The events leading up to the Great Financial Crisis of 2008/2009 did not fit the data. Patterns based on historical precedent failed to contemplate an outcome so violently different from expectations -> that the crisis would be the worst economic period since the Great Depression of the 1930s. Investors are left to contemplate what fundamental insights can be gained from the perspective of an investor taking measure of the deceptively calm landscape in 2007, only to experience a $6 trillion decline in national real estate values, a 50% drawdown in the S&P 500 and the social impact of massive numbers of home foreclosures over the next few years. The forces required to configure such an economic dislocation went far beyond predicted variability in economic cycles and into the realm of the flapping wings of butterflies. Failures of conventional risk analysis, scripted purely on linear/historical data sets, means investors today should consider ways to calibrate portfolio risk budgets to include factors that are linked to the current sources of market failures and financial excesses that are likely to escape conventional risk analysis all over again.
In case you’ve missed current political events for the last few years, what has unfolded is ever greater degrees of “ungovernableness” among the biggest Western liberal democracies, most evident in the U.S. and the U.K. The media-addled frenzy around a daily stream of rage about feverish party struggles obscures the real metric of instability: total debt that includes federal, state and local liabilities combined with unfunded commitments for benefits to citizens from the government, not to mention the swelling pile of debt among corporations, (underfunded) pensions and the citizens themselves. This number, which some suggest could be in the neighborhood of $200 trillion if you include “unofficial” indebtnetness, exceeds the official statistic of about $22 trillion for U.S. federal debt and is almost never mentioned in mainstream media. For example, here (table V1.F1) is the Congressional Budget Office’s estimate of Social Security’s net unfunded liability. This estimate alone is $34.2 trillion, as of 2017. Dozens of mechanisms, some imperceptible, mingle to propagate instability, but excessive debt and the narrative around it is the best indicator of the need for fresh thinking in risk management. I will explain how forces at work today are unique and powerful enough to make U.S. political risk a factor in estimating portfolio risk.
We could rationalize a massive increase in debt if we could point to improvements in such things as health, education, housing, food and infrastructure. But a quick summary of the metrics related to social cohesion and economic health point to something different: falling life expectancy, a spike in suicide rates, record levels of inequality, declining inter-generational economic mobility, record levels of wealth concentration and uneven distribution of income gains favoring the richest segment of society. Some of the products tied to these metrics include: prescriptions drugs, junk food (targeting children), mortgages, diplomas, and social media. A recent study by professor Gabiel Zucman suggests, “The bottom half of Americans combined have a negative net worth.” In fact, the levels of deterioration today are approaching those consistent with the destruction of tangible assets like crops and physical infrastructure that are commonly associated with periods of war. All of these declining conditions accumulated over decades and are not captured through the narrow prism of GDP growth because they are mostly linked to intangibles. And the recent period of increasing returns to capital at the expense of labor’s share of national income means social and political risks are rising - and corporate profit’s outsized share of GDP (the flip side of labor’s diminishing share) strikes directly at the pension industry’s +7% returns assumptions and spending rules. In this context, “ungovernableness” means unsustainable.
Even the most imaginative and far-reaching narratives about non-obvious economic fragility and off balance sheet risks are mere rants without constructive ideas about causes and solutions. Consider network effects, the popular economic construct applied to market concentration and increasing returns for strategies pursued by some leading tech companies. This dynamic economic agent is also known as demand side economies of scale. W. Brian Arthur, the economist credited with first developing the theory, described the condition of increasing returns as a game of strategic positioning and building up a user base to the point where “lock in” of dominant players occurs. Companies able to tap network effects have been rewarded with huge valuations and highly defensible businesses. But what about negative network effects? What if the same dynamic applies to the U.S.’s pay-to-play political industry where the government promotes or approves of something through a policy, subsidy or financial guarantee due to private sector influence. Benefits accrue only to the purchaser of the network effects, and consumers, induced by the false signal of large network size, ultimately suffer from asymmetric risk and experience what I’m calling a loss of intangible net worth for each additional member after the “bandwagon” wares off. If this were the case, then you would see companies experience rapid revenue growth (out of line with traditional asset leverage models), executives accumulating huge fortunes and political campaign coffers swelling. But the most striking feature would be the anti-social outcomes, the ones not available without the instant critical mass of government-supported network effects, the ones that, at scale, monetize a society’s intangible net worth.
