'We Shall Not Pass This Way Again'
Jack Bogle passed away last week. He may have been the only Wall Street mogul in history to have foregone personal enrichment all for the enrichment of his customers. He was the answer to "Where Are The Customers' Yachts?" and for this reason alone his career should be lauded.
Besides his enormous accomplishment, a multi-trillion dollar non-profit asset management firm in the midst of the most profit-focused sector of the economy, Bogle should be praised for his candor and honesty. He, perhaps better than most, understood and openly discussed the potential negative ramifications of his own invention.
One of these negative ramifications is that the common ownership enabled by the broad adoption of passive products encourages anti-competitive behavior among the companies invested in. Thus, to some extent, the benefit to investors comes at the expense of the rest of society.
But, as Charlie Munger hinted at years ago, the real problem with passive investing is that, as it grows more popular, it begins to undermine its most basic assumption. For it to work properly requires a significant degree of efficiency in the markets, efficiency that can only be provided by a deep and active pool of thinking investors. To the extent these folks are marginalized, the markets become less efficient and passive investing becomes less valid.
These "preposterous results" are exactly what we have seen recently as passive investing has been taken to the extreme. Investors, encouraged by the recent unprecedented success of a buy-and-hold approach, poured money into the funds pushing prices (and valuations) ever higher encouraging even more inflows in a virtuous cycle.
However, this was not at all what Bogle intended. Certainly, he may have understood well how his invention had been bastardized by those looking to rationalize the greed that drives every mania. His final counsel to investors seems directed squarely at these folks.
Here again, we should not only find reason to praise this legend of the business but also reason to emulate him. Imagine what we could accomplish if we all focused just a bit more on intellectual generosity delivered with a personal kindness.
Rest in peace, Jack.
Anticapitalism Goes Viral
It's hard to blame passive investing for all of the ills that plague our modern form of capitalism, namely an explosion of anti-competitive behavior along with an anti-labor movement that has contributed to income and wealth inequality like we have never seen before. There are certainly many other dynamics at work, including extreme monetary policy and growing corporate influence in Washington not to mention the natural forces of demographics and globalization.
All of these things have played their part in shifting the portion of profits that historically has gone to labor into the pockets of shareholders. And it's impossible to accurately attribute to each of them their rightful contribution to the problem. That said, it is also impossible to deny that the backlash against the current form of shareholder-first capitalism (damn the stakeholders) is gaining traction and the media is mirroring the sentiment of the populace.
The mood surrounding Davos this year also reflects both the growing anti-elitist sentiment and the willingness of people to openly speak about it. Anand Giridharadas, author of "Winners Take All", did a terrific job of summing up the current zeitgeist in this regard.
The viral popularity of Alexandria Ocasio-Cortez, the youngest woman ever elected to the House of Representatives, is also a testament to the strength of the opposition to the status quo in corporate America. Her very first speech broke C-SPAN viewing records last week and it couldn't be more obvious that she stands for taking back what corporations have usurped from people over the past 30 years or so. While some may write her off, as the New York Times recently reported she is moving the Democratic party sharply to the left, whether they like it or not.
This is a shift that bound to be a very expensive one. Modern Monetary Theory, the philosophical bedrock of the new policies proposed by progressives, posits that fiscal policy should not concern itself with the cost of policy; leave that to the Treasury and the central bank. The Fed can simply buy up all the debt the Treasury needs to issue in order to finance the government.
The idea here is that so long as we borrow in our own currency we can never borrow to the point of going broke. The truth is, just as passive investing is being used to rationalize greed in the markets today, MMT is simply being used to rationalize greed in politics.
And inflation is, to a great degree, reliant on Fed credibility - that is, the idea that the Fed will live up to its mandate by keeping inflation under wraps. With the Fed already technically insolvent, if it were forced by Congress (or even if it appeared to be forced) to monetize the debt then inflation could soon become a very big problem simply as a result of people believing it to be a problem.
MMT recognizes that such fiscal dominance and monetary accomodation could be inflationary. Their answer to this problem is, if inflation rises we can raise taxes to rein it in. With the trajectory of the debt already getting more vertical this could mean a significant rise in taxes. The most obvious candidate for such a shift would almost certainly be the recent corporate tax cuts. As I have noted here in the recent past, House speaker Nancy Pelosi has already promised they would be repealed.
