The Optimistic Thought Experiment

Sunday, May 4th, 2008

In The Optimistic Thought Experiment, Peter Thiel emphasizes the following points:

  • Any investor who ignores the apocalyptic dimension of the modern world also will underestimate the strangeness of a twenty-first century in which there is no secular apocalypse.
  • There are no good investments in a twenty-first century where globalization fails.
  • Almost every financial bubble has involved nothing more nor less than a serious miscalculation about the true probability of successful globalization.
  • Financial bubbles and exaggerated stories about globalization are nearly synonymous because the greatest uncertainties about the future of the world have involved questions about the rate and the nature of globalization.
  • Because there is not much time left, the Great Boom, taken as a whole, either is not a bubble at all, or it is the final and greatest bubble in history.
  • There is no good scenario for the world in which China fails.

I’d consider myself more inclined than most to consider the catastrophic effects of low-proability disasters — but Thiel seems to find this thinking central to his “macro” view:

Because there is not much time left, the Great Boom, taken as a whole, either is not a bubble at all, or it is the final and greatest bubble in history .

But because we do not know how our story of globalization will end, we do not yet know which it is. Let us return to our thought experiment. Let us assume that, in the event of successful globalization, a given business would be worth $ 100/share, but that there is only an intermediate chance (say 1:10) of successful globalization. The other case is too terrible to consider. Theoretically, the share should be worth $10, but in every world where investors survive, it will be worth $100. Would it make sense to pay more than $10, and indeed any price up to $100? Whether in hope or desperation, the perceived lack of alternatives may push valuations to much greater extremes than in nonapocalyptic times.

The reverse version of this sort of investment would involve the writing of insurance and reinsurance policies for catastrophic global risk. In any world where investors survive, the issuers of these policies are likely to retain a significant portion of the premium — regardless of whether or not the risks were priced correctly ex ante. In this context, it is striking that Warren Buffett, often described as the greatest investor of all time, has shifted the Berkshire Hathaway portfolio from “value” investments (no internet, no growth, often just businesses with stable cash flows) to the global insurance and reinsurance industries (perhaps one of the purest bets on the optimistic thought experiment).

If the preceding line of analysis is correct, then the extreme valuations of recent times may be an indirect measure of the narrowness of the path set before us. Thus, to take but one recent example, in 1999 investors would not have risked as much on internet stocks if they still believed that there might be a future anywhere else. Employees of these companies (most of whom also were investors through stock option plans) took even greater risks, often leaving stable but unpromising jobs to gamble their life fortunes. It is often claimed that the mass delusion reached its peak in March 2000; but what if the opposite also were true, and this was in certain respects a peak of clarity? Perhaps with unprecedented clarity, at the market ’s peak investors and employees could see the farthest: They perceived that in the long run the Old Economy was surely doomed and believed that the New Economy, no matter what the risks, represented the only chance. Eventually, their hopes shifted elsewhere, to housing or China or hedge funds — but the unarticulated sense of anxiety has remained.

I like his take on China:

To say the least, there are many eerie parallels between the Chinese stock market of early 2007 and the Nasdaq of early 2000: an abstract story of long-term, exponential growth; rampant speculation; and unprofitable or overvalued companies.

One intermediate possibility is that the China of 2014 will be like the internet of 2007 — much larger, but with winners very different from the ones that investors today expect. The largest New Economy business is Google, a company that scarcely registered in early 2000. Might it also turn out that the greatest Chinese companies of 2014 will be concerns that are private and tightly controlled businesses today, rather than the high-profile and money-losing companies that have been floated by the Chinese state?

At the very least, outsiders need to understand that China is controlled for the benefit of insiders. The insiders know when to sell, and so one would expect the businesses that have been made available to the outside world systematically to underperform those ventures still controlled by card-carrying members of the Chinese Communist Party. “China” will underperform China, and a “China” bubble exists to the extent that investors underestimate the degree of this underperformance.

Bringing this thought back to technology:

As with the distinction between China and “China,” there also exists a critical distinction between technology and investments called “technology.” To take a particularly easy case from the prior technology bubble, a “technology” company that sells pet food online by purchasing Super Bowl advertisements offline may not be a technology company at all. The solutions to hard engineering problems are not necessarily valuable, but it is unusual for the solutions to easy engineering problems to have much value in the long term.

A more subtle “technology” bubble may be occurring this time. A large number of large capitalization companies are effectively short innovation: companies such as Microsoft, Dell, IBM, Cisco, HP, and others. They benefit by modest changes to the status quo, but are threatened by massive innovation. This does not mean there are not massively innovative companies out there: Google and Intel, to name the two best-known brands, are. Merely, there is a difference between technology and “technology.” After all, even GM uses an impressive amount of electronics and computers.

And on to hedge funds:

Hedge funds (and “hedge funds”) seek high returns without the regulations that hamstring mutual funds and using leverage unavailable to mutual funds and even (except to a limited extent) to individual investors. The difference between a hedge fund and a “hedge fund” is this: a hedge fund seeks to allocate capital from less efficient uses to more efficient uses; a “hedge fund” seeks trading strategies. Mostly, “hedge funds” merely seek to replicate successful strategies of the past until they don’t work.

Ouch. Thiel clearly dislikes the “micro” view:

The retreat towards tactical cleverness hides a lazy agnosticism about the most fundamental questions of our age. Because we find ourselves in a world of retail sanity and wholesale madness, the truly great opportunities exist in the wildly mispriced macro context — rather than in the ever-diminishing spreads on esoteric financial markets or products. Indeed, one could go even further: What is truly frightening about the twenty-first century is not merely that there exists a dangerous dimension to our time, but rather the unwillingness of the best and brightest to try and make any sense of this larger dimension.

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