Some products tied to these metrics include: prescriptions drugs, junk food targeting children, mortgages, diplomas, and social media. The list of industries that are likely to have gained through the purchasing of network effects in D.C. maps closely to the decay that is visible in U.S. society.
The first is food’s transformation into junk food in a fashion similar to the “designed-to-fail” mortgage derivatives that were at least partially responsible for the decimation of the housing industry in 2008 and the resulting financial collapse. In 2013, I coined the term “metabolic donkey” to describe the methods junk food companies use to hoist bad outcomes (private profits, socialized losses) on consumers, often targeting children in the U.S. and abroad. Today, one in three children in this country is overweight or obese. Overweight children face a greater risk of developing diabetes, high blood pressure and asthma. For the majority of people, diabetes and fatty liver disease are a result of diet and lifestyle, as opposed to disease pathology. In fact the annual cost of the diabetes epidemic is $327 billion, including $237 billion in direct medical costs and $90 billion in reduced productivity, according to the American Diabetes Association. In the last ten years, the food processing and sales industry spent $288 million on lobbying in Washington. What is the purpose of such spending? One example is to continue counting tomato paste (in frozen pizza) as a vegetable in school lunches. Another is to protect SNAP recipients’ choice to prefer high-margin processed junk food over more healthy options. This particular issue attracts extreme vitriol. The perception is that targeting recipients of government food support is discriminatory if there is any suggestion of restrictive paternalism, even though SNAP diets are out line with Dietary Guidelines for Americans (USDA/HHS, 2015). Forget that such policies would be designed to reduce the negative health outcomes of a shortened, diseased life that junk food diets produce - and that the public treasury must underwrite the cost when the inevitable health disaster emerges. If you are going to remove any dimension of morality from governance and instead rely on the rule of law, then what happens when those laws are for sale?
Higher education is a travesty characterized by the stripping of value from the intangible concept of education. This happens through price inflation and debt accumulation as a direct result of a toxic mix of subsidized student loans and high-concept predatory marketing from schools that have no skin in the game when students default on loans. Total student loan balances stand at $1.5 trillion and carry a staggering 11% default rate for a commodity product with a luxury price. Vast numbers of students choose to acquire a mountain of debt only because the government sanctions it through the provision of lending, thereby reinforcing their choice. The explosion of student loans corresponds with the explosion of mortgage loans prior to the Great Recession. Government supported and government promoted for years before the greased wheels finally break down. There is a weak form of negative network effects at work in the government's engineering of the overall higher education disaster. The for-profit education industry is example of strong negative network effects because it includes the starkest example of a template for socializing costs and privatizing profits: the dumping of stock among the senior executives before the reality of the product’s inferiority comes to light. In the last ten years, the for-profit education industry spent $67.1 million on lobbying in Washington as the industry reeled from multiple fraud prosecutions in at least 37 states and the resulting corporate bankruptcies. Prior to the collapse, a variety of for-profit education industry players went public. Many of these so called free enterprise companies booked more than 90% of revenue on government-guaranteed student loans, while they, “own every lobbyist in town,” according to one U.S. Senator. The University of Phoenix, for example, a nationwide school with more than 254,000 students, received over $2.75 billion in federal financial aid as revenue. And company executives received compensation in the millions through cash and stock and then just walk away often by taking their for-profit entities thorough bankruptcy, an option not available to their student debt holders.
It’s not difficult to conclude that a 33% nationwide real estate decline during the Great Financial Crisis of 2008/2009 (the worst since the Great Depression of 1931) transformed the concept of home into a lottery ticket. The houses remained physically in tact but, for millions of Americans, their intangible value as a home was destroyed. While the government spent $16 trillion to prevent the collapse of the banking industry and to support other industries, the banking industry’s 2009 bonus pool topped $32 billion - while those banks had lost $81 billion during the crisis just one year prior. A recent Freedom of Information Act lawsuit initiated by Daniel Novack, First Amendment attorney based in New York City, reveals details of JP Morgan Chase’s involvement in mortgage fraud in the years leading up to the Great Financial Crisis. An excerpt includes, “By this action, the United States seeks to recover civil penalties” against JPMorgan Chase and its investment banking arm “for a fraudulent and deceptive scheme to package and sell residential mortgage-backed securities” that the bank “knew contained a material amount of materially defective loans.” J.P. Morgan Chase settled the lawsuit for $13 billion in 2013. In the last ten years, the securities and investment industry spent $998.1 million on lobbying in Washington. The peak was $104.75 million in 2010 after a media frenzy over the excessive bonuses in 2009.
