Editor's note: This Weekend Edition, we're taking a break from our usual fare to share how the "law of unintended consequences" is always at play in the markets. In this essay, Rob Spivey, the director of research at our corporate affiliate Altimetry, explains why you need to analyze the possible daisy chain of outcomes from your investment choices... and how a technique known as "pre-op" can help you make sharper financial decisions.

Unintended Consequences Rule the Stock Market

By Rob Spivey, director of research, Altimetry

Barbra Streisand would be the first to tell you things don't always go as planned...

Streisand is a talented performer, famous worldwide for her multidecade singing and acting career. She is one of only 18 EGOT winners – people who have been awarded an Emmy, Grammy, Oscar, and Tony.

And yet, one of her most notable contributions to our culture was off the stage. It's the so-called "Streisand effect."

In 2003, a photographer took a picture of Streisand's mansion in Malibu, California, and posted it online. Streisand heard about the photo and didn't like it being out there. She didn't want everyone to know where she lived and what her house looked like. So she sued the photographer and the website for $50 million for violating her privacy.

It only made matters worse...

You see, the lawsuit became an even bigger story than the picture. Now everyone wanted to know what Streisand was hiding... and they wanted to see where her house was. More than 400,000 people visited the website that hosted the picture in the following month. Instead of the lawsuit suppressing this information, it had the exact opposite effect.

This story demonstrates the "law of unintended consequences." If we do something with one outcome in mind, we might be just as likely to get another outcome – even the exact opposite outcome – if we're not careful.

Today, we'll talk about how this theory relates to investors. And we'll share how you can apply this knowledge to get ahead of the curve in the market.

The law of unintended consequences plays a huge role in business. A great example of this comes from tech company IBM (IBM) in the mid-1990s.

IBM's board decided to change management's compensation plan to increase the company's earnings per share ("EPS"). The board believed that was the one metric that most directly impacted shareholders and could send IBM's stock higher.

But that change to the compensation framework destroyed a lot of value for shareholders...

On its surface, the best way to improve EPS is by growing earnings. That usually entails growing the business and improving margins. However, savvy investors might recall what actually happened...

From 1995 through 2019, IBM enacted one of the biggest share-buyback programs in history. It bought back more than $200 billion worth of IBM shares.

That's about $80 billion more than its current market cap.

The board thought management would grow earnings by investing cash in the business... But management took another approach.

Finding new growth engines to push earnings higher is hard. Using all that cash flow to buy back shares and reduce the share count? That's much easier.

Management wasted money shrinking IBM's share count. It bought back shares instead of spending money on innovation, research and development, and other ways to drive growth.

In a technical sense, it achieved the board's intended effect: IBM's EPS did actually increase. It just wasn't the kind of increase that creates value for shareholders.

The share-buyback program really took off around 1999. Since then, IBM's stock is only up about 53%. The S&P 500 is up 235% in the same time frame. Take a look...

The IBM story shows that you don't always end up with the most obvious or basic outcome... especially in the markets. To protect your money as an investor, you have to consider the daisy chain of possible effects from your actions.

The law of unintended consequences is impacting investors right now...

Regular readers are likely well versed in the supply-chain supercycle by now. If you need a refresher, it refers to a huge wave of spending on things like construction, factories, and infrastructure in the U.S.

The supply-chain difficulties of the past two years have pushed inflation higher, have created shortages for all sorts of goods, and have caused a mismatch between supply and demand. That's driving more companies to build their supply chains closer to home.

Like the Streisand effect, the supply-chain supercycle is having some unintended consequences. Fortunately, they might actually be beneficial...

The return of industry and supply chains to the U.S. has meant soaring demand for blue-collar workers. Jobs in areas like construction, transportation, and warehouses are finally coming back... And they'll play an important role in the U.S. economy going forward.

Once you know about the law of unintended consequences, you'll start to see it in all corners of the market.

For instance, a similar domino effect is taking place in Japan. The Japanese government is focused on decreasing rates... which may be artificially boosting the market.

The fundamentals don't seem to explain the recent rally. Stocks may just be rising because of a wave of cash flowing into the market from the Bank of Japan. It's yet another example of actions in one part of the market changing things in another.

In your own investing, exercise caution... and think creatively about unintended consequences. The most straightforward way of thinking about an investment might not be the most accurate way to analyze it – or the most profitable.

To make the most of your investments, you must look beyond the surface. The best way to do this is by performing what's called a pre-op. That means stopping before you make an investment decision to ensure that you think everything through. Ask yourself questions like...

By asking these questions (and others), you'll discover possible unintended consequences of prospective investments. Equipped with this knowledge, you'll be able to make a more informed investment decision.

You'll also protect yourself from being blindsided in unfamiliar scenarios. Better yet, it can help you identify ideas that separate you from the pack.

Regards,

Rob Spivey

Editor's note: A financial crisis that most folks are getting completely wrong is ripping through U.S. stocks. That's why the founders of our corporate affiliates Altimetry and Chaikin Analytics are sharing an urgent message to explain the full story... and how you can prepare yourself to profit from it.

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