the best of all possible worlds/the invisible hand/modern portfolio theory …and stupid stuff

Leibniz

Scientific thinkers of the seventeenth- and eighteenth centuries in Europe described the universe as being like a gigantic, complex, smoothly-functioning watch.  This implies, they argued, that the cosmos must have been made by the supreme watchmaker = God.

G W Leibniz, the inventor of calculus, offered the idea (later lampooned by Voltaire in Candide) that ours is also the best of all possible worlds.  What about war, famine, disease, poverty…?  Leibniz’ view is that though we can imagine a world like ours, only better, that thought-experiment world is not possible.  Put a different way, Leibniz thought that behind the scenes God uses a calculus-like maximizing function for his creation.  The total amount of goodness in the world is the highest it can be.  Were we to make one existing bad thing better, other things would worsen enough that the sum total of good would be reduced.

Adam Smith

Around the same time Adam Smith introduced into economics basically the same idea, the “invisible hand” that directs individuals, all following their own self-interest, in a way that also somehow ends up serving the public interest.  This idea, still a staple of economics and finance, has the same, ultimately theological, roots–that behind the scenes a benificent God is working to create the best possible outcome.

since then

The scientific world has moved on since Leibniz and Smith, thanks to Hegel/Marx (social evolution), Schopenhauer (collective unconscious), Darwin (natural evolution), Kierkegaard (God of religion vs. god of science), Nietzsche (change without progress) and Freud (individual unconscious).

Twentieth-century physicists, starting with Einstein, have suggested that the universe is in fact messier and more unruly than Newton thought.

Nevertheless, the laissez faire assumption of the invisible hand that makes everything ok remains a key element of economic and financial theorizing.

Modern Portfolio Theory

Invented by academics over fifty years ago, MPT is what every MBA student learns in business school.  Its main conclusion is that the highest value portfolio (i.e., the best of all possible portfolios) is the market index.  A cynic might argue that the main attraction of a theory that says practical knowledge or experience in financial markets is useless is that it suits the interests of professors who possess neither.

However, the conclusion is not just convenient for the educational establishment.  It also fits squarely into the 18th century European Enlightenment view of the “invisible hand” guiding the market.

MPT requires a bunch of counter-intuitive assumptions, summed up in the efficient markets hypothesis, including that:

–everyone acts rationally

–everyone has the same information

–everyone has the same investment objectives

–everyone has the same investment time frame

–everyone has the same risk tolerances

–there are no dominant, market-moving players.

Granted all this, one can argue that any portfolio that differs from the market will be worse than the market.

The standard criticism of MPT is that it ignores the bouts of greed and fear that periodically take control of markets.  In fact, even while MPT was being formulated, markets were being roiled by the conglomerate mania of the late Sixties, the Nifty Fifty mania of the early Seventies and the wicked bear panic of 1974, when stocks were ultimately trading below net cash on the balance sheet and still went down every day.

Arguably anyone looking out an ivory tower window should have noticed that MPT had no way of talking about the crazy stuff that was roiling Wall Street almost constantly during that period–and which showed its assumptions were loony.  Nevertheless, theology trumped the facts.

today

In a way, MPT suits me fine.  The fewer people looking for undervalued companies the easier it is for the rest of us to find them.

However, one basic high-level assumption that even professional investors still make is that the economic/political system in the US functions relatively prudently and therefore the economy remains more or less stable.  But in essence this is only a different way of saying the “invisible hand” guides self-interest-seeking individuals in politics toward a socially beneficial result.

I’m not sure that’s true anymore, if it ever was.  For one thing, Washington has relied almost exclusively on monetary policy to fine-tune the US economy over the past generation–encouraging all sorts of unhealthy financial speculation and intensifying social inequality.  Washington has also done less than the ruling body of any other developed country to help citizens cope with dramatic structural economic changes over the past twenty years.  Resulting dissatisfaction has caused the rise to power of newcomers like Donald Trump who have pledged to address these issues but whose racism, venality and stunning incompetence appear to me to be doing large-scale economic and political damage to the country.

This development presents a significant issue for laissez faire theorists in the way deep emotionally-driven market declines do for the efficient markets hypothesis.  As a practical matter, though, the situation is far worse than that:  recent events in the US and UK illustrate, populating the halls of economic and political power with self-serving incompetents can do extraordinary amounts of damage.  Left unchecked, at some point this has to have a negative effect on stock returns.

