Hollow Men, Hollow Markets, Hollow World



Apocalypse Now (1979), based on “Heart of Darkness” by Joseph Conrad

Kurtz:  Did they say why, Willard, why they want to terminate my command?
Willard: I was sent on a classified mission, sir.
Kurtz: It’s no longer classified, is it? Did they tell you?
Willard: They told me that you had gone totally insane, and that your methods were unsound.
Kurtz: Are my methods unsound?
Willard: I don’t see any method at all, sir.
Kurtz: I expected someone like you. What did you expect? Are you an assassin?
Willard: I’m a soldier.
Kurtz: You’re neither. You’re an errand boy, sent by grocery clerks, to collect a bill.


It is my belief no man ever understands quite his own artful dodges to escape from the grim shadow of self-knowledge. 

The question is not how to get cured, but how to live.

– Joseph Conrad (1857 – 1924)

Billions of dollars are flowing into online advertising. But marketers also are confronting an uncomfortable reality: rampant fraud.
About 36% of all Web traffic is considered fake, the product of computers hijacked by viruses and programmed to visit sites, according to estimates cited recently by the Interactive Advertising Bureau trade group.

– Wall Street Journal, “The Secret About Online Ad Traffic: One-Third Is Bogus”, March 23, 2014

Over the last decade, institutional management of equity portfolios has increased from 54% to 81%. …

Institutional buys and sells accounted for 47% of trading volume between 2001 and 2006, but only 29% of trading volume since 2008.…

One of the most significant results of the tension between fewer market participants and larger parent order sizes is that the share of ‘real’ trading volume has declined by around 40% in the last five years.

– Morgan Stanley QDS, “Real Trading Volume”, Charles Crow and Simon Emrich, April 11, 2012

I first saw Apocalypse Now as a college freshman with two roommates, a couple of years after it had been released, and I can still recall the dazed pang of shock and exhaustion I felt when we stumbled out of the theatre. Nobody said anything on the drive back to campus. We were each lost in our thoughts, trying to process what we had just seen. Our focus was on Marlon Brando’s Col. Kurtz, of course, because we were 18-year old boys and he was a larger than life villain or anti-hero or superman or … something … we weren’t quite sure what he was, only that we couldn’t forget him.

When I reflect on the movie today, though, I find myself thinking less about Kurtz than I do about Martin Sheen’s Capt. Willard. Both Kurtz and Willard were self-aware. They had no illusions about their own actions or motivations, including the betrayals and murders they carried out. Both Kurtz and Willard saw through the veneer of the Vietnam War. They had no illusions regarding the essential hollowness of the entire enterprise, and they saw clearly the heart of darkness and horrific will that was left when you stripped away the surface trappings. So what made Willard stick with the mission? How was Willard able to navigate within a world he knew was playing him falsely, while Kurtz could not? I don’t want to say that I admire Willard, because there’s nothing really admirable there, and this isn’t going to be a web-lite note along the lines of “Three Things that Every Investor Should Learn from Apocalypse Now”. But there is a quality to Willard that I find useful in recalling whenever I am confronted with hard evidence that the world is playing me falsely. Or at least it helps keep me from shaving my head and going rogue.

The WSJ article cited above – where it now seems that more than one-third of all Web traffic is fake, generated by bots and zombies to create ad click-throughs and fake popularity – is a good example of what I’m talking about. One-third of all Web traffic? Fake? How is that possible? I mean … I understand how it’s technologically possible, but how is it possible that this sort of fraud has been going on for so long and to such a gargantuan degree that I don’t know about it or somehow feel it? I’m sure that anyone in e-commerce or network security will chuckle at my naïveté, but I was really rocked by this article. What else have I been told or led to believe about the Web is a lie?

But then I remember conversations I have with non-investor friends when I describe to them how little of trading volume today is real, i.e., between an actual buyer and an actual seller. I describe to them how as much as 70% of the trading activity in markets today – activity that generates the constantly changing up and down arrows and green and red numbers they see and react to on CNBC – is just machines talking to other machines, shifting shares around for “liquidity provision” or millisecond arbitrage opportunities. Even among real investors, individuals or institutions who own a portfolio of exposures and aren’t simply middlemen of one sort or another, so much of what we do is better described as positioning rather than investing, where we are rebalancing or tweaking a remarkably static portfolio against this generic risk or that generic risk rather than expressing an active opinion on the pros or cons of fractional ownership of a real-world company. Inevitably these non-investor friends are as slack-jawed at my picture of modern market structure as I am when I read this article about modern Web traffic structure. How can this be, they ask? I shrug. There is no answer. It just is.

