Decentralized finance (DeFi) can disrupt global finance – but only if Defi systems and central governments cooperate. Yes, sworn enemies cooperating for the greater good.
While each seems to be the sworn enemy of the other, ultimately, a cooperative relationship between decentralized and efficient (versus anachronistic and cumbersome) financial infrastructure and government central banks with stable currencies is absolutely necessary.
Defi transactions, to scale globally, require stable and predictable value. Government-issued currencies are the only reliable and foreseeable foundation. Cryptocurrencies, such as Bitcoin were never currencies. They are a sideshow that will remain a speculative asset, and increasingly unimportant.
Cryptocurrencies represent an architectural shift in how financial infrastructure and technology interact, and therefore, it is disrupting how the financial industry works globally. It is neither a new kind of money system nor a danger to economic stability. It is more important than that.
Technology is facing a substantial crossroads as policy changes with global resonance, such as China’s new crackdown on the country’s big tech companies (such as Ant Financial and Didi Global), the rising resistance to social media behemoths like Facebook, and the need for governments, whether in the United States, Western Europe, or China, to manage and control technological development. Regardless of any good intentions, this will add friction, inefficiency, and underperformance to the most dynamic global industry. The best intentions usually bring disastrous consequences. China cannot escape the law of unintended consequences. Trying to “manage” innovation and creativity takes away the often unplanned and serendipitous breakthroughs that make many significant advancements possible in the first place. From an economic perspective, capital is not going to invest in an uncertain environment where prosperity is managed and, despite great risk where most ventures will fail, the truly successful ones which make up for the losses and encourage capital to keep investing, will be mitigated. The vanguard of capital flight from China is beginning, and it will not ease if this policy and attitude are not revised. This attempt at “fairness and more equal distribution” will do nothing more than keep capital away and stifle any attempt at creativity, technical innovation, and economic advancement. The intention of this policy will yield the opposite outcome as a consequence. The signal means substance. Substance means innovation, creativity, and competitive dynamics that create the most effective innovations, the best solutions, and the most sustainable companies. Central planning, bureaucratic industrial policy, government-led economic management, and dictatorial focus have always failed, and always will. The US should not fall into this trap, regardless of how appealing it may be.
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.
Fundamental drivers for pricing valuations in public markets have changed. Now, there is a new interaction among factors unseen just recently. Advanced technologies such as artificial intelligence have had a profound impact on the tools available and analysis presented to even the most amateurish investor. Social media, such as Reddit, Twitter, and other platforms, have allowed access to information and influence from media “stars” driving demand in an almost herd-like mentality driving up prices, and causing extreme volatility. Finally, technology has enabled a trading floor to be in everyone’s pocket. That same trading floor allows access to any information on anything from anywhere, and communication with anyone or, via social media, receive communication and information (regardless of how dubious) from anyone about any security or investment strategy.
These factors will cause unprecedented market volatility, along with extreme price movements for well-known (or perhaps more accurately, well-publicized) companies and their securities. While the supply of securities remains somewhat constant, demand for those securities is increasing (sometimes exponentially) because many more investors are now chasing those same securities.
The price of anything cannot escape supply and demand dynamics. Recent IPO activity is an attempt to meet growing demand (and raise capital at attractive prices). The new supply from IPO’s, secondary stock issuances, and most recently and monumentally, SPAC offerings, still do not provide enough supply to quench a growing and overwhelming demand. The valuations, especially those given to the SPAC’s, are entering stratospheric levels that could hardly be justified under normal market conditions. Successful investors are the ones who understand adding return without corresponding risk is the most critical component of successful investing, especially given the new equation for valuation:
Economics + Advanced Technologies + Social Media = Price
These three components are now inexorably linked and constitute an influential role in determining valuation from now on.
The More Things Change…
The pandemic has challenged many preconceived notions about the economy, markets, and public policy – and has impacted the way we live. But the inescapable truth remains unchanged:
There is no magic answer. No solution other than superior skill enables an investor to earn a high return safely and dependably. That is even more true in today’s low-interest rate, low return Tower of Babel world.
When Everything is Going Great, It Probably Isn’t.
Things can only get better from here… said the turkey the day before Thanksgiving. It’s challenging to know when it’s too late because things go badly gradually, then suddenly.
