11: Tyranny of the Numerator, Modern Monopolies, Efficiency is the Enemy, Philosophy with Children, Louvre NFTs, Love in Cm
It was my best friend. Whether I was happy or sad, I spoke to my drum set - Marc Cerrone
Investing & Business
Tech, Inflation & the Tyranny of the Numerator
Reading time: ~20 minutes
Lyall Taylor, a financial blogger whose content I already commented in a previous issue, published a VERY interesting piece on the current state of the financial markets.
More specifically, I think he gets across a few very important points about the relation between asset valuations and the rates environments, and synthesizes the current situation quite well.
Insight #1: Asset prices are highly sensitive to changes in the cost of capital, linked to inflation
Lyall Taylor explains that a common misconception is to look at assets only through the numerator (i.e. the cash flows they generate), while not caring much about the cost of capital, or the denominator which determines the multiple we are likely to associate with a given cash flow:
Asset prices are highly sensitive to perturbations in the cost of capital, and the cost of capital in turn is highly sensitive to perturbations in the demand and supply for capital, just like the price of oil is highly sensitive to ever-changing demand and supply conditions. Furthermore, core fundamentals tend to change relatively slowly, but the cost of capital can fluctuate wildly in the short term, and it is variations in the latter that is the primary determinate of asset price volatility.
Insight #2: We are not in an “everything bubble”, we are faced with a plumbing issue
Numerator variations (amount of cash flows) have an effect on relative valuations, but not on valuations across the board (in all asset classes). They won’t lift all assets prices by their own strength, which LT deems is a common misconception:
Numerator effects have a significant influence on the relative valuations of assets/asset classes. However, this process cannot be extrapolated to the emergent absolute level of asset pricing in general, where denominator effects often play a more decisive role. […] Investors like Grantham for instance, look at rising markets and historically-high valuations and conclude that it is because investors are too optimistic on the economy and earnings (numerator effects), or surmise that there is an "everything bubble", when in fact this situation can exist even if everyone is bearish and pessimistic on the outlook for returns, simply because there is too much capital chasing too few assets, and the ever-volatile market clearing cost of capital has fallen.
In fact, sky-high valuations are logical once you factor in the scale of the current liquidity injections:
This US$120bn per month expansion in the money supply has flooded financial markets with extra liquidity. In the absence of this QE/deficit monetization, every US$120bn of US government fiscal stimulus injected into the system would need to be offset by US$120bn of liquidity being withdrawn from financial markets by investors/institutions acquiring US$120bn of new primary treasury bond issuance
Hint: that’s not exactly what is happening :-)
As this waterfall of cash has cascaded through financial markets looking for a home, it has started to flow into every nook and cranny, pushing up asset prices. Investors desperate for any sort of return on their cash will hunt high and low looking for any reasonable place to put their money, pushing asset prices up across the board. This is the "denominator effect" of an excess supply of liquid capital in action, and the apparent bull market it creates can have little to do with people's view on the economy, earnings, and valuations per se.
This here is the real explanation behind the boom of alternative² (or alternative alternative) assets such as cryptocurrencies, NFTs, collectibles… And its barely enough!
However, the SPAC IPO boom has still been inadequate to absorb all of the liquidity being created by the Fed. This is why we have seen spillovers into a new cryptocurrency boom, as well as an NFT boom, etc. There is too much capital chasing too few places to invest, so new assets are being manufactured to absorb the excess - including phantom digital assets.
What is interesting is that the market participants seem to agree about the fact that there is a flight forward when we look at asset classes, and that the most speculative might get hit hard if the winds changed directions. Basically as LT puts it, “All asset prices will suffer, but areas of excess will suffer the worst”. This is the reason why lately a little sneeze about a high CPI or Elon making a cold-feet statement was enough to send growth stocks or cryptocurrencies nosediving. The markets are frothy, but not because of sanguine financial projections, simply because of the amount of liquidity and reflexivity.