Healthcare is looking like a similar intangible asset that is being stripped of value for profit. If the U.S. healthcare industry were a country, it would be the fifth largest GDP in the world. Yet the health outcomes the industry produces are the worst in the industrialized world. The opioid epidemic represents the most striking example of “lock in” for a group of patients seeking pain relief but instead were victims of a corporate strategy to achieve negative network effects with a highly addictive drugs. Overdoses involving opioids killed more than 47,000 people in 2017, and 36% of those deaths involved prescription opioids. In the last decade, the pharmaceutical industry has spent more than $880 million at the state and federal level to fight regulations that would limit the availability of powerful opiods such as OxyContin, Vicodin and fentanyl in the U.S., according to an investigation by the Associated Press (AP) and the Center for Public Integrity. According to the AP report, prescription opioids are the cousins of heroin, prescribed to relieve pain. Sales of the drugs quadrupled from 1999 to 2010, rising in tandem with overdose deaths. In 2015, the U.S. doled out 227 million opioid prescriptions by legal physician advice, enough to hand a bottle of pills to nine out of every 10 American adults. A recent filing in Massachusetts, Attorney General Maura Healey is pursuing Purdue Pharma, the maker of OxyContin. Her office has exposed how Richard Sackler, then Purdue’s president and part of the Sackler family that owns Purdue, was personally involved in efforts to hide the drug’s deadly addictive quality in marketing materials targeting physicians. From 2007 to 2018, the Sacklers paid themselves more than $4 billion from opioid sales.
Negative network effects ultimately fail, but when the government provides the scale and the moat, the outcomes become a tragedy: social decline, massive government debt and record levels of wealth concentration among a narrow segment of society. Americans will have to come to terms with a government that fails to protect. The state of political polarization likely precludes any changes to the political industry. In fact, buying network effects from the government thrives when polarization dominates the narrative about solutions.
Investors should consider monitoring signals from the credit markets that indicate stress. Some of these would include: CBOE Volatility Index (VIX Index), Morgan Stanley Global Correlation Index, Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD and the 3-Month Commercial Paper Minus Federal Funds Rate (CPFF). Also, investors should look for increases in contributions to the political campaign industry as this could signal commercial stress inside an industry or company or could indicate an industry anticipating unwanted scrutiny of its business practices.
Innovation and Opportunity
Despite these challenges, U.S. capacity for innovation in the private sector remains strong, and it is likely the private sector will play a much larger future role in shaping better outcomes from consumers who take personal responsibility for their own health and welfare. In many ways the pace of innovation is picking up as new technologies emerge in big data, genomics, artificial intelligence and robotics – or in some cases combinations of these factors. New technologies are diffusing into traditional industries such that they are being changed on a fundamental level. I’m seeing the most dynamism in companies in the market cap range of $1 billion to $20 billion. There is a real possibility that the private sector will take over the basics like healthcare, home security, education and food (supply and prep), water and Internet infrastrcuture for a large segment of society. Space exploration is already down this path.
For investors, there are opportunities to profit from companies able to offer solutions. SodaStream built an at-home soda making business based on the merits of consumers’ producing something (by hand) and reaping the rewards of conservation through the use of one’s ability to reason that a beverage can be as good or better with half the sugar, sodium, calories and cost. Another company to consider is Tabula Rasa (TRHC), a company innovating in the field of medication safety. Tabula Rasa operates in a niche field of Healthcare IT. The Company, “uses sophisticated rules engines, scientific research, and proprietary algorithms to combine patient-specific data (including clinical data, data regarding the drugs a patient is taking, lab data, and, more recently, even a patient's genomic information) with pharmacokinetic and pharmacodynamics science (as well as published guidelines) to personalize the medication regime for each patient,” according to William Blair analyst Ryan Daniels. One problem the company is addressing is a major cause of death in the U.S.: adverse drug events (ADEs), responsible for an estimated 150,000 deaths annually. Its technology aims to prevent the estimated $4 billion in annual health care spending due to ADE’s, Daniels wrote in a recent report.
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