My sense is that if you talk to a professional in any walk of life today, whether it’s technology or finance or medicine or law or government or whatever, you will hear a similar story of hollowness in their industry. The trappings, the facades, the faux this and faux that, the dislocation between public narrative and private practice … it’s everywhere. I understand that authenticity has always been a rare bird on an institutional or societal level. But there is something about the aftermath of the Great Recession, a something that is augmented by Big Data technology, that has made it okay to embrace public misdirection and miscommunication as an acceptable policy “tool”. It’s telling when Jon Stewart, a comedian, is the most authentic public figure I know. It’s troubling when I have to assume that everything I hear from any politician or any central banker is being said for effect, not for the straightforward expression of an honest opinion.

The question is not “Is it a Hollow World?”. If you’re reading Epsilon Theory I’m pretty sure that I don’t have to spend a lot of words convincing you of that fact. Nor is the question “How do we fix the Hollow World?”. Or at least that’s not my question. Sorry, but being a revolutionary is a young man’s game, and the pay is really bad. More seriously, I don’t think it’s possible to organize mass society in a non-hollow fashion without doing something about the “mass” part. So given that we are stuck in the world as it is, my question is “How do we adapt to a Hollow World?”.  As Conrad wrote, the question is not how to get cured, but how to live. How do we make our way through the battlefield of modern economics and politics, a world that we know is hollow and false in so many important ways, without losing our minds and ending up in a metaphorical jungle muttering “the horror, the horror” to ourselves?


Two suggestions for adapting to the Hollow Market piece of a Hollow World, one defensive in nature and one for offense.

On defense, recognize that modern markets are, in fact, quite hollow and everything you hear from a public voice is being said for effect. But that doesn’t mean that the underlying economic activity of actual human beings and actual companies is similarly fake or bogus. The trick, I think, is to recognize the modern market for what it IS – a collection of socially constructed symbols, exactly like the chips in a casino, that we wager within games that combine a little skill with a lot of chance. There is a relationship between the chips and the real-world economic activity, but that relationship is never perfect and often exists as only the slimmest of threads. The games themselves are driven by the stories we are told, and there are rules to this game-playing that you can learn. But it’s a hard game to play, and it’s even harder to find a great game-player who will bet your chips on your behalf. A better strategy for most, I think, is to adopt an attitude of what I call profound agnosticism, where we assume that ALL of the stories we hear (including the narratives of economic science) are equally suspect, and we make no pretense of predicting what stories will pop up tomorrow or how the market will shape itself around them. What we want is to have as much connection to that underlying economic activity of actual human beings and actual companies as possible, and as little connection as possible to the game-playing and story-telling, no matter how strongly we’ve been trained to believe in this story or that. I think what emerges from this attitude can be an extremely robust portfolio supported by more-than-skin-deep diversification … a portfolio that balances historical risks and rewards rather than stories of risk and reward, a portfolio that looks for diversification in the investment DNA of a security or strategy as well as the asset class of a security or strategy.

On offense, look for investment opportunities where you have information that reflects an economic reality at odds with the public voices driving a market phenomenon. This is where you will find alpha. This is where you can generate potential returns when the economic reality is ultimately revealed as just that – reality – and the voices shift into some other story and the market matches what’s real. These opportunities tend to be discrete and occasional trades as opposed to long-standing strategies, because that’s the nature of the information beast – you will rarely capture it in a time and place where you can act on it. Almost by definition, if the information is being generated by a public voice it’s probably not actionable, or at the very least the asymmetric risk/reward will have been terribly muted. But when you find an opportunity like this, when you have a private insight or access to someone who does against a market backdrop of some price extreme … well, that’s a beautiful thing. Rare, but worth waiting for.


I’ll close with a few selected lines from TS Eliot’s The Hollow Men, because I’m always happy to celebrate a time when poets wore white-tie and tails, and because I think he’s got something important to say about information and communication, authenticity and deception.

                                                                 Between the idea
                                                                 And the reality
                                                                 Between the motion           
                                                                 And the act
                                                                 Falls the Shadow

What is the Shadow? I believe it’s the barrier that communication inevitably creates among humans, including the mental barriers that we raise in our own minds in our internal communications – our thoughts and self-awareness. Sometimes the Shadow is slight, as between two earnest and committed people speaking to each other with as much authenticity as each can muster, and sometimes the Shadow is overwhelming, as between a disembodied, mass-mediated crowd and a central banker using communication as “policy”. Wherever you find a Shadow you will find a hollowness, and right now the Shadows are spreading. This, I believe, creates both the greatest challenge and opportunity of our investment lives … not to pierce Eliot’s Shadows or to succumb to Conrad’s Heart of Darkness in our hollow markets, but to come to terms with their existence and permanence … to evade their influence as best we can, all the while looking for opportunities to profit from their influence on others.

