21 Aug 2012

"So You Say You Want A Revolution" - The Real New Normal

This month marks the 50th anniversary of Thomas Kuhn’s The Structure of Scientific Revolutions, one of the landmark philosophical texts of the last century.  The central thesis of the book is that science advances in fits and starts, clustered around the advent of new 'Paradigms' - a term that Kuhn introduced in the book and much of academia subsequently coopted as their own.  This was a novel thought for the times, since the conventional philosophy held that science advanced through the ages in plodding but rigorous steps.  Kuhn’s observation about science is equally applicable to capital markets, for the range of 'Paradigm shifts' underway goes a long way to explaining everything from why companies refuse to invest to why earnings multiples on U.S. stocks remain so low.  Today, in celebration of Kuhn’s opus, ConvergEx's Nick Colas offers up a list of the ‘Top 10 Paradigm Shifts’ currently underway.

Nick Colas, ConvergEx: So You Say You Want A Revolution
To those of us whose careers can now belly up to the bar and have a drink, the last +21 years of life interpreting the capital markets have seen remarkable change.  I managed to analyze the automotive sector for well over a decade in the 1990s/early 2000s without ever reading a speech given by a Federal Reserve chairman.  Now I review everything Chairman Bernanke says, no matter how trivial.  I was indoctrinated into the school of thought that U.S. equities return 8-11% annually, on average.  Now I blush at that laughable simplicity of the claim.  And many, many years ago, single stock research ruled the intellectual roost at virtually every asset manager with two nickels to rub together.  Now, between high correlations and supercomputers, most daily stock trading has little-to-no linkage to fundamental analysis.
One of the most influential books of the 20th century – Thomas Kuhn’s The Structure of Scientific Revolutions – celebrates its 50th anniversary this month, and there is much in this landmark text that helps explain how change occurs in complex human systems.  Since its initial publication, the book has become one of the most widely cited academic works in modern history and sold over 1 million copies.  Even 50 years on, Amazon currently has the anniversary edition listed at #12 in books about the philosophy of science and math and in the top 1,500 of all books currently for sale on the site.  I first read “Structure” in business school in an introductory strategy class and still have my dog eared copy on my bookshelf at home.
The message of Kuhn’s opus is simple: mankind’s scientific knowledge advances in fits and starts, centered on rival theories of how the world works.  These belief structures, which he called ‘Paradigms,” start life when existing theoretical models have run their course and no longer yield new insights. They are, at first, actually inferior at explaining the world around us versus their aged counterparts.  But with time, adherents to the new paradigm refine it to the point where it succeeds the old models.  Most activities that pass for “Science” actually do nothing more than try to prove the currently accepted “Paradigm.”  For mankind’s knowledge to advance materially, some renegade scientist must propose a “Paradigm shift” – a set of novel ideas which attempt to explain where the old model gets things wrong.  He or she may be initially shunned by the adherents of the old paradigm, but eventually they gather up followers interested in doing the research to prove the new models correct.
For me, this description also neatly describes how prevailing investment themes develop, mature, and then die in capital markets.  Granted, economics and stock market analysis are not as rigorously scientific as physics (Kuhn’s specialty), chemistry or other natural sciences.  The structure of how ideas become “Paradigms” is largely the same, however – as well as how those same notions eventually die off and get replaced by new ones.  In fact, what strikes me as most telling about the current investment climate is just how many “Paradigms” are currently in flux.
Here’s a quick “Top 10” style list of ideas which are undergoing noticeable change:
  1. U.S. equity market structure.  The Securities & Exchange Commission’s list of approved Alternative Trading Systems contains the names of dozens of venues where investors can buy or sell U.S. equities.  Keeping all these ATS’s in sync requires market participants who both put their own capital to work arbitraging price differences and spend the money to write computer code quick enough to beat the competition trying to do the same thing.  This structure is wildly different from that used before 1998, when the SEC formally approved the first regulations for these venues.  Old paradigm: Human traders at a few locations.  New Paradigm: Computerized systems coordinating many locations.
  2. Fragility of the global financial system.  While it may seem impossible in today’s world, the last +20 years have seen large institutions fail and markets whipsaw without it meaning financial Armageddon.  Remember the names Drexel Burnham and Lincoln Savings, or the date October 19, 1987?  If you don’t, it’s because the global financial system could absorb the shock seeing a major investment and/or commercial bank fail and a 22.6% one day decline in the stock market without wondering about the end of Western civilization.  Now, the market’s belief structure (“Paradigm”) seems to believe that the failure of any large institution is just the beginning of a long chain of falling dominos.  Old paradigm: smaller institutions, fewer common linkages.  New paradigm: large mission-critical institutions, intertwined by common ownership in similar financial assets.
