Best of 2015: Stories for Investors
Each year I look back at my favorite reads over our most recent lap around the sun. But before I get to those favorites, let me thematically highlight what I think are the biggest stories of the year for investors. Some of these themes make a more formal appearance in the actual favorites below. But many of these are my own thoughts about things that, I hope, offer the scant hints of possible investment themes not being covered well by the press.
Ambulatory or Ambulance?
To me there is no bigger story than the unanswered existential question that I think most of us have. This year’s elephant in the room award goes to [drum roll, please]: Can the global economy stand on its own two feet without central bank stimulus? And, by the way, this remains the biggest story since the global financial crisis. I wish I knew the answer to that $64-trillion question, but alas, I do not. Many wonder, including me: Have we reached the limits of monetary policy?
I do know that China occupied a good deal of my active mental bandwidth this year. There were plenty of topics, from the mundane — can we trust Chinese data? — to the yawning of their equity markets, to the end of the notorious demographics-killer “one-child policy,” and to the inclusion late last month of the renminbi in the IMF basket of global reserve currencies. But wait, there’s more! What will the Chinese do to transition their economy from a manufacturing juggernaut into a slower growth, higher productivity, consumer-driven nation? And is that necessarily a good thing to which to aspire, especially for the environment?
The Certainty of Demographics
Another important story not being discussed enough is that successful economic growth leads to demonstrably lower birth rates and, consequently, worse demographics. Much of what we call economic growth is of the “more mouths to feed” variety: New birth equals new need for food, clothes, education, transportation, health care, and so on. What does the world look like with a flattening and maybe even declining GDP? Obviously, so long as GDP per capita is growing along with productivity, there will still be what I call real economic growth (and I don’t mean inflation-adjusted). Real economic growth is finding how to get more from the same set of resources, or to get the same from a smaller set of resources. However, there will be a huge mental adjustment for investors, economists, politicians, and consumers when we get to a point where population growth decelerates in the aggregate.
Some other big stories are the disappearance of liquidity from fixed-income markets — more on this below — and the disappearance of company news from business publications. I remember in the early days of my career that reading the Wall Street Journal or the Financial Times was like reading the sports pages, but for business. Economic and central bank news certainly made appearances, but business news was, well, dominated by business. I dare you, even in earnings season, to pick a day when the headlines are predominantly about businesses. Instead, everything is about central banks and geopolitics. Interesting times!
Looking back at my favorite stories in this way opens a window into my subconscious as certain themes repeat themselves in my choices. It is these repeating themes that serve as the guideposts below.
Economics and Markets
One of the post-Great Recession trends that I track and that frankly worries me is the lack of investment in innovation by businesses. Instead companies plow cash into share buybacks, which have little long-term effect on a firm’s performance. Beyond the internet there is little innovation.
Liquidity drying up in the face of record issuance and central bank profligacy are not the only dilemmas confronting fixed-income investors. There is also concern about the mechanics of bond indices and how they can lead to volatile market swings. While debt remains historically cheap, corporate interest coverage ratios are worsening. [Interlude: That word historically is thrown around a lot, but really feel that word. In the span of debt market history, interest rates have never, ever, ever, ever been lower . . . wow!] With every bull market there is always an increase in bad underwriter behavior. In this case, liar loans are back on the upswing, despite their nuclear effect during the Great Recession.
State of Finance
I exited my retirement to join CFA Institute for several reasons. One of them was that I felt that finance was being dragged into oceanic depths by bad actors, and that it was a time for good people to do good things. [I hope you believe I am one of the good people.] Consequently, I am very sensitive to the state of finance from an ethics and client-centeredness perspective. Sadly, on average, most finance professionals believe our industry is unethical. Likely contributing to this perception is the continued special access to management granted to some investors and the abusive trading practices, like spoofing, of some high-frequency traders (for the record I am, on balance, in support of HFT).
But as we all know, harsh evaluations of our industry are not just limited to internal critics. Many who are tangential to our business also take aim our accepted “best” practices. For example, some reports find that the cost of a too-big financial sector on the US economy is 2% of GDP. Still others believe that mergers actually damage the economy.