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Two Shifting Narratives


Two brief observations on incipient shifts in powerful Narratives …

First, China. The pleasant charade that recent currency intervention was nothing more than an effort to reverse the “one-way bet” of speculators and to “increase volatility” as part of China’s accession to some brotherhood of liberal nations is starting to crumble.  Let me put it this way … you know that your preferred Narrative is in trouble when even the WSJ runs a piece titled “Yuan’s Decline Raises Concerns Over Currency War”. This is something I’ve written a lot about recently, here and here, and the political repercussions of slowing growth in China continue to make my risk antennae quiver. Politically speaking, weak real economic growth can be papered over by Fed-engineered financial asset price inflation in the US and by la dolce vita social policies in Europe. Neither option is available to Chinese leadership. China needs to make and sell more things – domestically, internationally, whatever – to keep the political machinery from coming unglued, and that’s the lens through which I see the China story.

Second, the Fed. I’ve been somewhat surprised by the trial balloons and back-bench grumblings posted recently by our favorite Fed amanuensis, Jon Hilsenrath – the latest out just this morning. It’s too soon to read a lot into this (although it can’t make Yellen, whose professional Narrative is all about being a “consensus builder”, terribly happy), but of note was the criticism leveled at Michael Woodford, probably the most influential economist you’ve never heard of. Woodford is the guy behind the notion that the Fed can create a market reality just by saying something. He is the academic theory behind recent “communication policy” practice. Consumer spending and business investment not up to snuff? Want to get that inflation engine started? Just say that you’re going to keep rates artificially low waaaaay longer than you ordinarily would. No need for reasons or justifications or credibility. Simply saying it will drive market expectations and thus make it so. (Here’s a link to a recent Woodford paper on all this, “Fedspeak”).

Is there a germ of truth in Woodford’s theory? Absolutely. Words matter, and the Fed’s words matter more than anyone’s. But this is the classic mistake that academic economists always make – the quasi-religious belief in theory over practice, in the triumph of bloodless ideas over the market’s fang and claw. Woodford’s ideas are sweet music to the enormous egos of the academics who control the Fed: you can save the world just by stating your brilliant policy intentions. Your words will become self-fulfilling prophecies as the markets shape themselves in expectation of your mighty deeds.

And so what do we get? Horror shows like Bernanke’s press conferences last summer or Yellen’s press conference last week. Here’s what I wrote last September after one of Bernanke’s performances in the Epsilon Theory note, “Uttin on the Itz”:



“In Young Frankenstein, Mel Brooks and Gene Wilder brilliantly reformulate Mary Shelley’s Frankenstein, a tragedy in the classic sense, as farce. The narrative crux of the Brooks/Wilder movie is Dr. Frankenstein’s demonstration of his creation to an audience of scientists – not with some clinical presentation, but by both Doctor and Monster donning top hats and tuxedos to perform “Puttin’ on the Ritz” in true vaudevillian style. The audience is dazzled at first, but the cheers turn to boos when the Monster is unable to stay in tune, bellowing out “UTTIN’ ON THE IIIITZ!” and dancing frantically. Pelted with rotten tomatoes, the Monster flees the stage and embarks on a doomed rampage. Wilder’s Frankenstein accomplishes an amazing feat – he creates life! – but then he uses that fantastic gift to put on a show. So, too, with QE. These policies saved the world in early 2009. Now they are a farce, a show put on by well-meaning scientists who have never worked a day outside government or academia, who have zero intuition for, knowledge of, or experience with the consequences of their experiments.”

Now, less than a year later, we are suffering through exactly the same sort of miserable song-and-dance routine, just with a different actor playing the Gene Wilder role. If the Fed was surprised by the rotten tomatoes thrown up on the stage last year, they ain’t seen nothing yet.

epsilon-theory-two-shifting-narratives-march-24-2014.pdf (213KB)


Surely You Can’t Be Serious



The Secret of life is honesty and fair dealing. If you can fake that you’ve got it made.

These are my principles, and if you don’t like them…

well, I’ve got others.

I’m not crazy about reality, but it’s still the only place to get a decent meal.

A child of five could understand this. Send me someone to fetch a child of five.

