Sensing sources of instability, many investors are at trigger alert for an anticipated sudden change in market direction while at the same time paralyzed by uncertainty as to its timing.
With bull markets in both stocks in bonds, across the globe, and for over five years, those who aren’t completely complacent about the ease of earning outsize returns are frightened about a coming crash. But what to do?
Enter the founder and chairman of Toqueville Asset Management, Francois Sicart, who in a letter to shareholders offers a seasoned investment perspective on the nature of black swans and the strategy he views as suited to our times.
Sicart begins his discussion of instability by recalling former MIT professor and central banker Charles Kindleberger’s theory of hegemonic stability.
Kindleberger, with whom Sicart was personally acquainted over three decades ago, argued that the world was more likely to be stable with a single dominant power rather than a more competitive international state system.
In Kindleberger’s view, it was the lack of a hegemon that led to the Great Depression, “as England no longer was able to exercise world leadership and the United States was not yet ready to assume it,” Sicart writes.
In that context, Sicart notes the growing sense that the United States’ hegemonic power today is waning. Emblematically, he quotes from a Financial Times review of Henry Kissinger’s new book, World Order:
“For the past 25 years, since the fall of the Berlin Wall and the collapse of the Soviet Union, the U.S. has occupied the role of hegemon. The unipolar moment is now coming to an inglorious end.”
In the economic sphere, the potential for a seemingly isolated incident to trigger “chain reactions with potentially destructive global consequences” is similarly an ever-present source of instability. Yet a hastily timed market exit is also not without risk.
Sicart illustrates that point quoting Keynes’ famous dictum that “the market can stay irrational longer than you can stay solvent.”
Seeking to elucidate the nature of instability, Sicart draws on the perspective of three theories of how disaster strikes economies and markets.
The first is Nassim Taleb’s famous black swan theory. Taleb notes that in the European mind swans were known to be white — until a single black swan was discovered in late 18th century Australia. From that moment, it was no longer possible to predict the probability of seeing a black or white swan, absent relevant data.
That metaphor of surprise led to Taleb’s view that world wars, pandemics and disruptive technologies are all black swans that are unpredictable except in hindsight for lack of historical precedent.
Just as Taleb warns that surprises will occur but investors have no ability to foresee them, so too does John Mauldin’s disaster theory, founded on physicists’ observations of avalanche data, leave investors without predictive powers.
“If you drop one grain of sand after another onto a table, a pile soon develops; eventually it takes only one grain to start an avalanche,” Sicart writes.
Yet a 1987 Brookhaven National Laboratory study demonstrated the inability to predict how much sand, how great the magnitude of the avalanche or when the phase transition would occur. There is an unknown “critical mass” or “tipping point,” which Mauldin calls “fingers of instability” that do the tipping when the sand pile is just on the verge of tumbling.
So once again, we know that stability won’t last, but can’t tell when stability will yield to instability.
Alas, that is in some sense the upshot as well of the third disaster theory Sicart cites — economist Hyman Minsky’s theory of why stability is itself the cause of instability.
The “Minsky moment” that became the popular explanation of the recent subprime crisis argues that the more comfortable investors are with a trend, the more it will persist, and then the more severe the correction will be when the trend suddenly fails.
Once again, the implication is that disaster is assured, though its timing is unpredictable.
Sicart’s conclusion: forecasting is futile — because predictions are overwhelmingly incorrect but also because they don’t matter.
“What really matters,” he writes, “is how much you stand to gain if you are right and how much you stand to lose if you are wrong. And that is mostly a matter of valuation.”
Today’s valuations, while not as overextended as before the subprime or dot-com crashes, are nevertheless higher than those that precede periods of outperformance.
“Meanwhile, complacency generally reigns while the grains of sand are piling up politically, economically and financially,” he writes.
For that reason, Sicart’s strategy is simply “to pause and wait, investing only in securities that might offer outsized potential gains over time if our analyses are vindicated, and keeping dry powder for future opportunities when valuations are more compelling.”
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