 

 

 

 

 

 

 

 

 

 

Keeping Score, September 2019

I’ve just updated my Keeping Score page for September 2019.  No sign so far of the traditional actively-managed mutual fund selloff in advance of the Halloween yearend.  I wonder why.  Is this a function of the AI era?   …the fact that passive money under management exceeds actively managed?   …is selling just late?

Will no selloff now mean no 4Q rally?    …that would be my guess.

autos, emissions and Trumponomics

I’ve followed the auto industry since the early 1980s, but have rarely owned an auto stock—brief forays into Toyota, later Peugeot (1986) and Porsche (2003?) are the only names that come to mind.

 

The basic reasons I see to avoid the auto manufacturers in the developed world:

–chronic overcapacity

–continuing shift of intellectual property creation, innovation, brand differentiation—and better-than-commodity profits–from manufacturers to component suppliers

–the tendency of national politics to influence company operations and prospects.

 

In addition, the traditional industry is very capital intensive, with a high capacity utilization required (80%?) to reach breakeven.  The facts that unit selling prices are high and new purchases easy to put off for a year or two mean that the new car industry is highly cyclical.

More than that, today’s industry is in the early stages of a transformation away from units that burn fossil fuels, and are therefore a major source of air pollution, to electric vehicles.  The speed at which this change is happening has accelerated over the past decade outside the US because pollution has become a very serious problem in China and because automakers in the EU have been shown to have falsified performance data for their diesel-driven offerings in a poorly thought out effort to meet anti-pollution rules.

California, which had a nineteenth-century-like city pollution problem around Los Angeles as late at the mid-1970s, has led the US charge for clean air.  It helps its clout that CA is the country’s largest car market (urban legend:  thanks in part to GM’s aggressive lobbying against public transport in southern CA in the mid-20th century).  CA has also been joined by about a dozen other states who go along with whatever it decides.  The auto manufacturers have done the same, because the high capital intensity of the car industry means building cars to two sets of fuel usage specifications makes no sense.

 

Enter Donald Trump.  His administration has decided to roll back pollution reduction measures put in place by President Obama.  CA responded by agreeing with Ford, VW, Honda and BMW to establish Obama-like, but somewhat less strict, requirements for cars sold in that state.  Trump’s reposte has been to call the agreement an anti-trust violation, to claim the power to revoke the section of the law that permits CA to set state pollution standards and to threaten to withhold highway funds from CA because the air there is too polluted (?).

 

Other than pollical grandstanding, it’s hard to figure out what’s going on.

Who benefits from lower gas mileage cars?     …Russia and Saudi Arabia, whose economies are almost totally dependent on selling fossil fuels; and the giant multinational oil companies, whose exploration efforts until recently have been predicated on demand increasing strongly enough to push prices up to $100 a barrel.

Who gets hurt by the Trump move?     …to the degree that it prolongs widespread use of inefficient gasoline-powered cars, the biggest potential losers are US-based auto firms and the larger number of US residents who become ill in a more polluted environment.  Why the car companies?  Arguably, they will put less R&D effort into developing less-polluting cars, including electric vehicles.  The desertification of China + disenchantment with diesel will have Europe and Asia, on the other hand, making electric cars a very high priority.  It wouldn’t be surprising to find in a few years a replay of the situation the Detroit automakers were in during the 1970s—when cheap, well-built imports flooded the country without the Big Three having competitive products.

It’s one of the quirks of the US stock market that it has very little direct representation of the auto industry.  So the idea that profits there will be somewhat higher as the firms skimp on R&D will have little/no positive impact on the S&P.  Even the energy industry, the only possible beneficiary of this Trump policy, is a mere shadow of its former self.  Like Trump’s destruction of the American brand—Apple has dropped from #5 in China to #50 since his election—all I can see is damaging downside.

I think the Trump policy is intentional, like his trade wars and his income tax cut for the super-rich.  The most likely explanation for all these facets of Trumponomics is either he doesn’t realize the potentially grave economic damage he’s doing or it’s not a particularly high priority.

 

 

 

 

 

 

 

 

WeWork (WE) and Wall Street: my take

I’ll start out by underlining that I don’t know enough about WE to have a usable investment opinion about the offering’s merits.  I do have opinions, though.  It’s just that they’re more like my thoughts about the Mets than a way to make money.  Anyway, here goes:

in general

–the WE structure isn’t new.  Think: a savings and loan, or a hotel chain, or an airline or an offshore drilling company, or a container ship firm–or, for that matter, a cement plant or a coal mine.  All these involve owning expensive long-lived assets which are typically debt financed and whose use is sold bit by bit.   Although there may be attempts at branding, with varying degrees of success, in the final analysis these are commodity businesses.