Room service? Send up a larger room. 
Groucho Marx (1890 – 1977)

In periods of great global stress, like after a World War or a Great Depression, it’s not only our politics and economics that are thrown for a loop, but also our art and entertainment. New art, and comedy in particular, that rejects or makes fun of the ancien regime after some enormous crisis is as old as Aristophanes. This art is subversive, often masking its contempt with “low comedy” like puns and slapstick, and no one in the past century was better at this than Groucho Marx. I’ve lately found myself thinking of Fed communications as a form of performance art … some sort of Dada-ist comedy routine where Groucho might stick his head out from behind a curtain and photobomb the press conference … and never more so than yesterday. If only it were so.

Yellen’s press conference was a disaster. Why? Because she said too much. Because on the one hand she took away the insane linkage between monetary policy and the unemployment rate – an ill-conceived and counter-productive misreading of market game-playing that I wrote about ad nauseam last summer, here and here – but on the other hand she gave a specific timing target for raising rates after QE is all tapered out. Combine this with the three-times-in-a-row pattern of cutting monthly QE purchases by $10 billion per meeting, and now even Jon Hilsenrath is projecting specific calendar dates for raising rates.

I mean, you really can’t make this stuff up. Did the Fed learn nothing from last summer? This isn’t an academic exercise, where statements are qualified and softened by exhaustive footnotes and asides so that no one is ever wrong. The market is a beast, not the review committee for the Quarterly Journal of Economics. Of course the market is going to leap at and devour a statement like Yellen’s 6 months comment, and you’d think that the Fed Chair would know that.

All together now, one more time with feeling: ambiguity is good; transparency is bad. You might think that transparency would be helpful in “shaping market expectations” the way you like, but you would be wrong. That’s not how the game is played. Can I nominate Bill Belichick for the Fed, at least as far as press conferences are concerned?

And I’m very sympathetic to Kocherlakota’s dissent … if you ARE going to take a stand with an explicit linkage to unemployment rates, then you can’t just say “oh, never mind that” less than a year later and expect that whatever new standards you set out for rate-setting are going to be particularly effective in molding expectations. It’s not a matter of credibility, per se. That’s a very specific word with a very specific meaning in game theory, and the simple truth is that the Fed will always be credible enough to be an effective game player. The problem is actually that the Fed is too credible, and that Yellen’s remark about raising rates within 6 months of stopping QE3 takes on far more import than was intended.

Sigh. Look, maybe I’m over-reacting here. Maybe we are all so freaking exhausted by the constant use of communication as policy, by the unceasing effort of the Fed and its media intermediaries to play the market, by the Orwellian nature of a monetary policy apparatus where everything is spoken for effect, that we will all just go about our business and slog along. And I’m sure we will see lots of back-tracking over the next few weeks, lots of data-dependence talk, lots of “Yellen really didn’t say anything new”, yada yada yada. But my fear is that we’ve set the stage for, if not an inflection point in the path of the stock market, then another rate shock similar to but smaller than last summer’s … an aftershock, in geological terms.

What am I looking for to see how this plays out? I think we are now even more strongly in a good-news-is-bad-news (and vice-versa) world. If we start seeing some strong economic data come out over the next few weeks and months, then I think the market – particularly the bond market and emerging markets – could get pretty squirrelly. Not that US stocks would be immune from this. Remember, the modern day Goldilocks environment for stocks has nothing to do with a happy medium between growth and inflation, but everything to do with growth being weak enough to keep an accommodative Fed in play. Strong growth data would augment a Common Knowledge structure that the Fed is on track to raise rates sooner and more rather than later and less, and that’s no fun for anyone. Then again, if global growth data remains weak – and you really can’t look at what’s coming out of China, Europe, or Japan and think that the global growth story is anything but weak – that creates enough uncertainty about the Fed’s path (not to mention the cover for political and economic Powers That Be to wage a full-scale media war to keep monetary policy in QE la-la land forever) to support the markets. Sounds a lot like Freedonia to me. Rufus T. Firefly for President?

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epsilon-theory-panopticon-march-16-2014-schematic epsilon-theory-panopticon-march-16-2014-foucault
Panopticon schematic, 1791 Michel Foucault, 1975 © Camera Press

The Panopticon: a new mode of obtaining power of mind over mind, in a quantity hitherto without example.
– Jeremy Bentham, founder of modern utilitarianism (1748 – 1832) 

But the guilty person is only one of the targets of punishment. For punishment is directed above all at others, at all the potentially guilty. 

– Michel Foucault, “Discipline and Punish: The Birth of the Prison”

Visibility is a trap. 