Insight #3: The FED is walking on thin ice, and might be caught off-guard by rising rates
What we can say with assurance is that the risks are very significant, and in my assessment, the Fed is showing an unhealthy degree of complacency with respect to these risks, that is now beginning to cross the border into outright recklessness […] The Fed is playing with fire, and if they get this wrong and inflation goes to 5-10%, they will likely engineer one of the worst recessions and financial crises in the past 100 years. It seems to be a remarkable misjudgment of the risk and reward associated with the current policy course. Given that central bank behaviour - as well as fiscal excess - has become steadily more and more extreme over the 13 years since the GFC, as complacency about inflation risk has grown, it was perhaps always only a matter of time before things were eventually pushed too far.
There has been no shortage of low-hanging fruits for years now, and while it’s tempting to party like it’s 1999 with markets that are red-hot, it’s also important to understand the implications of the denominator effect if you don’t want to be caught in the deflagration.
Modern Monopolies - Book Review by Niklas Säväs
Reading time: ~10 minutes
InvestingByTheBooks is a very cool website, which is already referenced on my personal website in my favorite links section, where people can contribute book reviews on financial subjects (including behavioral finance, equity analysis, trading psychology…)
As you might have noticed since the start of this little venture, I have a quirk for oligopolistic and monopolistic markets, because they often offer compelling investment opportunities, or at least interesting companies to look at.
This book review is about Modern Monopolies, a book written by A. Moazed and N. Johnson:
Insight #1: Modern Monopolies have evolved from their ancient form
The “Modern Monopolies” are not as the traditional monopolies who squeezed out as much profits as they could, instead these natural monopolies are loved by the customers as they offer a lot of value. At scale, every new customer adds value to others in the network which creates a virtuous cycle.
Insight #2: Network effect as the GOAT
Scale economics and value chain analysis backed by Henderson and Porter were the holy grail during the 20th century, but it has been dethroned by “the strongest moat of all” (according to Bill Gurley) - network effects. Why are not all launching platform businesses then? It’s very difficult to reach critical mass, measured by when the value to onboard the platform is greater than the cost, and there is only place for one or two in a niche. This explains why these types of companies raise huge amounts of cash in the early days as it normally takes up to 10 years to reach that stage. They disrupt whole industries and the incumbents lobby the regulators to stop them.
Insight #3: Make your homework before it’s too late!
Maybe you will still think many of these businesses are too expensive now (and possibly they are), but platform businesses are here to stay and if you don’t learn about them now you will wake up one day having missed a lot of opportunities.
In fact, it might already be a bit late given this was written in 2016 and the platform companies basically ran the show oveer the last few years, but it still interesting to have a good understanding of this business model. As a complementary source, I would recommend checking out Ben Thompson different articles on platform models, a list that has gotten considerably longer in 2021!
Thought-provoking stuff…
Efficiency is the Enemy
Reading time: ~10 minutes
This (efficiently written with a reading time sub 10 min) post by Farnam Street is an essay in defense of slack, and a commentary on Tom DeMarco’s book Slack: Getting Past Burnout, Busywork, and the Myth of Total Efficiency.
The article uses the example of a fictional office with a secretary names Gloria, whose job is to help the heroic CEO (Tony) get his job done as well as possible. Surprisingly at first, Gloria’s job appears very inefficient as she spends most of the day idle. But if you start considering the whole system, the pieces start to fall together:
All that time Gloria spends doing nothing isn’t wasted time. It’s slack: excess capacity allowing for responsiveness and flexibility. The slack time is important because it means she never has a backlog of tasks to complete. She can always deal with anything new straight away. Gloria’s job is to ensure Tony is as busy as he needs to be. It’s not to be as busy as possible.
In fact, in modern workplaces and in general in our daily lives, we are obsessed with the fact of reaching total efficiency:
As individuals, many of us are also obsessed with the mirage of total efficiency. We schedule every minute of our day, pride ourselves on forgoing breaks, and berate ourselves for the slightest moment of distraction. […] In a world of manic efficiency, slack often comes across as laziness or a lack of initiative. Without slack time, however, we know we won’t be able to get through new tasks straight away, and if someone insists we should, we have to drop whatever we were previously doing. One way or another, something gets delayed.
