by David Robertson, CFA
January 2017
People tend to be fairly optimistic about things naturally. Partly this simply reflects the fact that things tend to work out a good chunk of the time. As Diane Coyle noted in the Financial Times [here], optimism can also be a choice: "individuals make choices not only about bread-and-butter issues such as how much to consume and how long to work, but also about what to believe. People's wellbeing ('utility') depends also on believing things that make them feel good."
Sometimes though, wellbeing depends more on acute observation and accurate analysis than on beliefs. A turning point is one example; by definition it is not part of the "normal routine." As Lenin famously said, "there are decades where nothing happens, and there are weeks where decades happen." Coyle also recognizes such possibilities: "There are, however, many occasions when contagious denial and reality avoidance have terrible results." Indeed this is exactly what seems to be happening with many investors right now.
To be sure, it can be difficult to assess the investment landscape when economic and financial challenges are masked and the consequences of policy actions are deferred. Many investors, however, have been starting to accumulate anecdotal evidence that contradicts optimistic headlines and are starting to get an uneasy feeling that things aren't quite right.
For example, while the stocks of large public companies keep hitting new highs, they are also continuing to reduce headcount and issue mandatory furloughs. Strategy, vision, and leadership are being supplanted by frenetic efforts to hit earnings targets for corporate managers. Meanwhile, many investors are nervously waiting things out and hoping like heck that they will be able to retire before things get too bad.
These bottoms-up observations are corroborated by the top-down macro data. For example, David Collum highlights the challenges for consumer spending with a stark profile of the US consumer in his 2016 Year in Review [here]: "The wealth for middle-class households has dropped 30% since 2000, one in five kids lives in poverty, 46 million folks are on food stamps, 20% of the families have nobody employed." He concluded that, "The consumer is stretched by having no savings and gobs of debt—huge net debt ... An estimated 35% of Americans have debt that is more than 180 days past due."
Collum also summarized the erosion in the health of the corporate environment by way of a quote from Stanley Druckenmiller: “The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins and growing indebtedness.” Needless to say, this is not the stuff of sustainable recovery.
Although this evidence is by no means comprehensive, it is compelling enough to beg the question as to why so many investors seem to believe otherwise. It is in this regard that Coyle's insights are especially instructive: "individuals make choices ... about what to believe." In other words, many investors are guided not by cold, hard evidence, but by beliefs.
But belief systems and mental models can go wrong, especially when enticing narratives lure in willing or unexpecting victims. For example, shortly after the financial crisis in 2009, for example, many investors' concerns about debt were lulled by a narrative of "deleveraging". The idea was that public debt could be used to cushion the blow as households transitioned to lower debt. Public debt held up its side of the bargain as it climbed from 73.8% of GDP at the end of 2008 [here] to 104.8% as of the third quarter in 2016. The problem is that while household debt has declined, much of the decline was involuntary (i.e., homes got repossessed) and household debt levels are still quite high. Further, household debt is not evenly distributed. As David Collum noted, many households still have a huge debt problem.
Debt has grown even more rapidly in emerging markets. John Mauldin showed [here] that, "China's total debt stock more than tripled between 2000 and 2007 and nearly quadrupled from 2007 to 2014 as private-sector and local-government borrowers added more than $26 trillion in new debt. That explosion in domestic credit lifted the country's total debt-to-GDP ratio from 121% in 2000 to 158% in 2007 and to 282% by the end of 2014." The unfortunate conclusion is that deleveraging has been a nice belief, but just a belief. For those who have been watching, not only did the debt problem not go away; in most important respects, it got bigger.
Other examples of errant belief systems are also to blame for misperceptions. The Economist, for example, recently reported [here] on some examples of management theory that have "lost touch" with business reality. One of those ideas is that "business is more competitive than ever." In reality, however, "The most striking business trend today is not competition but consolidation."
In addition, many people still harbor the notion that "we live in an age of entrepreneurialism." Once again, "The evidence tells a different story. In America the rate of business creation has declined since the late 1970s. In some recent years more companies died than were born." Another Economist story reports [here] that, "The largest firms are expanding and smaller ones are withering on the vine," and concludes: "But today's incentives favour stasis. Many big firms thrive because of government and regulation."
