| Arete Quarterly Q313.pdf |
Welcome
When your eyes are open to a theme, it's amazing how often you see it. One of the theme's that has always driven Arete is that of creative destruction.
This theory was espoused by Joseph Schumpeter and describes how an economy actually grows — not as one monolithic entity plodding forward, but as a diverse group of businesses competing for prominence. New businesses with better ideas that operate more efficiently gain ground at the expense of older ones with stale ideas that operate less efficiently.
The phenomenon of creative destruction also rings out in other spheres of thinking. Robert Pirsig, who became famous for his philosophical ponderings in Zen and the Art of Motorcycle Maintenance, touched on the notion in his follow-up book, Lila.
In that book, Pirsig introduces a concept he calls Dynamic Quality. According to him, “What makes the marketplace work is Dynamic Quality.” As he elaborates, "the free market makes everybody richer by preventing static economic patterns from setting in and stagnating economic growth." In short, this sounds like another take on the theme of creative destruction.
This idea was also taken up recently by George Gilder in his new book, Knowledge and Power: The Information Theory of Capitalism and How it is Revolutionizing our World. As Gilder puts it, "The key to economic growth is not acquisition of things by the pursuit of monetary rewards but the expansion of wealth through learning and discovery. The economy grows … by accumulating surprising knowledge through the conduct of falsifiable experiments of free enterprises."
According to the information theory model, information is created through economic activity and transmitted through the various channels of the economic landscape. Once again, we have a framework that sounds a lot like creative destruction.
Gilder’s approach is interesting also because it clearly identifies an important potential obstacle to the process of economic growth. As he describes, "The most common and destructive source of noise, however, is precisely the institution on which we most depend to provide a clear and stable channel in the first place. When government either neglects its role as guardian of the channel or, worse, tries to help by becoming a transmitter and turning up the power on certain favored signals, the noise can be deafening."
While Gilder makes little effort to hide his political leanings, this is a risk endemic to evaluating economic theories which inevitably also intersect with political ideologies. Nonetheless, it is difficult to reject on an intellectual basis the notion that new information and ideas are good or that clear channels are the best way for them to be transmitted. As such, it is striking the degree to which many institutions are actively pursuing policies in direct contradiction to the theory.
Regardless of whether the issue is the debt ceiling, the Fed's quantitative easing program, or something else, the inflammatory rhetoric surrounding these issues is making the economy's information channels extremely noisy right now. Insofar as noisy channels reduce the efficiency and accuracy of messages sent (think bad cell phone connections), political squabbling is directly worsening the conditions for economic growth.
For now this is the world we live in and we must manage to it. The good news is that there is a useful model for how to move things forward. The challenge is that we have to find a way to follow the model. Until we do, it is quite likely that the process of creative destruction, and ultimately economic growth, will be a quite a bit slower than any of us would like.
Business Update
One of the goals I have always had is to make Arete's work as accessible as possible for investors. Part of the goal is to make it cheap and easy to do basic research on Arete, its research process, and value proposition. These things shouldn’t require a great deal of effort or be shrouded in mystery. I hope the contrast with many large fund families will be obvious.
Part of the goal has also been to make Arete’s commentary and insights available for better understanding and ultimately resolving investment challenges. I know I have lots of sources of data and commentary as an analyst, but precious few sources that I can really trust. Lots of companies sell “products” and encourage “transactions”. In contrast, I want Arete to help improve client outcomes; I want you to be better off.
In particular, one significant technology implementation I completed at the end of the summer was a refreshing of the Arete website. The primary objective of the project was to make the content, most in the form of newsletters, much more accessible to interested parties. Now, all past newsletter content is easily accessible to major search engines and can also be searched within the Arete website. Before, this content resided in pdfs which made it difficult to home in on specific topics.
My hope is that the aggregation of these articles will make it a lot more useful as a research source and a knowledge base. If a specific issue comes up and you'd like to pull up past comments, it's extremely easy to do. Whether you're doing work on "valuation", "proxies", some other issue, or just want to delve deeper into Arete's thinking, the latest refinements will make it really easy for you.
Of course I also have a goal of growing Arete and one of the best ways I can do that is by establishing my expertise. I try to do that through my writing in the newsletters and I try to do that through my other communications with investors. I hear from many people that they would like to have better and more trusted sources of information so they can get more confident in their investing. This is one of many efforts to address that demand.
While I see the website as a valuable and cost-effective way to share investment insights with people, I have no intention of stopping there. If you find Arete's material useful and would like to discuss how to employ it more broadly, let’s talk. As an independent business owner, I have a great deal of flexibility in talking to individuals or groups, presenting investment topics, and considering anything else that may make sense.
