Separating signal versus noise is challenging these days because today’s signal is more muddled than ever. One of the more unusual circumstances, which I covered in more detail in the article “Important and Unknowable” is that the immediate past is telling us extraordinarily little about the near future. That is unusual because we can typically…
The “Thucydides trap” is where a rising nation-state – for Thucydides it was Athens – must eventually have a violent confrontation with the existing dominant nation-state – Sparta in his time. It is a zero-sum game where there can be only one dominant nation-state as the eventual winner – and it is usually assumed to be the rising nation-state outdoing the dominant nation-state.
Today, many “experts” (and I have great disdain for self-proclaimed experts) believe this is the circumstance between the US and China. We are headed toward violent confrontation where there can be only one winner. I read the book by Thucydides about the conflict between Athens and Sparta (I cannot be dispassionate here about that outcome because my family is from Sparta on my father’s side). But I fundamentally disagree with Thucydides’s historical descriptions being used as analysis by anyone to describe global events, especially those between the US and China.
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.
Digital currencies, crypto assets, digitized securities, and distributed ledgers require an enormous amount of power. While the combination of these assets is subject to tremendous hype, the environmental impact has been mostly ignored. However, this is changing because there has been increasing alarm about crypto’s carbon footprint and environmental impact. While there are attempts to use alternative energy, such as solar farms, thermal heat, and wind farms, sustainability for processing digital assets is still evolving. One thing is clear, as advancements are made in clean and renewable energy, digital asset mining will reduce its requirement for carbon-based energy. This is an essential trend if digital asset processing is to be sustained as an important component of global finance. The trend toward digital assets disrupting global finance is irreversible, thus green energy solutions are essential, and a condition precedent in order to participate and profit from this economic opportunity. It is crucial for crypto mining to address the environmental concerns attached to digital asset processing and creation. There is an irreversible shift to decarbonization and lower carbon footprints. The digital asset market is not going to go away, but since energy is such a critical component, energy efficiency and green energy are the essential components to any long-term perspective of a digital asset strategy. The low-cost provider wins. With digital assets, that means the combining lowest carbon footprint with scale and the ability to connect to the electrical grid.
Prepare for more frequent and extreme volatility. New and powerful influences, ranging from social media and financial technology to algorithmic trading and esoteric valuation models, will increasingly upset market stability and bring unprecedented rewards and unpredictable disaster.
Predictable market conditions will be upset by sudden unpredictable movements.
Financial markets can be predicted reliably only when the world does not change. Even during periods of stability, judgment based on expectations and assumptions as much as hard facts and economic analysis, form the basis for buying and selling decisions. Market crashes and financial crises are a continuing and breathtaking reminder that markets are irrational and uncertain. Taken to an extreme, the combustible combination disrupts global markets and societies. New analytical tools and technologies appear to make worrying about unforeseen risks obsolete. But this naïve belief in technology’s ability to understand and predict catastrophic risk is a fundamental cause of that very catastrophe.
Stability is illusory because in an uncertain world, unforeseen changes can have seismic effects. The pandemic is only the latest example, but there are always greater risks inherent in markets than is acknowledged, and most investment strategies do not accurately reflect the risk that certain investments are assuming for a given return. Safety can be an illusion if the risks are not well understood, both systemic and undiversified.
As we have seen, oversight, regulation, or any sort of self-imposed moderation will continue to be ineffective or nonexistent, and always trail behind the most dangerous and detrimental market developments. Financial weapons of mass destruction continue to multiply and are now available via smart phone in everyone’s pocket. Expect more and greater turbulence.
“Being Digital,” the groundbreaking book by Nicholas Negroponte described what happens to a global economy when all assets can be digitized. Presciently predicting the impact on music, film, retailing, and commerce in general, Negroponte intuitively understood the disruption and the creative/destruction that would be unleashed when a globalized infrastructure could deliver all products and services, including assets and intellectual property, instantly via a worldwide digital infrastructure and network.
The same “digital” effect is impacting global finance today. Now, all financial assets are “being digitized” and can be delivered instantly on a global infrastructure, fundamentally upsetting the world’s largest industry with unprecedented creativity and destruction.
