The Origin of Wealth: Differentiate, Select, Amplify. Repeat.

I've just finished reading Eric Beinhocker's The Origin of Wealth (now available in paperback) and it is a remarkable tour de force - I'm not sure whether I like it as much as The Blank Slate, but it isn't far off. It is broadly about "complexity" in economics and covers a multitude of areas: evolutionary biology, cellular automata, non-linear systems etc etc, amongst which there is a lot of overlap.

There are a few observations I gleaned from the chapter on finance which I thought were peculiarly good advice and often ignored in the industry including the following:

• Ultimately surviving as an investor is what evolutionary biologists would call a "Red Queen" race. On the margin, trading is a zero sum game and the costs of adaptation or entry barriers are relatively low, as a result, what makes you a successful gene is remarkably similar to what makes for a long lasting asset manager: flexibility, the ability to evolve, and having at any one time a few different approaches to feel out the market and then ride the winners. How many funds or even PMs are genuinely capable of enacting a Plan B or C, and, more importantly, when circumstances change, how many would actually do so? There is a reason why one of the attributes that are allegedly common amongst a Paul Tudor-Jones or a Soros is the ability change one's mind quickly.
• Any given strategy that becomes successful for long enough is doomed to become crowded and cease to be so, often via a sudden collapse in returns. This is a little like cutting one's losses quickly but on a strategic level.
• Ideas or content driven businesses should be relatively small and flat in their hierarchical structure whereas process driven ones with a large number of interdependent parts need more hierarchy and explicit organization. Hands up who has seen a bloated liquid markets hedge fund with way too much head count where hardly anyone talks to one another which soon is wiped out by massive losses in one part of the business that could have been forseen? Too many examples to mention here.

The macro fund structure makes a lot more sense than most because it broadly gives a smart manager to do the right thing in exchange for liquidity for investors rather than locking them into something very specific like credit, real estate private equity or the like that only makes a whole lot of sense for some of the time.

One thought I did have on the back of this book was to wonder whether big macro trades may in fact be exhausted, at least in the medium term and whether the better bets may be a bit more micro: sector trades, country level trades and more event driven trades. Russell Napier of CLSA is convinced that there's no point trying to fade a major equities correction driven by inflation until it gets to 4%, similarly, given the reflexive nature of monetary stimulus and Ben Bernanke's reappointment it may be the case that any real shocks are going to be heavily dampened by the Fed so long as the public outrage can be kept in check.

Longer run, it’s basically a given that US budgets are going to be in deficit for a while yet, similarly, it appears that at the long end of the yield curve the bids are mostly coming from US banks that are holding excess reserves and riding a steep yield curve to rebuild their equity. The problem with this is that as the financial system improves, it's going to be really hard to keep mortgage rates under control (ie, once JPM feels comfortable making loans etc again they don’t need to hold 30 year bonds up the wazoo so yields go up). This leads to problems as follows:

a. The curve is going to stay steep since as the economy recovers the marginal buyers of the long end disappear, this could adversely affect equity markets and lead to corporations borrowing short more often in turn leading to greater volatility in recessions (ie, refi risk is high when you have to roll a lot of your debt annually).

b. As a response, US bond issuance is going to be much heavier in lower duration (ie, t bills etc). Is it possible that over time this could lead to more severe currency and short rate volatility in the US?

But that, as they say is for the longer run and in the long run we're all dead. The more pertinent story might just be that rather than hunting for elephant moves in FX and the like, investors should be looking for more rabbit sized moves in industries and countries and pack the appropriate firearms.

Comments

[Robert Mart...:]

Nemo:

"...there's no point trying to fade a major equities correction driven by inflation until it gets to 4%, similarly, given the reflexive nature of monetary stimulus and Ben Bernanke's reappointment it may be the case that any real shocks are going to be heavily dampened by the Fed so long as the public outrage can be kept in check."

Well put and insightful.

The public SHOULD be outraged over the soaring deficits and Washington's bailout mentality (giving cash for clunkers, saving GM at the expense of bondholders, and rewarding excessive risk-taking by declaring a bank "too big to fail"). We're pulling out all stops to revive our debt-laden economy, and creating the Mother of All Asset Bubbles. We are curing the housing/credit bubble by giving a drunk another drink. As you put it, easy money from the Fed is one way to avoid civil unrest.

Political rants aside, inflation below 4% is not a terrible environment for stocks. Firms with pricing power will pass on costs, and firms in commodity sectors will have lots of upside leverage from the growth in global demand (esp. energy & basic materials). Therefore, it makes sense to be flexible about playing rising inflation. I'll have to add some high dividend stocks, to my inflation-play ETFs: seekingalpha.com/artic...

