Second level thinking about investing in artificial intelligence

Failure to drive second-level thinking… who wins in the autonomous vehicle wars? … what second-level analysis suggests for price controls … gold sets new all-time high

But then what could happen?

This is the question most people (and investors) aren’t great at asking – let alone answering correctly.

We are decent to look ahead to the first bifurcation decision and its potential results. But beyond that, most people stop evaluating.

Too often, this lack of “second-level thinking” leads to a series of suboptimal results. In the investment world, the consequence is usually underperformance.

In his book, The most important thingOaktree Capital co-chairman Howard Marks writes:

First-level thinking is simplistic and superficial, and almost anyone can do it (a bad sign for anything involving an attempt at superiority).

All the first-level thinker needs is an opinion about the future, as in “The company’s outlook is favorable, meaning the stock will rise.” Second-level thinking is deep, complex, and complicated.

Let’s start today Digest looking at an example of first and second level thinking through an AI investment lens. We will do this with the help of our macro expert, Eric Fry.

As I noted last Friday DigestEric is hosting a live event Thursday at 1 PM ET called the Road to the AGI Summit. It’s a summary of his months of research into the investment implications of AGI, or “Artificial General Intelligence.”

The ability to ask “but then what could happen?” will be critical to the success of investments in the AGI world.

What is the best way to invest in the automotive industry in the coming era of AGI and autonomous vehicles?

Let’s start with the first level to analyze this market. Here is Eric:

At first glance, observers might think that the Road to AGI involves winners, such as automakers General Motors Co. (GM)and losers, sharing firms such as Uber Technology Inc. (UBER).

However, a closer look at the industry reveals that the opposite may be true once autonomous vehicles (AVs) truly emerge. Ride-hailing firms could emerge as winners, while automakers become losers.

Why? After all, in the coming era of amazing technology, won’t we all want these next generation self-driving cars of the future?

Well, with first-level thinking, yes, of course we will. And that means there’s likely to be huge demand for autonomous vehicle manufacturers.

But what does second-level analysis reveal?

Eric points out a critical overlooked detail…

Cars are parked 95% of the time. So there is enormous utility that is not being used. Until now, this utility was blocked because, without a driver, cars were little more than very expensive paperweights.

But with artificial intelligence, we are entering a world where cars can drive themselves. This frees them up to serve an entire family, household or group of friends. Cars are no longer tied to their user.

So instead of a family where mom and dad have their own cars and two teenagers share a third car, there is now the potential for one car to efficiently transport every member of the family (assuming compatible scheduling). Or better yet – how about avoiding the cost of buying cars entirely (and programming complications) and only paying for their occasional use?

Through this lens, you see the advent of autonomous vehicles changing value added away from the vehicle itself and to vehicle movement.

Back to Eric:

Rideshare firm Uber will benefit from AGI as it can quickly become a marketplace for these services.

Why buy a Tesla Robotaxi when Uber can send you the nearest car at the lowest price?

So if ride-hailing companies like Uber play their cards right, them would be the ones who benefit the most on the Road to AGI, rather than the automakers who ultimately perfect autonomous driving.

Again, Eric will discuss this type of second-level thinking on Thursday, August 22 at 1:00 PM ET at The road to the AGI Summit. To reserve your place, click here. This type of deeper analysis will be essential for investors in the coming age of AGI.

In the meantime, let’s look at the potential risks of failing to consider second-level thinking in our economy

Over the weekend, Vice President Harris unveiled her first major policy initiative if elected president — a proposal to ban “price gouging.”

From Harris:

We all know that prices went up during the pandemic when supply chains shut down and failed. But our supply chains have improved now and prices are still too high.

The Harris campaign added:

Vice President Harris knows that rising food prices remain a major concern for American families. Many large grocery chains that saw production costs fall, however, kept prices high and posted their highest profits in two decades. While some food companies have passed on these savings, others have not yet.

The Harris campaign went on to say it would set “clear rules of the road to make it clear that big corporations cannot unfairly exploit consumers to make excessive corporate profits from food and grocery products.”

Harris made similar statements about the rental market, pledging to “take on corporate landlords and curb unfair rent increases”.