Finally, if you get a chance, please let me know what you think of the new website format. I don't do things like this as academic exercises; I do them to try to help investors. If there is a tweak here or there that could make it a lot more useful, I'd love to hear it. If there are larger issues that make it cumbersome; I'd like to hear that too. It doesn't do Arete any good if we're not helping people out.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
After a brief glitch in the market at the end of the second quarter, stocks quickly resumed their upward trajectory in the third quarter. Markets had initially been spooked by the prospect of the Fed tapering its quantitative easing (QE) program, but Fed governors responded quickly to the commotion by talking down the prospect of reducing monetary assistance.
So the story goes and so it has gone for the last three years. If the economy slows down, throw some money at it. Voila. Threat of a Eurozone crisis? Throw some money at it. Declining labor force participation? Throw some money at it. We've documented a number of times now how this progression has led to an ever greater disparity between economic fundamentals and stock prices, so we won't repeat that exercise here. Make no mistake, though, the divergences continue to grow ever larger.
What we can do is try to understand the mechanisms generating the stock market reactions and to evaluate their implications. In this regard, Ben Hunt from Epsilon Theory has done some very nice work weaving game theory and history into a perspective on behavioral economics.
According to his analysis, "Like all effective Narratives it's simple: central bank policy WILL determine market outcomes." In addition, “Like all effective Narratives it has a great deal of ‘truthiness’ … it rings true to our intellect even as it appeals to our emotions.”
As Hunt clarifies, though, "But here’s the crucial point … whether these opinion-leaders and Narrative creators thought open-ended QE was a wonderful thing or a terrible thing, they ALL agreed that Fed policy had been responsible for the current stock market level.”
Insofar as investors buy into the Narrative, then, it doesn’t matter whether they believe policy is good or bad. According to the Narrative, the rational action is to keep buying stocks.
In fact, many retail investors have done just that. As noted in a recent article entitled "Investors flock to high-yield bonds and stocks" in the Financial Times, "Equity funds saw their biggest weekly inflows on record, according to Bank of America Merrill Lynch, with $25 bn sent largely into exchange traded funds."
In one sense, it is easy to intellectualize this course of action. Debt costs are extremely low and the Fed has committed itself to preventing any major disaster. Given these facts, and according to this logic, it is either silly or complacent to NOT leverage up and buy stocks. Indeed, record high margin debt indicates this is precisely what a number of market participants are doing.
Further, this isn't even really a decision for many participants; it is an automatic response. For managers that depend on gathering assets, managers in publicly owned companies that need to show increasing earnings, people worried they might get fired if they don’t keep up, and large banks that can make more money buying market futures on their proprietary trading desks than from making loans, there isn’t a decision to make. They have to participate. These groups create a self-reinforcing loop which feeds momentum and keeps stocks headed higher. Nothing much has changed in five years.
Of course an investor can take a different course of action by challenging the veracity of the Narrative of the "All powerful Fed". The logic behind this course of action is that Narratives are inherently fragile and eventually will crumble. Hunt clearly warns, “Still, the assignment of value to any symbolized asset [stocks in this case] is inherently a social construction and will inevitably change over time, occasionally in sharp and traumatic fashion.”
It’s hard to say what the proximate cause of a change in Narrative might be, but there are a lot of candidates. Higher interest rates could seize up a number of businesses and we have already seen this happen with residential mortgages. There are still plenty of opportunities for sovereign debt crises, Eurozone issues, and war erupting in Syria or any number of other places. In addition, something as mundane as an especially weak quarter of revenue or earnings growth could finally break the Narrative. When it does break, there is a long way for stocks to fall in order to reach attractive valuations.
Both paths have their challenges. If you follow the Narrative, you do fairly well for a while, but face ever increasing risks of significant losses at some indeterminate point in time. If you resist the Narrative, you wait some indeterminate period of time for the Narrative to break and then you need to be nimble enough to buy stocks cheaply during whatever window of opportunity presents itself afterwards.
Neither position is strikingly attractive. Both depend significantly on good timing which is virtually impossible to develop a reliable process around. Arete has opted for the latter largely because it is more amenable to valuation discipline.
Nonetheless, the Fed’s policy of quantitative easing has certainly changed the nature of the investment proposition for everyone. As one strategist remarked, “There may be no buy and hold assets for the next ten years.” If true, this would imply lower returns and higher risk — important variable changes for the retirement equation.
Although we don’t follow other managers closely and certainly don’t try to emulate their investment decisions, we do pay attention to a handful of managers for whom we have a great deal of professional respect in order to gain insights and perspective.
One of these, the hedge fund, Baupost Group, recently announced it was returning capital to investors by the end of the year. Baupost covers all major asset classes around the world and determined it didn’t see enough attractive opportunities to invest capital its clients had already given it. This decision powerfully underscores the many challenges in the current investment environment.
