Core Curriculum


I distributed this Epsilon Theory reading list last summer, but it never made it to the website. Given the volume of requests I receive for this and seeing as how the direct subscriber list is about 10x what it was last summer I figured it was high time to reprint.

I haven’t any right to criticize books, and I don’t do it except when I hate them. I often want to criticize Jane Austen, but her books madden me so that I can’t conceal my frenzy from the reader; and therefore I have to stop every time I begin. Every time I read Pride and Prejudice I want to dig her up and beat her over the skull with her own shin-bone.
– Mark Twain

Once upon a time in the dead of winter in the Dakota Territory, Theodore Roosevelt took off in a makeshift boat down the Little Missouri River in pursuit of a couple of thieves who had stolen his prized rowboat. After several days on the river, he caught up and got the draw on them with his trusty Winchester, at which point they surrendered. Then Roosevelt set off in a borrowed wagon to haul the thieves cross-country to justice. They headed across the snow-covered wastes of the Badlands to the railhead at Dickinson, and Roosevelt walked the whole way, the entire 40 miles. It was an astonishing feat, what might be called a defining moment in Roosevelt’s eventful life. But what makes it especially memorable is that during that time, he managed to read all of Anna Karenina. I often think of that when I hear people say they haven’t time to read.

– David McCullough

You need to read more science fiction. Nobody who reads science fiction comes out with this crap about the end of history.

– Iain Banks

A scholar is just a library’s way of making another library.
– Dan Dennett, “Consciousness Explained”

I still feel – kind of temporary about myself.

– Willy Loman (“Death of a Salesman”, by Arthur Miller)

I’ve had dozens of requests to put together a reading list for Epsilon Theory, and I’ve resisted. There’s something uncomfortable about telling people what they should read, of recommending this book but not that one to you because it happened to resonate with me. Also, as Mark Twain said, I haven’t any right to criticize other authors (unless I really, really hate their books!), and I have zero interest in engaging in the all-too-familiar academic exercise of dueling criticism. Been there, done that.

But the roads I’m trying to explore with Epsilon Theory are not the commonly traveled paths of investment theory and practice, and I can appreciate that it would be useful for my readers to have some sort of field guide for this unfamiliar territory. And from a personal perspective, it’s more than just comforting to compile a list like this. Books provide grounding. They help us feel less temporary about ourselves, to use Willy Loman’s memorable phrase, and I’m certainly no exception to that. So with the caveat that this is an entirely impressionistic and non-comprehensive exercise in what has been useful for my personal intellectual grounding, and should be thought of as pointing you to a shelf in the library from which you might want to engage in your own exercise in discovery, here goes …

Statistics and Econometric Analysis

Edward Tufte is best known today for his books on information display – The Visual Display of Quantitative Information, 2nd ed. (2001), Envisioning Information (1990), Visual Explanations: Images and Quantities, Evidence and Narrative (1997), etc.  These books are amazing in every way, both as resource and as inspiration. But less well known is Tufte’s academic career as a statistician at Princeton’s Woodrow Wilson School, where he collaborated with one of the founders of Information Theory, John Tukey. In 1974 Tufte wrote what I believe is the single best book in explaining both the basic techniques and the meaning of applied statistics – Data Analysis for Politics and Policy. Whether you’re a newbie to statistical applications or a Ph.D in econometrics, this is an incredibly useful book (and although out of print, there are plenty of used copies circulating on Amazon).

I’ve mentioned the work of Gary King, Director of Harvard’s Institute for Quantitative Social Science, in my note Rise of the Machines. If you’re already a fluent speaker of the language of econometrics, his work on ecological inference and likelihood functions is both groundbreaking and extremely useful. But one of King’s great skills is his ability to apply econometric techniques to pretty much any area of inquiry, including fields of study that, for whatever reason, tend to be strangers to this methodology. King’s book with Robert Keohane and Sid Verba – Designing Social Inquiry: Scientific Inference in Qualitative Research (1994) – is an excellent read for anyone who wants to think more rigorously about causality and inference in markets, politics, and our social lives. This is not a statistics book. It’s a how-to-think-about-statistics book.

Game Theory and Information Theory

The classic primer on game theory is Games and Decisions: Introduction and Critical Survey, by Duncan Luce and Howard Raiffa. Originally published in 1957, the 1989 edition is still in print, still assigned in courses all over the world, and is still the most comprehensive work on game theory for non-mathematicians. If you’re really interested in game theory, you must have this book. Other classic books on game theory include Robert Axelrod’s Evolution of Cooperation and Thomas Schelling’s The Strategy of Conflict. These are wonderful books, full of real-life examples of game theoretic applications. But if you only have time for one classic book on game theory, I’d recommend William Riker’s The Art of Political Manipulation (1986). The chapter on Abraham Lincoln and the strategic decision-making involved with the Lincoln-Douglas debates is alone worth the price of admission.