–in good times, this is a favorable structure for a company to have.  Costs remain relatively constant as selling prices rise, so most of the increase drops down to the pre-tax line.  Rental/purchase contracts may limit annual price increases, but investors typically factor in anticipated rises relatively quickly

–in bad times, it’s not great.  Customers may stop purchasing with little notice, sometimes walking away from contracts or renegotiating them sharply downward (using the threat of termination as leverage).  Offshore drilling rigs are an extreme example of feast/famine cyclicality

–because of cyclicality, PE multiples for mature firms with this structure tend to be low.  When such companies come to market, they tend to try to ride a wave of energy generated by previously successful IPOs–meaning that simply the appearance of their offering documents is a sign of potential overheating

WE

–in the case of WE, investor perception appears to be frosty.  This is partly because of what I’ve just written.  Also, from what I’ve heard and read, the 350+-page prospectus is not particularly illuminating (I’ve flicked through it but haven’t analyzed it myself)

 

investment implications

The arrival of the WE prospectus coincides with a sharp selloff in the shares of recent tech-related IPOs.

Two possible reasons:

Wall Street thinks that the marketing campaign for WE heralds the end of the line for the current IPO frenzy, on the argument that the underwriters would be presenting a higher quality offering if they had one.  This is what I think is going on.

The other possibility I see is the week-long, humorous but kind of scary Alabama weather discussion, an episode I think makes anyone question the mental stability of Mssrs. Trump and Ross.

In any event, given that some newly-listed tech names have fallen by a quarter or more over the past week or so, I think it’s time to sift through the ashes.

 

Having said that, I do suspect that a significant rotation away from these former market darlings, triggered by WE but based on valuation, is now underway. This will only mark a fundamentally new direction for the stock market if the tariff wars go away completely.  I don’t think this will happen.  So I’d buy a partial position now and hope to pick up more on further weakness.  Remember, too, that this is a highly speculative corner of the market, so it’s not everyone’s cup of tea.

 

 

Trump’s economic “plan”

So far the Trump administration has launched two countervailing economic thrusts:

income taxes.   

Starting in 2018, the corporate tax rate was reduced from a highest-in-the-world 35% to a more nearly average 21%.  The idea was to remove the incentive for highly taxed US-based multinationals, like pharmaceutical firms, to shift their businesses elsewhere.  In the same legislation the ultra-wealthy received a very large reduction in their income taxes, as well as retention of the carried interest provision, a tax dodge by which private equity managers convert ordinary income into less highly taxed capital gains (this despite Mr. Trump’s campaign pledge to eliminate carried interest).  Average Americans made out less well, receiving a modest reduction in rates coupled with loss of real estate-related writeoffs that skewed the benefits away from heavily Democratic states like California and New York.

Washington made little, if any, attempt to end special interest tax breaks to offset the lower corporate rates.  The result in 2018 was a yoy increase in individual income tax collection of about $50 billion, more than offset by a drop in corporate tax payments of about $90 billion.  Given the strong economy in 2018, the IRS would likely have taken in $150 – $175 billion more under the old rules than it did under the new.

What I find most surprising about the income tax legislation is that the large deficit-increasing fiscal stimulus it provides came at a time when none was needed–after almost a decade of continuous GDP growth in the US and the economy at very close to full employment.

the tariff wars.

Right after his inauguration, Mr. Trump pulled the US out of the Trans-Pacific Partnership, a trade group aiming to, among other things, fight China’s theft of intellectual property.  However, exiting the TPP for a go-it-alone approach hurt US farmers, since it also meant higher (and escalating each year) tariffs on US agricultural exports to TPP members, notably Japan.

Next, Trump presented the tortured argument that: (1) that there could be no national security if the economy were not growing,  (2) that, therefore, the presence of foreign competition to US firms in the domestic marketplace threatens national security,  (3) that Congress has given the president power to act unilaterally to counter threats to national security, so (4) Trump had the authority to unilaterally impose tariffs on imports.  So he did, in escalating tranches.

No mention of the fact that tariffs slow GDP growth, so under the first axiom of Trump logic are themselves a threat to national security.

Not a peep from Congress, either.

Recently, Mr. Trump has announced that he also has Congressional authority, based on a 1977 law authorizing sanctions against Iran, to order all US-based entities to cease doing business with China.

Results so far:

–the predictable slowdown in economic growth in the US

–retaliatory tariffs that have slowed growth further

–higher prices to consumers that have for all but the ultra-wealthy eaten up the extra income brought by the new tax law

–a sharp drop in spending on new capital projects in the US by both foreign and domestic firms

–tremendous pressure by Trump on the Federal Reserve (in a most un-Republican fashion (yes, I know Nixon did the same thing, but still…)) to “debase” the dollar.

