Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. The more different you are from the person that defined a rule the less you should follow the rule. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.

Unconventional wisdom: Is investor complacency out of touch with reality?

“All is for the best in the best of possible worlds.”

- Voltaire

In the movie A Beautiful Mind Russel Crowe portrays mathematician John Nash. In one memorable scene Nash and his colleagues are all interested in a blonde woman sitting in a bar with a group of her friends. Nash quickly concludes if they all approach the blonde none of them will get a date with her or any of her friends.

Nash explains it is far better for each of them to approach another woman in the group. Nash’s rationale for his proposed plan is more than a technique to meet women. What he is explaining is the Nash equilibrium.

The Nash equilibrium was an advance in the study of strategic interactions between two or more parties – a.k.a, game theory. John Nash did not win a Nobel Prize because he came up with a good technique for picking up women. It was game theory’s usefulness in assessing situations like the current tariff stand-off that impressed the Nobel Committee.

A sense of complacency has settled over markets with the tariff situation far from resolved. In early April investors were panicking. Now? Not so much. Since ‘liberation day’ on April 2nd the ASX 200 is up 3.70% and the S&P 500 is only down 1.77% as of the 2nd of May. Does any of this make sense?

What is game theory and what can it teach us?

The Nash equilibrium describes a situation where multiple parties find themselves in a stalemate. They reached an equilibrium because no party could benefit by changing their own strategy.

Nash’s insight was that it was impossible to predict how each single player would act in isolation. However, you can gain valuable insights into likely outcomes by looking at what would happen if one player changed their strategy and the others didn’t.

One derivation of the Nash equilibrium is the concept of mutually assured destruction. Most commonly associated with the cold war it describes a situation where neither party gains from attacking the other party. The cost is too high.

Given the risk of trying to defeat an advisory the status quo is maintained even if that isn’t ideal for any of the parties. This is Reagan’s peace through strength policy or Roosevelt’s wonderful quote about speaking softly and carrying a big stick.

I am going to explore three scenarios that could unfold with tariffs. I will focus on the stand-off between the US and China because those are the highest current tariffs and have the potential to be most destructive to world trade and the Aussie economy.

Mutually assured destruction

Investors seem to believe that we are facing a mutually assured destruction scenario with trade. How else can you explain how calm markets are when the tariffs currently in place are universally perceived to be economically disastrous.

Proponents of this view believe the current tariffs can’t be maintained because they would result in mutually assured destruction of the Chinese and American economy. Americans would face empty shelves and rampant inflation. Unemployment would spike in China.

The hope is that some combination of Chinese concessions and a retreat by Trump will bring things back to the status quo. Investors want to believe this scenario will happen. I want to believe this scenario will happen.

Just observe what investors react to and what is ignored. Markets railed meaningfully when Trump announced the US and China were negotiating. There was no market reaction when the Chinese denied talks were taking place.

A prisoner’s dilemma

What if this isn’t mutually assured destruction. What if this is another game theory scenario – the prisoner’s dilemma. In a prisoner’s dilemma there is an incentive for each party to make a decision that leads to a non-optimal outcome for everybody.

Imagine two criminals getting questioned by police in two different interrogation rooms. If neither confesses there isn’t enough evidence to charge them with a crime. However, if one confesses in exchange for a lighter penalty they both go to jail with the non-confessor serving a longer sentence.

If this tariff stand-off is a prisoner’s dilemma one party could decide that the short-term pain is worth it because they will ultimately earn a relative victory. Trump was doing a lot of talking about the pain being worth it when he first announced his tariff program. He is now blaming market volatility on Biden. Is this prepping the public for a longer stand-off?

In mutually assured destruction powerful and plentiful nuclear weapons made their use unimaginable. Think of the prisoner’s dilemma as a conventional war. The same wars that have happened countless times throughout history because one side thought they could win.

What would cause Trump to keep tariffs? He miight think victory was worth some inflation, unstocked shelves, lower growth and maybe a mild recession. Especially if victory meant manufacturing returning to the US and a severely damaged Chinese economy diminishing their geo-political influence.

Winning for Xi would be Trump eventually backing down and rolling back the tariffs. That could happen if US voters turn against Trump if the economy goes into free fall. It could happen if the implosion of the stock or bond market forces his hand. In both cases his backflip would be to the long-term benefit of China as the US would lose credibility in the world and isolate itself from allies.

When the status quo isn’t maintained despite mutually assured destruction

In Stanley Kubrick’s satire Dr. Strangelove nuclear war occurs despite mutually assured destruction. Why? Because one of the actors is crazy.