As for information theory, the obvious classic is Claude Shannon’s The Mathematical Theory of Communication, which served as the midwife for this entire field. It’s for the really serious student, though, the equivalent of reading Von Neumann and Morgenstern to learn about game theory. Much more accessible are two books by James Gleick: Chaos (1987) and The Information (2012). Thinking about the world in terms of information and subjective probabilities goes back at least to the 18th century work of Thomas Bayes, and two recent works – Nate Silver’s The Signal and the Noise (2012) and Sharon McGrayne’s The Theory That Would Not Die (2011) do a Gleick-ian job (high praise indeed!) of making this perspective accessible for the non-specialist.

The game and information theoretic research that I’m finding most useful today is not written by economists or political scientists, but by linguists and biologists. There’s a scope and a sweep to this work, as well as an explicit incorporation of evolutionary theory, that I find extremely useful. David Lewis’s book Convention (1969) is a good example of this, as he is trying to explain the development of social coordination solely with the tools of strategic decision-making under informational uncertainty (game theory), without resorting to the deus ex machina of human exceptionalism or consciousness.

There’s nothing special about the human animal in this perspective, no sense in which some unique reasoning capacity has created this convention that is more True with a capital T than that convention. In Signals (2010), Brian Skyrms takes the Convention games developed by Lewis to a new level of usefulness by directly incorporating evolutionary models of learning, showing how “communication and coordination of action are different aspects of the flow of information, and are both affected by signals.” It’s a dense book in parts, to be sure, but worth the effort. Markets are just as much a social exercise in communication and coordination as language, and what linguists call Convention is what economists call Common Knowledge. I think that pretty much everything that Lewis and Skyrms describe generically for language can be transferred to a better understanding of markets … there’s a lot that can be mined from this work even if it never talks about markets directly.

Markets and Risk

Of course, there are some authors that make explicit the connection between markets and either game theoretic or information theoretic concepts of risk, and they deserve special mention. Most of these will always be familiar to Epsilon Theory readers, so I’ll just list them here in no particular order. Again, this is not intended to be a comprehensive list, just what has been meaningful to me!

  • John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936)
  • George Soros, The Alchemy of Finance (1987)
  • Benoit Mandelbrot, The (Mis)behavior of Markets (2004)
  • William Poundstone, Fortune’s Formula (2005)
  • Peter Bernstein, Against the Gods (1996)
  • Nassim Taleb, Fooled by Randomness (2004)

Also, each of these authors has written several books, each useful in its own way. Enjoy!

Behavior and Human Nature

Well … this is obviously a rather large area of inquiry, so I just want to note a couple of authors who are directly relevant to the Epsilon Theory perspective on markets.

First, Daniel Kahneman and Amos Tversky pretty much invented the modern academic study of behavioral economics, and their core book is an edited collection of papers (along with Paul Slovic) titled Judgment under Uncertainty: Heuristics and Biases (1982). It’s still in print. More recently Kahneman wrote Thinking, Fast and Slow (2011), which covers most of the ground of Judgment under Uncertainty but in a much more entertaining fashion.

Second, you can’t have a conversation about human behavior without discussing the work of E.O. Wilson. While it’s not as directly applicable to Epsilon Theory as the linguistic research of Brian Skyrms, Wilson’s work is formed on the same foundation of evolutionary theory and an insistence on seeing the human animal as just that and nothing more (or less). I defy you to read The Social Conquest of Earth(2012) and not think differently about the world.

Third, it would take another three pages of dense writing to engage with the intense academic debate regarding the fundamental nature of human consciousness and, by extension, human behavior and human decision-making. In a nutshell, the argument is over whether any aspect of the human mind is separate from the collection of neurons and engrams and chemicals that make up a human brain. The most outspoken proponent of the “no” position is Dan Dennett, and in books like Consciousness Explained (1992) and Darwin’s Dangerous Idea (1996) he puts forward an argument for an entirely empirical and naturalist view of the human mind that I find compelling. Dennett is an accessible writer for the non-academic, but even better is Giulio Tononi, a neuroscientist at the University of Wisconsin, who achieved in Phi: A Voyage from the Brain to the Soul (2012) a beautiful (there’s no other word for it) exposition of the naturalist view of human consciousness.

Finally, I’d be remiss if I didn’t mention a couple of historians who continue to be instrumental in developing my perspective on human nature and social behavior. As with the Market and Risk section I’ll just put this highly non-comprehensive list out there without comment.

  • Robert Caro, The Power Broker (1975)
  • Steven Englund, Napoleon: A Political Biography (2005)
  • David McCullough, The Greater Journey: Americans in Paris (2012)
  • Amity Shlaes, The Forgotten Man (2008)
  • Liaquat Ahamed, Lords of Finance (2009)


The important role of Narrative is a common thread throughout the Epsilon Theory notes, and in some ways it might be the most original concept I’ve developed for an improved understanding of markets. But it’s also the least amenable to a standard bibliography.

