This article was written by Nicholas Mitsakos : Chairman and CEO at Arcadia Capital Group.
Inflation, Predictions, Disruptions, and Not Really Knowing Anything.
Economic predictions have always been highly variable and uncertain, and, for some reason, relied upon as if the future were a magical algorithm. Essentially, economists would make one fundamental mistake. They thought they were practicing a science. Data could be collected, inputted, and a predictive algorithm could be generated. Even Nobel Prize winners like Paul Samuelson believed that with enough data we could come to understand the economy and how it functioned.
This is nonsense. As Daniel Kahneman and Amos Tversky have shown us, human behavior and irrationality, combined with unpredictability and randomness (thank you Naseem Taleb) make this even a questionable social science. Using existing analysis and algorithms to reliably forecast is a fool’s errand, essential for someone’s tenure, and maybe even a Nobel Prize, but doesn’t add much that is useful. Some of the more laughable Nobel Prizes have been given to people who determined that markets were efficient. They are not. Economies can be predicted with useful data input. They cannot. A couple of inputs about inflation and the unemployment rate, and we know how to manage an economy. We can’t. That last one is the Philip’s Curve – true for a limited time and then it goes spectacularly wrong – a lot like most risk and market prediction models.
Essentially, an economist is a portfolio manager who is not accountable, never makes an investment, nor leaves any historical record. Except for John Maynard Keynes, who understood quite well the shortcomings of economic theory and embraced the randomness and uncertainty of the economy and the irrationality of the market, and therefore could be a good investor, no well-known economist (or TV pundit) is actually a successful investor. All those predictive models proved useless, especially by those who espouse them.
While it is more reasonable to say, “I have no idea what the future holds, nor do I recognize what the critical inputs are that should be measured,” that is not going to get anybody a book deal, or hired in academia, or get anyone to pay exorbitant fees for “insightful” predictions.
The Future Matters
But every investor’s success is determined by what happens in the future. Having a perspective about it, and making economic bets, and allocating a portfolio toward that outcome is essentially what an investor does. Success, a career, and often wealth, are determined by an ability to do this. Or, perhaps more accurately, one can look for short-term “trainwrecks” that will ultimately correct themselves (ala Warren Buffett or Howard Marks) or look for long-term trends based more on emotion and optimism (Paul Tudor Jones, and anything that might be labeled a “disruptive” technology – current examples include Cathy Woods at ARK).
Investment success depends on successfully predicting the future. Since the tech bubble burst in 2000, understanding the direction of the economy, the actions of the Federal Reserve and Treasury, world economic events, and other economic and fiscal policies that impact markets and economies globally (such as the financial crisis in 2008) are challenging (to say the least). Yet, the combined challenge of understanding what is going on and successfully predicting outcomes, and then allocating a portfolio based on that is almost insurmountable, but also inescapable and essential.
Disruption Means Uninterrupted Profit, Doesn’t It?
It also can mean substantial loss. What is often forgotten about “creative destruction” is that, while one can profit handsomely from creation, there is also destruction. Upheaval, sometimes dramatic, can create extraordinary opportunities, as well as irreparable harm (Netflix versus Blockbuster).
Essentially, important sectors can be disrupted via technological innovation, but the investment choice is not on the innovation, and not against the legacy companies. It is a choice of companies implementing innovation for competitive advantage. It is not simply technological advancement versus laggards. It is dedication and focus to use innovation as a competitive weapon.
The industry that is disrupted matters. As discussed in “Being Digital,” when content can be created, distributed, and consumed globally, it disrupts significant business models, including all the infrastructure and economic models currently in existence. But, the so-called “laggards” can find a way to innovate within this disruption. A good example is the music industry. It suffered tremendous disruption, but the major music labels who were dinosaurs 10 years ago are now profitable and growing. Understanding what needs to be destroyed along with what needs to be created or modified are the more important decisions.
Disruption in finance is creating the vanguard of this very same thing. Companies are receiving substantial valuations simply because they are participating in an area of tremendous innovation, such as decentralized finance and blockchain-based businesses, but this is not what will ultimately define success. Success is a sustainable business model with a competitive advantage – that metric never changes. The world is too random and unpredictable. Relying on a single technology for a short-term “flash” in valuation is not sustainable. Real business models matter.
Investors need to think like successful business people. What is my competitive advantage, and how can I sustain it? Focusing on a large and growing industry is a good start, but while that is necessary, it is not sufficient. Understanding what will be valuable in the long term – predicting the future – is what matters. This is usually too difficult a challenge. Great minds are trying to think about how to predict all sorts of things and are failing miserably.
Whatever You Think, Say It Loudly.
Captain Obvious Strikes Again
“Just read a few articles about inflation and central-bank policy, and you will understand that people can quite authoritatively tell you what just happened, and they also have no idea what’s going to happen. The loudest and more assertive predictions are sure to be the most incorrect.”