– Michel Foucault, “Discipline and Punish: The Birth of the Prison”

There is little doubt that hedge funds have entered a new era of transparency and public openness – a transformation that I believe will benefit investors, the public, and regulators… One immediate benefit of this requirement to your industry should be that transparency will enable you to shed the secretive, “shadowy” reputation that some would say has unfairly surrounded you.
– Mary Jo White, SEC Chair, speech to Managed Funds Association, October 18, 2013

The advance of civilization is nothing but an exercise in the limiting of privacy.
– Isaac Asimov, “Foundation’s Edge”

Whatever games are played with us, we must play no games with ourselves, but deal in our privacy with the last honesty and truth.
– Ralph Waldo Emerson (1803-1882)

In 1791, Jeremy Bentham published a book describing what was clearly a revolutionary design for prisons, factories, schools, hospitals – any institutional building where a few administer instruction, discipline, or care to the many. This design, what Bentham called a Panopticon, was trumpeted as “Morals reformed — health preserved — industry invigorated — instruction diffused — public burdens lightened — Economy seated, as it were, upon a rock — the Gordian knot of the poor-law not cut, but untied — all by a simple idea in Architecture!” No shrinking violet here, but the booming, confident voice of the father of utilitarianism, a man who wrote 30,000,000 words in a lifetime of social activism.


Jeremy Bentham, by Henry William Pickersgill

A Panopticon has a large circular watchtower in the middle of a larger circle of cells or offices or classrooms or whatever functional task space is appropriate for the building at hand. The outer circle of cells has inner walls and doors made of transparent windows, and the reverse is true of the central watchtower, which is completely opaque as seen from the outside. From the watchtower you can see perfectly into every cell, but from a cell you can see nothing in the watchtower. Importantly, any occupant of a cell can see pretty much every other occupant of every other cell.

The beauty of the Panopticon, per Bentham, was that the occupants of each cell would soon come to police themselves. That is, the only thing necessary to create the perception of being watched and monitored and punished for bad behavior was the constant possibility of being watched and monitored and punished for bad behavior, together with the communal witnessing of your fellow prisoners behaving as if they were watched and monitored and punished for bad behavior. It’s not necessary for a guard or overseer to watch each prisoner at all times; what’s necessary is for each prisoner to live in a perfectly transparent cell, so that each prisoner thinks that he is being watched at all times. As Bentham wrote, the Panopticon design was a means of controlling the minds of prisoners or workers through mental force, as opposed to the traditional goal in 18th century prisons and workhouses of controlling bodies through brute force. Just like the warden in Cool Hand Luke, just like Dick Clark with American Bandstand, Bentham understood the enormous power of the crowd seeing the crowd. What he added to the calculus of social control was the important catalyst of transparency.

Thinking of transparency and openness as an instrument of social mind control is a hard pill to swallow in an era of social media and reality TV. So many of us embrace personal openness and the sharing of our thoughts…so many of us, as Christopher Hitchens ruefully noted about himself, run towards a camera instead of run away…that it seems almost un-American, rather impolite, and certainly anti-modern to maintain privacy and secrecy in our social relationships. We live in an age where transparency is lauded as a personal virtue and touted as a hallmark of liberty, where public confession is a celebrated ritual and a trusty engine of popular entertainment, where our employers expect as a matter of course that our private lives will merge with our business lives to allow constant access and attention. We live in an age where government requires disclosure of private investment strategies and holdings under the guise of “risk management”, where failure to disclose a private opinion on public securities can be a crime, where – as Dave Egger’s chillingly writes in The Circle –  “Secrets are Lies”, “Sharing is Caring”, and “Privacy is Theft”.

Transparency has nothing to do with freedom and everything to do with control, and the more “radical” the transparency the more effective the control…the more willingly and completely we police ourselves in our own corporate or social Panopticons. This was Michel Foucault’s argument in his classic post-modern critique Discipline and Punish: The Birth of the Prison, which – just because it was written in an intentionally impenetrable post-modernist style, and just because Foucault himself was a self-righteous, preening academic bully as only a French public intellectual can be – doesn’t make it wrong. The human animal conforms when it observes and is observed by a crowd, at first for fear of discipline but ultimately because that discipline is internalized as belief and expectation.

To be clear, I’m not saying that transparency is a bad thing for the society or institutions that enforce it. I simply want to call it by its proper name…an extremely powerful instrument of social control, not a “benefit” for the watched. Firms like Bridgewater that famously require a culture of transparency are, I believe, far more efficient and robust than their competitors that don’t. To take a trivial example apropos in mid-March, do you think that a lot of time is wasted at Bridgewater during work hours by employees sending around NCAA tournament brackets? Yeah, right. Not because there’s some “rule” against researching your NCAA bracket while at work, but because it would be unthinkable (and I mean that in a purely literal sense of the word) to do so within the glass walls of an effective Panopticon. A Panopticon crushes any sense of complacency in its residents, and that’s a really big plus for a modern institution. For the residents themselves, of course, that lack of complacency may manifest itself as a wee bit of constant stress. Or to take an example from the investment industry as a whole, SEC Chair Mary Jo White is absolutely right when she says that transparency is good for regulators. Heck, it’s greatfor regulators. But she’s entirely disingenuous when she touts the removal of secrecy as a good thing for private investment funds.

