Dramatic Consequences

The World’s Chess Game

The breadth of the economic and market impact will depend on what types of sanctions are applied by the West. It’s likely such measures would further target a combination of Russian banks, investment, and trade (such as through barring Russia from the cross-border SWIFT network), and potentially, energy. In response, Putin could also retaliate through the energy sector, as well as through cyberattacks on the United States and Europe. The situation is fluid to say the least. I approach these things thinking like a chess player. What is my opponents to best move? What is my best move, or least worst move, in response? And so on… the whole board not only includes Ukraine, but also Estonia, Latvia, and Lithuania, as well as China and Taiwan. If the West is unwilling to do anything meaningful except give passionate speeches, that is definitely a cue for China to be more aggressive.

Learning

Remembrance of Things Past – Liquidity, Stability, and Predictability

Financial markets are imbalanced and lack liquidity in crucial sectors, even historically stable and predictable markets such as the global bond and currency markets. Investments are slanted in one direction more frequently and the markets are vulnerable to big price swings as a result. These large global markets are not immune to ever more lopsided trades creating extreme volatility. This occurs even when a small change occurs in positions, sentiment, or news. Even the world’s most liquid markets, US dollar currency trades and US Treasuries, are seeing skewed positioning resulting in surprisingly large shifts in prices and Treasury bond yields.

The market now leans too far one way or the other, and that imbalance will be forced to reverse more powerfully and unpredictably.

Innovation

Stupidity and Misery by Another Name

A National Investment Authority, an idea gaining traction among the administration, would be responsible for “devising, financing, and executing a long-term national strategy of economic development and reconstruction.”

This is not the job of a government; this is the role of the free market. The market does this quite well, and government does this quite poorly. An NIA is another way to bring misery and inefficiency.

Policy reflective of central planning, socialism, or industrial policy brings misery to all. This discredited philosophy that tortured so many in Eastern Europe and Soviet Russia seems to be getting more traction today bewilderingly. It leads to nothing more than bureaucratic idiocy, waste, and disregard for any consumer needs.

Misery

When up is down

Investors expected that the Fed would not only end its bond buying program, but many believed it would also raise interest rates. While the Fed did agree to taper its bond buying, essentially decreasing its $150 billion monthly bond buying program by $15 billion per month, ending the program in 2022. However, the Fed kept interest rates the same and clearly signaled that it would not raise interest rates anytime soon, and almost definitely not until the taper of its bond buying was completed – in other words, not for at least one more year.

Investors who had been betting on the Fed raising interest rates wagered on the yield curve flattening for Treasuries. Therefore, they invested in short-term Treasuries believing those would outperform longer-term Treasuries, as well as 10-year and 30-year bonds. Instead, we are seeing the opposite happen. Short-term bonds are dropping in price and yields are approaching their highest levels since March 2020. Meanwhile, prices for long-term bonds have climbed. This same phenomenon is happening for government bonds that only in the United States, but also in the UK, Canada, and elsewhere.

Up and Down

Reality, Euphoria, and the Market

There are warning signs that the stock market is transitioning from some form of reality to misguided euphoria. The S&P 500 is up almost 10% in the last 30 days. However, this broad optimism doesn’t seem to be matched by many forms of fundamental reality.

Earnings are barely moving, and profit margins are under pressure from higher wages and rising product costs. However transitory one imagines supply chain constraints and lack of available workers, the situation has certainly extended much further than most predicted.

Inflation

Lessons on inflation

Central bank independence and fiscal responsibility matter, even though the Western world is acting as if these rules no longer apply. Well, perhaps. But the world has given us three examples where the consequences are extreme when these basic foundations of economic policy are ignored or violated.

Lessons on Inflation

Failures are not Failure

Failures are essential for success. The NASA flight director, Gene Kranz, who is famous for the Apollo 13 quote, “Failure is not an option” has been misunderstood. Mr. Kranz did not mean “don’t fail.” He meant was that there will be a solution, think boldly and courageously because, while the solution may not be obvious to you now, you will find it eventually.

Accepting failures is not accepting failure.

Failures – trial and error, unforeseen roadblocks, creative thinking, visions, and revisions that a minute will reverse – lead to insight, innovation, creativity, and unforeseen breakthroughs. That’s success.

Failure is when you stop.

Biotechnology

Noise and Unpredictability

Distinguishing what’s happening in the market and the direction of important market metrics – the signal – from garbled, inconsistent, and mostly useless data – the noise – is extremely challenging today. Information is contradictory and transient making data and critical events more confusing and indistinguishable. Unusual circumstances brought about by the pandemic, subsequent supply chain interruptions, inconsistent production and demand, and unclear economic forecasts combined for almost unprecedented uncertainty and unpredictability.

Typically, near-term predictions are reasonable and reliable because we have immediately available and fairly accurate data making short-term predictions reasonably accurate. In other words, we can estimate what will happen because we have a good idea what just happened. But this is not the case today. Predictions based on the near-term past are more muddled now than ever. While we used to be able to say we can see a trend, whether that’s inflation, economic growth, or some other important metric, too much volatility, irrelevance, and lack of applicability (after all, who is going to project from a base that includes a pandemic impacting global supply chains and production?), we really can’t reasonably rely on any of that data to try to find a trend or connect the dots generating a near-term forecast with any meaningful depth of data and understanding

More intense volatility occurring more often will be characteristic of this market from now on. An investment strategy must withstand and profit from this. The only clear signal from the market is that there is far too much noise and not enough of a clear signal. Without clarity, determining an investment strategy is flying blind with no instruments.

Core holdings combined with an ability to withstand and profit from volatility and unpredictability are essential for investors today.

Signal vs Noise

Ptolemy, Galileo, and Financial Markets

Assume nothing, new models and analytical tools, coupled with constant revision, questioning everything, reassessing, and re-analyzing, are essential to success in today’s markets. Often, and we are seeing that in today’s market, relying on bad assumptions, dogma, or prior belief can be disastrous.

This story about medieval astronomy applies directly to investment strategies, market valuations, and portfolio construction today. It’s the same lesson –begin by questioning the very assumptions on which an entire system is built. There is also a very specific application of this model that is particularly current.

One of the most valuable lessons is to assume no knowledge and analyze closely every initial assumption. Nothing is so obvious that it can’t be questioned. Unexamined ideas and assumptions will eventually be useless. Any assumptions and any model used to explain and predict anything (whether it’s the movement of planets or financial markets) needs to go back to first principles and discard any assumptions, preconceived knowledge, or bias.