Too big not to fail

We moved out of the big city a number of years back to a smallish city in central Virginia.

Every year, as spring returns, I notice a big difference between home now and home back then. There is a balance of nature that goes on now.

The bugs come out, and the bats come out to eat them. The mice and voles are born, and the snakes, fox and owls are there to greet them. Black snakes keep away the copperheads and water moccasins (and keep the mice out of my house).

On many occasions living in the suburbs, I would walk outside in the evening into my backyard and be eaten alive by mosquitoes. There were no bats, no barn swallows. It was a monoculture of about three types of trees, six bushes and two grass types.

It’s good for business, however, since it takes a huge amount of effort to keep a monoculture going. It’s unsustainable of course, but that doesn’t stop all the suckers from trying.

And this broader reality is reinforced when I see the fate of big companies with big competitive moats. They make one strategic error too many and their artificially sustained existence can’t be sustained any longer.

Too big not to fail

I heard a quote many years ago, I can’t remember who said it, but basically it was a warning that when something became a dominant force (like a company) it was likely that its dominance was coming to an end.

I remember when Microsoft was a juggernaut consuming or destroying everything in its wake and then the Justice Department stepped in and threw a spanner in the works. The company still made Bill Gates the wealthiest man on the planet, but the company had to re-evaluate how it did business.

I saw the same thing happen the other week with the United Airlines fiasco.

The airline industry has a huge competitive moat and it’s been sustained by corporate welfare and friendly legislation for decades. It’s beyond competition, and that is evidenced not just because it felt justified in brutalizing a 69-year-old passenger and humiliating him and his family, but all the other incidents that preceded and followed it.

United isn’t interested in passengers or being nimble. It’s part of club and it’s about numbers, not people. The same can be said of the banks and the insurers at this point.

These are artificially created and sustained monocultures. They weren’t too big to fail, and many should have been allowed to die a quick death in 2007-08, but the Federal Reserve stepped in to “save” the banking system. Not one CEO of these institutions faced criminal charges. And the banks that were deemed “too big to fail” are even bigger today.

These dinosaurs won’t be wiped from the face of the earth, but they will have their reckoning and our choice will be to build new monocultures for them or let them die a natural death at the hands of the market.

Are you ready for disruption?

Now, the Fed’s accommodating monetary policy is artificially sustaining these monocultures.

Did you know, from 2009-16 the market correlation — the measure of stocks moving in lockstep with one another — was between 70-95 percent? That meant if one stock went up, there was a 70-95 percent chance that other stocks would rise as well.

This is why passive funds (index funds) have done so well recently. The market is a monoculture as well.

The problem is, the Fed as well as other central banks are no longer priming the pump; the monoculture that we’ve had for almost a decade is being disrupted.

To that end, so far this year market correlation is now down to 57 percent. And there’s a good chance it will head lower before it heads higher.

This problem will be far more significant for industries and companies that have ossified in their oligarchies. Already we see that one smart and bold guy with vision has disrupted the banking industry, car industry, aerospace industry and the energy sector. These are arguably the four industries with the biggest competitive moats of them all, at least that’s what we thought.

Beyond the American oligarchs

The thing is, it’s not that hard to find alternatives and just avoid these monocultures.

Because there are healthy industries out there that are still being run by the free market, where creative destruction still occurs with regularity.

One is healthcare. The drug companies, while massive, have hospitals, prescription benefit managers and insurance companies to keep them in check. Yes they get hauled up in front of politicians for show trials, but the real competitive limits are built by all the parties in the system competing for resources.

Here look to the big drug companies that know how to navigate rough water.

Tech is another place to look for safety and stability as the markets adjust to a new reality. Big cap tech will be a safe place in the volatility, especially tech firms that are linked to logistics, artificial intelligence and the Internet of Things.

A reader recently made mention of REITs (real estate investment trusts). Yes, REITs are good as well, but you have to be careful when you choose them. Some are overbought here, some have exposure to properties like shopping malls that are losing anchor stores or rely too much on renewed consumer spending. I’ll have more on REITs soon.

— GS Early

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