It Matters What Other People Think
One of the follies of “value investing” (by the way, all investing is “value investing.” When was the last time anyone tried to invest and not capture an increase in value, believing that what they were purchasing was underpriced? – so much for the jargon) is that there is a belief that what I think is all that matters, and is also what will occur. This is self-centered nonsense. As John Maynard Keynes pointed out:
“if you are trying to predict the outcome of a beauty contest, the person you think will win is not what matters. It’s the person you think most of the other people will vote for. That’s how you pick a winner.”
The same is true in the markets. I know economic thinking does not like to hear this, because economists believe they can simply use a formula to pick a winner regardless of what the rest of the market thinks, but this is usually a losing strategy. What the rest of the market thinks is what matters. It determines price, growth, and liquidity. Your personal opinion is quaint, but not useful.
Bet against irrationality all you want, you will lose. As George Soros pointed out, the market is “Reflexive,” meaning that the actions we as individuals take with investment choices impact the market and how the market moves, and that movement impacts future investment choices we make, and so on. The modern terminology that captures this for both businesses and investment is the “Closed Loop.” Once we realize that our decisions are in a Closed Loop (our actions impact investment and that impacts its value, and that impacts our future actions, etc.), and those that are in a virtuous Closed Loop will spiral up in value. Examples include companies like Amazon and Apple, or an investment portfolio focusing on sustainable technological innovators.
Important and Knowable.
Any information, to be useful, must be something that can be measured and predicted. Or as Warren Buffett put it, “important and knowable.” Unfortunately, the most important information is extremely challenging to both measure and predict. One reason why investors don’t perform above an average index (it is an average so it’s a tautology to say that most people won’t perform above the average – one of the other lies that come from statistics) is that investments are based on little more than hopeful prediction and anachronistic measurement. Warren Buffett has been a very successful investor in his early years because he looked at “trainwrecks” and was able to effectively buy assets quite cheaply and produce fantastic returns. But, since 1995, he has not performed any better than the S&P 500 index. That is hardly investment genius and is not an indication of anyone whose predictions should be relied upon for superior performance.
In other words, it’s very easy to be right if you essentially focus on the consensus – the overall market index measurement – because that doesn’t require work or challenging forecasting. You have no competitive advantage implementing whatever knowledge or predictive model you have. That is why investors earn average returns, regardless of one’s reputation.
Agnosticism is the Wiser Choice
You still don’t know what you’re talking about.
Most investment successes have taken many people by surprise. It’s only looking backward that we can connect the dots. What should have been “obvious” while it was happening is never obvious, and it is only with hindsight that we piece together what occurred. Then, with this newfound “insight” it is hoped that a clear algorithm for success can now be applied to new situations. It cannot because this is nonsense.
Ignore both “Captain Obvious” and “Captain Hindsight” because none of their perspectives or insights are useful to make any successful prediction. Things are “obvious” and clear with “hindsight” but none of that input is meaningful for predicting the future.
Most forecasts are unhelpful and consensus around predictions is a useless tool or inconsequential perspective. These inputs are mostly useless.
“Mostly harmless means you are harmful. Mostly useless means you are destructive.” Douglas Adams
Mostly useless means there is no actionable item that is unique. One thing innovative successful companies do is create an actionable and unique product or service that distinguishes them from their competition, and that distinction remains an advantage, and management sustains that advantage over time. The same is true with any investor. In this case, the advantage is knowing that randomness, unpredictability, and the inability to identify all the important factors will impact the value of any investment – and then plan for that without bias.
“You don’t know what the future holds, and being agnostic about it is much wiser than the self-delusion of thinking that you know what is going on and can therefore predict what will happen.”
One of the funniest things one can ever hear at a cocktail party is “I’m a futurist.” You might as well simply say you are a self-deluded fool tricking people into thinking you know something that you don’t because you can simply say absurd things based on connecting dots that you fabricate and sell to others. More charitably, greater minds have put it more succinctly:
“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what’s going on.”
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
“Stimulus and Silliness” discussed the overcompensation by central banks and governments to the economic impact of the pandemic. Over the last 16 months, the Fed, Treasury, and Congress have used a firehose of money to support, subsidize, and stimulate workers, businesses, state and local governments, the overall economy, and the financial markets. The result, unsurprisingly, is confidence in a strong economic recovery, skyrocketing asset prices, and fear of rising inflation.
We have labeled this “Silliness” and these actions would typically result in both strong economic growth and higher profits, along with a tighter labor market and higher wages. Therefore, inflation would increase and the Fed would, by necessity, raise interest rates. The rise in interest rates would dramatically and negatively impact many asset values, especially the high-growth, innovative, and “disruptive” companies whose valuations depend on cash flows generated long into the future, and an increase in interest rates would dramatically and negatively impact the present value of these investments.