With corporate leverage off the charts, higher interest rates would certainly pressure margins at least as much as a higher corporate tax rate, not to mention the other cost pressures associated with a shift from disinflation to inflation. In addition, higher discount rates applied to lower profits (amid margin contraction) would be doubly painful for investors. In other words, these societal shifts we are witnessing represent an indirect attack on both corporate profit margins and valuations.
Tech Has A Target On Its Back
The sector most representative of the margin explosion in recent years, not to mention elitism and the centralization of power, is also uniquely at risk of a reversion of profit margins to a more historical norm.
In fact, the majority of tech companies are already reporting they expect a contraction in profit margins in the fourth quarter - even with the favorable comparisons created by the tax cuts!
It may ultimately turn out that the profit margins of recent years were inflated by the fact that companies simply ignored investing in costs they are now discovering were crucial to the long-term health of the business.
Some are even beginning to ask whether these companies should be held accountable for intentionally under-investing in precautionary measures that clearly should have been taken. What would Facebook's financial liability were it found guilty of such in the case of the Myanmar genocide? More realistically, what will it cost Facebook to try to prevent a recurrence of the tragedy there or anywhere else on the planet?
There is, in fact, a lawsuit currently underway that could determine, in a small way, the legal liability for companies in this situation and thus has major implications for almost every big tech company in existence.
Even if they are not found to be legally liable, the companies are beginning to understand that not investing in protecting users, while it may be good in the short run in terms of the bottom line, has major long run implications for the top line.
While it may seem as if users are oblivious, the facts show that the (well-deserved) damage done to Facebook's reputation over the past 12 months is having an affect on its users. This is part of the strong impetus Facebook now has to spend a great deal of money trying to fix its unfixable problems. It is also a clear warning to every other company in the industry. Protect the bottom line at the long run risk of the top line.
The groundswell of support for the backlash against big tech also continues to gain steam. Time magazine this week made it the focus of its issue featuring an in depth piece on Facebook by Roger McNamee calling for a plethora of new regulations for the industry.
The issue also includes a piece written by Apple CEO, Tim Cook, calling for even more regluation of not only the companies that collect and track our data but also the companies that aggregate and sell it, the data brokers.
As I have written before, the impetus to rein in big tech is a nonpartisan issue. At his confirmation hearing this week, the nation's new Attorney General made several comments on the topic. Breaking Views reported: "He told senators that he would like the department to become more involved in anti-competitive issues, privacy and data concerns. He said the market power of Silicon Valley firms could allow them to discriminate against rivals."
Surely, there are not many things that the Trump administration and the progressive left see eye to eye on but this is one. Don't be surprised to see greater scrutiny of proposed mergers in the tech space and even proposals to break up the big conglomerates.
Most troublesome for the individual companies, though, may be the mutiny already underway on the part of their workforce. Recode reports that these folks, "have experienced years of growing frustration with what they find to be the tech industry’s pursuit of profit at all costs, including ignoring ethical standards." They are fed up and willing to hold their employers' hostage in order to have a greater say. Any threat to the "profit at all costs" way of doing business is obviously a risk to profit margins.
All of these things, as I am wont to say, are closely interrelated. The rise of passive investing and elistism at the corporate and political levels along with the trends of globalization and disinflation are now at a major inflection point or maybe they have already passed it. Going forward centralization of power as embodied by big tech will trend towards greater competition and decentralization. Cryptocurrency may be dead but the inspiration behind it is stronger than ever. Globalization and disinflation are evolving into populist and nationalist policies that are clearly inflationary.
As a result, investors will need to give up the "ignorance is bliss" approach to the markets in favor of a much more thoughtful one. They will need to avoid companies most at risk of margin contraction and most exposed to labor cost and political pressures. Most importantly, they will want to avoid companies that most embody the elitism society is now railing against. They will also need to avoid the asset classes and strategies that benefitted most from a disinflationary and plutocratic environment and try to focus on those that benefit from an inflationary and populist one.
More than ever before understanding the macro backdrop, rather than simply closing one's eyes and buying stocks with both hands, will be the key to surviving and thriving in the future. Passive investing has had a great run and while the central lessons of it - what Bogle really gave us, namely broad diversification and rock-bottom costs - will remain, "we shall not pass this way again." The way forward will likely reward a vastly different approach to that which was rewarded in the recent past.