There’s a strong post-modern (in the academic sense of the word) component to any evaluation of Narrative, as it pervades the work of authors like Michel Foucault and Jean Baudrillard, but I have a hard time recommending their books. Do I think that Foucault and Baudrillard have important things to say, things that are relevant to a real-world investor in 2013? Yes, I do. Foucault’s Discipline and Punish(1995), for example, is a meaningful book, not only for the ostensible topic – how the social institution of the Prison was constructed on the basis of Narratives that served the interests of the powerful – but for how all social institutions, such as the Corporation and the Market, are similarly constructed on the back of similar Narratives. Those Narratives change over time, creating structural risks in the institutions that seem so permanent to anyone immersed in those institutions, and that’s definitely relevant to every investor. Unfortunately, there’s an intentional obtuseness and opacity to the language spoken in these self-consciously post-modern projects that make them inaccessible. These books are written as an enormous conceit, one which masks their useful embedded signals. So if you have a year to spare and can tolerate impenetrable language mazes … then yes, I heartily recommend Baudrillard’s Simulacra and Simulation (1995). Otherwise, not so much. The best I can do on this front is to take a useful concept from the post-modern canon – Foucault’s use of Bentham’s idea of the Panopticon, for example – and try to make it relevant in a future note.

There’s a better way to develop a sensitivity to the role of Narrative in markets than reading Baudrillard, I think, and it takes two forms.

First, I think it’s important to read as much non-mediated history as possible. Peter Vansittart wrote two excellent books – Voices 1870-1914 (1986) and Voices from the Great War (1985) – where he compiled as many written excerpts as he could find from both the famous and the ordinary as they experienced a world in structural flux. Studs Terkel did much the same with The Good War: An Oral History of World War II (1997) and Hard Times: An Oral History of the Great Depression (2005). Is there some degree of mediation in the compilation of these excerpts or the construction of these oral histories? Of course. But all the same you get a much more unvarnished picture of what it meant to live in those times, and comparing that picture with what “history” has taught us will make you a much more active and aware consumer of mediated history today.

Second, I think it’s important to know what the Stories are. This has a serious component – I think that I’ve read almost everything Joseph Campbell has written (and that’s a lot!) – but it also has a component that will strike some as flaky or less-than-serious. I read a lot of science fiction. I read a lot of comic books. To be sure, there’s an enormous range in quality in both of these fictional forms. For every Iain Banks, Neil Gaiman, or Mike Carey there are dozens of eminently forgettable sci-fi and comic authors, and the truth is that not everything written by Banks, Gaiman, and Carey is that memorable. But it’s in the consistent if not constant exposure to the Stories in all sorts of different guises, forms, and formats – some well-constructed, most less so – that one gains an appreciation for how vital and present the Stories are in the nightly news and the daily CNBC wrap-up of market events. Inside every Narrative is a Story, just wrapped up in a different set of events. The human mind may be a collection of neurons, engrams, and chemicals, but human society is in large part of collection of Narratives. It’s the Stories we tell ourselves that keep us together, and we tell the same Stories over and over, from the cradle to the grave. I think it’s important to maintain an awareness of those Stories and that aspect of social construction in our adult lives, and I am certain that I’m a better investor for it. As C.S. Lewis, who forgot more Stories than most of us will ever know, wrote “No book is really worth reading at the age of ten which is not equally – and often far more – worth reading at the age of fifty and beyond.” Amen, brother Lewis!

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The Business of Epsilon Theory


I started the Epsilon Theory project nine months ago with the publication of a “Manifesto” and an email to a few hundred friends and colleagues. Since then nearly 7,000 investors across more than 2,000 financial services firms have signed up for the direct distribution list, and through forwarding and republishing the effective Epsilon Theory audience is several multiples of that. On a personal level the response has been overwhelming, humbling, gratifying…but most of all invigorating. I wake up every morning champing at the bit to write, and there are now more than 80 notes and emails on the website, with hundreds of pages of content. Epsilon Theory is tapping into and releasing a hungry energy that was there long before I started writing about it, and I am certain that we are just at the starting point of what’s possible here.

I am also certain that a crucial aspect of the Epsilon Theory project is to keep access as barrier-free as possible. Part of that is requiring minimal identifying information from readers who want to join the distribution list. Part of that is encouraging the forwarding and republishing of these notes. But the biggest part of keeping access to Epsilon Theory barrier-free is to keep access actually, in fact…free. My partners and friends here at Salient make that possible, and it’s exactly this sort of forward-thinking attitude towards information and investing that convinced me to join the firm. Not only has Salient given me the economic freedom to pursue the Epsilon Theory project without the constraint of making a living from it, but more importantly they have given me the intellectual freedom to pursue the project without the constraint of selling from it. It’s not that I don’t support Salient investment strategies or that we’re not thinking about specific investment or trading ideas that might come out of my work, but Epsilon Theory is simply not the right venue to have a conversation about specific investment ideas.

So here’s what I’d ask. If you’re interested in hearing about what we have to offer at Salient today, or if you’re interested in learning about what we’re developing for the future in an Epsilon Theory vein, let me know. Tell me more about yourself and what your interests are, and we can move that conversation forward through more appropriate channels.