As you noted, the banks are riding the yield curve to rebuild their balance sheets. But this DOES punish savers, such as the elderly mother cited last week by a SA commenter. seekingalpha.com/artic... Fed policy punishes savers for their thrift, while rewarding profligate debtors. Widows and orphans beware...

I would also say that public anxiety is ALREADY near the boiling point: The debates over health care reform have degenerated into partisan hate-fests that teeter on the edge of violence. Americans fear that something is deeply wrong, though they can't quite articulate it; perhaps they fear an ongoing decline in living standards, which I describe at length in "The Deflation of the American Dream". seekingalpha.com/artic...

Finally, you posit that the yield curve will stay steep "since as the economy recovers the marginal buyers of the long end disappear." I guess this would happen because of rising inflation fears: Why buy 30-year corporate paper at 8% if inflation is headed to 4%+ ? If debt issuance migrates to the short end, some industries will suffer disproportionately. Utilities need long-dated financing, and so do nursing homes.

"...investors should be looking for more rabbit sized moves in industries and countries and pack the appropriate firearms."

Well said! Though if we're in a Bugs Bunny market, that makes me Elmer Fudd.

Rob

Sep 05 09:22 AM

[User 357705:]

Behind EVERY fortune is at least one crime.

Sep 05 01:42 PM

[locksmith:]

I've not read The Origin of Wealth but I think I'll order it. There was a related and insightful piece Peak Oil, Peak Credit, What Should We Do?. debunking current CAPM model on TOD last week.

Sep 05 02:08 PM

[locksmith:]

is link:
campfire.theoildrum.co...


On Sep 05 02:08 PM locksmith wrote:

> I've not read The Origin of Wealth but I think I'll order it. There
> was a related and insightful piece Peak Oil, Peak Credit, What Should
> We Do?. debunking current CAPM model on TOD last week.

Sep 05 02:09 PM

[Bull Run:]

The origins of America's wealth has been the wealth of it's middle class. No other nation in the history of the world had a middle class which encompassed such a large percentage of it's population, which was as wealthly as America's. Steal workers, Auto workers, Farmers, shop keepers, were all part of this enormous population of middle class, which owned 2 cars, a home, a summer cottage, and were able to send their children to college. This middle class, contributed wealth and real production to America, unlike today's Wall Street wealth, which has NO GDP, or contribution to production. This was the America that the rest of the world envied. America's lifesyles, and it was this mass of wealth that America's Middle class had built up,that was now coveted, by Wall Street, particularily after the mid 70's when America's real growth period was over. Hence the beginning of Wall Street scams. (Exotic investment vehicles). 1) S&L government backed loans. 2) Junk bond scam 3) The wwwdotcom scam.4) Turning the NASDAQ into a venture exchange 5) Stock options instead of dividends 6)Wall street's finest hour, the sub prime loan scam. 7) Wall streets latest, Life insurance into asset backed bonds scam. America now has lost it's middle class. America's homes and jobs that could support this lifestyle are all but gone... Where did this wealth all GO?? Over the last decade, 41% of all domestic profits, have gone to NY investment banks, NY brokerage firms, NY banks, NY managed funds. This then ends up in less than 2% of America's population, NOT in America's middle class, but in a very small tight community of Wall Street insiders living in Green. Conn. Is this the capitlism that Adam Smith invisioned?? All of America's wealth originated in America's middle class, which has now been transfered to Wall Street. History will look back on America, and question the moral and ethical transfer of wealth, which has brought down the wealthest nation on earth.

Sep 05 03:57 PM

[sixpackistan:]

amen. lower manhattan doesn't create, manufacture, design, build or really do anything other than stand in the middle of every transaction in america- just like, say, it's biggest partner and supporter: the federal government. go figure. i wonder who learned from whom?


On Sep 05 03:57 PM Bull Run wrote:

> The origins of America's wealth has been the wealth of it's middle
> class. No other nation in the history of the world had a middle class
> which encompassed such a large percentage of it's population, which
> was as wealthly as America's. Steal workers, Auto workers, Farmers,
> shop keepers, were all part of this enormous population of middle
> class, which owned 2 cars, a home, a summer cottage, and were able
> to send their children to college. This middle class, contributed
> wealth and real production to America, unlike today's Wall Street
> wealth, which has NO GDP, or contribution to production. This was
> the America that the rest of the world envied. America's lifesyles,
> and it was this mass of wealth that America's Middle class had built
> up,that was now coveted, by Wall Street, particularily after the
> mid 70's when America's real growth period was over. Hence the beginning
> of Wall Street scams. (Exotic investment vehicles). 1) S&L government
> backed loans. 2) Junk bond scam 3) The wwwdotcom scam.4) Turning
> the NASDAQ into a venture exchange 5) Stock options instead of dividends
> 6)Wall street's finest hour, the sub prime loan scam. 7) Wall streets
> latest, Life insurance into asset backed bonds scam. America now
> has lost it's middle class. America's homes and jobs that could support
> this lifestyle are all but gone... Where did this wealth all GO??
> Over the last decade, 41% of all domestic profits, have gone to NY
> investment banks, NY brokerage firms, NY banks, NY managed funds.
> This then ends up in less than 2% of America's population, NOT in
> America's middle class, but in a very small tight community of Wall
> Street insiders living in Green. Conn. Is this the capitlism that
> Adam Smith invisioned?? All of America's wealth originated in America's
> middle class, which has now been transfered to Wall Street. History
> will look back on America, and question the moral and ethical transfer
> of wealth, which has brought down the wealthest nation on earth.

