“The hardest thing in the world is to break free from the perspective imposed by an entrenched social construction while you’re immersed in it.” – W. Ben Hunt
New Investing Perspectives using Game Theory and Common Knowledge from W. Ben Hunt
In fewer words, Mr. Hunt is exclaiming it is very difficult and highly uncomfortable (for most) to remove themselves from the herd. On New Year’s Day, it would have been much less acceptable to ascribe a negative assessment to the stock market than it is today. Since then, the Dow Jones index experienced a sharp 7% drop and the volatility index rose to its highest level in seven months; all for what reason? There were rumors of instability in emerging economies, some initial debt ceiling worries, and a few economic indicators were softer than expected. In other words, conditions were no different from what has existed since 2010. The failure in this analysis is the insinuation that surges in volatility must be attached to a tangible economic event or that volatility is a market imperfection.
As unappealing as it was to narrate poor conditions in December, it was equally unappealing to narrate positive conditions in the months to follow; but the positivity amidst volatility is at least as compelling as a negative assessment amidst confidence.
Should it be viewed as a coincidence that volatility arising for “no apparent reason” closely followed the Fed’s reasserted commitment to reduce asset purchases? Should it be assumed the present level of volatility is a bad thing? Those who have read this Economic Outlook for the last year or more are familiar with the notion that the Fed’s balance sheet activity and “communication tools” merely serve to increase confidence by assuring investors and the public “not to worry… everything will be okay” and this practice has engendered deeply rooted complacency.
The chart on the previous page was initially published in the 2nd Quarter 2013 Economic Outlook. Study the period of March 2005 to March 2007; as opposed to the prior period, there was a high degree of complacency (low volatility) that enabled the creation of the credit bubbles that fueled the financial crisis. What has followed since this chart was published (after the thick black line) has been nothing other than a recreation of a complacency bubble (to a lesser degree than in 2006‐07).
Yet people continue to rationalize that positive stock market performance infers that the economy is strong. Given the continued economic weakness and stock market strength, it is becoming increasingly clear that the stock market is driven more by the Fed than by economic conditions.
- TS Bank 2nd Quarter 2013
Fortunately, another year passing brings an enhanced understanding of market mechanics. What is better understood now is the economic event itself is not what moves markets, but how the event impacts the existing perceptions and belief structures of investors that moves markets. There was plenty to fret about during the debt ceiling debate in the second half of 2013, yet the markets remained calm. Yet in January, there were few material domestic concerns and the markets were in turmoil. The difference lies within slight changes behind the belief structure of the markets. As the debt ceiling was being debated, the markets held it as common knowledge that the Fed would continue to be infinitely accommodative to subjugate any unwanted volatility. While the Fed continues to be highly accommodative, it has now sent the same message a parent sends to their child who recently graduated college and got a job;
“Now that you’re standing on your own two feet, you need to grow up and start paying your own bills!”
As was stated in last quarter’s Economic Outlook, it is not as if the U.S. has a tough‐love parent in the Federal Reserve. The Fed of today is still going to be the controlling parent that continually hovers and is on‐guard for any missteps.
A key point is not the accommodation the parent is willing to provide that matters most; it is the child’s perception of independence. If the child trudges through the next several years believing “Mom has my back, I can coast for a while,” then the attitude will be a detriment to the child’s long term success. This is the mentality that has been reinforced time and again by the Greenspan Era, bank bailouts, emergency liquidity programs, and by QE Infinity.
Caution must be exercised before drawing the conclusion that investors are now less complacent thus the problem must be solved. The principal point is to not allow the market media news to define your perception of market health. The sole objective of major market commentators is to achieve high viewer ratings, not to deliver an accurate assessment. Why does this matter? If an investor continues to follow major market news, they’ll always be in the herd and will blindly follow others’ perceptions and subsequent investment behaviors. To some, this is great, because they would rather be wrong along with everyone else than to stand out like a sore thumb regardless of the outcome.
