As we approach the end of the summer, Covid-19 health risks remain prevalent. The new delta variant continues to shed uncertainty around a robust economic recovery. Amid the new variant’s increasing infection rates (even in vaccinated individuals), the Federal Reserve announced that the in-person plans for the Jackson Hole symposium would be replaced with a virtual event on August 27, 2021. This decision may preclude a broader “pullback,” or slowdown of economic activity, and pause robust economic recovery. Some data supports this case as air travel decreased by 10% from the mid-July high, restaurant reservation cancellation rates increased, and retail sales dropped 1.5% from June 2021. However, not all the data points to an economic slowdown—jobless claims continue to trend down, and leading economic indicator signals a positive outlook. Therefore, economic data remains as uncertain about the potential implications of the renewed Covid health risks as are central bankers and investors alike.
Adding fuel to the economic fire, policymakers have a difficult decision: when to taper. With equity valuations at almost unsustainable levels, this monetary policy decision could prove to be the catalyst that can drive a seasonal market pullback that to some, seems long overdue. This dynamic can potentially lead to additional questions such as: how significant will this pullback be? Will it be an acute or obtuse reaction? And which sectors will come out winners after the equity normalization? All these questions have many appropriate answers, depending on specific opinions, idiosyncratic risk, and economic policy support. Therefore, the answers to these questions remain constrained and too goal-oriented to produce an accurate answer. As investors muddle through the current uncertainty, one definition remains pivotal to highlight: Market disequilibrium remains the backbone to arbitrage opportunities.
The history of economics remains rooted in the determinate calculus of individuals such as philosopher Rene Descartes and the conservative theories of physics’ influence on economic equilibrium and the definitions of utility theory. For reference, the price equilibrium is the price associated when supply meets demand. However, the conservative nature of economics (rooted in the first law of thermodynamics) assumes that individuals are rational, all alternative utility equations have been referenced, and all information available is known, and the demanded service or product has no other uses or functions. However, as investors, the economic-based efficient market theory seems to generate pockets of arbitrage opportunities through the misalignment of information interpretation, information asymmetry, and emotional reactions. Therefore, as we analyze economic theory and the overall market valuation, we can determine that disequilibrium exists on the heels of innovation, open system structure, bounded rationality, emotional influencers, the inability to completely pre-state innovative technologies or products, and the appropriate “re-deployability” of resources rooted in the idiosyncratic human capital (or organizational make-up) of a company.
As investors, it remains pivotal to thoroughly understand the assumptions of economic theory, how it applies to modern society, and the increasing involvement and interdependence on technological innovation. With this defined, “evolutionary economics” remains the central foundation directing current market valuations and economic interpretations. As we enter the new, post-Covid world, economic indicators seem to be going through a regime shift, technological dependence continues to multiply at an exponential rate, and equity valuations continue to become disconnected with current balance sheet operations as they reflect future (unstandardized) values. In short, equities appear to be in a speculative valuation state, but is that definition of speculation rooted in the classical economic theory of a closed system plagued by conservative biases? Potentially, but what remains an even more unnerving question is: How do we determine the next market bubble or economic downturn if traditional indicators and classical economics have bounded applications?
The answer to this question remains much more complex. In short, if investors understand that the economy can be an open system where innovation can lead to either goal-oriented functions or shadow (hidden) options through serendipitous arrangements or strategic redeployment, then a market bubble can be anticipated with potentially a smaller shock factor. In short, an open system interpretation of the economy can provide a fundamental understanding of innovation and the compounding and derivative effect on economic development and market performance. Therefore, as discussed in New Thought to Financial Metrics and briefly in Alternative Approach to Value Investing: Is it “Reflex” or “Novel?,” the use of traditional financial metrics may be too conservative to yield a realistic forecast of a disruptive company or industry. Furthermore, strategic advantages and human capital assets can be the key to unlocking future profit-generating investments.
Additionally, alternative ways of interpreting the balance sheet can uncover healthy capital deployment techniques by management and a vigorous affinity to advancements. The balance sheet interpretation (at a very derivative degree) is also influenced by the assumption of a closed economic system while also compounding those assumptions with accounting’s intrinsic conservative bias and inherent human mistakes. Regardless, most information asymmetry comes from cognitive misinterpretations of the data, the origination of the information, and the appropriate applicability. In short, despite the case for an open economic system rooted in technical jargon, most market inefficiency comes from basic human emotions that cause overselling or overbuying events. As remains the case with most social dynamics, in application, emotions regularly overpower investor intelligence or “rationality.” This dynamic (as we have discussed in previous pieces) creates illegitimacy discounts or premiums rooted in behavior generating investing opportunities.
In short, fund managers and investors must understand the limits of traditional economic theory (even with the relativity argument as the relativity of innovation remains undefined) as it is the basis of market interpretation. Additionally, market interpretation must be made in a piecemeal approach that allows investors to recognize rent-generating core competencies of a company such as human capital, intangible assets (churn rate, patents, intellectual property, etc.), and innovation. In short, even though valuations of equities appear overdrawn in the near term (which may be true), the new world of technological interdependence may fundamentally change the way investors value equities and potential investments. Therefore, a deeper analysis of the balance sheet focusing on company financials from the perspective of a current “healthy” capital deployment and future return on investments remains pivotal to weather potential equity seasonal pullbacks and optimize upward market trajectory in the wake of disequilibrium generating arbitrage opportunities.