These insights point to an even bigger problem, and one that is also often clouded by false beliefs: Our capitalistic economic system is no longer as dynamic and flexible as it used to be. In fact, this possibility is one that increasingly troubled Joseph Schumpeter, one of the greatest thinkers on the subject of economic dynamism. Later in his career, "He [Schumpeter] became increasingly preoccupied not only with heroism but with bureaucratisation, and not with change but with decay."
The Economist shines a light on the current state of the economic system: "Today capitalism exists without capitalists - companies are 'owned' by millions of shareholders who act through institutions that employ professional managers whose chief aim is to search for safe returns, not risky opportunities." Further, "lobbyists and other vested interests have by now made a science of gaming the system to produce private benefits." In other words, capitalism has become diluted and a less powerful force in compelling growth.
One of the special dangers of economic decay is that it can also metastasize into political decay: "And populism feeds on its own failures. The more that business copes with uncertainty by delaying investment or moving money abroad, the more politicians will bully or bribe them into doing 'the right thing'. As economic stagnation breeds populism, so excessive regard for the popular will reinforce stagnation."
In regards to the political landscape, those who have managed to shrug off Brexit and the US presidential election as anomalies would do well to pay heed to John Boehner's observations as reported in the Financial Times [here]: "We are in the middle of a political revolution. Not just in America but Europe too ... And what makes the pattern doubly unnerving and unpredictable is that it is people, such as Mr Trump, Mrs May or Angela Merkel who are shaping events, rather than established party platforms or policy programmes." In short, the political environment has become even more idiosyncratic and unpredictable than it normally is.
An important danger is that once political decay sets in, problems become more intractable. As the Economist described [here], "If Mr Trump's policies are a mystery, his approach to politics is not. The Republicans won office by systematically undermining trust in any figure or institution that seemed to stand in his way, from Republican rivals to his Democratic opponent, leaders of Congress, business bosses, the news media, fact-checkers or simply those fessi who believe in paying taxes." The unfortunate conclusion is that, "A lower-trust America will be harder to fix."
A broad interpretation of the evidence, then, indicates that economic decay is a core, underlying problem. Congress has largely absolved itself of any responsibility to act, a position best captured by Chuck Schumer's comment that, "the Fed's the only game in town". The Fed, and other central banks, have acted through easing monetary policy. This course, while useful in mitigating the crisis, has since only served to mask and defer problems, not to actually solve them. As a result, time is running out and the risk/reward proposition for market exposure has become very unappealing. David Collum captured the sentiment with a quote from the chief investment officer for a European insurer, "The world’s central banks can’t save us anymore. . . . The trade now is to hold as much cash as possible."
Of course there are plenty of more optimistic interpretations driven by different belief systems. Not that other beliefs and belief systems are necessarily bad; they aren't. In fact, we learn a great deal from other beliefs and from the process of reconciling them with our own. But when belief systems impair our ability to sense and observe our surroundings, they become distinctly unhelpful.
One of those belief systems is that of blissful ignorance - which fulfills a need for positivism regardless of prevailing evidence. Another is that of cheerleading which is based on the belief that what the economy really needs is a revival of "animal spirits". "Cheerleaders" believe that the best way to restore those animal spirits is to tirelessly spew out positive spins on every news and data item. While the concept of animal spirits is a useful one, the belief that they can be controlled more through news flow than through consumers actually observing and acting on attractive economic opportunities is at once, less than completely truthful, patronizing to consumers, and counterproductive to economic problem solving.
Yet another belief system may actually result from a coping mechanism that belies deeper and darker concerns. In his book, Hillbilly Elegy, JD Vance references a December 2000 paper by Carl A. Markstrom, Sheila K. Marshall, and Robin J. Tryon. He notes, "Their paper suggests that hillbillies learn from an early age to deal with uncomfortable truths by avoiding them, or by pretending better truths exist. This tendency might make for psychological resistance, but it also makes it hard for Appalachians to look at themselves honestly." It is not hard to infer that some "optimistic" beliefs are, paradoxically, more reflective of economic hardship than of true improvement.
