Sentiment and flows: The investment thesis refined

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InsiderFinance Wire

9 min readMar 9, 2024

The investment thesis, as presented in the original post on the subject, maintains that in an increasingly digitized global economy the lasting value is likely to accrue to networks — in contrast with sole products or services that over time become commoditized or disrupted by newer forms in an ongoing stream of innovation. Networks, however, come in a wide assortment, varying in their density, their (de)centralization, their interconnected layers, their scope, and other such network qualities that drive long-term value in varying degrees. The so-called Magnificent Seven, which started life as The Big Five (or its distorted variant FAANG), have been evolving case studies to this way of seeing things for well over a decade, and even the two new arrivals to the mix, both product companies, are operating on promises of artificial intelligence, which is a deep data network construct.

This follow-up installment, like two intermediate ones that preceded — here and here — is an attempt to extend the case through a high-level view of the deepest and most complex network of them all, the global financial markets and related economic systems, which, like their lesser counterparts in the digital realm, are marked by cluster formations, network effects, winner-takes-most power law distributions, and, most importantly perhaps, the transmission of sentiment, much like a social network. This latter quality is a principal subject of the notes that follow, even when only implied. Like its predecessors, this post presents a thesis, it is not a forecast. If anything, it might serve to shape a context for the current market environment and its potential trajectories.

The pattern set and broken

This being macro level commentary, we begin with a simplified premise that aggregate economic value may be represented with two variables based on the cap rate valuation method — expected economic output as numerator and capital cost as denominator — resulting in a higher estimate as the numerator grows and/or the denominator diminishes. While it has been the case for the past several decades that the denominator has fallen as interest rates have, more or less consistently, the numerator’s is a more complicated story…
After more than a century of regular and pronounced economic expanse, pushed by the advent of new technologies and practices — the industrial revolution, electricity, telecommunications, automotive and aerospace developments, film, television and radio, computing — and geopolitical events that included major wars requiring rebuild and replenishment, we arrived at a point some thirty years ago at which the last of the seemingly endless line was reached: the Internet and mobility…
During this time, as technology innovation was for the most part focused on disruption (breakage) and alternative modes of competition and productivity enhancement to bring prices down, markets were dominated by financial innovation to offset and grow: new financial products and structures, new trading systems, new investment categories, global extensions, and other such efficiency enhancing ways that, together with steadily falling rates, served to lift value from the denominator (rather than the numerator) side. It is indicative and a testament to this parallel path, that U.S. stock market capitalization has substantially outpaced GDP growth during the described period, arriving at a ratio of almost 200% of GDP today compared to roughly 66% 30 years ago…
With the exception of isolated periods in which financial markets overstepped — the S&L crisis, the LTCM blow-up, the dot-com bubble and burst, and most damagingly perhaps, the Global Financial Crisis — the blueprint worked well to sustain and build market value even as underlying fundamentals may have underwhelmed. With COVID and its global economic shutdown, the described dynamic was shaken up…
What may have been tepid but comfortable economic growth pre-COVID became for a short period an almost-nothing — this being the numerator of the basic value formula — calling for especially aggressive action from the denominator side. Financial engineering was taken to previously unseen extremes with monetary and fiscal policy worldwide, intended to protect value when economic fundamentals had nearly collapsed and threatened to resuscitate in an unsatisfactory manner.

The mood and expectations linger

Neglecting the inflationary effects and attempts to counter these in COVID’s aftermath, we now find ourselves in a significantly higher rate environment than we have seen in decades, bringing us back to the original value formula with what is now, on one hand, a lightly damaged or at least disturbed numerator, and a far less supportive denominator, on the other…
The markets’ reaction has been natural, everything considered, accustomed as it is to a very different set of circumstances. While counting the seconds until rates should come back down again — are we there yet? are we there yet? — the markets are now also on the hunt for signs that economic drivers like in the olden days are resurfacing — a new frontier, a boost from innovation, a global transformation… whatever it takes…
Enter Artificial Intelligence (AI), the most glaring recent find. Enter mass-market pharmaceuticals with new vaccines and weight loss medications. And, if all else fails, enter the economic lift that can happen with unlimited fiscal and/or monetary support — the tacit catching-on of Modern Monetary Theory (MMT). Even cryptocurrency, previously written off as a toy around the fringes of polite society, is now having an institutionally supported resurgence…
The described reactions, in address to both sides of the value calculation to the same impatient end, is maybe the effect of decades spent in a trajectory. It is the only way we know. Markets rise, markets fall, but really for the most part rise, because in one way or another, whether from the top or bottom of the fraction, the support has been there all along. We can’t conceive it otherwise… and who knows, maybe we’re correct to think so and expect it…
And it’s also worth remembering that the financial innovation of passive investment vehicles, which have come to dominate the market (more than 50% of composition by the most recent data, and growing), is inherently predicated on the long-standing trajectory continuing. There is thus a practical necessity in the market “to think so and expect it.”