Not only are traditional parts of the finance industry receiving scrutiny and criticism, even in frontier areas of the sector, like behavioral finance, critics are emerging. Witness the five-year report card on the progress of “nudge” programs initiated globally by governments to affect the behavior of the public. In short, many are starting to believe that once the novelty period surrounding the initiation of a “nudge” is over, people tend to revert back to their old behaviors. But there is some good news on the horizon. Specifically, the influential law firm of Wachtell, Lipton, Rosen & Katz, a long-term supporter of shareholder value thinking, is calling for the end of quarterly earnings reports because they believe it takes the eyes of companies and investors off of the long-term investment prize.
Those of you who have followed my writing for a long period of time know that one of my endless sources of fascination is studies of consciousness and the mind. This is because our consciousness and our minds are the real discounting mechanisms, and the better they function, the more successful we will be in serving our clients. Of course, to do this we need a better understanding of brain functions, like memory and memory formation, which are formed by brain wave harmony. One fiction that has persisted in popular culture is that different parts of the brain have exclusive functionality. Neuroscientists continually find an orchestra at work when examining the functioning of the mind and not the fabled solo violinist.
One way to literally change the physical structure of your brain is through mindfulness meditation. Meditators routinely score better than non-meditators on all kinds of mentally taxing activities, and they respond much less instinctively, too. Even if you are not a meditator, you can still improve your mental functioning. One way suggested by ace investor Ray Dalio is to acknowledge what you do not know. If we can improve our consciousness and our minds — and I know we can — then we need not fear the rise of the machines so chronically and acutely.
Environment, Social, and Governance (ESG)
A perennial interest of mine is the rise of ESG considerations as important return and risk tools. I realize that in certain parts of the world, the “E” component of ESG remains a subject of controversy. If you are something of a skeptic, then you are likely pleased to know that carbon credits may actually be leading to increased levels of pollution in some locales. Interestingly, Yale researchers documented that the more educated members of the public are about climate science, the more polarized they become.
If you do believe that climate change is an important risk factor to consider in evaluating investments, then you will love this infographic that shows what is warming the world. Another research paper reveals what a road map would look like for all 50 US states to become fully sustainable. Sadly, reports are emerging that China’s coal consumption is higher than reported, which will shock no one living in Beijing or Shanghai.
From the “S” aspect of ESG comes this story that considers what would happen if the richest person in every country gave all of their money to the poor. And from the “G” part is this excellent thought piece about better ways to compensate executives.
While there are always many technological advances to marvel at, I tend to focus on those that change the big stuff, and it does not get any bigger than electricity. Anything that changes electricity generation, distribution, and storage is going to be highly in demand and beneficial. For many decades now, one of the hurdles facing renewable energy versus fossil fuels is storage technology. Two new battery technologies look set to change everything. First is a battery anode that uses light and titanium nitride to create a battery that charges very quickly and is safer for the environment. Second is a long-sought-after advance in the quality of lithium batteries.
Too often we think of technology as devices that are manufactured. But new ways of thinking and organizing are also technology: take, for example, smarter electrical grid logistics that will reduce waste. Lastly, machine learning has many passionate proponents. Could it be that their bias ends up corrupting the quality of the machines they have “taught” to “learn?”
While on the subject of machines and number crunching, this excellent commentary discusses the limits of financial modeling to describe risk. Meanwhile, Indiana University researchers have created a new fact-checking algorithm that is incredibly good at discovering falsehoods. At a more micro scale, more and more research papers now report a Cohen’s d effect size, yet how do we interpret it?
Things Maybe in Which Only I Am Interested
Now, at the risk of torturing you, let me share with you some of my favorite reads this year that have absolutely nothing to do with my day job. I readily admit to some very wonky, non-finance reading. A particular favorite is quantum physics. Researchers have found that the line between classical and quantum physics is not as distinct as is implied by Bell’s Theorem. Specifically, the line needs to move quantum effects further up the continuum toward the classical world. This result is shocking, and continues to whittle away at the preeminence of the physics you likely learned in school. Along the same lines, researchers believe it is possible to use light to create matter! To me this is a truly WOW! kind of story.
Last, and in an entirely different realm, sometimes it is difficult for this gruff old portfolio manager to coexist with his nonprofit colleagues. Here is a piece in celebration of the office villain — or at least the person willing to “tell it like it is.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.