We have our own beliefs and they include the notion that the vast majority of economic challenges are eminently fixable. However, and it's a big however, such problems can only be fixed in a meaningful and sustainable way if the underlying problems are accurately diagnosed and then properly treated. Our greatest concern is not the depth of economic decay but rather the depth of various beliefs systems that prevent proper diagnosis and treatment of the problems. Unfortunately, much of what we have seen is people, as Vance describes, "reacting to bad circumstances in the worst way possible."
As a result, the most important thing investors can do right now is to insulate themselves as best as possible from unhelpful belief systems so that they can observe and analyze the landscape as dispassionately and accurately as possible. This suggests exerting a higher intensity effort than in the past and making a greater effort to prevent belief systems from affecting observations. As Gillian Tett recommends, "To survive in 2017, investors will need to use tools taken not just from the world of economics, but from psychology, sociology, and political science too." As for a useful "treatment" program, "Investors should also embrace 'optionality': the only way to prepare for a world of uncertainty is to stay as flexible and diversified as possible."
In conclusion, a surgeon friend of ours once described his career as "a chronology of medical advances," referring to the long, steady progress of technology and medical treatments and the benefits patients have enjoyed as a result. This is an apt analogy for economic progress as well and one of the conclusions of Robert Gordon in his book, The Rise and Fall of American Growth. One of Gordon's key points is that as much quantitative measures of the standard of living improved between 1870 and 1970, the quality of life also improved immeasurably during that time. The lesson is that we have a lot of resources; things are likely to get better if only we apply them.
So, it is natural to go through cycles and to experience adversity once in a while. It happens. When it does, the most productive course of action is to acknowledge the challenge, deal with it, and move on. It is both unfortunate and counterproductive when treatable conditions deteriorate significantly just because someone prefers to "deal with uncomfortable truths by avoiding them."
January 2017
People tend to be fairly optimistic about things naturally. Partly this simply reflects the fact that things tend to work out a good chunk of the time. As Diane Coyle noted in the Financial Times [here], optimism can also be a choice: "individuals make choices not only about bread-and-butter issues such as how much to consume and how long to work, but also about what to believe. People's wellbeing ('utility') depends also on believing things that make them feel good."
Sometimes though, wellbeing depends more on acute observation and accurate analysis than on beliefs. A turning point is one example; by definition it is not part of the "normal routine." As Lenin famously said, "there are decades where nothing happens, and there are weeks where decades happen." Coyle also recognizes such possibilities: "There are, however, many occasions when contagious denial and reality avoidance have terrible results." Indeed this is exactly what seems to be happening with many investors right now.
To be sure, it can be difficult to assess the investment landscape when economic and financial challenges are masked and the consequences of policy actions are deferred. Many investors, however, have been starting to accumulate anecdotal evidence that contradicts optimistic headlines and are starting to get an uneasy feeling that things aren't quite right.
For example, while the stocks of large public companies keep hitting new highs, they are also continuing to reduce headcount and issue mandatory furloughs. Strategy, vision, and leadership are being supplanted by frenetic efforts to hit earnings targets for corporate managers. Meanwhile, many investors are nervously waiting things out and hoping like heck that they will be able to retire before things get too bad.
These bottoms-up observations are corroborated by the top-down macro data. For example, David Collum highlights the challenges for consumer spending with a stark profile of the US consumer in his 2016 Year in Review [here]: "The wealth for middle-class households has dropped 30% since 2000, one in five kids lives in poverty, 46 million folks are on food stamps, 20% of the families have nobody employed." He concluded that, "The consumer is stretched by having no savings and gobs of debt—huge net debt ... An estimated 35% of Americans have debt that is more than 180 days past due."
Collum also summarized the erosion in the health of the corporate environment by way of a quote from Stanley Druckenmiller: “The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins and growing indebtedness.” Needless to say, this is not the stuff of sustainable recovery.