Why?

A falling currency can temporarily give the appearance of faster growth.  But it can also do serious, and permanent, damage to a country by reducing national wealth (Japan is a good example).  Its only “virtue” as a policy measure is that it’s hard to trace cause and effect–politicians can deny they are mortgaging the country’s heritage to cover up earlier mistakes, even though that’s what they’re doing.

–an apparent shift in the goal of US trade negotiators away from structural reform in China to resuming purchases of US soybeans

my take

–if there had been a plan to Trump’s actions, tariffs would have come first, the tax break later.  The fact that the reverse happened argues there is no master strategy.  Again no surprise, given Trump’s history–which people like us can see most clearly in his foray into Atlantic City gaming.

–what a mess!

A better way to combat China?    The orthodox strategies are to strengthen the education system, increase scientific research spending and court foreign researchers to come to the US.  Unfortunately, neither major domestic political party has much interest in education–Democrats refuse to fix broken schools in large urban areas and Republicans as a party are now against scientific inquiry.  The white racism of the current Washington power structure narrows the attraction of the US in the eyes of many skilled foreigners.   The ever-present, ever-shifting tariff threat–seemingly arbitrary levies on imported raw materials and possible retaliatory duties on exported final products–means it’s very risky to locate plant and equipment in the US.

For what it’s worth, I think that were the political situation in the US different there would be substantial Brexit-motivated relocation of multinationals from London to the east coast.

investment implications

To my mind, all this implies having a focus on software companies, on low-multiple consumer firms that focus on domestic consumers with average or below-average incomes, and on companies whose main business is in Asia.  Multinational manufacturers of physical things for whom the US and China are major markets are probably the least good place to be.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

fr

America: a weakening brand

When I first became interested in Tiffany (TIF) as a stock years ago, one thing that stood out was that the company was doing a land office business in almost all facets of its rapid international expansion.  One exception:  the EU.  I quickly became convinced that the reason was because TIF is an American company.

For Europeans, France, Germany, Italy, and to a lesser extent the rest of the EU, are the font of all knowledge and culture.  As local literature and philosophy make clear, being situated on the sacred soil of (fill in any EU country) is the key to its superiority.  The US,  lacking requisite hallowed ground, is a semi-boorish johnny-come-lately.  Sporting a piece of jewelry from an American firm therefore implies one has suffered a devastating reversal of fortune that puts “authentic” jewelry out of reach.

 

In the rest of the world, however, the US is a symbol of aspiration.  America stands for freedom, opportunity, cutting-edge technology, the best universities and an ethos that prizes accomplishment not heritage.  It’s “all men are created equal”  “give me your …huddled masses yearning to be free” and “I am not throwing away my shot.”  Wearing, or just owning, a piece of American jewelry becomes a symbolic linking of the holder to these national values.  It hasn’t hurt, either, particularly with an older generation (paradoxically, ex the EU) that the US made a monumental effort to help heal the world after WWII.

 

The “brand” of the United States has taken a real beating since Mr. Trump has become president.  Surveys, one of which is reported in INC magazine, show a sharp drop in US prestige right after his victory and continuing deterioration since.   I don’t think the biggest negative issue is the president’s insecurities, his constant prevarication, his very weak record as a real estate developer or his (hare-brained) economic policies while in office.  I see the worst damage coming instead from his love of leaders with poor human rights records and his disdain for women and people of color …plus the whiff of sadism detectable in his treatment of both.

 

Whatever the precise cause may be, the deterioration of the America’s reputation under Mr. Trump is a very real worry for domestic consumer companies.  Damage will likely show itself in two ways:  weaker sales to foreign tourists, and the absence of positive surprises from foreign subsidiaries.  For domestic retail firms, it seems clear that economic recovery has finally come to the less wealthy parts of the US over the past year or two–witness the profit performance of Walmart or the dollar stores.  On the other hand, it seems to me that people who have trusted Mr. Trump in the past–like the banks that lent him money, the contractors who built his casinos, those who bought DJT stock and bonds, farmers who voted for him–have all ended up considerably worse off than the more wary.  So while they may be good temporary hiding places, holders should be nimble.

One final thought:  brands don’t deteriorate overnight but the cumulative damage can be enormous.  The first to react will be younger consumers, who have the least experience with/of the “old” brand.   They will be the most difficult to win back.  As well, as time passes, their views will be increasingly important in commerce.