The larger meaning of the statements made on CNBC has absolutely nothing to do with specific investment advice or news. CNBC really could not care less about the actual content of what is being said. The purpose of CNBC’s game is not to tell you WHAT to think, but HOW to think, that thinking about investing in terms of some sell‐side analyst’s anodyne story about fundamentals or some trader’s breathless story about open option interest is smart or wise or what all the cool kids are doing. Why? Because CNBC can create inexpensive content essentially at will to fill this demand, allowing them to sell advertisements and take cable carriage fees. Nothing evil or wrong about this. It’s what for‐profit media companies DO. But the content they are producing is no less of a theatrical production than the State of the Union address, no less of a multi‐level game, and it needs to be understood as such. – W. Ben Hunt
What is present today that didn’t exist on New Year’s Day is investors actually believe the market could experience a prolonged correction; this belief structure in itself is healthier than the one extrapolating forward the S&P500’s 29% return in 2013. As 2014 progresses, make the decision to continually strive to form an assessment of the common knowledge of the market from an outsider’s perspective. It is impossible to understand the complexities of the market to sufficiently predict its next moves. However, it is less difficult to see the investor crowd as a singular person, to see its gaffes and follies, and to try to guess what the person’s next step will be (given changes in the environment). This approach will not likely earn a guaranteed risk adjusted return on a stock portfolio, but may at least help a person to know when to run or when to seek cover.
One example of this approach is what was used above in the labeling of the Fed and the market as parent and young adult and the analysis of the expectations for “coddling”. Armed with this differentiated perspective, a market observer may be able to better anticipate the market impact of positive or negative news surprises. This may explain why, over the last few years, the markets have occasionally surged on bad news and fallen on good news (wavering expectations of whether the parents would offer assistance or not). To use a poker analogy, one must play the player, not the cards.
Why did the market experience weakness in January and not in December (when the first reduction in asset purchases took place)? After the first reduction, there still was uncertainty whether the Fed would fix the deceleration at $10 billion per month or whether they would backtrack if conditions proved to be more shaky (in Bernanke’s words: to be data dependent). To continue the analogy, the young adult was still wondering if Mom would provide assistance after an unexpected financial headwind. The Fed’s meeting in January occurred shortly after the release of some less optimistic economic data, yet they reasserted the intent to taper at a $10 billion per month pace. The creation of a consistent trend more greatly affirmed in peoples’ minds the ultimate timeframe and speed of QE deceleration. In many ways, the second taper was much more significant than the first. Given the expectation for a consistent trend going forward, it will be much more disruptive to expectations if the Fed deviates from the $10 billion per month pace; such an event would likely be impactful to the markets.
Having covered the common knowledge structure of today’s market, let us look forward to what may be key market trends that might influence the market’s current beliefs.
Emerging trends in Corporate Earnings
Corporate earnings could become the fly in the ointment for stock market performance in the coming quarters. Corporate profit margins (follows a mean reverting pattern) have been at near record highs over the last several years but are losing steam. Two factors that could tighten profit margins in the near term are inflation in payrolls and infrastructure investment. Both of these would be largely positive for near term economic growth and health, but would have negative impacts on earnings and stock price performance.
Compared to the cash from earnings, corporations have been investing a minimal amount in infrastructure. The investment into infrastructure assets took a huge hit during the financial crisis and has not recovered from pre‐crisis lows. This rate of fixed investment hardly recovered from the dot‐com bubble before the financial crisis began. Another way to interpret this situation is businesses have been holding onto infrastructure equipment for much longer than in the past. If true, it is only a matter of time before businesses will have to “catch up” on what is likely a pent up need.
