As distasteful as the level of polarization has become in the political arena, it seems to be metastasizing to other areas of our lives as well. The dismal performance of stocks at the end of last year followed by equally spectacular performance in the latest quarter serves as a nice illustration of the increasing presence of extreme opposites.
Often, polarization occurs along ideological or philosophical lines. Increasingly, however, polarization is also occurring along the dimension of fantasy versus reality. While there are always elements of complacency and exuberance at the end of a business cycle that cause future views to become untethered from reality, the depth and breadth of opposite extremes are deeper and more fundamental today.
One area where extreme differences are becoming quite visible is in corporate leadership. This probably shouldn't be too surprising since running a large company is a quasi-political exercise anyway. On one extreme is the approach of pursuing brutal efficiency. On the other is the approach of creating a spectacular new vision for the future.
The formula for success for the efficiency approach is to provide products faster, cheaper and more reliably. Walmart exemplified this approach in the retail business by leveraging economies of scale to drive down purchasing and distribution costs and by aggressively deploying information and automation systems to improve logistics. More recently Amazon has applied the principles of efficiency to the online realm and Kraft Heinz (KHC) developed the zero-based budgeting (ZBB) methodology (which has become a de facto standard) for keeping costs down in the food industry.
The formula for creating a spectacular new vision tends to focus much more on innovation and growth opportunities and not so much (or at all) on costs or profits. The key challenge in these cases is to overcome lack of imagination. Not surprisingly, the approach is incorporated by many tech and biotech firms.
As Izabella Kaminska reports in the Financial Times [here], such companies often try to convey their values of vision and open-endedness by way of creating unusual titles for corporate leaders. She notes, "Where preposterous titles in the past concentrated on over-defining job roles in excruciating detail, today's vogue is for exactly the opposite. The more ambiguous, meaningless and mystical, the better."
For example, back in the mid-1990s, at the very beginning of the internet boom, Jerry Yang started a trend by proclaiming himself, "Chief Yahoo". At the time it really was quirky, charming, and indicative of a new era. The unusual move successfully conjured an impression of edginess and innovativeness.
No longer, however. Kaminska claims, "Today's job abstractionism doesn't feel progressive, forward-thinking or scientific." She adds, "And that is the problem: wishy-washy roles encourage wishy-washy thinking, which distracts leaders and investors from the realities at hand. The corporate world would be much better off with more chief critical thinking officers ready to speak truth to power rather than fanning it further." Indeed, such abstractions seem to encourage abstraction from reality more than anything.
But the efficiency paradigm clearly has its own shortcomings as well. When KHC reported its fourth quarter earnings, Almost Daily Grants (February 22, 2019) described the results as "calamitous". Not only did revenue barely grow and margins collapse, but asset impairment charges and regulatory scrutiny revealed serious missteps. Too often, it seems, the goal of efficiency can simply be a euphemism for cutting corners.
The phenomenon of extreme differences is also increasingly appearing in financial numbers, which are the life blood of markets. Andrew Smithers conducted research on the usefulness of accounting numbers and his work was summarized by Jonathan Ford [here].
Smithers' compared corporate after tax profits from US national accounts (NIPA) with the reported earnings of the S&P 500 and noted that "In the decades from 1947-57 to 1992-2002, the volatility of the two series is very similar". However, he also observed, "in more recent years, there has been a big divergence. After 1992-2002, the profits published by quoted companies have been five times more volatile than those in the national accounts." The interpretation Smithers suggests that "corporate data now provide worse information than before."
Normally, lower quality information gives investors pause and valuations would be trimmed accordingly. Not so in this environment. Now, the response to degraded financial information is to use even poorer financial information. Ford reports: "The ironic consequence of all this is that investors increasingly rely on non-Gaap numbers for valuation. These are not only idiosyncratic, and thus not always capable of comparison, they are also devised by bosses whose views may well be richly coloured by their own outsize incentives."
Henny Sender highlights some prominent examples of "unusual measures of corporate performance" [here]. Specifically, she mentions "gross merchandise value" as a metric commonly used by e-commerce firms and "community adjusted" earnings which is a controversial metric recently introduced by WeWork.
