Market Overview Q416: Diagnosing the Problem

People tend to be fairly optimistic about things naturally. Partly this simply reflects the fact that things tend to work out a good chunk of the time. As Diane Coyle noted in the Financial Times, optimism can also be a choice: "individuals make choices not only about bread-and-butter issues such as how much to consume and how long to work, but also about what to believe. People's wellbeing ('utility') depends also on believing things that make them feel good."


Sometimes though, wellbeing depends more on acute observation and accurate analysis than on beliefs. A turning point is one example; by definition it is not part of the "normal routine." As Lenin famously said, "there are decades where nothing happens, and there are weeks where decades happen." Coyle also recognizes such possibilities: "There are, however, many occasions when contagious denial and reality avoidance have terrible results." Indeed this is exactly what seems to be happening with many investors right now.

To be sure, it can be difficult to assess the investment landscape when economic and financial challenges are masked and the consequences of policy actions are deferred. Many investors, however, have been starting to accumulate anecdotal evidence that contradicts optimistic headlines and are starting to get an uneasy feeling that things aren't quite right.

For example, while the stocks of large public companies keep hitting new highs, they are also continuing to reduce headcount and issue mandatory furloughs. Strategy, vision, and leadership are being supplanted by frenetic efforts to hit earnings targets for corporate managers. Meanwhile, many investors are nervously waiting things out and hoping like heck that they will be able to retire before things get too bad.

These bottoms-up observations are corroborated by the top-down macro data. For example, David Collum highlights the challenges for consumer spending with a stark profile of the US consumer in his 2016 Year in Review: "The wealth for middle-class households has dropped 30% since 2000, one in five kids lives in poverty, 46 million folks are on food stamps, 20% of the families have nobody employed." He concluded that, "The consumer is stretched by having no savings and gobs of debt—huge net debt ... An estimated 35% of Americans have debt that is more than 180 days past due."

Collum also summarized the erosion in the health of the corporate environment by way of a quote from Stanley Druckenmiller: “The corporate sector today is stuck in a vicious cycle of earnings management, questionable allocation of capital, low productivity, declining margins and growing indebtedness.” Needless to say, this is not the stuff of sustainable recovery.

Although this evidence is by no means comprehensive, it is compelling enough to beg the question as to why so many investors seem to believe otherwise. It is in this regard that Coyle's insights are especially instructive: "individuals make choices ... about what to believe." In other words, many investors are guided not by cold, hard evidence, but by beliefs.

But belief systems and mental models can go wrong, especially when enticing narratives lure in willing or unexpecting victims. For example, shortly after the financial crisis in 2009, for example, many investors' concerns about debt were lulled by a narrative of "deleveraging". The idea was that public debt could be used to cushion the blow as households transitioned to lower debt. Public debt held up its side of the bargain as it climbed from 73.8% of GDP at the end of 2008 to 104.8% as of the third quarter in 2016. The problem is that while household debt has declined, much of the decline was involuntary (i.e., homes got repossessed) and household debt levels are still quite high. Further, household debt is not evenly distributed. As David Collum noted, many households still have a huge debt problem.

Debt has grown even more rapidly in emerging markets. John Mauldin showed that, "China's total debt stock more than tripled between 2000 and 2007 and nearly quadrupled from 2007 to 2014 as private-sector and local-government borrowers added more than $26 trillion in new debt. That explosion in domestic credit lifted the country's total debt-to-GDP ratio from 121% in 2000 to 158% in 2007 and to 282% by the end of 2014." The unfortunate conclusion is that deleveraging has been a nice belief, but just a belief. For those who have been watching, not only did the debt problem not go away; in most important respects, it got bigger.

Other examples of errant belief systems are also to blame for misperceptions. The Economist, for example, recently reported on some examples of management theory that have "lost touch" with business reality. One of those ideas is that "business is more competitive than ever." In reality, however, "The most striking business trend today is not competition but consolidation."

In addition, many people still harbor the notion that "we live in an age of entrepreneurialism." Once again, "The evidence tells a different story. In America the rate of business creation has declined since the late 1970s. In some recent years more companies died than were born." Another Economist story reports that, "The largest firms are expanding and smaller ones are withering on the vine," and concludes: "But today's incentives favour stasis. Many big firms thrive because of government and regulation."

These insights point to an even bigger problem, and one that is also often clouded by false beliefs: Our capitalistic economic system is no longer as dynamic and flexible as it used to be. In fact, this possibility is one that increasingly troubled Joseph Schumpeter, one of the greatest thinkers on the subject of economic dynamism. Later in his career, "He [Schumpeter] became increasingly preoccupied not only with heroism but with bureaucratisation, and not with change but with decay."

The Economist shines a light on the current state of the economic system: "Today capitalism exists without capitalists - companies are 'owned' by millions of shareholders who act through institutions that employ professional managers whose chief aim is to search for safe returns, not risky opportunities." Further, "lobbyists and other vested interests have by now made a science of gaming the system to produce private benefits." In other words, capitalism has become diluted and a less powerful force in compelling growth.