Although this evidence is by no means comprehensive, it is compelling enough to beg the question as to why so many investors seem to believe otherwise. It is in this regard that Coyle's insights are especially instructive: "individuals make choices ... about what to believe." In other words, many investors are guided not by cold, hard evidence, but by beliefs.
But belief systems and mental models can go wrong, especially when enticing narratives lure in willing or unexpecting victims. For example, shortly after the financial crisis in 2009, for example, many investors' concerns about debt were lulled by a narrative of "deleveraging". The idea was that public debt could be used to cushion the blow as households transitioned to lower debt. Public debt held up its side of the bargain as it climbed from 73.8% of GDP at the end of 2008 [here] to 104.8% as of the third quarter in 2016. The problem is that while household debt has declined, much of the decline was involuntary (i.e., homes got repossessed) and household debt levels are still quite high. Further, household debt is not evenly distributed. As David Collum noted, many households still have a huge debt problem.
Debt has grown even more rapidly in emerging markets. John Mauldin showed [here] that, "China's total debt stock more than tripled between 2000 and 2007 and nearly quadrupled from 2007 to 2014 as private-sector and local-government borrowers added more than $26 trillion in new debt. That explosion in domestic credit lifted the country's total debt-to-GDP ratio from 121% in 2000 to 158% in 2007 and to 282% by the end of 2014." The unfortunate conclusion is that deleveraging has been a nice belief, but just a belief. For those who have been watching, not only did the debt problem not go away; in most important respects, it got bigger.
Other examples of errant belief systems are also to blame for misperceptions. The Economist, for example, recently reported [here] on some examples of management theory that have "lost touch" with business reality. One of those ideas is that "business is more competitive than ever." In reality, however, "The most striking business trend today is not competition but consolidation."
In addition, many people still harbor the notion that "we live in an age of entrepreneurialism." Once again, "The evidence tells a different story. In America the rate of business creation has declined since the late 1970s. In some recent years more companies died than were born." Another Economist story reports [here] that, "The largest firms are expanding and smaller ones are withering on the vine," and concludes: "But today's incentives favour stasis. Many big firms thrive because of government and regulation."
These insights point to an even bigger problem, and one that is also often clouded by false beliefs: Our capitalistic economic system is no longer as dynamic and flexible as it used to be. In fact, this possibility is one that increasingly troubled Joseph Schumpeter, one of the greatest thinkers on the subject of economic dynamism. Later in his career, "He [Schumpeter] became increasingly preoccupied not only with heroism but with bureaucratisation, and not with change but with decay."
The Economist shines a light on the current state of the economic system: "Today capitalism exists without capitalists - companies are 'owned' by millions of shareholders who act through institutions that employ professional managers whose chief aim is to search for safe returns, not risky opportunities." Further, "lobbyists and other vested interests have by now made a science of gaming the system to produce private benefits." In other words, capitalism has become diluted and a less powerful force in compelling growth.
One of the special dangers of economic decay is that it can also metastasize into political decay: "And populism feeds on its own failures. The more that business copes with uncertainty by delaying investment or moving money abroad, the more politicians will bully or bribe them into doing 'the right thing'. As economic stagnation breeds populism, so excessive regard for the popular will reinforce stagnation."
In regards to the political landscape, those who have managed to shrug off Brexit and the US presidential election as anomalies would do well to pay heed to John Boehner's observations as reported in the Financial Times [here]: "We are in the middle of a political revolution. Not just in America but Europe too ... And what makes the pattern doubly unnerving and unpredictable is that it is people, such as Mr Trump, Mrs May or Angela Merkel who are shaping events, rather than established party platforms or policy programmes." In short, the political environment has become even more idiosyncratic and unpredictable than it normally is.
An important danger is that once political decay sets in, problems become more intractable. As the Economist described [here], "If Mr Trump's policies are a mystery, his approach to politics is not. The Republicans won office by systematically undermining trust in any figure or institution that seemed to stand in his way, from Republican rivals to his Democratic opponent, leaders of Congress, business bosses, the news media, fact-checkers or simply those fessi who believe in paying taxes." The unfortunate conclusion is that, "A lower-trust America will be harder to fix."