What’s my investment point in this little diatribe? As investors in highly regulated public markets we are all operating within a Panopticon of sorts. Some of us more obviously than others, but we’re all similarly situated to a rough degree. It’s critical to understand the dynamics of the crowd watching the crowd within a regulatory environment of forced transparency so that we can have a realistic notion of what’s possible and what’s not as we try to achieve our personal or institutional investment goals.

Capturing alpha in an investment strategy requires private information. To the degree that forced regulatory transparency and Big Data technology reduce private information by turning it into common knowledge, there is less alpha in markets. That’s a cold, hard fact. Finding alpha has never been easy. It’s always been the rarest thing in the investing world, but now it’s truly an endangered species, particularly in the stock-picking world of fundamental analysis of public companies. We have moved from a regulatory environment where illegal private information was pretty much defined as stealing the orange growers’ crop report from the USDA a la Trading Places (Mortimer Duke: “Turn those machines back on!”), to an environment where the mere existence of market-beating investment returns is treated as prima facie evidence that you must have been doing something illegal to generate those returns. Professional investors today are scared to death of private information on public companies. It’s never been more expensive or difficult to acquire, and the regulatory assumption is that – if it works – then it must have been illegally obtained. No wonder, then, that so many hedge fund giants accustomed to investing on the basis of private information are sailing as fast as they can for the safe harbor of advocacy and activism, where a large position and a board seat or two may cost you dearly in terms of liquidity but allows you to legally obtain and act on private information as a company insider. And even if you don’t reach the promised land of board membership and true insider status, at least you can talk up your own book with incessant public statements about your “investment thesis” without drawing regulatory scrutiny. All of the big boys play the Common Knowledge game today, because that’s how they adapt to a Panopticon. They make themselves more visible to the crowd and make more public statements because they can create, for a while at least, their own investing reality. They know that if they speak loudly enough and long enough, enough of us little guys will follow their lead on the stock. It’s what little guys DO.

Wow, that’s a pretty bleak assessment, Ben. Isn’t there some hope for alpha still out there in the world, even for the little guys? Sure. It’s in your neighborhood. It’s in your family business. It’s in whatever you know really well, some endeavor that by dint of education or experience you happen to have private information about. That’s where you’ll find alpha. Remember Peter Lynch and “buy what you know”? There’s a lot of wisdom in that, so long as you keep in mind that in Lynch’s day you could know an Apple or a Microsoft in a way that is impossible and/or illegal today. In today’s public markets I think it’s still possible to find managers with private information, but you have to look in the cracks and crevices of the market, in relatively small niches where the traders and investors that I refer to as beautiful parasites still live. These managers tend to be relatively small, and they are almost always superb game-players, able to generate alpha by, as Keynes put it, “guessing better than the crowd how the crowd will behave.”

And remember, too, that finding alpha isn’t the only reason to invest in public markets. Liquidity is important. Tagging along with broad-based economic growth through a broad-based capital market is important. But most of all diversification is important. Harry Markowitz, the father of Modern Portfolio Theory, always bristles at that label, saying that there’s nothing modern about it at all. He’s exactly right. Portfolio theory is an old, wonderful idea. You can dress it up in scientific finery as MPT does, and there’s definitely a role for that, but there’s also a very real danger that the arcane language and self-appointed priesthood of modern economic science gets in the way of a personal appreciation of the very real benefits of a diversified portfolio. I’ve written recently about applying the Adaptive Investing lens to questions of diversification, and I’m going to continue focusing on that in the future. Because while alpha in public markets may be rare and getting rarer as private information vanishes before the onslaught of forced transparency, diversification is still there for the taking. And that’s an opportunity I’m happy to use my media microphone to encourage.

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Question: Mr. President, a clarification if I may. The people who were blocking the Ukrainian Army units in Crimea were wearing uniforms that strongly resembled the Russian Army uniform. Were those Russian soldiers, Russian military?
Putin: Why don’t you take a look at the post-Soviet states. There are many uniforms there that are similar. You can go to a store and buy any kind of uniform.
Question: But were they Russian soldiers or not?
Putin: Those were local self-defense units.