If you’re not particularly interested in a direct conversation about Salient or Epsilon Theory-related investment ideas, that’s fine, too. I’m committed (and Salient is committed) to Epsilon Theory for the long haul, and I’ll keep writing like I’ve been writing so long as I’m tapping into this vast reservoir of hungry energy. Stay thirsty, my friends.

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The Adaptive Genius of Rigged Markets



Same as it ever was, same as it ever was, same as it ever was, same as it ever was

– Talking Heads, “Once in a Lifetime”

You may be a business man or some high degree thief

They may call you Doctor or they may call you Chief

But you’re gonna have to serve somebody, yes

You’re gonna have to serve somebody

Bob Dylan, “Gotta Serve Somebody”


Horace Clark, Vanderbilt’s son-in-law, was always a favorite with the stately old gentleman. Having decided to wed the young lady, he called upon his future father-in-law, and, without preliminary, began – “Commodore, I wish your daughter in marriage.”
“You mean, you want my money,” growled Vanderbilt from his chair.
“You and your daughter be damned,” flamed out the young lawyer, as he clenched his hat in his hand and turned to leave the room.
“Hold on, young man,” said Vanderbilt, straightening himself on his feet. “Hold on. I rather like you. I only said you should not have my money. You can have my daughter.”

– James Medbery, “Men and Mysteries of Wall Street” (1870)

David Byrne, of Talking Heads fame, is something of a personal hero of mine for the way he handles the business of his music. Byrne is famously protective of the copyrights associated with his work, in the sense of controlling the uses of the music for long-term goals rather than a short-term pay-off, and it’s a non-myopic approach to intellectual property I’ve tried to adopt with my own work. I also appreciate Byrne’s ability to put on a show. His music stands on its own, for sure, but Byrne was into multimedia before it was a word, and part of his genius has been an ability to reinvent consistently the experience of his music. I know it sounds crazy to anyone under the age of 30 that a Big White Suit could be both revolutionary and really cool as performance art, but there you go. More to the point, Byrne knew when to move on from the Big White Suit. He knew how to adapt to a world that was still hungry to hear what he had to say, but not if it were presented in the same way ad nauseam.


If you don’t adapt, you die. Or worse … for an artist, anyway … you become uncool and passé. Your performance art becomes performance shtick. And yes, I’m looking at you, Elvis Costello. There’s an adaptive genius to the David Byrne’s and the David Bowie’s of the world, quite separate from their musical genius, and that’s what I want to examine in this note. 


Adaptive genius is not limited to the popularly beloved and the socially respected. It’s not only, in zoo-keeping terms, the “charismatic vertebrates” like elephants and giraffes who demonstrate this quality, but also decidedly non-charismatic invertebrates like the hookworm. I’ve written before about why I believe that parasites are beautiful creatures from an evolutionary perspective, which is another way of saying that they possess adaptive genius. It’s the same sort of beauty I see in parasitic market participants who generate real alpha by feeding off a consistent informational edge they identify from either non-economic or differently-economic market participants. As I wrote in “Parasite Rex”, a giant pension fund isn’t engaged in commodity markets because it has an opinion on the contango curve of oil futures; it’s trying to find a diversifying asset class for a massive portfolio that needs inflation protection. If you’re an experienced trader in that market and you see signs of the giant pension fund lumbering through the brush … well, you’re in the wrong business if you can’t skin a few dimes here. This is what good traders DO, and the really good ones have devised effective processes so that it’s not just a one-off trade but an expression of a robust strategy.

Parasites, whether they exist in nature or in markets, are almost always models of efficiency and adaptive genius. I may dislike them. I may well be the host from which they suck out resources. I may want to squash them without mercy. But I can’t help but respect their evolutionary prowess and ability to carve out an informational advantage. And if I get the chance, I’d like to invest money with them.They’re not the only source of alpha in this world (you can also create an informational advantage by perceiving the world differently and more correctly than most), but they are, I believe the most consistent and powerful source of alpha out there.

Or at least they provide the most consistent and powerful source of alpha within the limitation of being a market participant, of being a buyer or a seller of a security in order to express an opinion on whether that security will go up or down in price in the future. Of course, if you could hijack the entire infrastructure of the market, if you could somehow develop an omniscient view of market communications and intentions under the guise of market-making or liquidity provision … then you’d be talking about some serious alpha. 

Oh wait … that’s exactly what happened with Getco and Virtu and their High Frequency Trading (HFT) brethren.

I don’t want to belabor the details of how this market infrastructure hijacking works. You’re better off reading Michael Lewis’s book or, better yet, check out Sal Arnuk and Joe Saluzzi’s Themis Trading website and read their book, “Broken Markets”. But I will share my experience of how this hijacking plays out in the professional investment world. My bona fides: co-managed a large long/short equity fund where we experienced all this on a daily basis, wrote extensively about HFT and market structure in client letters, and was part of a loose group of like-minded buy-side managers exploring these issues for the past 5 years. I was an HFT critic way before it was cool to be an HFT critic, and here’s our core complaint: in an HFT-dominated market infrastructure, you can always get your order filled but you will never get a better price than your limit. 