The potential to create a very misleading impression of financial condition with alternative metrics was the subject of a report on the cloud software industry in the FT's Alphaville [here]. The article highlights the fact that the average free cash flow margin for the cloud companies is 8.6% which is impressive. However, that margin falls to a far less impressive -0.6% when the real expenses of stock compensation are included.
At the end of the day, alternative metrics like these are better designed to tell stories than to provide information content. Sender notes, rightly, that such alternative measures "are no substitutes for profits or a path to them." As the Alphaville report also points out, however, "Investors don't seem to care that much."
Extreme differences are also becoming increasingly evident in the realm of economics and public policy. While these fields have always invited ideological differences, more recently a gap has developed along a different dimension. One extreme advocates for bold policy intervention and has little concern for unintended consequences. The other extreme seeks to understand problems in order to diagnose them accurately and address them constructively.
The first camp is captured well by Larry Summers and his thesis of "secular stagnation". He recently wrote an essay for the Brookings Institution with Lukasz Rachel that Grants Interest Rate Observer (March 22, 2019) summarized: "Today's low interest rates constitute a clarion call for even more aggressive government intervention." In addition, "if towering government deficits fail to do the trick, the theorists would force still lower interest rates, more QE down the throat of the body politic. Anything but nothing is their policy prescription ..."
The second camp is exemplified by economists Atif Mian and Amir Sufi, authors of the book, House of Debt. They decided to write the book because they found that the predominant "bank-lending" view of the economy failed to explain several important aspects of the financial crisis. More recently, Mian and Sufi (along with Ernest Liu) took up the anti-establishment mantle again [here] by presenting "an alternative interpretation of 'secular stagnation'."
While they acknowledge, "a lower interest rate is [traditionally] viewed as expansionary for the production side of the economy," they don't stop there. They also find: "A reduction in long-term interest rates tends to make market structure less competitive within an industry. The reason is that while both the leader and follower within an industry increase their investment in response to a reduction in interest rates, the increase in investment is always stronger for the leader. As a result, the gap between the leader and follower increases as interest rates decline, making an industry less competitive and more concentrated."
The analysis by Liu, Mian, and Sufi contrasts with more conventional analyses for several reasons. One is that rather than focusing exclusively on the consumer/demand side of the equation, it also considers the production/supply side of the equation. In doing so, it also goes to lengths to model production realistically, i.e., by explicitly accounting for competition. Finally, it also links the effects of lower rate policies (favored by the secular stagnation camp) to lower aggregate productivity growth. In other words, Liu, Mian and Sufi demonstrate that aspects of current economic policy actually exacerbate the problems it is supposed to solve.
The emergence of these examples of extreme differences begs a number of questions. Why this is happening? Why are views diverging rather than converging over time? Why are people gravitating to ever-more fantastic claims at the expense of accepting reality?
One possible, partial explanation is the growing level of abstraction that technology has created from real processes and things. Online shopping, online payment systems, and streaming entertainment are all widely used services that distance consumers from the real efforts that go into making them work.
A similar idea was hinted at in an FT report on video games [here] that revealed how virtual reality is increasingly penetrating into our everyday worlds. Herman Narula, chief executive of Improbable, a London-based start-up, noted, “I would go as far as to say [gaming] is the single most important thing happening right now in our culture". Reed Hastings, head of Netflix, effectively corroborated the claim when he stated, “We compete with (and lose to) Fortnite more than HBO."
Narula has an especially good vantage point from which to make his assessment; his firm makes simulation technology to create “virtual worlds” in games and other applications. In terms of what the future holds, he goes even further: “It’s [gaming is] going to change the way we make money and relate to each other and form our most important relationships."
While technology-enabled abstraction goes some way to explaining the increasing acceptance of fantasy over reality, it doesn't explain why polarization is increasing. For that, Ben Hunt provides useful perspective [here]. He describes the political landscape that is increasingly dominated by political extremes as a "widening gyre".