– Vladimir Putin press conference, March 4, 2014

Kane: Read the cable.
Bernstein: “Girls delightful in Cuba. Stop. Could send you prose poems about scenery, but don’t feel right spending your money. Stop. There is no war in Cuba, signed Wheeler.” Any answer?
Kane: Yes. “Dear Wheeler: you provide the prose poems. I’ll provide the war.”

– Orson Welles, “Citizen Kane”

Indeed, expectations matter so much that a central bank may be able to help make policy more effective by working to shape those expectations. … Communication about policy is likely to remain a central element of the Federal Reserve’s efforts to achieve its policy goals.
– Ben Bernanke, “Communication and Monetary Policy”, November 19, 2013

There’s no one thing that’s true. It’s all true.
– Ernest Hemingway, “For Whom the Bell Tolls”

Last Friday I wrote an Epsilon Theory email highlighting the media Narrative around China’s shift in monetary policy and associated manipulation of the yuan as a prime example of The Power of Why…a facile “explanation” designed to satisfy the business model imperative of financial media (and financial advisory services, more broadly) as well as the political interests of powerful institutions, in this case the Chinese state. I wasn’t surprised that the epicenter of this Narrative was a newspaper owned by Rupert Murdoch, whose close ties to the Beijing regime are legendary, and I tried to be kind in not calling out the beat writers who I’m sure were provided with precise talking points. But I am surprised by the degree to which mainstream economists and China watchers have uniformly swallowed and promulgated the notion that this sea change in Chinese monetary policy – which is far more impactful on global economics and investing than anything that happens in the Ukraine – is not only entirely benign but part and parcel of China’s accession to liberal modernity and the brotherhood of Western nations.

There are two levels to the official Chinese line on their monetary policy shift – one for the hoi polloi and one for the professional economist/analyst community. I’ll deal with both, and apologies in advance for the density of the latter, which requires a bit of inside-baseball lingo.

The first argument is that China is seeking to end the “one-way bet” (I only wish I had copyrighted this phrase two weeks ago, like Pat Riley did with “three-peat”) on the yuan going up in value. This argument appeals to a Western, liberal-minded opposition to rigged markets and evil “speculators”. Unfortunately, it’s complete hogwash, the linguistic equivalent of US politicians who clamor for “a level playing field” while voting for the usual assortment of pork barrel goodies. It’s wordplay, entirely symbolic in nature, no different than my saying that I’d like to end the one-way bet on gravity. The Chinese government intentionally created this one-way bet, because the alternatives – either a free-floating currency or a fixed currency regime – would have resulted in unacceptable domestic economic damage in the former case or unacceptable international political damage in the latter case. The yuan has been going up in a highly predictable fashion because that’s exactly what the Chinese government wanted and imposed. To say now that they are shocked…shocked!…at the speculation this engenders is a stratagem in the best tradition of Casablanca’s Capt. Renault.

Are there speculators (I call them beautiful parasites) who eat the tiny trading crumbs created by the Chinese government’s non-economic dribbling of the yuan higher? Of course. Is the Chinese government – like governments everywhere – genuinely delighted to crush these lamprey eels if they can? Sure. But are they the reason China is shifting its monetary policy? Please.

The inside-baseball argument is more nuanced, but ultimately just as misleading. In version A, China is trying to engender a wider “volatility band” in the yuan so that it will ultimately trade like a market-oriented currency. In the still more nuanced (and thus still more appealing to economists) version B, China is seeking to reduce volatility in domestic interbank lending and associated interest rate spreads, and as a result is “transferring” that volatility to currency exchange rates. Again, all with the goal of making Chinese monetary tools and policy more in-line with Western monetary tools and policy.

The problem I have with this argument – and the reason my risk antennae are quivering – is the orchestrated and intentional linguistic focus on volatility. The word “volatility” means something. It’s an important and powerful word. There are assumptions behind the word and its meaning. Those assumptions are not just violated here; they are crushed. The word “volatility” means nothing in the context of a highly manipulated data series. Or rather, it means something entirely different from what it means in a non-manipulated context. It’s ersatz volatility. Potemkin Village volatility. Faux volatility. I could go on. Whatever it is, it doesn’t mean what you think it means.

I’ll spare you the dissertation on stochastic underpinnings of econometric concepts. Suffice it to say that what’s happening here is like someone telling you that he has a random number generator when really he’s just spouting off numbers that pop into his head and sound kind of random. Trust me, these are not random numbers. But if you treat them as random numbers, say for some encryption program, you’re going to be very sorry. Similarly, if you treat “volatility” in a yuan/dollar time series the same way you treat volatility in the euro/dollar time series, say for some relative value forex trading program…well, good luck with that. You, too, are going to be very sorry.