Emerging Trends in the Employment Situation
The other factor worth keeping an eye on is trends in wage inflation. Growth in hourly earnings seems to have finally caught footing in 2013 by growing at a pace slightly above the overall inflation rate. However, after taking a closer look at the situation, it appears there is imbalance in where wage inflation is coming from and it is largely due to demographics. The total amount of job growth over the last year has seen suspiciously close to the number of baby-boomer retirees, therefore one could reason the job growth over the last year likely required relatively skillful or experienced employees. Thus there was unchanged demand for skilled labor than in the past, but with a lower supply of skilled workers. Looking forward, given demographic evidence, it is reasonable to believe the supply of skilled labor will continue to be pressured lower as boomers begin retiring at an escalating pace.
To add some context to the boomer‐retirement situation, there will be 3.65 million boomers turning 65 each year for the next 16 years. While many will continue to work for another several years, this will inevitably create a vacuum of skilled talent at many businesses. The question is if the incoming supply of skilled labor will be sufficient to replace what is being lost through retirees?
The chart to the right suggests it will be a struggle, as there are only 3.9 million currently unemployed with post‐high school education. Also, according to the National Center for Educational Statistics, there is projected to be 2.7 million associates or bachelor’s degrees awarded per year. In summary, there are roughly 1 million more boomers turning 65 each year than there are people attaining professional educations. This skilled labor mismatch is likely to continue to push wage inflation for skilled workers, but is unlikely to trickle through to other labor pools. This factor alone may exaggerate the existing income disparity that is already heavily debated today.
To compound the situation, many are claiming the recent revisions to the Affordable Healthcare Act dis‐incentivize individuals who might otherwise seek relatively low wage employment. Even the overly‐optimistic Congressional Budget Office said “the ACA will reduce the total number of hours worked, on net, by about 1.5 percent to 2.0 percent during the period from 2017 to 2024, almost entirely because workers will choose to supply less labor. The reason for the reduction in the supply of labor is the provisions of the ACA reduce the incentive to work for certain subsets of the population."
The primary supply of desirable jobs are positions formerly filled by an employee who likely had over 30 years of experience, add to this the pent up need for businesses to make productivity enhancing investments and the disincentives created by the Affordable Care Act and one can easily envision a growing divide in socioeconomics.
It is puzzling how the architects behind the Affordable Care Act failed to see how it would only perpetuate the growing socioeconomic divide it sought to shrink. Given recent comments out of the White House, it appears the disincentives that perpetuate this growing divide are actually tool low wage worker can use to liberate themselves from the shackles of employment.
[In regards to the notion of ACA creating a drag of two million jobs…] Individuals will be empowered to make choices about their own lives and livelihoods, like retiring on time rather than working into their elderly years or choosing to spend more time with their families. At the beginning of this year, we noted that as part of this new day in health care, Americans would no longer be trapped in a job just to provide coverage for their families, and would have the opportunity to pursue their dreams.
‐White House press release, February 4th 2014
Without crediting or discrediting the intentions behind this statement and behind ACA in general, one cannot ignore the lasting economic repercussions this mindset will create. Take a moment and re‐read the White House quote and ask the question, “What message is the White House sending to Americans?” The quote relays opinions, of course; but it also conveys a deeper underlying message. How different is that message from the one given by the White House 100 years ago?
I don’t pity any man who does hard work worth doing. I admire him. I pity the creature who does not work, at whichever end of the social scale he may regard himself as being.
– Theodore Roosevelt
Now, what does the shifting of jobs in a knowledge‐based economy have to do with work incentives in the Affordable Care Act? If we structure a society in which people are incentivized not to work, we are going to create a society that not only produces less but that displays a growing disparity in the distribution of wealth. If we offer people economic reasons not to work, we should not be surprised when they take us up on the offer. We can disguise that offer as all sorts of necessary social reforms, but at the end of the day a smaller labor force will affect the size of the pie that we all want to see grow and to partake of. I refer you back to Bastiat [quote], … ‘it is the unseen things in well intentioned public policies that will have small, incremental, but finally significant effects upon the whole economic body’.
– John Mauldin