When your eyes are open to a theme, it's amazing how often you see it. One of the theme's that has always driven Arete is that of creative destruction.
This theory was espoused by Joseph Schumpeter and describes how an economy actually grows — not as one monolithic entity plodding forward, but as a diverse group of businesses competing for prominence. New businesses with better ideas that operate more efficiently gain ground at the expense of older ones with stale ideas that operate less efficiently.
The phenomenon of creative destruction also rings out in other spheres of thinking. Robert Pirsig, who became famous for his philosophical ponderings in Zen and the Art of Motorcycle Maintenance, touched on the notion in his follow-up book, Lila.
In that book, Pirsig introduces a concept he calls Dynamic Quality. According to him, “What makes the marketplace work is Dynamic Quality.” As he elaborates, "the free market makes everybody richer by preventing static economic patterns from setting in and stagnating economic growth." In short, this sounds like another take on the theme of creative destruction.
This idea was also taken up recently by George Gilder in his new book, Knowledge and Power: The Information Theory of Capitalism and How it is Revolutionizing our World. As Gilder puts it, "The key to economic growth is not acquisition of things by the pursuit of monetary rewards but the expansion of wealth through learning and discovery. The economy grows … by accumulating surprising knowledge through the conduct of falsifiable experiments of free enterprises."
According to the information theory model, information is created through economic activity and transmitted through the various channels of the economic landscape. Once again, we have a framework that sounds a lot like creative destruction.
Gilder’s approach is interesting also because it clearly identifies an important potential obstacle to the process of economic growth. As he describes, "The most common and destructive source of noise, however, is precisely the institution on which we most depend to provide a clear and stable channel in the first place. When government either neglects its role as guardian of the channel or, worse, tries to help by becoming a transmitter and turning up the power on certain favored signals, the noise can be deafening."
While Gilder makes little effort to hide his political leanings, this is a risk endemic to evaluating economic theories which inevitably also intersect with political ideologies. Nonetheless, it is difficult to reject on an intellectual basis the notion that new information and ideas are good or that clear channels are the best way for them to be transmitted. As such, it is striking the degree to which many institutions are actively pursuing policies in direct contradiction to the theory.
Regardless of whether the issue is the debt ceiling, the Fed's quantitative easing program, or something else, the inflammatory rhetoric surrounding these issues is making the economy's information channels extremely noisy right now. Insofar as noisy channels reduce the efficiency and accuracy of messages sent (think bad cell phone connections), political squabbling is directly worsening the conditions for economic growth.
For now this is the world we live in and we must manage to it. The good news is that there is a useful model for how to move things forward. The challenge is that we have to find a way to follow the model. Until we do, it is quite likely that the process of creative destruction, and ultimately economic growth, will be a quite a bit slower than any of us would like.
Business Update
One of the goals I have always had is to make Arete's work as accessible as possible for investors. Part of the goal is to make it cheap and easy to do basic research on Arete, its research process, and value proposition. These things shouldn’t require a great deal of effort or be shrouded in mystery. I hope the contrast with many large fund families will be obvious.
Part of the goal has also been to make Arete’s commentary and insights available for better understanding and ultimately resolving investment challenges. I know I have lots of sources of data and commentary as an analyst, but precious few sources that I can really trust. Lots of companies sell “products” and encourage “transactions”. In contrast, I want Arete to help improve client outcomes; I want you to be better off.
In particular, one significant technology implementation I completed at the end of the summer was a refreshing of the Arete website. The primary objective of the project was to make the content, most in the form of newsletters, much more accessible to interested parties. Now, all past newsletter content is easily accessible to major search engines and can also be searched within the Arete website. Before, this content resided in pdfs which made it difficult to home in on specific topics.
My hope is that the aggregation of these articles will make it a lot more useful as a research source and a knowledge base. If a specific issue comes up and you'd like to pull up past comments, it's extremely easy to do. Whether you're doing work on "valuation", "proxies", some other issue, or just want to delve deeper into Arete's thinking, the latest refinements will make it really easy for you.
Of course I also have a goal of growing Arete and one of the best ways I can do that is by establishing my expertise. I try to do that through my writing in the newsletters and I try to do that through my other communications with investors. I hear from many people that they would like to have better and more trusted sources of information so they can get more confident in their investing. This is one of many efforts to address that demand.
While I see the website as a valuable and cost-effective way to share investment insights with people, I have no intention of stopping there. If you find Arete's material useful and would like to discuss how to employ it more broadly, let’s talk. As an independent business owner, I have a great deal of flexibility in talking to individuals or groups, presenting investment topics, and considering anything else that may make sense.
