Markets and Chaos Theory

*"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design." * F.A. Hayek

The infinite complexity combined with infinite diversity (in infinite combinations) that we see in nature is by definition incomprehensible and unpredictable by man. This is, at least in my view, a core truth.

Further, I believe that when material complexity is created by man, **it cannot be predicted, but also adds an inherent instability and lack of balance. When this occurs, balance and stability cannot be restored without reducing complexity**… and depending on the motivation of the system’s design, this reduction often will not occur absent an external catalyst.

Complexity (and Chaos Theory) applied to Economics

Most people I know agree that Communism, while quite interesting in theory, cannot be applied in practice because of the realities of human nature. What is less obvious is that a pure free market economy cannot exist for similar reasons unless all participants share similar ethics and intent of balance rather than gain in a zero-sum game.

Absent that shared morality, such a market must be regulated to some degree by moral men. Otherwise, the complexities described will emerge in a semi-organic way over time and I see no way to avoid that eventuality.

I believe we may be approaching the apex of this level of complexity in the world economy– the problem is it is unknowable in my opinion whether or not the catalyst I describe has yet occurred, when it will, or even IF it will within the next 100 years. I hear people speak of manipulation by private parties and even governments… but if you accept that as true, what makes you think it will CHANGE? Those that seek to benefit from imbalance can maintain the perception of relative stability despite overwhelming pressures. I believe such a catalyst is likely occur, but do not believe I can know if it will occur in my lifetime or that of the next generation.

 

As I’ve recently been quoted as saying, Macro-Economics has officially been replaced by Chaos Theory—time to go find a butterfly to step on so I can turn this thing around!

Fulcrum Components

This is true for the market as a whole. There are also fulcrum components in said market that have similar unpredictable qualities. My father in law believes that gold is one of these key fulcrum points, as do many other extremely knowledgeable economists both in and out of academia and the investment community. It is not that I do not share this view, but rather that I do not have sufficient understanding to FORM such a view. (He has more knowledge and both professional and personal experience in these matters, and I trust that– but my personality forces me to draw my own conclusions.)

However, removing gold from the picture…

When referring to a fulcrum point within a materially complex “free” market, accurate prediction is (I believe) as impossible as predicting the market itself. Interpreting the stimuli that trigger the visible responses is similarly impossible, even through hindsight, prior to the shroud of complexity being removed via a catalyst.

In other words, it is impossible to know where such events are the result of intentional manipulation of said fulcrum point by governments or the abstract creations of unscrupulous investors that seek to exploit artificial imbalance.

Putting theory into practice

[box type=”warning”]It goes without saying (and yet somehow it doesn’t) that I cannot and do not give investment advice. I can only explain the motivations of my own actions. Now that I’ve got that out of the way…[/box]

 

 

 

One can attempt to leverage arbitrage created by such imbalance if fulcrum points are avoided. For example… I cannot truly predict whether we will see massive deflation, hyper-inflation, or something in between. I *suspect *that we will see a brief period of moderate deflation followed by a sudden inflection point followed by significant inflation (but not hyper-inflation.) However, this is a very weak theory based on my analysis of the parts of the picture I can both see and verify, which is a very small percentage of the picture. Absent knowledge of the fulcrum points, imbalance I cannot have much confidence in this prediction. As a result, I seek balance in my own portfolio through diversity to protect from either instance.

However, I do perceive speculative examples where I have more confidence. The example is Mc Donald’s. I believe that this company’s balance sheet is strong, and that they are secure company with a solid brand. However, in this market that’s only a partial indicator– one must dig beneath the surface.

Unique and scalable business model

Their business model is inherently scalable. This is obvious– they can, at less expense than most companies, expand and contract to meet demand due to the franchise model.

What is less obvious is their level of diversification because they are not structured as a conglomerate. Think about what happens when you do a detailed market analysis and buy a piece of unimproved land, and then build a McDonald’s on it. How much does the value of that land increase? Now, lease it to a franchisee… if that franchisee is unsuccessful due to incompetence they will sell to another franchisee. If your market research was flawed (or the purchase poorly timed) the location will go out of business. However, you can still sell the land at a profit, unloading a bad location on a competitor.

Given sufficient scale, which MCD has achieved, this is a very STABLE model in addition to its scalability. However, they also have an additional edge in terms of their strategy as I perceive it.

Price Perception and Margins

They have been expanding their dollar menu for a while now– well before this turmoil was noticed by most. Now they have a structured element of their menu that is understood by the market as “the lowest priced option.” They can ramp the price point up and down easily once this perception is in place based on inflationary or deflationary forces. So long as they preserve profitability (which is quite easy) they are indexed to inflation.

However, their margins are not. Margins will stay about the same on the core items… burgers, etc. However, margins are very high on sides like fries, and incredible on beverages. Improving in a material way on margins that approach 50:1 is a pretty nice situation, and provides MCD with a lot of flexibility.

The X-Factor: Trade Down

However, there’s an X-Factor that makes me feel even safer. I believe that, in the long run, for every billion dollars in market capitalization Starbucks gives up, MCD’s increases by at least 100M in a bad economic climate. This is ONE example of a trade-down element I feel protects this stock.

In America, our poor people die from obesity, not starvation… it’s it because a dollar menu is all they can afford?

(Photo Credit: Injas World)