Alice and the White Queen

Is the market trying to believe impossible things?

Illustration: John Teniel. Source: Wikipedia

A classic “children’s” book – that isn’t really for children – is Lewis Carrol’s Through the Looking Glass, his sequel to Alice in Wonderland. In the book, Alice and the White Queen have this exchange:

“There’s no use trying,” Alice said. “One can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Sometimes the market confronts us with what seems like impossible issues – things that appear to be part of the market’s calculation, but things that we know to be impossible. Here are a few:

The bond market is priced as if low inflation and negative real rates will be with us forever. Negative rates in Europe and Japan are the most egregious examples. In Germany, the 2-year Government bond yields minus 0.75%. In Switzerland it’s minus 1%, in Japan minus 0.1%. But even in emerging markets, stable, low inflation is expected. Colombian 10-year bonds yield 3.5%; Hungary yields 3%; South Korean (bordering a rogue nuclear power) yields 2.1%. The deep and liquid government bond market is assuming that inflation will never come back – even in emerging markets with a history of populism and hyperinflation. Hungary experienced the highest rate of inflation ever recorded in the 1940s: 200% per day.

Photo: Mizerák István. Source: National Museum, Budapest

Second, the Big Five tech stocks are priced as if they are unassailable. In the short run, this is clearly true. Facebook enjoys network effects: people join Facebook because other people are using it. Kids’ sports teams, local VFW Chapters, labor unions, and nonprofits all use Facebook to share information. Google uses information from billions of searches and clicks every day to improve its search algorithm – making it even more attractive as a search engine. Amazon does the same thing with purchase information – making online shopping ever-easier.

But size ultimately defeats itself. Large corporations become bureaucratic and layered. Rules that once made sense in a limited context become institutionalized and universal. And perhaps most importantly, the incentives to work for a large corporation are different than those presented by a small company. That’s why Steve Ballmer left a good job and P&G to be Microsoft’s 30th employee. It’s not about the pay, it’s about the autonomy – and doing something new that can change the world. And eventually big companies run into physical limits to growth. Mark Zuckerberg has said that projects aren’t really interesting unless they can impact at least billion users. But just there aren’t that many billion-consumer projects.

Finally, market participants seem to believe that cash is a source of stability – both in the economy, and within corporations. Certainly, in the short-run, this is true. Cash is a key element of credit risk. If you want a $1 million loan, it’s helpful to have $2 million in cash on hand. And cash is currently quite high, both as a percentage of our economy and total nonfinancial debt.

Source: GMO, Federal Reserve

But in the long run, cash is a source of instability. Among governments, excess cash holdings inspire envy, leading to external threats and internal dissention. Income inequality doesn’t usually bother people when the income is earned. No one singles out entrepreneurs who work hard and create something new as plutocrats. They created something totally new.

Similarly, within corporations, big piles of cash on the balance sheet can lead otherwise sensible managers to do something stupid. They didn’t get to be managers through their timidity – they usually have a healthy combination of charm, ability, and animal spirits. If they’re successful in business, high returns on equity eventually lead to excess cash, posing a temptation to them – or outsiders, who want to “unlock” that value. Accumulated cash is like a dragon’s hoard, inspiring irrational conflict and delusional dreams.

Illustrator: Arthur Rackham. Source: Wikipedia.

In order to believe that the market is truly efficient, you have to believe these “impossible” things. Of course, they aren’t impossible. Just not very probable. Eventually, growth and inflation will come back – especially in the developing world. The temptations of populism and deficits are just too much. Eventually, large companies will yield to small companies as the engines of innovation. Eventually, cash hoards will be dispersed. We just don’t know how long it will take.

It’s not comfortable to consider multiple scenarios with uncertain outcomes in our investment portfolios, but as Voltaire once noted, “Doubt is not a pleasant condition. But certainty is absurd.”

Douglas R. Tengdin, CFA

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