The principal of arbitrage
lies at the heart of economic analysis. Indeed, it may be the only
positive statement that economics has to make. It is, however,
immensely powerful. Arbitrage, in turn, stands on the strong shoulders
of thermodynamics, the most robust area in all of physics
Thermodynamics says simply that temperature differentials
cannot persist over time between objects in physical communication.
The end result is thermal equilibrium--the state in which there
is no further tendency for temperature to change. Thermal equilibirium
is the physicist's definition of death.
Almost all activity in life reflects the
physical manifestations of thermodynamic processes. It is why the
chemical reactions occur in our cells. It is why sunlight leads
to photosynthesis. It is why volcanoes erupt and tectonic plates
shift to make earthquakes. And it is why weather systems form.
In fact, weather systems are the best and simplest
metaphor for economic change. We all know what happens when high
and low pressure systems try to occupy the same space--thunder,
lightning, tornadoes, and hurricanes.
I think of global investing as an exercise in meteorology.
My job is to identify thethermodynamic events--usually changes
in tax rates, government spending, regulatory policies, or monetary
policy--that lead to localized temperature or pressure differentials
which set up the arbitrage situations we use to make money.
A change in zoning lawsthat alters
cash flows, for example, creates a return differential that forces
a change in the value of a piece of land. A tax law change that
impacts after-tax returns leads to a return differential that forces
a change in the value of a piece of capital equipment. A change
in monetary policy that increases inflation increases the returns
on tangible assets relative to securities, forcing a change in
stock and bond prices. All can be viewed as weather systems moving
across the weather map of the global economy.
I also like the weather map metaphor because it
reminds me of two important facts. First, extraordinary investments,
like weather systems, are transitory phenomena. Even the best
investments don't generate excepitonal returns forever.
Second, investing, like meteorology and thermodynamics,
is not an exact science. It can help you to identify the storm
systems that are going to make things happen. And it can tell you
what things will look like when the storm has passed and thermal
equilibrium has been once again restored. But it tells you very
little about what happens in between.
There is no exact science that describes the disequilibrium
states which occur while change is taking place either in physics
or economics. This is important because all of the real money is
made and lost during the disequilibrium adjustment--nobody makes
or loses money in equilibrium. That's why faith in the end result
and the liquidity to withstand the turbulence and chaos along the
way are so important.
The global weather map gives me a hat rack to give
structure to the thousands of factoids that fill the news every
day so I can boil it all down to a manageable number of themes
to watch closely.
The way to make money investing is to identify a
storm system that is powerful enough and likely to be long-lasting
enough to serve as an energy source for revaluing a portfolio.
Then you move capital into position to take advantage of the implied
prices changes.
For the past twenty years the weather map has been
obscured by one huge storm system, a stationary El niņo front,
as the world went through convulsions learning to live without
inflation. Although we are still cleaning up the wreckage, that
storm is over now. In its place we have a large number of localized
weather systems as individual countries attempt to compete for
the capital they need to grow.
This environment favors hedge fund investors over
long-only investors who can no longer ride falling interest and
rising valuations. And it favors investors who can break camp quickly
to take advantage of change over the battleships we built for the
long bull market. Investors will have to be quicker, have a bigger
canvas, and be willing to take both long and short positions to
benefit from these conditions. |
These are the themes that I use to develop investment strategies.