This series of events ought to harm asset values. This one is a layup in the world of predictions. But, this prediction would be wrong so far (not that it’s going to remain wrong, it’s just that the timing and extent of any impact are uncertain). The uncertainty and inability to predict with accuracy the outcome from these inputs make for even greater investment risk. This is where being an agnostic is a powerful tool. Experience teaches us that there should be runaway inflation, but there is not. Historical data, based on the long-trusted Phillips Curve, have proven illusory and ineffective in predicting both interest rates and employment.
US inflation is low, and any increase in inflation is seen as transitory and unsustainable. The market certainly believes this inflation is transitory because the 10-year Treasury is that 1.22% – a drop from 1.74% from six months ago. Yet, topline inflation data have shown price rises above 3% and more inflation on the immediate horizon. The long-term prospects for interest rates should be just the opposite. But they are not.
Should we care, and if so, what should we do?
It’s Best Not to Care.
In other words, be agnostic. It is mysterious that inflation is not at higher and more sustainable levels. That may be due more to knowing very little about what inflation is versus our inability to predict it. Also, what is obvious to any observer is that long-term interest rates and the economic outlook regarding inflation are based on expectation more than actual data.
How we feel about things governs one of the most important statistics in the economy. Try modeling that.
Life is getting tougher for investors because the most important factors are more and more unpredictable. Increases in home prices, materials, and components, labor shortages, consumer price index increases, all spell doom for investors betting on low interest rates.
- Are all these factors merely a result of inefficient functioning as the global economy tries to return to some sense of normalcy?
- As the economy functions normally once again, will inflationary concerns, and, therefore, interest rates, stay low?
- Will the 10-year Treasury, at 1.22%, and the 30-year Treasury at 1.89%, remain near these levels?
It is impossible to know the answer. This critically important metric is not knowable. There is an intelligent argument on both sides, but there is no way of knowing the outcome of the inputs we have seen over the last 16 months. So perhaps the best advice, to quote Charles Bukowski, is “don’t try.”
Into the Jaws of Uncertainty.
Uncertainty has caused some investors to look for a hedge, historically gold, and more recently, cryptocurrencies such as Bitcoin or Ether. Cryptocurrency has risen in value in 2021 between 60% to 140% – a great hedge against market moves. But this is based on so many factors driving demand that, if we tried to predict the value of crypto itself, it’s fair to say that, like the markets, we don’t know what’s coming. We can only predict that these assets, like the markets themselves, will behave in ways that will often make little or no long-term sense.
Economists, forecasters, and the market, in general, have nothing useful to contribute. Predictions become more cartoonish and laughable when we hear things like:
“low interest rates sent the stock market up, but then inflation fears sent the market down until lower rates to stimulate the economy were established, and that sent the market up, and then ultimately the market went down on fears of being overheated, and the day ended flat with no conviction about whether or not interest rates would rise or fall.”
One thing we can add is that most predictions seem too good to be true, and almost always are. The economy is not a perpetual motion machine, nor is it a credit card with no limit and no requirement to pay the balance. The current notion that “deficits don’t matter” seems patently silly and naïve to think that we can simply print money without any economic discipline to generate sustainable profitable businesses with the efficient use of capital.
“Money goes where it’s needed, but it stays where it is treated well.”
Walter Wriston (former CEO of Citicorp)
That means it has to generate a return and not be co-opted by governments and public policy, nor be flooded by capital with no economic discipline.
Deficits may be a reasonable way to jumpstart a sluggish economy, but they are not sustainable. Current thinking is that fiscal discipline, debt repayment, and the idea of a balanced budget are anachronistic and useless. It is dangerous to stress test this idea because the downside is potentially cataclysmic. Capital likes a free market, but we hardly have a free market with money today. Constant stimulus does not create economic discipline.
What Do We Do?
Since predicting is mostly useless – which means it’s dangerous – having strong beliefs are more perilous than being agnostic, and uncertainty and randomness still dominate markets and the economy – and always will. It’s best to plan for this by taking a few pages from Naseem Taleb’s “The Black Swan” and “Fooled by Randomness,” among other sources.
- Build a portfolio that can profit from innovative disruption. These investments have proven to outperform the market for more than 100 years and, while choices require revision (i.e. IBM, RCA, Polaroid, Xerox, Kodak, etc.), there are still plenty of opportunities to identify those companies offering sustainable innovation and disruption. You may not know all the winners, but you will do well. Put your money there.
- Build substantial hedges against dramatic and unpredictable market movements, and expect volatility to be more intense and more frequent – and invest appropriately.
- This combination will withstand any of the movements to come – most of which will be unpredictable and will profit disproportionately from disruptive growth and volatility while protecting downside risk.
Whatever happens, there will be some economist who will say, “See, I told you so.” Of course, we know that he or she didn’t do anything of the sort, but probably needed tenure or a book deal so had to say it loudly and with the conviction of an expert.
Finally, more than anything, “beware of experts.”