Crypto assets are the manifestation of that digital form. While there is debate about whether or not an asset can truly be “digital,” the market has spoken. While there will be continued volatility, speculation, creation, and destruction, a digital platform for financial transactions ranging from the simple transfer of funds to complex financial transactions, investment, and lending are here, disrupting a multiple trillion-dollar industry.
Bitcoin is an innovative, rapidly expanding network for storing and exchanging value among investors.If it’s an asset, does it have an inherent value, like gold? Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin.
It’s a cryptoasset that has the safe haven characteristics of gold and will potentially compete with it for a place in portfolios. Bitcoin is not a currency and will not be adopted as a new medium of exchange. It is not a stable store of value, nor can it be easily transmitted and exchanged for any good or service at a consistently predictable value. But, that’s not important from an investor’s perspective. Bitcoin remains incredibly volatile, and its correlation with other major assets has been inconsistent, but allocations are seen as suitable among an increasing number of investment professionals, and, increasingly, it is seen as an alternative investment equivalent to a derivative or other call options, given the potential for spectacular returns. The downside is well-defined while the upside can be asymmetric and significant.
Cryptocurrencies Hit New Highs. Should we be terrified?
Probably.
Bitcoin, Ether and, the most recent joke, frenzy, and punch line, Dogecoin, have increased 10x to 20x over the last 12 months. A spectacular return, but can it last?
Probably not.
The forces driving the eye-watering returns are the same as those that drove the insanity behind GameStop: the equivalent of a trading floor in every pocket funded with excess cash looking for disruptive investment opportunities and charging forward like an out of control herd – or lemmings – however you want to envision it. Cryptocurrency became the overwhelming target of Reddit day traders and mobs. Social media influencers, led by various forms of PT Barnum imitators like Elon Musk and many less sophisticated contributors, combined with the public listing of Coinbase to create a massive rally.
Risk is the permanent loss of capital.
It is not volatility, nor is it uncertainty. It is the realization of a loss. Therefore, risk is hard to understand because it is only clear with hindsight that a loss has occurred. Understanding how risk works can avoid this permanent loss by avoiding the mistakes that cause the permanent loss of capital.
Risk can also be used advantageously. Knowing that there is the prospect of loss, planning, and investment strategies that profit from these losses put you on the right side of the equation. Risk can be used to an investor’s advantage.
Essentially, anti-fragile (to coin Naseem Taleb’s term) strategies can benefit from volatility, uncertainty, and loss. Randomness permeates all markets, which means risk is always present. Knowing that, investment strategies need to be able to withstand unpredictable or unforeseen stresses. Not all risk factors can be known, or even if potential risks are identified, the magnitude and timing are unknown. What can be certain is that they will occur, and a portfolio that is “fragile” can be devastated
“I believe that the present, accurately seized, foretells the future.” V.S. Naipaul There is a lot of uncertainty today in the markets, but there has always been uncertainty in the markets. We have never had certainty regarding the economy or the future. The most reasonable exercise, as V.S. Naipaul reminds us, is simply to understand the present. So what’s going on? The economy is accelerating. Inflation isn’t a problem. The Fed is going to keep interest rates as close to zero as possible for the foreseeable. These components are driving valuations higher, and in some cases, approaching stratospheric levels. Some concern is warranted in certain sectors, but overall, things seem to be relatively steady and not too overblown. Earnings appear likely to grow, and in many cases, quite rapidly, for the next couple of years – assuming something unforeseeable does not occur (but this probability is not zero). Bitcoin has a few interesting characteristics worth understanding. It is a decentralized, permissionless, peer-to-peer network of computers that’s permanent and unhackable .An investment in Bitcoin is, in reality, a part of the peer-to-peer computer network (essentially, a slot on the database), and almost all of those slots have been allocated. Only 21 million Bitcoins will be produced and 18.5 million have already been mined and circulated. Price is a function of supply and demand (see Economics 101).Arguments about “inherent value” are, and always will be, meaningless. Is there really some kind of “inherent value” in gold? We just decided it was valuable to us. The same is happening with Bitcoin. Bitcoin supply grew 2.5% in 2020; it will grow 2.0% in 2021.The question for Bitcoin valuation is simple: Is demand growing faster or slower than 2.0% annually?