We talk a lot about evolving markets.  When we use that phrase, evolving, we think of gradual change.  In reality, evolutionary change is anything but gradual.

People think of change as happening along the blue line to the left.  A little change every year.  But what really happens is like the red line.  Things go along with not much change for a very long time, then there’s a dramatic change, and then an entirely new "normal" takes hold.  This big change is what’s called a "punctuated equilibrium."

What we’ve recently seen in the financial services industry is a punctuated equilibrium.  For years the banks went along with only minor change.  They kept slowly enhancing the products and services, a little bit each year.  Regulations changed, but only slightly, year to year.  Then suddenly there’s a big change.  Something barely understood by the vast majority of people, credit default swaps tied to subprime mortgage backed securities, became the item that sent the industry careening off its old rails.  That’s because the underlying competitive factors have been changing for years, but the industry did not react to those underlying factors.  Large players continued as if the industry would behave as it had since 1940.  Now, suddently, the fact that everything from asset accumulation to liability management and regulation will change – and change rapidly.

When punctuated equilibrium happens, the old rules no longer apply.  The assumptions which underpinned the old economics, and norms for competition, become irrelevant.  Competition changes how returns will be created and divvied up.  Eventually a new normal comes about – and it is always tied to the environment which spawned the big change.  The winners are those who compete best in the new environment – irrespective of their competitive position in the old environment.  The one thing which is certain is that following the old assumptions is certain to get you into trouble.

I’ve been surprised to listen to "financial experts" on ABC and CNBC advising investors since this financial services punctuated equilibrium hit.  Consistently, the advice has been "don’t sell.  Wait.  Markets always come back.  You only have a paper loss now, if you sell it becomes a real loss.  Just wait.  In fact, keep buying."  And I’m struck as to how tied this advice is to the old equilibrium.  Since the 1940s, it’s been a good thing to simply ride out a downturn.  But folks, we ain’t ever seen anything like this before!!  This isn’t even the Great Depression all over again.  This is an entirely different set of environmental changes.

In reality, the best thing to have done upon recognizing this change would be to sell your equities.  The marketplace is saying that global competition is changing competition.  How money will be obtained, and how it will be doled out, is changing.  Old winners are very likely to not be new winners.  Competitive challenges to countries, as well as industries and companies, means that fortunes are shifting dramatically.  No longer can you consider GM a bellweather for auto stocks – you must consider everyone from Toyota to Tata Motors (today the total equity value of Ford plus GM is 1/10th the value of Toyota).  No longer can you assume that real estate values in North America will go up.  No longer can you assume that China will buy all the U.S. revolving debt.  No longer can you assume that America will be the importer of world goods.  How this economic change will shake out – who will be the winners – is unclear.  And as a result the Dow Jones Industrial Average has dropped 40% in the last year.

To all those television experts, I would say they missed the obvious.  How can it be smart to have held onto equities if the value has dropped 40%?  Call it a paper loss versus a real loss – but the reality is that the value is down 40%!  To get back to the original value – to get your money back with no gain at all – will take a return of 5% per year (higher than you could have received on a guaranteed investment for the last 8 years) for over 10 years!  That’s right, at 5% to get your money back will take 10 years!!  Obviously, you would have been smarter to SELL.  And every night this week, as the market fell further, these gurus kept saying "hold onto your investments.  It’s too late to sell.  Just wait."  Give me a break, if the market is dropping day after day, how is it smart to watch your value just go down day after day!  You should quote Will Rogers and say to these investment gurus "it’s not the return on my money I’m worried about, it’s the return of my money"!!

Or read what my favorite economist, Mr. Rosenberg of Merrill Lynch wrote today "There is no indication…that the deterioration in the fundamentals is abating…all the invormation at hand suggests that the risk of being underinvested at the bottom is lower than the risk of being overexposed to equities….in other words, the risk of geing out of the market right now is still substantially less than the risk of continuing to overweight stocks…what matters now is to protect your investments and preserve your capital." (read article here)

The world is full of conventional wisdom.  Conventional wisdom is based on the future being like the past.  But when punctuated equilibrium happens, the future isn’t like the past.  And conventional wisdom is, well, worthless.  What is valuable is searching out the new future, and learning how to compete anew.  Right now it’s worth taking the time to focus on future competitors and figure out how you can take advantage of serious change to better your position.  You can come out on top if you head for the future – but not if you plan for a return to the past.