Sep 05 07:16 PM

[macro -N- i...:]

Here's an example of the failure to adapt/ no plan B mindset: "I would rather pay a 20% premium on pseudo-closed end fund UNG than buy a different equity, and I put all of my savings into it and margined. I think I should average down,don't you? " Thanks for the suggested readings as opposed to a plug. Anyone who researches what happens to a country when it switches from an industrial base to a financial base will be an onlooker instead of a victim.

Sep 06 12:39 AM

[Pat C:]

Interesting interpretation and comments. I read it (twice and that's saying something - it is not a small book) and it is profound in its insight about the evolution of economics. Its interesting that you used the "Red Queen" race, my favorite was the experiment in "sugar land" and his nonpolitical conclusions. Great book - I highly recommend it to everyone.

Sep 06 01:49 PM

[NationalDef...:]

It appears this crucial statistic has escaped most commentators and independent bloggers alike. The privately owned Federal Reserve reported on June 11, 2009 in its series issue Z.1 Flow of Funds Accounts of the United States, line Debt growth, borrowing and debt outstanding tables (see spreadsheet d3.csv inside the zip archive) the latest calculated debt levels by category of sector in the US economy. Once the category items are added up, an astonishing figure of $59933.6 billion or nearly $60 Trillion results. Has this been mentioned at all on the MSM or on the blogs? I can’t recall a single instance of it. Everyone still operates with the $53 Trillion figure from 2007 reports and the %350 Debt/GDP ratio.

By that measure if we were to take the Q1 2009 reported US GDP of $14,097.2 billion and divide Q1 2009 total US debt level of $60 Trillion by that GDP number we would get an astonishing record Debt to GDP ratio of 425%.

This is unprecedented and is showing that the US economy is being crushed by the debt that is growing in absolute terms thanks to all kinds of US Government and privately owned Federal Reserve’s liquidity injection and asset prop-up schemes while at the same time the GDP is shrinking. Hence the conclusion is logical that these efforts are not working while they are piling on unprecedented levels of debt outstanding that are not possibly going to be payed back, and therefore will be defaulted on by definition. This is going to blow up in a quite dramatic deflationary bust event soon enough. One can only surmise whether it will be some kind of a credit event such as default by major US coroporation(s) or fear driven bond price drop that may lead to jump in interest rate. But in any case this is going to be deflationary as debt bubble begins to crack at the seams in earnest. It is only a matter of time. By the way, in the week before Labour Day of 2009 gold prices spiked up to nearly $1000 which is indicative of credit stress as investors flee to safety of gold from even the safest U.S. Treasuries. Gold as we know is nobody’s liability and therefore rises during credit stress situation in the economy. Surely this spike was not caused by rising inflationary expectations as gold performs abysmally during periods of inflation as any one can verify it by looking at the gold price decline since 1980 through early 2000’s when economy was in its boom years.

As a side note, the above mentioned Federal Reserve spreadsheet pegs U.S. Federal debt only at $6.7214 Trillion which is obviously excluding the Treasury debt that various Agencies of the Federal Government are holding and therefore make it appear as if the Government ows it to itself. The $60 Trillion figure is therefore a conservative estimate.

ndainfo.wordpress.com/.../

Sep 06 08:41 PM

[Moon Kil Woong:]

sixpackistan's statement mirrors very closely to what Gordon Gekko said about what he did. We don't create, we own! Well banks are owning a lot of everything by watching the middle class implode. And who does the government reward for this, the banks. The real wealth shift is material goods. Material goods, no matter how you value them, are all migrating to the financials and out of the public's hands. The only way they go back to the public is if the public borrows more from the bank to buy them back.

Back to the article... it is getting harder to make money due to not just evoloution but by the fiascoes of GS and others in masking real trading as well as arbitrary behaviors by the government. Esssentially they break the traditional capitalist model because the capitalist, free market model is being broken by the powers that be.

Strangely, few seem to care. While human individuals worry and go about their business (providing they have ones), cold calculating eyes are looking upon their assets and how they can make them theirs. They are not martians, they are too big to fail banks and bankers (zombie and non zombie alike).

Sep 08 07:07 AM