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.

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.

 

 

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.

 

 

 

yield curve inversion, external shock and recession

Stock markets around the world sold off yesterday in wicked fashion after the yield on the 10-year Treasury “inverted,”  that is, fell below the yield on the 2-year.  This has very often been the signal of an upcoming recession.  Typically, though, the inversion happens because the Fed is raising short-term interest rates in an attempt to slow too-rapid economic growth.  So it’s first and foremost a signal of aggressive Fed tightening, which has in the past almost always gone too far, causing an economic contraction.

In the present case, this is not the situation.  The Fed is signalling ease, not tightening.  Arguably, arbitrage between long-dated US and EU government bonds is suppressing the 10-year.

While trading robots, unleashed by the inversion, may have been behind the negative stock market action yesterday, my sense is that this is not all that’s going on.  I think the market is beginning to step back and focus on the bigger economic picture.  It may not like what it sees, namely:

–worldwide, economies are now being hit by a significant negative external shock.  It’s not a tripling of the oil price, as was the case in the 1970s, nor a collapsing financial system, as in 2008.  Instead, this time it’s the Trump tariffs, which appear to be reducing growth in the US by more than expected (not that anyone had extremely precise thoughts)

–the 2017 tax bill is not paying for itself, as the administration claimed at the time, but is adding to the government deficit instead–implying that further fiscal stimulation is less likely.  Giving extra cash to the ultra-rich, who tend to save rather than spend, and keeping tax breaks for industries of the past hasn’t bought much oomph to growth, either

–channeling his inner Herbert Hoover, Mr. Trump is trying to export the weakness he has created by devaluing the dollar.

 

Stepping back a bit to view the larger picture,

–pushing interest rates near to zero, depreciating the currency and defending the politically powerful industries of the 1970s all seem to mirror the game plan that has produced thirty years of stagnation in Japan and similar results in large parts of the EU.  Not pretty.

–on a smaller scale, this brings to mind Mr. Trump’s fundamentally misguided and ultimately disastrous foray into Atlantic City gaming, a venture where he appears to have profited personally but where those who supported and trusted him by owning DJT stock and bonds were financially decimated.

 

It seems to me that Wall Street is starting to come to grips with two possibilities:  that there may be only impulsiveness, and no master plan or end game to the Trump trade wars; and that Congresspeople of all stripes realize this but are unwilling to do anything to thwart the president’s whims.  In other words, the real issue being pondered is not recession but Trump-induced secular stagnation.