A broad interpretation of the evidence, then, indicates that economic decay is a core, underlying problem. Congress has largely absolved itself of any responsibility to act, a position best captured by Chuck Schumer's comment that, "the Fed's the only game in town". The Fed, and other central banks, have acted through easing monetary policy. This course, while useful in mitigating the crisis, has since only served to mask and defer problems, not to actually solve them. As a result, time is running out and the risk/reward proposition for market exposure has become very unappealing. David Collum captured the sentiment with a quote from the chief investment officer for a European insurer, "The world’s central banks can’t save us anymore. . . . The trade now is to hold as much cash as possible."
Of course there are plenty of more optimistic interpretations driven by different belief systems. Not that other beliefs and belief systems are necessarily bad; they aren't. In fact, we learn a great deal from other beliefs and from the process of reconciling them with our own. But when belief systems impair our ability to sense and observe our surroundings, they become distinctly unhelpful.
One of those belief systems is that of blissful ignorance - which fulfills a need for positivism regardless of prevailing evidence. Another is that of cheerleading which is based on the belief that what the economy really needs is a revival of "animal spirits". "Cheerleaders" believe that the best way to restore those animal spirits is to tirelessly spew out positive spins on every news and data item. While the concept of animal spirits is a useful one, the belief that they can be controlled more through news flow than through consumers actually observing and acting on attractive economic opportunities is at once, less than completely truthful, patronizing to consumers, and counterproductive to economic problem solving.
Yet another belief system may actually result from a coping mechanism that belies deeper and darker concerns. In his book, Hillbilly Elegy, JD Vance references a December 2000 paper by Carl A. Markstrom, Sheila K. Marshall, and Robin J. Tryon. He notes, "Their paper suggests that hillbillies learn from an early age to deal with uncomfortable truths by avoiding them, or by pretending better truths exist. This tendency might make for psychological resistance, but it also makes it hard for Appalachians to look at themselves honestly." It is not hard to infer that some "optimistic" beliefs are, paradoxically, more reflective of economic hardship than of true improvement.
We have our own beliefs and they include the notion that the vast majority of economic challenges are eminently fixable. However, and it's a big however, such problems can only be fixed in a meaningful and sustainable way if the underlying problems are accurately diagnosed and then properly treated. Our greatest concern is not the depth of economic decay but rather the depth of various beliefs systems that prevent proper diagnosis and treatment of the problems. Unfortunately, much of what we have seen is people, as Vance describes, "reacting to bad circumstances in the worst way possible."
As a result, the most important thing investors can do right now is to insulate themselves as best as possible from unhelpful belief systems so that they can observe and analyze the landscape as dispassionately and accurately as possible. This suggests exerting a higher intensity effort than in the past and making a greater effort to prevent belief systems from affecting observations. As Gillian Tett recommends, "To survive in 2017, investors will need to use tools taken not just from the world of economics, but from psychology, sociology, and political science too." As for a useful "treatment" program, "Investors should also embrace 'optionality': the only way to prepare for a world of uncertainty is to stay as flexible and diversified as possible."
In conclusion, a surgeon friend of ours once described his career as "a chronology of medical advances," referring to the long, steady progress of technology and medical treatments and the benefits patients have enjoyed as a result. This is an apt analogy for economic progress as well and one of the conclusions of Robert Gordon in his book, The Rise and Fall of American Growth. One of Gordon's key points is that as much quantitative measures of the standard of living improved between 1870 and 1970, the quality of life also improved immeasurably during that time. The lesson is that we have a lot of resources; things are likely to get better if only we apply them.
So, it is natural to go through cycles and to experience adversity once in a while. It happens. When it does, the most productive course of action is to acknowledge the challenge, deal with it, and move on. It is both unfortunate and counterproductive when treatable conditions deteriorate significantly just because someone prefers to "deal with uncomfortable truths by avoiding them."
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