What does this mean? Imagine that you’re an equity PM and you want to buy $5 million worth of XYZ stock today. You have a positive fundamental view on the company, the stock’s been weak of late, and for whatever reason you’ve decided that today is a good time to pull the trigger and add to your existing position here. Average daily volume in the stock is, say, $500 million, so your order is going to be about 1% of that – not inconsequential for how the stock trades, but highly unlikely to have a big market impact. All the same, though, you tell your trading desk that you want to put a limit on the order, say 1% above wherever the price settles after the market opens. So now it’s 10:05 am, XYZ stock is trading at $50.00, and your trader hits the button to buy 100,000 shares with a limit of $50.50. Your trader is not an idiot, so of course he’s chopping up this order into smaller pieces, either via some chopping algorithm you’ve got in your order management system or, more likely, some chopping algorithm that your prime broker uses to rout the big order through various execution venues over the course of the day. There are plenty of these algorithms to choose from, all designed to hide your willingness to pay up to $50.50 for XYZ stock when it’s currently trading at $50.00.

But then the most amazing thing happens. As soon as your trader hits the button at 10:05 am to launch the buy order, volume at $50.00 – which was humming along quite nicely – strangely dries up. As if by magic, the market price for XYZ stock marches straight up, often in minimally sized 100 share lots, until it hits $50.50. At that point volume miraculously reappears, and your order starts to fill in earnest. The price might tick higher by a penny or two every now and then, which means that you stop buying, but it always seems to tick right back down to the $50.50 mark where your order continues to fill. A few minutes later you get a message from your trader that the XYZ order is done, at an average price of $50.48. Your trader is happy because he completed the order as per your instructions. You’re happy because you’ve got the 100,000 shares of XYZ at an acceptable price. But you are only minimally happy. You only achieved your reservation price, which seems odd because you saw the stock trading at $50.00 before you got active, and you’re probably seeing the stock trading at $50.00 now that you are no longer active.

No matter how hard you try to manage your trades, no matter what chopping algorithm you use or how closely you watch the Bloomberg screen, it’s as if whoever is on the other side of your trades has a bug planted in your office so that they are overhearing your conversations with the trading desk and picking off your limit orders. You rarely do better than the worst price you will tolerate, and that only happens when your trader finds a natural – a real human being who wants to sell what you want to buy, or vice versa. Otherwise your counterparty is a “liquidity provider”, some technology company whose Big Data computer systems, combined with direct data feeds and frictionless order execution authority to and from trading venues, allows them to identify the contours and depth of the aggregate limit order book in stock XYZ. Your effort to buy 100,000 shares of XYZ forms a pattern, regardless of how you try to hide it, and it’s a pattern that the powerful induction engines of HFT algorithms will quickly recognize. And once your pattern is identified within the context of a limit order book, your private information – the price you are secretly willing to pay for a share of XYZ stock – has been stolen from you just as surely as if there really were a listening device planted next to your trading desk.

Are there ways to mitigate this sad state of affairs … or rather, this minimally happy state of affairs? Sure. You set tighter limits. You look for opportunities to provide liquidity rather than just absorb it. You trade less frequently but more aggressively. You hire experienced traders who can tell when a machine is picking them off and know where to look for naturals. But it’s only a mitigation, not a solution. A good trader on an equity desk used to be able to make you money by beating the volume-weighted average price (VWAP) on a consistent basis. Today it’s all VWAP all the time, thin gruel that supplies enough calories and nutrients to keep you alive, but tastes like … thin gruel. Institutional investors are angry about HFT because it has turned actively managed order execution and tactical portfolio decision-making from a source of fun and profit into a dreary toll-paying exercise. Day after day, trade after trade, we are skinned. And we know it. But it’s always just within the tolerance levels that we ourselves set, which is really the brilliance of the whole thing.

When you talk to anyone in the HFT world, you inevitably get three arguments as to why the current situation really isn’t a problem.

#1 – “But our margins are razor thin. We really don’t make much money in our business, or at least we don’t make much money anymore, because the secret is out and it’s so darn expensive to maintain our machines.”

My response: Boo-freakin’-hoo.

#2 – “But we provide a valuable service to markets with our liquidity provision. Without our participation the bid-ask spread in every trade would be wider, and market volumes would plunge.”

My response: Look, I admire the fact that you are not an Ebola-esque parasitoid that kills its host in a gory, blood-spewing mess, but rather something more akin to a parasitic worm that provides its host with a bit of protection against certain auto-immune diseases as it gorges itself. It’s an evolutionarily stable strategy (ESS), and I think it’s adaptive genius. Really, I wish I had thought of this whole HFT idea myself, and I’m more than a little jealous. But give me a break about liquidity and bid-ask spreads. The life of an active manager was so much more fun and profitable (or at least that was our perception of the experience) with lower liquidity and wider bid-ask spreads. We’ll take our chances in a worm-less market environment, thank you very much.

#3 – “But there’s always going to be someone extracting rents from the market infrastructure. We’re certainly no worse than the parasites before us, and in some ways we’re better for you.”

My response: Ummm … that’s a pretty good point.

