The Bear’s Lair: Keynesian beauty contests are long-term losers

Emperor Rudolf II

Emperor Rudolf II
Source: Dennis Jarvis

One of John Maynard Keynes’ favorite conceits, expressed in Chapter 12 of his 1936 “General Theory” was that selecting stocks was like a beauty contest in which you selected the six most attractive faces from a panel of 100 photographs – the person who agreed most exactly with the consensus winning a prize. For once, Keynes was right – in the short-term, stock markets do work like that, with the consensus “most beautiful” stock going up most. However, in the long-term selecting the consensus idea of stock market beauty will lose you money, and the eccentrics who stick to their own ideas will shape the future and reap the richest rewards. We just don’t know which eccentrics will win out.

Keynes’ idea reflects the reality that in the short-term, stock prices will reflect the consensus of investors about their value. Thus, as an investor, you should attempt to predict what your fellow investors will do, and not follow your own analysis and preferences. Keynes suggested that if other investors were attempting to judge by the same criteria, the wise investor would attempt to ascertain, not what other investors would think most “beautiful” but how those other investors would assess the market. In practice, while Keynes thought investors would bury themselves in an infinite loop, I do not believe anybody actually does this. Instead, the world of investors today appears to be divided into three classes: those that assess the popularity of investments, those that do their analysis properly and the vast majority, who mutter “Efficient Market Hypothesis” and then invest to match some broad-based stock market index.

Indexers may be in for a nasty shock shortly, incidentally. If Tesla (NASDAQ:TSLA) is admitted to the Standard and Poor’s 500 index at its present absurd over-valuation, thus representing a substantial share of the index because of its market capitalization, it will take the index down with it when reality dawns, so indexers who have been forced through their indexing to buy Tesla will lose money.

To return to the Keynesian beauty contest, it seems to me a poor way to pick investments in all but the shortest term, and an even worse way to determine where the market and the economy are going. To show you why, let me tell you about two monarchs about 70 years apart who devoted money, time and their very high intelligence to the science pursued by the most fashionable thinkers of their time. One was England’s King Charles II (1630-85, ruled 1649 or 1660-85). The other, two generations earlier, was the Holy Roman Emperor Rudolf II (1552-1610, ruled 1576-1610).

Both men were tolerant of the religious divisions within their domains; indeed both were by the standards of their day free-thinkers, without a strong commitment to any particular religious sect. Neither was particularly successful at his day job of running the country, and both of them suffered in historians’ esteem from the collapse of their regimes shortly after their death – Charles II through the 1688 ‘Glorious Revolution’ that deposed his brother and the Stuarts and Rudolf even more unpleasantly by the 1618 start of the Thirty Years War. However, both men had in common their high intelligence and commitment to the leading scientific thinkers of their day, backing them with funding and support, encouraging them to gather around their courts, and seeking to understand and foster the scientific advances of their time.

In Charles II’s case, this meant taking a keen interest in astronomy (primarily for navigation) physics and chemistry. This interest has greatly improved Charles II’s reputation with posterity. He founded the Royal Society and patronized Robert Hooke (1635-1703), Robert Boyle (1627-91) Christopher Wren (1632-1723) and Edmond Halley (1656-1742). With the good luck of having Isaac Newton (1642-1727) invent most of modern physics in its early years, the Royal Society and Charles II’s patronage thereof has a direct link both to both the Industrial Revolution and to modern science. One additional advantage for Charles II: Francis Bacon, Viscount St. Alban (1561-1626) had in 1620 in Novum Organum propounded the Scientific Method, of experimentation interacting with theoretical revision. This was propagated to scientists generally by the Royal Society and adopted thereafter by both scientists and practical inventors. Thus Charles II, by patronizing the fashionable sciences early in his reign, greatly helped British scientific and economic power over the next four centuries.

Seventy years earlier, Rudolf II shared Charles II’s interest in astronomy, being a major patron of Tycho Brahe (1546-1601) and Johannes Kepler (1571-1630), both of whom he attracted to his capital in Prague. However, the other fashionable sciences Rudolf patronized have a less solid reputation today: they were astrology, alchemy and necromancy. This reflected the intellectual climate of the time. Astrologers and alchemists were present in most of the courts of Europe, for example one of Elizabeth I’s key advisors was John Dee (1527-1608). As for necromancers, the Holy Roman Empire of the late sixteenth and early seventeenth century saw the highest rate of witch burnings in history, showing the “science” to be unpopular with the Church but very fashionable.

Although the Holy Roman Empire’s alchemists achieved a number of advances in the next century, notably the phlogiston theory of combustion (Johann Joachim Becher) and the discovery of phosphorus (Hennig Brand), Rudolf’s favored sciences all except astronomy proved to be more or less dead-ends, doing nothing for the long-term growth of the Holy Roman economy or for the long-term scientific reputation of the Holy Roman Empire and its successor states.

Without Bacon’s Scientific Method or the luck of Newton’s work coinciding with the monarch’s efforts, Rudolf II’s scientific efforts, intelligent, whole-hearted and expensive though they were, led to no bright future. As intelligent and well-meaning as Charles II, and the greatest art collector of his time, Rudolf’s scientific efforts, making Prague the intellectual capital of Europe during his reign, nevertheless turned out to be the equivalent of buying Xerox, Digital Equipment and Polaroid in 1972 – they proved to be overpriced failures.

Investors in the current stock market may think they have got the Keynesian beauty contest taped. They buy Facebook (NASDAQ:FB), Alphabet (NASDAQ:GOOG) Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Microsoft (NASDAQ:MSFT) and Tesla, and watch their portfolio grow in value. Like Keynes judging a beauty contest, they do not need to know anything about the companies in which they buy stock, only that they are overwhelmingly popular among other investors, particularly the Millennial day-traders served by Robinhood and its competitors.

This ignorance has been blissful during 2020, but in the long run these companies and the people who invest in them are the Rudolf II’s of our day – heavily concentrated in the equivalents of alchemy, astrology and necromancy, the fashionable intellectual pastimes of our age. Social media and search will be commoditized by 2050, with their advertising business flat, Apple will not have come out with a truly ground-breaking product for the 39 years since Steve Jobs died, Amazon will be a low-margin discount retailer, Netflix will be a minor player in the hyper-competitive media world, Microsoft’s “cloud” will be a dull utility and Tesla will be an automobile manufacturer, rated like Ford.

By 2050 there will be new ideas, new world-expanding paradigms, and they will have been invented by individual eccentrics who do not follow fashion (Isaac Newton and Steve Jobs both being classic examples of that type). They will initially find it difficult to get money, because the gigantic lakes of venture capital are controlled by fashion-followers, who will not recognize their merit. Only those who look for truly beautiful beauty contest contestants, rather than following the consensus, will be capable of finding these individuals and investing early in their potential.

Followers of Maynard Keynes, whether his beauty contest theory or his “stimulus” fiscal follies and monetary madness, will by 2050 be irretrievably bankrupt.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)