In fact, that’s something that I’ve already seen commented by others. For example, Alexey Guzey, a blogger whose website I browse regularly, has written an interesting series on productivity, expanding on his experience in optimizing his work output and general satisfaction. I think the short paragraph about eliminating slack speaks for itself:
This is very well summarized by DeMarco in his book:
“It’s possible to make an organization more efficient without making it better. That’s what happens when you drive out slack. It’s also possible to make an organization a little less efficient and improve it enormously. In order to do that, you need to reintroduce enough slack to allow the organization to breathe, reinvent itself, and make necessary change.”
Philosophy with Children
Reading time: ~15 minutes
Aeon published an interesting article by Jana Mohr Lone, a professor of philosophy at the University of Washington, where she advocates that philosophy could be taught at a much younger age, and that children can actually help adults in tackling some contemporary philosophical problems.
I’m sure that some of you, readers, will share this experience of asking philosophical questions at a young age, whether it was to adults during the day time or at night. It seems that the process of getting to grasp your own identity pushes you towards metaphysics and noetics:
When I ask children what questions they wonder about, their responses typically include questions such as: why am I here? Who am I? Why is there hatred in the world? What happens when we die? How do I know the right way to live? One parent told me that her three-year-old daughter keeps asking her: ‘Mommy, why do the days just keep coming?’ […] Early in life, young children begin to try to make sense of their worlds and to understand the way things work. Almost as soon as they can formulate them, children begin asking questions about the concepts they hear and the world they experience. Around age four, children start asking what we call ‘why questions’. Why are people mean to other people? Why do I have to go to school? Why don’t dogs talk?
Some of these questions are even central to most of the adults that you might know. Here is an example of a 10-year old shattering your take on life:
I want to know why we work hard and worry about money, and what we’re going to do when we grow up, what we’ll do for work and food and shelter, when one day we’re just all going to die. I mean, what’s the point? What does it mean to be alive?
It seems that children, because they spend so much time reflecting and trying to understand their place in the world, are as capable as adults when it comes to coming up with fruitful philosophical questions:
Philosophical wondering is part of being a human being. What is the right thing to do? Why do people have to die? Is this person really my friend? When we think about such questions, we’re doing philosophy, participating in a tradition that’s been around for thousands of years. Most adults who ponder philosophical questions aren’t professional philosophers, but that doesn’t disqualify them from engaging in philosophical enquiry. Likewise, the fact that children are beginners at philosophy doesn’t mean that they’re not doing philosophy at all.
In fact, if children can’t really come to terms with philosophical texts that are difficult to understand even for adults, they have an ability to complement our knowledge and tackling of abstract concepts with their innovative and curious thinking patterns:
For children, philosophy is a profoundly imaginative and playful endeavour. They exhibit what is sometimes referred to as ‘beginner’s mind’, a way of approaching experience with a fresh and receptive perspective. The writer John Banville refers to childhood as ‘a state of constantly recurring astonishment’. […] Adults and children both come to philosophical encounters with important capacities. Adults contribute life experience, conceptual sophistication, and a facility with language and reasoning. Children bring a fearlessness about thinking creatively, without worrying about making a mistake or sounding silly, and a willingness to share their thoughts openly.
That’s part of the reason why many philosophers have been advocating for a deeper inclusion of philosophy in school curriculums, and especially for including it much earlier under a less theoretical, more playful form. Here we have Jana Mohr Lone, but I remember a piece written by the Belgian Luc de Brabandère, a fellow of the BCG Henderson institute, who made a similar request to Belgian officials. Giving the opportunity of making children practice philosophy would have interesting externalities:
Doing philosophy with children invites adults to connect with the special capacities present in childhood – wonder and curiosity, vibrant awareness and imagination, and a boundless sense of the possible – and thus to enliven and expand our own philosophical universe.
Arts & History
Le Louvre Online
Quick one this week as the site speaks for itself, but I recently discovered that the Louvre had started putting a great number of its masterworks in a digitalized format on their website.
While you are waiting for museums to reopen, you can do your own curated visit from home by browsing the different collections!
Treat for the Ears
L’arme fatale, selon Cerrone, c’est un peu de douceur sur un beat qui bastonne, recette appliquée dès son premier album, Love in C Minor, en 1976.
Other Interesting Links
Until next week!
Antoine