I love to read memoirs and first-hand accounts of markets, and recently I’ve been focused on the late 19th century, particularly the period 1873 – 1879 … what was called back then the Great Depression until the 1930’s rolled around and the name had to be changed to the Long Depression (even more apropos for the UK, where the depression/recession lasted until 1896). The story of the Long Depression is one of a market panic and a liquidity crisis that collapsed financial institutions everyone thought were too big to fail, followed by a 20+ year period of puzzlingly high unemployment, anemic growth, political fragmentation, and experimental monetary policy. Sound familiar?

But even as one reads these memoirs and histories for whatever macro-economic lessons they might provide for coping with our own Long Recession, you cannot help but be struck by the constant discussion of market structure in these materials. And it’s not a dry description of the formal aspects of the market. No, for the most part it’s a full-throated celebration of the men and the institutions that controlled the flow of information within markets by controlling the machinery of markets. Men like Cornelius “Commodore” Vanderbilt, who was renowned for setting up friends and relatives with “points” and “tips” so as to drive the price of some stock way up, only to betray them with one last false tip that would give the Commodore a chance to exit his long position and then turn around and short the stock, crushing both the price and his “friend”. Men like Jay Gould and Diamond Jim Fisk, who bribed entire state legislatures to get their way on market rules and came within an inch of cornering the entire US gold market.

You can’t have a market in a mass society without constructing a robust market infrastructure. What is that infrastructure? It’s not a building on the corner of Broad Street and Wall. It’s not a trading pit on South Wacker. Market infrastructure is a collection of rules for the playing of a massive game.Market infrastructure is information. And whoever masters those rules, whoever sees the information flowing between market participants most clearly, whoever can create private information by becoming embedded within that information flow … well, one way or another they’re going to make a fortune, and one way or another it’s going to come out of the hide of the rest of us.

Ultimately, I think the problem for HFT liquidity providers is not that they are skinning investors, but that they are outsiders. They’re doing what the keepers of the market infrastructure keys have always done – skin investors, retail and institutional alike, to the outer limits of what technology and the law allows. But while their outward behavior and appearance may be familiar, they are clearly an alien species on the inside, without so much as a microgram of Wall Street DNA. They are Rakshasa’s. HFT liquidity providers are technology companies disguised as financial intermediaries. They hijacked the market infrastructure in the aftermath of the Great Recession, stealing it away from under the noses of the big financial firms who had come to see control over market structure as their birthright, and they had a good run. But now the big boys want their market infrastructure back, and they’re going to get it.

I won’t be shedding any tears for the demise of the HFT shops, and there’s no small amount of entertainment value in the witch hunts and show trials to come. But I’m not so naïve as to expect some magical return to the halcyon trading days of yesteryear where, to paraphrase Garrison Keillor and his description of the children of Lake Wobegon, all of our trades beat VWAP. The big boys will co-opt the Big Data skinning techniques of the HFT shops, just as they have always co-opted the technologies of social control and surveillance. Oh sure, they will make the theft of my private information regarding limit orders even more palatable than the HFT guys did, because that’s the genius of a highly evolved, highly adaptive parasite – they possess an extremely robust ESS (evolutionarily stable strategy). But you can’t un-ring this Big Data bell.

No, Dylan said it best. You gotta serve somebody, and that certainly goes for all of us who choose to participate in modern markets. There is a rigged quality to all market structures in all times and in all societies, and you’re going to serve whoever controls the information flow of the market, because that’s what market structure IS. This was true in 1870, it was true in 1970, and it will be true in 2070. But don’t worry, you’ll hardly feel a thing. In fact, you’ll be happy to serve – albeit minimally happy, and increasingly to the limits of your minimal happiness – those who are manning the market structure gates, because that’s the adaptive genius of these particular parasites. Same as it ever was, same as it ever was, same as it ever was, same as it ever was.

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Beta Earthquake


One of the things I like to keep my eye on when I’m puzzling out what’s going on in the market are the specific company factors that loosely define concepts like Momentum and Value. I do this because any sort of big market move, like we’ve seen over the past week, is inherently over-determined and over-explained. That is, there are dozens of “reasons” trotted out by the financial media and various experts, ALL of which are probably right to a certain degree. The trick is to see if you can identify an underlyingexplanation that both accounts for a large chunk of the various rationales AND distinguishes or predicts unexpected nuances between the rationales. Here’s an example of what I mean.

We all know that momentum-driven, high-beta stocks have been particularly slammed of late. Even as the overall market maintained its highs (until last Friday, anyway), particular sub-sectors like Internet stocks or biotech stocks have been crushed. What we’d like to know is whether this is somehow specific to a certain group of stocks – call them Momentum stocks – or whether these stocks are just the canary in the coal mine due to their high-beta nature for a more broadly based market dislocation. So let’s not look just at Momentum factors over the year to date (which we know have been slammed), but also factors connected with Value and Quality. If high Value and high Quality stocks have done well as high Momentum stocks have done poorly, then there’s no need to look deeper than that. Momentum is the culprit, and maybe this market trauma will be contained there. On the other hand, if there are weirdnesses or distinctions between the three broad categories, then something deeper is probably at work.

