Paradigm Shifts

A core investment principle is: identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.

There are relatively long periods (about 10 years) in which markets and market relationships operate in a certain way (i.e. “paradigms”) that most people adapt to and eventually extrapolate so they become overdone, which leads to shifts to new paradigms in which the markets operate more opposite than similar to how they operated during the prior paradigm. Identifying and tactically navigating these paradigm shifts well and/or structuring one’s portfolio so that one is largely immune to them is critical to one’s success as an investor.

There are always big sustainable forces that drive the paradigm. They go on long enough for people to believe that they will never end even though they obviously must end. A classic one of those is an unsustainable rate of debt growth that supports the buying of investment assets. It drives asset prices up, which leads people to believe that borrowing and buying those investment assets is a good thing to do. But it can’t go on forever because the entities borrowing and buying those assets will run out of borrowing capacity while the debt service costs rise relative to their incomes by amounts that squeeze their cash flows. When these things happen, there is a paradigm shift. Debtors get squeezed and credit problems emerge, so there is a retrenchment of lending and spending on goods, services, and investment assets so they go down in a self-reinforcing dynamic that looks more opposite than similar to the prior paradigm. This continues until it’s also overdone.

Another classic example is that extended periods of low volatility tend to lead to high volatility because people adapt to that low volatility, which leads them to do things (like borrow more money than they would borrow if volatility was greater) that expose them to more volatility, which prompts a self-reinforcing pickup in volatility. There are many classic examples like this that repeat over time. Understanding which types of paradigm exists and how they might shift is required to consistently invest well. That is because any single approach to investing—i.e. investing in any asset class, investing via any investment style (such as value, growth, distressed, etc.), investing in anything—will experience a time when it performs so terribly that it can ruin you. That includes investing in “cash” (i.e. short-term debt) of the sovereign that can’t default, which most everyone thinks is riskless but is not because the cash returns provided to the owner are denominated in currencies that the central bank can “print” so they can be depreciated in value when enough money is printed to hold interest rates significantly below inflation rates.

In paradigm shifts, most people get caught overextended doing something overly popular and get really hurt. On the other hand, if you’re astute enough to understand these shifts, you can navigate them well or at least protect yourself against them. The 2008-09 financial crisis was one such period. It happened because debt growth rates were unsustainable in the same way they were when the 1929-32 paradigm shift happened. History has taught us that there are always paradigms and paradigm shifts and that understanding and positioning oneself for them is essential for one’s well-being as an investor and beyond.

Market pricing reflects expectations of the future; as such, it paints quite detailed pictures of what the consensus expectation of the future is. Then, the markets move as a function of how events transpire relative to those expectations. As a result, navigating markets well requires one to be more accurate about what is going to happen than the consensus view that is built into the price. That’s the game. That’s why understanding these paradigms and paradigm shifts is so important.

The consensus view is typically more heavily influenced by what has happened relatively recently (i.e. over the past few years) than it is by what is most likely. It tends to assume that the paradigms that have existed will persist and it fails to anticipate the paradigm shifts, which is why we have such big market and economic shifts. These shifts, more often than not, lead to markets and economies behaving more opposite than similar to how they behaved in the prior paradigm.

What follows is a description of the paradigms and paradigm shifts in the US over the last 100 years. However, going back as far as the year 1500, the same things happen over and over again for essentially the same reasons. Of course, they’re not exactly the same, and important changes have occurred since then (i.e. how central banks have come and gone and changed). However, big paradigm shifts have always happened, and they happened for roughly the same reasons.

To show them, we have divided history into decades, beginning with the 1920s, because they align well enough with paradigm shifts to convey the picture. Though not always perfectly aligned, paradigm shifts have coincidentally tended to happen around decade shifts (i.e. the 1920s were “roaring,” the 1930s were in “depression,” the 1970s were inflationary, the 1980s were deflationary, etc.). Also, looking at 10-year time horizons helps one put things in perspective.

Before briefly describing each of these decades, there are a few observations you should look out for when we discuss each of them.

  1. Every decade had its own distinctive characteristics, though within all decades there were long-lasting periods (i.e. 1 to 3 years) that had almost the exact opposite characteristics of what typified the decade. To successfully deal with these changes, one would have had to successfully timed the ins and outs or faded the moves (i.e. bought more when prices fell and sold more when prices rose) or had a balanced portfolio that would have held relatively steady through the moves. The worst thing would have been to go with the moves (sell after price declines and buy after price increases).
  2. The big economic and market movements undulated in big swings that were due to a sequence of actions and reactions by policy makers, investors, business owners, and workers. In the process of economic conditions and market valuations growing overdone, the seeds of the reversals germinated. For example, the same debt that financed excesses in economic activity and market prices created the obligations that could not be met, which contributed to the declines. Similarly, the more extreme economic conditions became, the more forceful policy makers’ responses to reverse them became. For these reasons, throughout the 10 decades we see big economic and market swings around “equilibrium” levels. The equilibriums are:

    1. Debt growth that is in line with the income growth that is required to service debt;
    2. The economy’s operating rate is neither too high (because that will produce unacceptable inflation and efficiencies) nor too low (because economically depressed levels of activity will produce unacceptable pain and political changes); and
    3. The projected returns of cash are below the projected returns of bonds, which are below the projected returns of equities and the projected returns of other “risky assets” (because the failure of these spreads to exist will impede the effective growth of credit and other forms of capital, which will cause the economy to slow down or go in reverse, while wide spreads will cause it to accelerate).
  3. At the end of each decade, most investors expected the next decade to be similar to the prior decade, but because of the previously described process of excesses leading to excesses and undulations, the subsequent decades were more opposite than similar to the ones that preceded them. As a result, market movements due to these paradigm shifts typically were very large and unexpected and caused great shifts in wealth.
  4. Every major asset class had great and terrible decades, so much so that any investor who had most of their wealth concentrated in any one investment would have lost almost all of it at one time or another.
  5. Theories about how to invest changed frequently, usually to explain how the past few years made sense even when it didn’t make sense. These backward-looking theories typically were strongest at the end of the paradigm period and proved to be terrible guides for investing in the next decade, so they were very damaging. That is why it is so important to see the full range of past paradigms and paradigm shifts and to structure one’s investment approach so that it would have worked well through them all. The worst thing one can do, especially late in a paradigm, is to build one’s portfolio based on what would have worked well over the prior 10 years, yet that’s typical.

1920s = “Roaring”: From Boom to Bursting Bubble. It started with a recession and the markets discounting negative growth as stock yields were significantly above bond yields, yet there was fast positive growth funded by an acceleration in debt during the decade, so stocks did extremely well. By the end of the decade, the markets discounted fast growth and ended with a classic bubble (i.e. with debt-financed purchases of stocks and other assets at higher prices) that burst in 1929, the last year of the decade.

1930s = Depression. This decade was for the most part the opposite of the 1920s. It started with the bursting reactions to high levels of indebtedness and the markets discounting relatively high growth rates. This debt crisis and plunge in economic activity led to economic depression, which led to aggressive easing by the Fed that consisted of breaking the link to gold, interest rates hitting 0%, the printing of a lot of money, and the devaluing of the dollar, which was accompanied by rises in gold prices, stock prices, and commodity prices from 1932 to 1937. Because the monetary policy caused asset prices to rise and because compensation didn’t keep up, the wealth gap widened, a conflict between socialists and capitalists emerged, and there was the rise of populism and nationalism globally. In 1937, the Fed and fiscal policies were tightened a bit and the stock market and economy plunged. Simultaneously, the geopolitical conflicts between the emerging Axis countries of Germany, Italy, and Japan and the established Allied countries of the UK, France, and China intensified, which eventually led to all-out war in Europe in 1939 and the US beginning a war in Asia in 1941. For the decade as a whole, stocks performed badly, and a debt crisis occurred early, which was largely handled via defaults, guarantees, and monetization of debts along with a lot of fiscal stimulation.

1940s = War and Post-War. The economy and the markets were classically war-driven. Governments around the world both borrowed heavily and printed significant amounts of money, stimulating both private-sector employment in support of the war effort and military employment. While production was strong, much of what was produced was used and destroyed in the war, so classic measures of growth and unemployment are misleading. Still, this war-effort production pulled the US out of the post-Great Depression slump. Monetary policy was kept very easy to accommodate the borrowing and the paying back of debts in the post-war period. Specifically, monetary policy remained stimulative, with interest rates held down and fiscal policy liberally producing large budget deficits during the war and then after the war to promote reconstruction abroad (the Marshall Plan). As a result, stocks, bonds, and commodities all rallied over the period, with commodities rallying the most early in the war, and stocks rallying the most later in the war (when an Allied victory looked to be more likely) and then at the conclusion of the war. After the war, the United States was the preeminent power and the dollar was the world’s reserve currency linked to gold, with other currencies linked to the dollar. This period is an excellent period for exemplifying 1) the power and mechanics of central banks to hold interest rates down with large fiscal deficits and 2) market action during war periods.

1950s = Post-War Recovery. In the 1950s, after two decades of depression and war, most individuals were financially conservative, favoring security over risk-taking. The markets reflected this by de facto pricing in negative levels of earnings growth with very high risk premia (i.e. S&P 500 dividend yields in 1950 were 6.8%, more than 3 times the 10-year bond yield of 1.9%, and earnings yields were nearly 14%). What happened in the 1950s was exactly the opposite of what was discounted. The post-war recovery was strong (averaging 4% real growth over the decade), in part through continued stimulative policy/low rates. As a result, stocks did great. Since the government wasn’t running large deficits, government debt burdens (government debt as a percent of incomes) fell, while private debt levels were in line with income growth, so debt growth was in line with income growth. The decade ended in a financially healthy position, with prices discounting relatively modest growth and low inflation. The 1950s and the 1960s were also a period in which middle-class workers were in high demand and prospered.

