This market commentary is drawn from Brad Slingerlend of NZS Capital’s December newsletter, Stuff I Thought About Last Week (“SITALWeek”) #460.
We are no strangers to bubbles and narrow markets, having invested through some interesting times during the last several decades. Indeed, our Complexity Investing framework was created to explain how to invest in an unpredictable world. One strategy we use in times like this is to shift narrow predictions to broader predictions, both at the individual stock level and the overall portfolio level. At one point a few months ago, I expressed to our investors that the market was evolving into a single prediction: one AI startup was going to build a multi-hundred-billion-dollar business in just 2-3 years. Could it happen? Sure, but is it the most likely outcome? Probably not. Are we concerned about circular revenue (aka vendor financing, as we called it during the telecom bubble) and increased leverage? Yes. The fact that everyone seems to be consenting participants doesn’t make it OK. It reminds me of the great Penn & Teller cup-and-ball trick done with transparent cups. Even in plain sight, it’s still a trick. There is no better metaphor for market bubbles than the transparent cup and balls – despite being in on the trick, it still fools you.
Our job as investors today, in terms of how we think about the world at NZS Capital, is to identify and seek to take advantage of the broader (higher probability) predictions that may be connected to the markets’ AI gamble.
For example, we can create a more agnostic portfolio in which we carefully match positions to the range of outcomes encompassed by two diametrically opposed world views: in one world, AI meets investors’ high expectations and we are off to the races; in the other, classic negative feedback loops and efficiency gains create a more predictable, linear progress curve for AI’s impact on the world, economy, and markets. My hope is actually for a linear impact, because I think it’s important that the pace of change is slow enough to allow entrepreneurial job creation to replace those lost to AI. But, as they say, hope in one hand and spit in the other, and see which fills up faster.
That tongue-in-cheek aside, I am not, in fact, overly negative about the bumpy road ahead. Indeed, I’ve found it much more productive to view the world through the lens of skeptical optimism. As I’ve noted in the past, neither cynicism nor pessimism have been winning long-term investment strategies. Skepticism is always prudent, but optimism is the only way to make money in the long term. In many ways, it’s nearly impossible to have a successful investment strategy or philosophy that expresses pessimism when the world is optimistic. It does work occasionally, just as a stopped clock is right twice a day. However, by being optimistic when the world is pessimistic, you are more likely to collect the treasure that’s lying around the economic landscape. You don’t even need to find the end of the rainbow. So, now is a good time to prepare to be optimistic for when the world turns pessimistic. It was Buffett who famously said: “be fearful when others are greedy, and be greedy when others are fearful”. I think the first part of Buffett’s aphorism is a tough way to make a living as an investor, given that things are always getting better over time, and the second half sounds a little too cynical to me. So, with a great deal of unmerited hubris, let’s rewrite that quote as: “Be appropriately skeptical when others are optimistic, be optimistic when others are pessimistic, and never be cynical”. OK, I admit, Buffett’s is a tad more catchy.
Another bit of traditional advice for long-term investors, often trumpeted by Buffett in the past, is to own a passive index like the S&P 500. I wonder if that suggestion needs some updating as well, given the current, narrow prediction that’s overtaken the stock markets? At the moment, the top five stocks in the S&P 500 are around 30% of the index, and they are all highly correlated with each other (NVIDIA, Apple, Microsoft, Alphabet, and Amazon). Is that a diversified long-term portfolio, or is it a risky, concentrated bet on one theme? A more appropriate approach today might be closer to the agnostic – but still very active – portfolio construction mentioned above. The good news for investors today is that the narrow, single-prediction stock market has resulted in some fantastic, high quality growth businesses being left for dead across many sectors (for example, software, where I believe systems of record and vertical market software are well positioned for either AI path the world may take).
This discussion of ephemeral bubbles reminds me of one of my favorite quotes from one of my favorite movies, Harvey (based on the original play). At one point Elwood P. Dowd, played by Jimmy Stewart, is at a bar, perhaps with a 6’2” tall seemingly invisible rabbit, and Mr. Wilson from the sanitarium asks the bartender about Dowd, “Is he alone?” To which the bartender replies, “Well, there’s two schools of thought, sir”. Right now, there are very much two schools of thought. Perhaps that mischievous pooka is real, or perhaps not, but we certainly all want to believe in the big bunny. So, as the evening wears on, we remain skeptically optimistic for the near future as we see how the AI platform wars shake out. Over the longer time horizon, we are giddy for the explosion of new ideas, companies, and scientific revolutions that the massive AI platforms will enable, which I look forward to writing about in the coming years.
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