Gordian Knots

March 15, 2018

Last week saw two Gordian Knots breach the surface of our imaginations. One economic. One geopolitical.
A legend associated with Alexander the Great, the Gordian Knot is often used as a metaphor for an intractable problem resolved by finding a loophole or through some creative thinking. Enabling one to "cut the Gordian Knot," and quickly solve what had recently been a difficult dilemma.
For investors and geopolitical observers, those Gordian Knots came in the divisive forms of:
1. North Korea's nuclear weapons program.
2. The U.S. trade deficit, and the Trump administration decision to enact steel tariffs on imports.
Of course, the question facing investors in the weeks ahead is how much these situations could affect stock prices. And though it may seem a shallow way to view the world, that is the role we play.
So, consideration of such topics remains critical. And our clients rely upon our ability to derive some insight into such issues. Ultimately, we believe that the only item that truly matters to markets is earnings growth. So, for either of these dustups to really matter, they would have to somehow reduce consumer spending. Which would adversely impact corporate earnings. And send share prices lower.
Regarding these matters, Nick Colas of DataTrek Research recently provided some useful and unusual vantage points on how investors may weigh these issues. And how long and deep any price discounting could potential reach. We will excerpt Colas' view in this week's missive. For your intellectual and investment benefit. As usual, his insight is both provocative and useful. Provided mostly verbatim from his Tuesday night report, with a few minor edits. Enjoy.
. . . . .
"Market Blind Spots: Tariffs and Geopolitics
Every person who enjoys the gift of sight still has a blind spot in each eye. That's natural - there is a tiny bit of your retina where the optical nerve connects that has no photoreceptor cells. In fact, all vertebrates have a blind spot in each eye. Our minds make up for it by assuming whatever we see near the blind spot is similar enough, and fills in the gaps without us even noticing.
In some sense, successful investing is a matter of exploiting the market's collective blind spots. There are pieces of information that are very much visible, but the crowd still doesn't see them. Get the entire picture, blind spot included, and the way forward is much clearer.
Take as one example the recent furor over President Trump's proposed trade tariffs on steel and aluminum. Conventional wisdom says they are misguided and potentially dangerous to economic growth. There seems to be a horse race, in fact, to see who can come up with the largest hypothetical dollar impact from the move. The last one we saw stretched well into the billions.
The math, robust or not, misses the point completely, because economic decision making in the real world doesn't always use a calculator. We have mentioned a behavioral finance concept called the "Ultimatum Game" before, but here is a quick reprise:
-- Two strangers enter a room and a researcher has them flip a coin. The winner of the toss gets $100.
-- The winner has to offer a split of the $100 to the loser in one yes-or-no proposal. If the loser accepts the split, both get to keep the money. If the loser declines, neither party gets anything. Either way, the game is over.
-- Classical finance (the sort that comes up with tariff impact calculations, it seems) says the loser should accept $1. That's more than they came in with, and the marginal utility of that dollar is positive.
-- In the real world, the loser rarely takes anything less than $30-$40. They will walk away if offered smaller amounts, even though it hurts their interests. Yes, they do it out of sheer anger at being offered too little. Spite is an economic motive. And it is powerful enough to cause self-harm as measured by classical economics.
This is the blind spot many market observers have when looking at the tariff debate. The political calculus - how Americans feel about the role of trade in their lives - is closer to the Ultimatum Game than classical economics. The math may be interesting to policy wonks and analysts, but it is not the defining issue that will determine the outcome of this debate. It is 100% political.
The other blind spot example that comes to mind is the notion that capital markets (especially equities) operate in part like a bookie, keeping odds on a range of potentially disruptive geopolitical events. We saw some of the narrative today, as North Korea seemed to make some overtures about giving up its nuclear arsenal in return for keeping its current government in place.
"Shave 3.7 basis points off the risk adjusted discount rate in your DCF valuation models... North Korea is coming to the table!" said nobody, ever. The current global geopolitical environment has no lack of concerns, and US equities still sport much higher than historically average valuations. That should put to bed the notion that equity valuations are a finely tuned radar system for potential inbound threats.
Our belief is that US equity markets actually discount geopolitical events only as they become credible near-term problems and the major determinant of how much they will ding valuations is simple: will it hurt consumer spending?
Finding historically analogous situations to the current one in North Korea is difficult. You need a limited scope of engagement, one or more nuclear powers in the mix, and a "Big brother effect" (one or both parties must have a close superpower ally with their own nuclear arsenal). Here are three that fit the bill:
1. The Cuban Missile Crisis (1962). Net effect on the S&P 500 from October 16(Kennedy meets with select individuals in DC, and word starts to leak) to October 26(the USSR agrees to remove the missiles): down 4.4%. At its worst, the crisis took 6.3% off the index. Now, 1962 wasn't a great year for stocks - the S&P was down 8.8% - but this crisis was not the cause. At worst, it was half the decline.
2. Lead up to the Israeli/Arab Six Day War (1967). Recall that common wisdom had it that Israel was a nuclear power at this point and closely allied with the United States. From May 14th, when Egyptian President Nasser moved troops into the Sinai to June 5th, the start of the conflict, the S&P 500 was down 5.4%. By the time the war was over, the index was only 2.5% lower. Worth noting: the S&P 500 was up 23.8% in 1967.
3. Falklands War (1982). This one came by surprise; nuclear-armed Britain heard about it from a telex authored by the governor of the islands as Argentinian forces walked the streets. From start to finish (April 2nd to June 14th), the S&P 500 was down by 4.5%. Total S&P 500 return for the year: 20.4%.
The blind spot lesson here is that markets don't dial in geopolitical risk factors the same way they anticipate corporate earnings or economic data. In the case of a "contained" crisis, they respond as it becomes a clear threat. After that, fundamentals reassert themselves."

Securities offered through Dempsey Lord Smith LLC – Dempsey Lord Smith LLC, Rome, GA Member FINRA / SIPC / MSRB.

Advisory Services offered through Dempsey Lord Smith, LLC, an SEC Registered Investment Advisor. Clearing through and accounts held at Charles Schwab & Co., Inc.

Dempsey Lord Smith, LLC nor Hyde Park Wealth Advisors LLC provides tax or legal advice and you should consult your accountant and/or attorney if considering an investment of this type. Hyde Park Wealth Advisors LLC is not controlled by or a subsidiary of Dempsey Lord Smith LLC. Investing in Alternative Investments come with a variety of risks that could result in a complete loss of principal investment.

Alternative Investments offered as private placement securities are offered only to qualified accredited investors via confidential private placement memorandum. Income and returns are not guaranteed and there are no assurances investments will meet their stated objectives.

© 2024 Hyde Park Wealth Advisors. All Rights Reserved