1960s = From Boom to Monetary Bust. The first half of the decade was an increasingly debt-financed boom that led to balance of payments problems in the second half, which led to the big paradigm shift of ending the Bretton Woods monetary system. In the first half, the markets started off discounting slow growth, but there was fast growth, so stocks did well until 1966. Then most everyone looked back on the past 15 years of great stock market returns and was very bullish. However, because debt and economic growth were too fast and inflation was rising, the Fed’s monetary policy was tightened (i.e. the yield curve inverted for the first time since 1929). That produced the real (i.e. inflation-adjusted) peak in the stock market that wasn’t broken for 20 years. In the second half of the 1960s, debt grew faster than incomes and inflation started to rise with a “growth recession,” and then a real recession came at the end of the decade. Near the end of the 1960s, the US balance of payments problem became more clearly manifest in gold reserves being drawn down, so it became clear that the Fed would have to choose between two bad alternatives—i.e., a) too tight a monetary policy that would lead to too weak an economy or b) too much domestic stimulation to keep the dollar up and inflation down. That led to the big paradigm shift of abandoning the monetary system and ushering in the 1970s decade of stagflation, which was more opposite than similar to the 1960s decade.

1970s = Low Growth and High Inflation (i.e. Stagflation). At the beginning of the decade, there was a high level of indebtedness, a balance of payments problem, and a strained gold standard that was abandoned in 1971. As a result, the promise to convert money for gold was broken, money was “printed” to ease debt burdens, the dollar was devalued to reduce the external deficits, growth was slow and inflation accelerated, and inflation-hedge assets did great while stocks and bonds did badly during the decade. There were two big waves up in inflation, inflation expectations, and interest rates, with the first from 1970 to 1973 and the second and bigger one from 1977 to 1980-81. At the end of the decade, the markets discounted very high inflation and low growth, which was just about the opposite of what was discounted at the end of the prior decade. Paul Volcker was appointed in August 1979. That set the stage for the coming 1980s decade, which was pretty much the opposite of the 1970s decade.

1980s = High Growth and Falling Inflation (i.e. Disinflation). The decade started with the markets discounting high inflation and slow growth, yet the decade was characterized by falling inflation and fast growth, so inflation-hedge assets did terribly, and stocks and bonds did great. The paradigm shift occurred at the beginning of the decade when the tight money conditions that Paul Volcker imposed triggered a deflationary pressure, a big economic contraction, and a debt crisis in which emerging markets were unable to service their debt obligations to American banks. This was managed well, so banks were provided with adequate liquidity and debts weren’t written down in a way that unacceptably damaged bank capital. However, it created a shortage of dollars and capital flows that led the dollar to rise, and it created disinflationary pressures that allowed interest rates to decline while growth was strong, which was great for stock and bond prices. As a result, this was a great period for disinflationary growth and high investment returns for stocks and bonds.

1990s = “Roaring”: From Bust to Bursting Bubble. This decade started off with a recession, the first Gulf War, and the easing of monetary policy and relatively fast debt-financed growth and rising stock prices; it ended with a “tech/dot-com” bubble (i.e. debt-financed purchases of “tech” stocks and other financial assets at high prices) that looked quite like the Nifty Fifty bubble of the late 1960s. That dot-com bubble burst just after the end of the decade, at the same time there were the 9/11 attacks, which were followed by very costly wars in Iraq and Afghanistan.

2000-10 = “Roaring”: From Boom to Bursting Bubble. This decade was the most like the 1920s, with a big debt bubble leading up to the 2008-09 debt/economic bust that was analogous to the 1929-32 debt bust. In both cases, these drove interest rates to 0% and led to central banks printing a lot of money and buying financial assets. The paradigm shift happened in 2008-09, when quantitative easing began as interest rates were held at or near 0%. The decade started with very high discounted growth (i.e. expensive stocks) during the dot-com bubble and was followed by the lowest real growth rate of any of these nine decades (1.8%), which was close to that of the 1930s. In this decade, as in the 1930s, interest rates went to 0%, the Fed printed a lot of money as a way of easing with interest rates at 0%, the dollar declined, and gold and T-bonds were the best investments. At the end of the decade, a very high level of indebtedness remained, but the markets were discounting slow growth.

2010-Now = Reflation. The shift to the new paradigm, which was also the bottom in the markets and the economy, came in late 2008/early 2009 when risk premiums were extremely high, interest rates hit 0%, and central banks began aggressive quantitative easings (“printing money” and buying financial assets). Investors took the money they got from selling their financial assets to central banks and bought other financial assets, which pushed up financial asset prices and pushed down risk premiums and all asset classes’ expected returns. As in the 1932-37 period, that caused financial asset prices to rise a lot, which benefited those with financial assets relative to those without them, which widened the wealth gap. At the same time, technological automation and businesses globalizing production to lower-cost countries shifted wages—particularly those in the middle- and lower-income groups—while more of the income gains over the decade went to companies and high-income earners. Growth was slow, and inflation remained low. Equities rallied consistently, driven by continued falling discount rates (i.e. from central bank stimulus), high profit margins (in part from automation keeping wage growth down), and, more recently, from tax cuts. Meanwhile, the growing wealth and income gaps helped drive a global increase in populism. Now, asset prices are relatively high, growth is priced to remain moderately strong, and inflation is priced to remain low.

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