  3. Reliance on political decision makers to maintain European currency union.  No one ever wondered if the French Franc or Italian Lira would survive.  Or the Drachma, for that matter.  Elected governments – or dictatorial ones, for that matter – were inextricably tied to their national currencies.  Now, the euro needs a friendly pat on the back from policymakers pretty much every day, or it goes off to sulk.  Old paradigm: single-country currencies, beholden to local fundamentals and political systems.  New paradigm: currency blocks, managed across multinational boundaries by unelected officials.
  4. Sustainable long term stock market returns.  About the same time I was reading “Structure,” I was also learning that U.S. stocks rose an average of 8-11% on a compounded basis over a 10-15 year time frame.  Since the year 2000, the S&P 500 has been to 1,500 twice, only to fall back again in the following years to 800 or below.  Investors of all stripes have taken notice, pulling almost $500 billion from U.S. stock mutual funds since 2007 and doing less trading of individual stocks.  Old paradigm: Buy and Hold.  New paradigm: Better safe than sorry.
  5. Exchange Traded Funds versus stocks.  While the belief in the U.S. stock market has taken a hit, ETFs continue to grow.  Some of the most successful launches over the past year are in low-volatility products, which buy stocks that exhibit below-average levels of price movement.  Dividend-oriented investing has also been popular.  Old paradigm: “Widows and orphan stocks” like utilities.  New paradigm: “Widows and orphans ETFs” like emerging market dividend products and a good “Min-vol” fund.
  6. How to perform single - stock research.  Twenty years ago, most public companies didn’t even do quarterly earnings conference calls.  You got the press release faxed to you, you called the investor relations rep or the chief financial officer, and prayed they would call you back that day.  If you wanted an annual report, the company would mail it to you.  Now, the Internet makes all this look silly, of course.  But it also means that getting an investment edge is all that much harder.  Old paradigm: Call the company, its competitors, its suppliers, the analysts that follow it, and go to trade shows and conferences.  New paradigm: let someone else do the work – just buy a diversified index.
  7. Volatility.  Wild and whippy action in stock markets is nothing new, and we didn’t need market structure problems to have a 22% one day crash in 1987.  The difference is that the S&P 500 still returned 6% in that year.  Now, volatility means the risk of losses that might take years to replace.  Old paradigm: Buy and hold. New paradigm: Buy the dips, sell the rallies.
  8. Substandard economic expansion.  From low consumer confidence to still-high unemployment to structural underemployment, the current U.S. economic “Recover” is extremely weak versus historical norms.  Old paradigm: +5% GDP growth for a year or two off the economic “Bottom.”  New paradigm: Recovery? What recovery?
  9. Unusual central bank policies and tools.  The job of a central banker used to be pretty simple.  Lower interest rates in a recession, increase them in a recovery.  Fight inflation by never letting your local economy overheat.  Now, you need to have a full-fledged fixed income desk and portfolio management system to track the billions – if not trillions of dollars/euros of bonds you need to buy in order to execute on your policy decisions.  Old paradigm: quiet, unknown central bankers toiling in relative obscurity.  New paradigm: central banker as rock-star hedge fund manager.
  10. Corporate reinvestment policies.  Used to be that well regarded growth companies all took great pains to expand their businesses. Maybe they integrated vertically, buying up customers or suppliers.  Or perhaps the company in question grew their international operations, launching their brand into large developed markets  high-growth emerging economies.  Now, most companies seem to have dividend/buybacks closer to the top of their lists.  Can you imagine the response most CEOs would get if they announced a new initiative to expand in Europe right now?  Old paradigm: winning companies reinvest and grow as quickly as is prudent.  New paradigm: slow and steady may not actually win the race, but it won’t likely get you fired, either.
The bottom line here is that a lot has changed in 20 years or so.  And it’s not just a few “Big” concepts; it’s practically everything from what makes for winning corporate strategy to how investors of all stripes consider basic asset allocation.  In the language of Kuhn’s opus, there are many “Paradigm shifts” all occurring at once.  That doesn’t necessary spell disaster.  But it does mean that a whole range of “Old” ideas are heading out the door as an equally expansive set of new paradigms are moving in and setting up shop.  Remember that new paradigms don’t often have as much to them as the old ideas they replace.  They are often actually inferior.  Over time they get their bearings, yes.  But the transition is rough. 

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