He goes on to explain, in weightier language: "This is the breaking of mediative and cooperation-possible political institutions and practices, and their replacement by non-mediative and cooperation-impossible political institutions and practices. This is what it looks like, in a modern Western context, when things fall apart."
This didn't just happen; it has been gradually worsening for years. As Hunt describes, "we have long forgotten the horrors of literal war and why we constructed these cooperatively-oriented institutions in the first place." In short, "We got soft." Without fresh memories of the atrocities of war to serve as reminders of the costs of not cooperating, we gradually lose our will to exert the effort to work together.
A parallel exists for understanding the widening gap between fantasy and reality. In the absence of a recession in the last ten years, many people may have forgotten how painful an economic downturn can be and how punishing the market can be when extravagant growth expectations evaporate.
Regardless of the causes, the increasing presence of extreme opposites in many spheres of our lives has significant implications for the investment landscape. Notably, it is louder, more acrimonious and more unsettled.
As Janan Ganesh describes [here], "The problem in western democracies is not mass confusion about points of fact. The problem is that, even when apprised of the facts, even when exposed to the most objectively persuasive arguments, millions of voters remain unmoved. In a blurring of the line between politics and sport, they have picked their team, and that is that." To put hopes for progress in "technical reform", he instructs, is to "rather downplay the psychological depth of what is going on."
Ganesh speaks of politics, but the same dynamics are at play in economics and public policy and other areas as well. It is not that there aren't smart people or great ideas (there are); it is that such ideas can't get sufficient popular support to effect change in a "widening gyre". In other words, it is not fair to expect that problems will get resolved by reasonable people just sitting down and hashing them out.
Given this unsavory mixture of opposite extremes, how can long-term investors best manage through it all?
One obvious immediate possibility is simply to resist the temptation to increase exposure to risk assets. It may not be fun to wait on the sidelines (at least in the first quarter) but it doesn’t mean you’re wrong either. Look around the investment landscape and the people who are most conservative in this regard are generally those who have the most skin in the game. Those who are managing their own money, those who don’t believe someone will bail them out if things go wrong, and those who are most accountable, are far less inclined to buy into current market prices than others. The $100+ billion in cash that Warren Buffett has at Berkshire Hathaway serves as a powerful beacon for patience.
Perhaps the easiest course of action is to just go ahead and join the fray in order to participate in rising markets. You don't have to buy into fantastic growth claims or believe in the strength of fundamentals to rationalize such a course. All you really have to believe is that monetary authorities are committed to keeping stock prices inflated and that enough other investors will also pursue a similar course to keep the momentum marching along.
This course involves a number of implications, however, each of which has non-trivial consequences. First, as much as major central banks may want to support asset prices, they have only limited ability to do so. Valuations can be thought of as a natural force like gravity. The longer they stay aloft, the more likely it is they will eventually fall back down to earth. Performance in the fourth quarter of 2018 was a vivid reminder of this.
Another implication is that the act itself of chasing growth stocks that benefit disproportionately from low rates can aid in retarding the economy. If Liu, Mian, and Sufi are anywhere close to being correct in linking low rates with more concentrated industries and lower productivity growth, then anything that facilitates the continuation of artificially low rates also promotes lower economic growth, whether intentional or not.
There is also a third way. If you believe authorities will continue to succeed in supporting asset prices and don’t want to or can’t afford to resist exposure entirely, then it may make sense to have long positions in broad markets, but short (or underweight) positions in individual securities. “Points of fact” tend to matter a lot more for individual stocks than for major indexes in this environment.
One exercise I regularly conduct is to determine economic returns, infer market-implied growth rates from current prices, and compare these with fundamental business conditions in order to identify stocks that may be vulnerable to a sharp selloff. Interestingly, more and more short/avoid ideas are hitting the radar.
In conclusion, the depth and breadth of opposite extremes, including a widening gap between fantasy and reality, is worse today than it has been historically. Investors should be forewarned that under these conditions, opposites don't attract; they grow even further apart. As a result, investors face an unattractive set of choices and are going to have to work harder than ever to ensure their goals are met.