Are Markets Crowding Innovation?

If you want to mix innovation with the evolution of industry structure then go no further than the Museum of Arts and Metiers in Paris, where upon entering you are confronted by Foucault’s Pendulum – the device that was deployed to demonstrate the Earth’s rotation. 

In the part of the museum beyond the Pendulum there is a fascinating collection of old planes and cars from the turn of the 19th century, a time when France alone had over 600 car manufacturers. Even from 1881, France had a primitive electric car. By 1899, in Germany Ferdinand Porsche had built an electric car that could travel at 100km per hour. I think it is a good example to illustrate the point of ‘this time is different’…in the sense that it is not of course. 

The dynamics of competition, the ability of certain companies to marry technological innovation with financial acumen and an appeal to customers, meant that those 600 car manufacturers were whittled down to a handful, the same being true in the UK, US and elsewhere. This was notably also the case in the railroad industry which in 1900 made up close to 40% of the market capitalisation of the UK and US stock markets. 

With this at the back of my mind, the only rationale I can ascribe to the car industry today is that financial markets are betting that Tesla (whose market capitalisation is equal to that of its nine main rivals put together) and Rivian (whose USD 110 bn market cap reflects a total of zero vehicles sold), will be the ‘winners’ of the struggle to dominate the electric car vehicle industry, notwithstanding the fact that other car manufacturers sell an already large range of electric vehicles, and that the likes of Apple and Intel are entering this market.

It may be that investors have an eye on Apple, perhaps the most forceful example of a winner takes all company. It is now worth nearly USD 3 trn and with four other social media related stocks, part of a group of five companies that make up 25% of the market capitalization of the US stock market (the highest concentration since the 1930’s). Without these stocks, the year’s performance of the Nasdaq index would be closer to 7% than 21%.

Apple’s products are rated as the most popular with the US consumer, and will have thus benefitted from the COVID triggered fiscal stimuli across countries, and it has recently announced that like Facebook/Meta, it will be entering the metaverse (with smart glasses and a headset). Yet all is not quite rosy. Details of a mysterious investment deal with China have been disclosed and the company has recently warned suppliers that orders of its iPhone 13 are slowing. One might expect the stock to have weakened on these news items but instead it has rallied by 9%, outperforming broad indices by 6%, which is unusual for such a large stock.

What appears to be driving Apple’s stock, like that of Tesla, is activity in the options market. Over the past two weeks, there have been millions of call option contracts (with short expiries) bought on Apple, and this heavy activity induces buying of the underlying stock by brokers. The oddity is that the options market is supposed to be a derivative of the stock market (though this year volumes in the options market surpassed those in the stock market for the first time), not its master.

That this can happen in the case of a stock like Apple suggests that financialization as a trend is accelerating and is having real world side-effects. Remember that in theory, events and activity in the real world should be reflected in financial market prices, and not so much the other way around.

There are plenty of implications here, notably that fund managers that restrict their analysis to bare fundamentals will not pick out security moves driven by market micro-structure effects and will be prone to underperform.

More importantly there becomes a growing issue of market stability – recall how the mountain of derivatives that was based on the US housing market soon came to engulf that market. It may mean that assets that become heavily financialized, in turn endure periods of what appear to be inexplicable volatility. This has happened in the commodities sector when metals like silver have had ETF’s (exchange traded funds) structured around them.

Overall, it points to a problem of economic veracity – disentangling the elements of true technological innovation from those of financial innovation, and I suspect that once the financial market geniuses disappear, the promise of the electric cars and gadgets of the future will be more pedestrian.

Have a great week ahead,

Mike

PS – Next week’s note will be the last of this year, and will in keeping with tradition, feature my attempts to forecast the trends of the next year, as well as a few book recommendations.

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