It might be time to start worrying about tech-stock valuations. Usually, all it takes is a few overly ebullient stock analysts to set off an alarm. When unreasonableness takes over (remember all those analysts’ reports from March 2000? The NASDAQ could only go up and all those internet funds were going to double again in 2001?). In March 2000, the bellwether for this nonsense was Henry Blodget’s recommendation of Amazon with a target price of $400.00 by March 2001 (at the time Amazon was trading for about $60.00 a share). Instead of being $400.00 in March 2001, Amazon’s price was $5.97 per share.
Long Term Value Means Long Term
Of course, Amazon has created an amazing business model and is fundamentally rewriting technology services and customer logistics. Trading at almost 100 times earnings the market believes there is much more growth and profitability to come. Really? Regardless of your perspective about that, Amazon is an example of investments that are either “don’t bother it’s ridiculous” or “never sell it’s ridiculous.”
The market may stay permanently irrational about companies like Amazon, or Amazon may catch up to the market’s irrationality. What should an investor do? The answer is simple – don’t play. By that I mean you either buy the stock and ride the tiger (which means you can never get off – or sell) or stay out of the jungle completely – don’t ever buy. Half measures rarely have good outcomes.
Amazon is exemplary. This tiger has rallied substantially since those woeful days in March 2001 to close above $3,200 per share in February 2021. So, even if you listened to the absurdity belched out in March 2000, and on paper, had substantial losses from your Amazon investment for several years, if you held on, you are brilliant and rich (more like lucky; but it’s smarter to be lucky than lucky to be smart). Don’t listen to the analysts and don’t get off.
Businesses that combine closed-loop, arms dealer and monopoly characteristics represent something fundamental that is shifting in the global economy. They represent automation that is pervasive, smart, and is a layer that sits across the entire economy. Data processing and prediction build these business models. They permeate all services, including supply chains, logistics, mobility, and consumer offerings. Pervasive and innovative, they represent opportunities for increasing investment returns. Incumbents enhance their position, generate increasing value, create challenging barriers, enable more innovation to solidify their position and will sustain their value because of this new competitive dynamic. Innovation is always a threat, and value can be created from a new entrant, but the bar is increasingly higher for both the level of disruption and quality of innovation to an existing or even new market.
To be sure, new opportunities will be created as new technology develops. An example is the wireless data and smart phone market. Essentially, 4G mobile technology enabled the substantial value creation at Facebook, Netflix, Uber and AirBnB. These companies could build their services on top of this technological platform and create not only a new competitive business, but a new market where they could be the dominant player. As 5G develops and we see unimagined high-speed for data, entertainment, communication, and other services, we will have new businesses and opportunities created on this platform – only so much can be imagined today, others which are yet to come. But there will be real-time connection with customers enabling new and innovative products and services, artificial intelligence permeating software and communication enhancing quality and innovation further, enhanced gaming (perhaps even to a professional level), and virtual reality and augmented reality perhaps finally becoming the market opportunity that has been imagined for many years. This list is far from exhaustive, and without doubt, there will be valuable companies created whose business models we can’t quite imagine today.
The history of AI shows that attempts to build human understanding into computers rarely work. Instead, most of the field’s progress has come from the combination of ever-increasing computer power and exponential growth in available data. Essentially, the ability to bring ever more brute computational force to bear on a problem-focused on larger data sets…
Productivity, expansion, and entrepreneurship were enabled through the adoption of new technology. Undeniably, the net economic benefit was substantial. But lives were disrupted, jobs were lost, and what would be seen with a historical perspective as an obvious beneficial choice, was anything but obvious to those so immediately and negatively impacted.
Technological advancements produce net benefits for society. But for every advancement, there is a cost. Leadership and subsequent public policy must address this shortfall. As in the past, the solution has been training and education leading to economic inclusion and prosperous lives.
History has taught us the net benefit of technological advancement, the turmoil it brings, and the solution required.
Technological innovation ignites economic growth feeding further innovation. But, has our relentless progress irrevocably tipped the balance from a virtuous circle of innovation and growth to a downward spiral of disaster and decline?
A global economic and political chess game is on between the United States and China. There are many moves, defensive and offensive strategies, short- and long-term gains, but, unlike chess, mutual victory is possible.