So why the intentional (and intentionally misleading) focus on volatility as the WHY behind a monetary policy shift? What’s at stake here and what’s really going on?

First, let me be clear on what I’m NOT saying. I am not saying that Chinese government economists and policy apparatchiks are out and out lying when they say that they want to crush currency speculators and diminish interbank lending volatility, particularly that latter part. I think that the Chinese government – like governments everywhere – is terrified of domestic lending seizures or dislocations and will do pretty much anything to mitigate that risk. I also think that the government functionaries who communicate with Western economists and analysts (and not coincidentally tend to speak really good English) are likely true believers in the ultimate liberalization of the Chinese economy along a more or less Western model.

But it’s not the whole truth. It’s not even, I believe, the essential truth.

The essential political truth in China – the glue that keeps the Party, the Army, and 1.4 billion people cobbled together – is economic growth. Economic growth is the fundamental WHY of the modern Chinese State, its raison d’etre. This is why Deng Xiaoping mattered so much, because he gave the Chinese State a coherent and attractive alternative to the ultimately self-destructive Permanent Revolution and Vanguard Party of Mao. But if economic growth fails in China, if the WHY of Deng Xiaoping’s vision fails…then so does the modern Chinese State. The liberal nations of the West can withstand a Great Recession, even a Great Depression, because there’s a WHY to small-l liberalism that transcends expediency and the “glory of wealth”. Not so China. Or at least not so this China, with this governing philosophy.

What I’m saying is that the Chinese government is demonstrating the primacy of domestic politics over everything else. Just like the US government is demonstrating with QE. Just like the Russian government is demonstrating in its actions against Ukraine.

What I’m also saying is that the Chinese government is communicating its monetary policy with language that tries to misdirect, that tries to mask its true political face. Just as the US government communicates its monetary policy. Just as the Russian government communicates its foreign policy.

China must maintain a certain level of economic growth. What that level is, or how we would measure or know it from the outside, I have no idea. But I have no doubt that the Chinese leadership, who live and breathe the political diktat of economic growth every single day, know it quite well. Or rather, they know it when they see it, and they know it when they don’t. Every other consideration – faux “volatility bands” and thumping of currency “speculators” foremost among them – is at best epiphenomenon or side-effect to the core imperative of delivering growth.

Is growth in China falling off a cliff? No way. If it were, we would have seen this sort of policy shift months ago, and a lot more drastic stuff today. But is growth in China uncertain, within a political environment where the governing regime is not only accustomed to certainty but requires a high threshold level of growth for its survival? Yes, I believe it is, and that is more than enough to mobilize the traditional pro-growth tools of monetary policy – easy credit and a weaker currency – into high gear.

In the Chinese context, easy money is not central bank balance sheet expansion or even lowering short rates. It’s turning a blind eye to credit expansion in the shadows. It’s guaranteeing liquidity to banks so that they don’t worry about interbank lending. It’s bailing out wealth management products. How long will they do this? Until the uncertainty goes away.

In the Chinese context, a weaker currency is not some free-floating pound that gets devalued by 20% in a day amid a flurry of recrimination and regret. It’s a carefully managed yuan that probably looks flat versus the dollar over the next 18 months rather than upward sloping. And if exports get tougher or the yen gets cheaper, maybe it’s got a downward bias. But compared to the past 8 years of a steadily increasing yuan, this is a big deal. A really big deal. It will create significant trade tensions with the US, and it will make Japan’s devaluation/inflation course that much more difficult to achieve. But you know what? China doesn’t care. The last 8 years have been a monetary policy of choice. Today we see a monetary policy of necessity. Maybe the West and its army of China apologists will go for the whole “it’s only benign volatility” line, and maybe they won’t. No matter. The Middle Kingdom takes care of its own.

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Two Quick Points


Two quick Epsilon Theory points before the jobs report tomorrow.

First, remember the Goldilocks Narrative of the post-Great Recession Era…slow growth keeps the Fed in play, so disappointing but still positive job numbers are an initial shock but ultimately market friendly. Conversely, surprisingly good job numbers may be good news for the real world, but not for the market.

Second, I’m seeing clear signs of a new Technology Bull sub-Narrative in recent weeks…that there is something special and powerful about tech stocks regardless of what happens with the Fed or job numbers or the rest of the world. The investment language of Growth and the grammar of Extrapolation are running rampant, and that can create a very powerful market dynamic within a certain orbit of securities. These sub-Narratives can run for a long time.

epsilon-theory-two-quick-points-march-6-2014.pdf (26KB)