For Value I’ll use free cash flow (FCF) yield as a quick-and-dirty indicator of the concept, and for Quality I’ll use cash flow return on invested capital (Cash ROIC). We can argue about alternative measures of these categories, and there’s certainly some conceptual overlap between Value and Quality, but I think these are pretty well-acknowledged, if not standard, operationalizations of what Value and Quality mean. For both, I’ll chart the isolated performance of each factor against the MSCI US large-cap universe. Again, maybe you’ll get different results if you look at different universes of stocks or different operationalizations of Value and Quality. Knock yourself out.

Here’s the year-to-date performance chart for my Value factor, FCF yield:


Source: FactSet, Salient Capital Advisors, LLC, April 2014.

Pretty much what you’d expect if the answer to our puzzle were simply: Momentum Is Bad. FCF yield turned on a dime the last week in February, just as Momentum stocks started to tank, and hasn’t really looked back since.

But here’s the year-to-date performance chart for my Quality factor, cash flow ROIC:


Source: FactSet, Salient Capital Advisors, LLC, April 2014.

Unlike Value, Quality did not turn up at all as Momentum collapsed. Instead, it has continued to drift down along with Momentum.

What does this mean? What is an underlying explanation that can account for Momentum failing and Value working, but Quality NOT working? When one of my colleagues here at Salient saw these charts he said, “looks to me like the market is trading on a narrative of risk appetites and fear rather than toward some notion of seeking fundamentals or selling overbought growth stocks; otherwise Quality would be working, too.” To which I replied, “Amen, brother!”  The notion that this market sell-off is limited to biotech or Internet or some other high-flying sub-sector because the market “realized” that these stocks were too expensive or out of concern with earnings this quarter (both explanations that I’ve seen of late in the WSJ and FT), just doesn’t hold water. These high-beta stocks are being hit hardest because they are at the epicenter of a broad market or beta earthquake. This is what it meansto be high-beta…you live by the broad market sword and you die by the broad market sword.

What’s the source of this beta earthquake? What tectonic plate is shifting beneath our feet? Only the bedrock bull Narrative of the past five years – “the Fed has got your back.” As I wrote last week, the Common Knowledge on Fed policy is starting to shift. The crowd is sniffing the air, sensing a change in the easing/tightening Narrative and acting on that by selling – and the less fundamentally-grounded the security the more furious the selling – just as they acted on prior market-positive shifts in the easing/tightening Narrative by buying – and the less fundamentally-grounded the security the more furious the buying.

Is this the Big One? Is this the beta earthquake that sends the stock market down into correction or bear market territory? I have no idea. Or rather, if you can tell me what US growth data looks like over the next six months then I’d be happy to make a market prediction, but I certainly don’t have a US growth crystal ball and I don’t think you have one, either.

Anemic growth remains the Goldilocks scenario for markets, not so cold as to make for a recession but not so hot as to take the Fed out of play for “emergency” monetary policy implemented on a permanent basis. Good real-world news is bad for markets, and vice versa, because that’s the dynamic that impacts Common Knowledge around the Fed. The market is in a tough spot right now, as good news will not make the market go higher (Fed stays on the tightening path) and bad news can make the market go lower if it’s really bad news (or if the Fed gives more signals that they’re tightening regardless of how bad the news gets).

This tough spot is made even tougher by both a market fatigue with Fed jawboning (excuse me… communication policy) and a growing sense, fair or not, that the Yellen Fed is kind of flailing around right now. The dominant Narrative by a mile is still Central Bank Omnipotence, where the Fed is responsible for all market outcomes, but there are definitely signs of a growing counter-Narrative, one that I call “The Incompetent Magician”, that bears close watching. The Incompetent Magician Narrative is a story that’s very dangerous for markets, because it’s a story of loss of control. This is what makes private sources of liquidity dry up, this is what makes for a deep bear market, and this is what would drive gold into the stratosphere. The Incompetent Magician Narrative has been around for decades, usually resting deep in the depths of counter-cultural media and the like, sort of like a flu virus that can lay dormant for years within an animal population. Over the past few weeks, though, I’ve seen a few outbreaks of this virus, or at least a strain of the virus, within mainstream media. Nothing to be concerned with yet, but like I say…something that bears watching.

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The King is Dead. Long Live the King.


Le roi est mort, vive le roi!
French proclamation as coffin of old king is placed into burial vault of Saint Denis Basilica.

The throne shall never be empty; the country shall never be without a monarch.
English Royal Council on death of Henry III in 1272, proclaiming Edward I king even though he didn’t get the news until months later.

Every time I thought I’d got it made
It seemed the taste was not so sweet
So I turned myself to face me
But I’ve never caught a glimpse
Of how the others must see the faker
I’m much too fast to take that test
David Bowie, “Changes” 

What we’re witnessing right now in US markets is a shift in the Narrative structure around Fed policy, and it’s hitting markets hard because the Narrative structure around the Fed as an institution has never been stronger or more constant.