Finally, if you get a chance, please let me know what you think of the new website format. I don't do things like this as academic exercises; I do them to try to help investors. If there is a tweak here or there that could make it a lot more useful, I'd love to hear it. If there are larger issues that make it cumbersome; I'd like to hear that too. It doesn't do Arete any good if we're not helping people out.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
After a brief glitch in the market at the end of the second quarter, stocks quickly resumed their upward trajectory in the third quarter. Markets had initially been spooked by the prospect of the Fed tapering its quantitative easing (QE) program, but Fed governors responded quickly to the commotion by talking down the prospect of reducing monetary assistance.
So the story goes and so it has gone for the last three years. If the economy slows down, throw some money at it. Voila. Threat of a Eurozone crisis? Throw some money at it. Declining labor force participation? Throw some money at it. We've documented a number of times now how this progression has led to an ever greater disparity between economic fundamentals and stock prices, so we won't repeat that exercise here. Make no mistake, though, the divergences continue to grow ever larger.
What we can do is try to understand the mechanisms generating the stock market reactions and to evaluate their implications. In this regard, Ben Hunt from Epsilon Theory has done some very nice work weaving game theory and history into a perspective on behavioral economics.
According to his analysis, "Like all effective Narratives it's simple: central bank policy WILL determine market outcomes." In addition, “Like all effective Narratives it has a great deal of ‘truthiness’ … it rings true to our intellect even as it appeals to our emotions.”
As Hunt clarifies, though, "But here’s the crucial point … whether these opinion-leaders and Narrative creators thought open-ended QE was a wonderful thing or a terrible thing, they ALL agreed that Fed policy had been responsible for the current stock market level.”
Insofar as investors buy into the Narrative, then, it doesn’t matter whether they believe policy is good or bad. According to the Narrative, the rational action is to keep buying stocks.
In fact, many retail investors have done just that. As noted in a recent article entitled "Investors flock to high-yield bonds and stocks" in the Financial Times, "Equity funds saw their biggest weekly inflows on record, according to Bank of America Merrill Lynch, with $25 bn sent largely into exchange traded funds."
In one sense, it is easy to intellectualize this course of action. Debt costs are extremely low and the Fed has committed itself to preventing any major disaster. Given these facts, and according to this logic, it is either silly or complacent to NOT leverage up and buy stocks. Indeed, record high margin debt indicates this is precisely what a number of market participants are doing.
Further, this isn't even really a decision for many participants; it is an automatic response. For managers that depend on gathering assets, managers in publicly owned companies that need to show increasing earnings, people worried they might get fired if they don’t keep up, and large banks that can make more money buying market futures on their proprietary trading desks than from making loans, there isn’t a decision to make. They have to participate. These groups create a self-reinforcing loop which feeds momentum and keeps stocks headed higher. Nothing much has changed in five years.
Of course an investor can take a different course of action by challenging the veracity of the Narrative of the "All powerful Fed". The logic behind this course of action is that Narratives are inherently fragile and eventually will crumble. Hunt clearly warns, “Still, the assignment of value to any symbolized asset [stocks in this case] is inherently a social construction and will inevitably change over time, occasionally in sharp and traumatic fashion.”
It’s hard to say what the proximate cause of a change in Narrative might be, but there are a lot of candidates. Higher interest rates could seize up a number of businesses and we have already seen this happen with residential mortgages. There are still plenty of opportunities for sovereign debt crises, Eurozone issues, and war erupting in Syria or any number of other places. In addition, something as mundane as an especially weak quarter of revenue or earnings growth could finally break the Narrative. When it does break, there is a long way for stocks to fall in order to reach attractive valuations.
Both paths have their challenges. If you follow the Narrative, you do fairly well for a while, but face ever increasing risks of significant losses at some indeterminate point in time. If you resist the Narrative, you wait some indeterminate period of time for the Narrative to break and then you need to be nimble enough to buy stocks cheaply during whatever window of opportunity presents itself afterwards.
Neither position is strikingly attractive. Both depend significantly on good timing which is virtually impossible to develop a reliable process around. Arete has opted for the latter largely because it is more amenable to valuation discipline.
Nonetheless, the Fed’s policy of quantitative easing has certainly changed the nature of the investment proposition for everyone. As one strategist remarked, “There may be no buy and hold assets for the next ten years.” If true, this would imply lower returns and higher risk — important variable changes for the retirement equation.
Although we don’t follow other managers closely and certainly don’t try to emulate their investment decisions, we do pay attention to a handful of managers for whom we have a great deal of professional respect in order to gain insights and perspective.
One of these, the hedge fund, Baupost Group, recently announced it was returning capital to investors by the end of the year. Baupost covers all major asset classes around the world and determined it didn’t see enough attractive opportunities to invest capital its clients had already given it. This decision powerfully underscores the many challenges in the current investment environment.
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