In the movie the rogue US Air Force General Jack Ripper initiates an attack on the Soviet Union. He does this because he believes the Soviets have been putting fluoride in American’s water and it is stealing their bodily fluids. I’m not making that fluoride thing up. Go watch the movie.

A nicer description than crazy is zealot. Hear me out on the zealot scenario. A simplistic view of the impact of free trade and globalisation in the US is that it benefited some groups and crushed others.

The educated class thrived with careers in fields that expanded as technological advancement enabled the US to sell more services globally. The new industries that have popped up in the last couple decades primarily employed educated workers in smaller but higher paid workforces.

As their salaries grew the educated class got access to cheaper goods imported from overseas. They profited as share prices rose. They had more disposable income to spend on things like educating their children. They were thriving in the new self-proclaimed meritocracy. And if they advanced solely because of their own merit those that struggled had only themselves to blame.

We can contrast this with the blue-collar workers in the US. High paying union jobs with good benefits disappeared. The jobs went overseas or were replaced by technology. The only options available were unemployment and minimum wage jobs. Being a minimum wage worker kept getting worse. The inflation adjusted US minimum wage is currently 40% lower than the minimum wage in 1970.

Economically speaking if wages in one area of the workforce don’t keep up with inflation people move on to other professions. Unless there are no other choices. Instead of sympathy, a robust social safety net, or investments in education the blue-collar workers got chastised for poor choices. Anger and resentment built up and the search began for who to blame. As often happens the blame was pinned on the beneficiaries of the new economic order.

There is much more nuance to the situation than I’ve described. Yet we seem to be losing our ability as a society to appreciate nuance. I do think my description captures the high-level narratives that serve as a backdrop to Trump’s presidency and the tariff negotiations.

In his first term Trump took figures from the Republican establishment as part of his team. These were people that largely believed in the existing global order even if they had their own spin on it. That is normal in politics.

In his second term the commonality between his cabinet members seems to be resentment against the so called elites who benefit from globalisation.

Is this real resentment? Is this political pragmatism to play to Trump’s base? Is it enough resentment to rip down the global order?

Depending upon how real and deep this resentment is things might get interesting. Economic damage can start to look like justice if you are angry enough and don’t have anything to lose.

Final thoughts

What does the future hold? The short answer is I don’t know. I’m optimistic that thing will work in the long-run. I have not sold anything from my portfolio and have kept investing according to my plan.

Yet I’m shocked the market isn’t down more – or in the case of Aussie shares down at all. I just don’t know what is driving the optimism that is reflected in share prices.

I think the second two scenarios I outlined are creditable. I don’t think they are the most likely outcomes but the market seems to be discounting them entirely.

Nobody I talk to is optimistic. Business leaders don’t seem optimistic. Companies are throwing their hands in the air and removing earnings guidance. The US just reported negative growth in the first quarter. The fundamentals have changed. Prices haven’t.

Perhaps the conclusion to take from what is happening is the most obvious one. What the share market does over the short-term makes no sense. Trying to figure it out will drive you crazy and empty your wallet.

I logged into my brokerage account this morning. When I’m feeling unsettled I like to look at my transactions history page to see what dividends have come in. It is my market anxiety ritual. Not exactly meditation but you aren’t reading this to get my wellness tips.

In the past week I’ve received a dividend from global liquor giant Diageo (NYSE: DEO) which I first bought on April 29th 2008. When I made this purchase George W. Bush was in the White House. But Trump was doing important things as well. He started his spin-off TV show Celebrity Appretice that year. In case you are interested Piers Morgan won the inaugural season.

More relevantly just a month earlier in March 2008 Bear Stearns was sold for $2 a share to JP Morgan after trading at $60 a share a week earlier. Apparently Bear had bought some bad mortgages. By June the S&P 500 crossed into bear market territory. Things would get much, much worse.

There were several reasons I bought Diageo in 2008 but one of them was the simple fact that I thought people would keep drinking Johnnie Walker, Guiness and Tanqueray.

They have despite – or maybe because of – the events of the last 17 years. Diageo has had a rough run lately and is nowhere close to my best investment. But the dividend is up more than 50% and earnings have more than doubled.

My advice is to keep your focus on the horizon and ignore what is right in front of you. Mentally prepare for some more volatility and concentrate on what you are trying to accomplish. That is all that matters.

I would love to hear your thoughts. Email me at mark.lamonica1@morningstar.com

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What i’ve been eating

My first great meal outside of Australia after COVID was Christimas dinner at Shoukouwa in Singapore in December 2021. I returned last week and it is as good as I remembered and still the best sushi I’ve had outside of Japan. Pictured is Hokkaido Hairy Crab with crab roe sauce and just a bit of caviar.

Crab