay off bank loans. Prices of securities will fall in consequence. This all applies to New York in particular, but I understand it is in general also applicable to London and elsewhere.

And so I have come down to having fifty or so curves kept going of the prices of Stock Exchange 'market leaders', in an effort to decide what the tendency of Stock Exchange prices is doing. And if by extraordinary chance, things go the way they are predicted and Stock Exchange prices of Industrials in America and this country drop away-well then, if no other factors come into the picture, then I imagine the time will have come to buy.

I am, Yours sincerely, R.G. CASEY

1 John Maynard Keynes, eminent economist and at the time Fellow and Bursar of King's College, Cambridge.

2 Theodor Gregory, Professor of Banking in the University of London and Governor of the London School of Economics.