Now, politics is not our focus here in the Digest. But the economic impact of various policies can be directly in our wheelhouse because of the impact on corporate earnings and, by extension, stock prices. So please understand, we are evaluating a policy, not a candidate.

That being said, what does this proposed price control policy look like through a first and second level frame of mind?

River. Very bad.

The failure of first level thinking on price controls

In the early 2000s, Venezuelan President Hugo Chávez implemented strict price controls on a wide range of staple foods such as flour, milk and cooking oil.

The goal of this top-level thinking seemed admirable—to make essential goods more affordable for the poor in the face of rising inflation.

What the Venezuelan government has not asked is “but then what might happen?”

So take a moment and think for yourself…

From a manufacturer/retailer perspective, what might happen when there is a limit to what a manufacturer can charge for a good, but its cost structure remains the same?

Well, logic suggests that the manufacturer/retailer will either get lower profits or no profits at all. However, they are disincentivized to produce the good.

In the case of Venezuela, the result was “no profit”. As a result, many manufacturers/producers have stopped producing or importing the goods. This led to severe shortages where store shelves were empty and huge lines became common as people searched for rare items.

Meanwhile, insufficient supply led to black markets where the same goods traded at horribly inflated prices. Wealthier Venezuelans could afford the goods, but the poor—whom the price controls were supposed to help—couldn’t pay the cost.

Venezuelan farmers have found it increasingly difficult to cover their costs profitably. So they reduced domestic production, making the country more reliant on imports that were often inadequate. The increase in the deficit added upward pressure on inflation.

We could go on (mass social unrest) but you get the point. What appeared to be an admirable decision at the first level backfired horribly due to a lack of analysis at the second level.

Regarding Harris and price gouging, what is the definition of “gouging”? The term implies that there is a certain level of profit margin that would not be considered excess. what is it Who sets it? What is the specific economic rationale?

Keep in mind that margins in the big box food sector are slim – typically just 1% – 3%.

Below is a chart spanning from 1985 to last year showing the net profit of grocery stores after taxes. You’ll see that this net profit temporarily rose to 3% in 2020, but since last year has fallen to 1.6%, which is roughly in line with levels dating back to 2004.

Are you seeing a steady rise in prices?

The same problems arise with rent control policies. In short, unless you’re lucky enough to get one of those rent-controlled units, a market where the natural balance between supply and demand has been distorted by government intervention means higher prices.

Whether Harris wins the White House or not, let’s hope this policy is abandoned. History, logic, and second-rate thinking suggest that it will ultimately hurt the people it intends to help.

Finally, be aware of second-tier certainty from your own financial “experts”

Since “XYZ” didn’t happen this time (so far), it won’t happen eagerly.

This is the conclusion of a poorly considered first-level analysis, such as what we read below The Wall Street Journal back in 2022.

If you’re having trouble seeing the main headline, it says “Gold Loses Safe Haven Status.”

The article went on to point out gold’s failure to rise in a high inflation environment. She cited various “experts” who made bearish predictions for the yellow metal.

This type of first-level analysis implied that just because gold had not moved higher up to that point, such price gains would not occur.

Back to Eric, here’s what he wrote about gold at the same time:

The yellow metal barely registers a pulse at this point. Most of the Madame Tussauds wax figures seem more vibrant and realistic.

But that’s just how gold behaves from time to time. It “does nothing” for such long periods of time that investors begin to doubt that it could fog up a mirror.

Gradually, they turn their backs on the comatose metal and leave him for dead. But that’s usually when it comes alive.

So how did that go?

Well, since WSJhis article, gold exploded 52%, outpacing the S&P’s 43% gain. And earlier today, it set a new all-time high of $2,524.88 an ounce, surpassing a previous high set on Friday.

It seems that just because gold has not enjoyed a price rally since 2022, the conclusion that such a rally would not happen was a classic first level error in analysis.

If anything, the dormant price was fuel for the 50%+ rally that would follow, as various gold short sellers had to liquidate their short positions once the precious metal finally received a bid.

Kudos to Eric as well as any second tier thinkers who bought gold based on his analysis two years ago.

The bottom line: the next time we’re faced with an important decision—investment-related or not—we’d be wise to stop and ask ourselves, “but then what could happen?”

good evening

Jeff Remsburg