As more and more generally positive US growth data comes out, most recently in last Friday’s jobs report, the Narrative around Fed policy is shifting from “The Fed will keep rates low forever and ever, amen” to “the Fed is on rails to raise rates sooner and more than you thought”. And that’s a real bummer if you’re long this market, particularly in a momentum or high-beta name.

A Narrative is just another name for what game theory calls Common Knowledge, which for my money is the most powerful force in human society. Common Knowledge is what topples governments, builds cathedrals, and starts (or ends) wars. It darn sure moves markets, particularly in a period of extreme global political fragmentation and stress, as we last saw in the 1930’s and before that in the 1870’s. As Keynes noticed (and successfully traded on with his own investments), market sentiment is driven by the creation or dissolution of Common Knowledge, and you can’t play the Game of Sentiment well if you’re not focused on it.

Common Knowledge is not just public information. It’s public information that everyone thinks that everyone thinks. It’s a signal that’s broadcast publicly by a powerful “missionary” like Yellen or Draghi or a Famous Investor on CNBC or a Famous Journalist in the WSJ, so that we all know that we all heard the message. And if we think that everyone else has heard the message, then the rational behavior is to act as if the message is true, regardless of our private beliefs or observations. This is the Emperor’s New Clothes…each of us can see with our own eyes that the guy is naked, but we’re not really looking at the Emperor. We’re looking at the crowd. Each of us is looking at all of us, and all of us know it.

So when the WSJ tells us that the Friday jobs report was good and strong, when Jon Hilsenrath tells usthat this jobs report keeps the Fed “on track”, when Fed Governor Bullard tells us today that Fed actions have been “sufficiently aggressive”, when Janet Yellen tells us that she has a schedule in mind for raising rates…well, those are powerful public statements by incredibly influential missionaries. This is what creates Common Knowledge. We all heard these statements, and more importantly we all believe that everyone else heard these statements, too. So now we will all start to act as if the statements are true for Fed policy, no matter what we privately think the Fed will do or not do, and that behavior becomes a self-fulfilling prophecy, a snowball rolling downhill, as more and more of all of us start to believe that this is what all of us believe. This is the power of a crowd looking at a crowd, and it’s a bitch.

What we’re not seeing – and this is why the Narrative shift in Fed policy intentions is hitting the market so hard – is a change in the underlying and more fundamental Narrative that has controlled global markets for the past five years…the Narrative of Central Bank Omnipotence. I’ve written about this a lot (here and here, in particular), so I won’t repeat all that, but the Common Knowledge structure around the Fed and other central banks in general terms is that the Fed is responsible for market outcomes. It’s not that the “Fed has got your back” or that the Fed will always make the market go up. It’s that the Fed is large and in charge. Central bankers giveth, and central bankers taketh away. That’s the Narrative of Central Bank Omnipotence.

It’s become fashionable of late to say that the Fed doesn’t have as much impact on markets today as it has in recent years. This is, I think, an entirely wrong-headed reading of the game-playing in markets today. Or more charitably, from a game-theoretic perspective there has been zero evidence of a diminution in the underlying Common Knowledge belief structure that the Fed and its brethren are responsible for market outcomes. On the contrary, as these last few days and weeks and months suggest, a belief in the Fed as the ultimate arbiter of markets has never been stronger. The modern Goldilocks market environment is growth strong enough to avoid outright recession, but weak enough to keep the Fed in play. Whenever (and wherever, as this dynamic has been mirrored in Europe, China, and Japan) signs of strong growth and thus diminished central bank support have emerged, markets have sold off. It’s only when growth falters and the drumbeat of increased or continued central bank support re-emerges that markets recover. When real world good news is market bad news, and vice versa, then rest assured that the Narrative of Central Bank Omnipotence is alive and well.

This Common Knowledge belief structure around the institution of the Fed is like the Common Knowledge belief structure around the institution of the monarchy in feudal Europe – incredibly powerful, phenomenally resistant to change, and imbued through popular belief with the power to determine economic outcomes. The Narrative around a particular Fed policy or Chair or regime will change and shift, just as the particular monarch sitting on a throne changed over time. But the underlying institution and its ability to shape the world through its core or existential Narrative changes much more slowly. Importantly, it’s the maintenance of the institution – not the maintenance of any particular king or any particular set of policies – that’s crucial for social control. That was true in 13th century England and 18th century France, and it’s just as true in 21st century western democracies with central banks.

Bottom line: “don’t fight the Fed” is a reflection of the institutional power of the Fed and the Narrative of Central Bank Omnipotence. It cuts both ways. You don’t want to be short anything when the Fed is easing, and it’s hard to be long anything when the Fed is tightening. The crowd is picking up on a shift in the easing/tightening Narrative and is beginning to act on that by selling, just as they acted on prior market-positive shifts in the easing/tightening Narrative by buying. Different monarchs; same monarchy. What’s to come? More of the same, I suspect. Good real world news is bad market news, and vice versa, for as far as the eye can see. Why? Because the crowd is not going to fight the Fed.

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