Technicals now fundamental

A notable characteristic in the atmosphere described is this: AI, the use of diabetes drugs for weight loss, MMT, bitcoin as a currency, are all at best in beta testing, as it were, and more truly in alpha trials, or possibly not even that, maybe in early development. The case of bitcoin is past the developmental stage but searching for a use case that is not speculation. In other words, in our quest to satisfy the needs of a perpetually rising market, we rush to ascribe new frontier status (like electricity and cars and so on, in the past) to forms that are still in early venture stage with unknown outcomes…
Another way to think about the phenomenon is through the distinction between technical and fundamental drivers of market flows. If fundamentals represent the underlying substance and technicals financial supply and demand for it, we may be at a point where technicals have become fundamental. And if a bubble (which isn’t really that until it pops) can be defined as a wide divergence between the two perspectives in favor of technicals, then can conditions really be in place for a bubble to form if technicals and fundamentals are the same?
The preceding is a top-down view. From a bottom-up perspective, if enterprise value can be determined by the sum of its core asset value and its optionality (the future unknown and possibly unknowable extensions or transformations), and looking past the nuances and details that differentiate marketable options from enterprise optionality, we accept that option value is supported by low interest rates and high volatility. As the financial environment is now opposite — high rates and low volatility — how does this fundamentally compute for AI and other untested assets driving the broader market up?
Separately, we see a growing value gap between mega cap and small cap equities, and within that largest capitalization category between the global tech contingent (which are the major networks) and other constituents. True to the network nature of financial markets — just like social networks converge on influencers, influences, and other magnets of attention — there are also winner-takes-most manifestations and a long tail in the market’s network graph. And when investment vehicles — passive or active — are also growing and concentrating according to winner-takes-most patterns, there is a need for the investment and trading supply of large industrial counterparts to satisfy growing demand to put capital to work. This speaks to technicals, but in a fundamental way.

Meanwhile, the economy and economics

The global economy and our understanding of it may have reached a level of complexity that is beyond reduction, beyond a unified perspective, and one might even say, beyond comprehension. There is rarely one cause for every effect, and each stems from a chain in which each link could break (and does) in multiple directions, sometimes contradictory, especially when global crosscurrents are also factored in…
And our growing access to the most minute economic data, rather than solidifying our understanding of and confidence in economic modeling, may have had the opposite effect. Firstly, it often serves to underscore the complexity described above; secondly, it leads to frequent reconsideration of meanings (to the detriment of common sense?), such as for instance in the way we think about and quantify inflation, now sliced and diced in ways that have lost all significance; and thirdly, as the right (or wrong) data can support virtually any argument with skillful presentation, the abundance of data-supported theory may have multiplied to a point of incapacitation…
So, on the back of this as well, it is conceivable that technicals in markets — which is to say, momentum — are now as valid a fundamental underpinning as any.

The market network trades in sentiment

There is an apparent breakage, thus, not only between conventionally formed views of fundamentals and technicals, but also between institutional, enterprise and theoretic categories and their degree of market influence. While some prominent investors have described it as a “broken market,” maybe we are merely witness to an innate progression that may or may not reverse…
Perhaps at some point the pattern self-corrects or mean-reverts so to speak — phenomena regularly noticed in markets otherwise — or maybe at some point the surging market capitalization of U.S. stocks as a multiple of GDP will trigger a snapback. Or, in the way that so-called vigilantes did in the 1990s when debt levels were seen as excessive, maybe again with debt levels now dwarfing those of the past. And maybe that ripples out to other markets, globally interconnected. But whether or not any of these things take place, the event will be a function of sentiment rather than discipline, and sentiment, although contagious, is unpredictable, beyond the limits of detached calculation…
With such a fragmentation of unknowns and constant theory formation, reformation, and abandonment, the sentiment that grows out of uncertainty, for now, may still and all be a drive for liquidity protection — as seen in M&A and private capital diminution versus money market flows and same-day expiring options in contrast, and, possibly as well, the rush to the most liquid stocks around, under the guise of, say, AI bullishness (a technology that no one, let’s be honest, understands)…
… until a bigger breakage happens, which may not be a breakage based on finance fundamentals or nuts and bolts (as was the case with the GFC and dot-com bubble burst), but a breakage of prevailing sentiment, a swing that may be caused by widespread disbelief, distrust in one’s own views and one’s conclusions, without a substitute to fill the void (*).
This is not an improbable outcome within a fat-tailed distribution on both sides, and the possibility is an overhang that lingers.
(*) Footnote: The Fed Chair attempted to express this view — “navigating by the stars under cloudy skies” — and was summarily criticized for it. The market’s immediate reaction was negative, but the episode was soon forgotten.

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