Best of List


I’ll have a new full-length Epsilon Theory note out early next week (“Going Gray”), but wanted to pass along two background points.

First, a replay of last week’s webinar – “The Game of Thrones and the Game of Markets” – is available from our friends at RIA Channel, and can be accessed here.

Second, for all the new subscribers to Epsilon Theory (the original June 2013 direct distribution list has recently doubled again, for the sixth time) I know that the website can be daunting with about 100 meaty notes to sift through. We’ll be releasing an improved organization for the website shortly, along with an entirely new application we’re calling the Risk Dashboard – a real-time resource that monitors current market risks as seen through an Epsilon Theory lens . . . stay tuned! In the meantime, I thought it might be helpful for new subscribers to have a Top 10 list of the most popular notes, a Best of Epsilon Theory, if you will. In reverse chronological order:

Fear and Loathing on the Marketing Trail, 2014
Stalking Horse
When Does the Story Break?
Hollow Men, Hollow Markets, Hollow World
Parasite Rex
Adaptive Investing: What’s Your Market DNA?
A Game of Sentiment
It Was Barzini All Along
How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories
Epsilon Theory Manifesto

And for a series of shorter reads, don’t forget the Email archive.

I’ve said it before and I’ll say it again: Epsilon Theory is tapping into and releasing a hungry energy that was there long before I started writing about it, and I am certain we are just at the starting point of what’s possible here. Where does our collective effort end up? No idea. But it’s going to be one heck of a ride.

epsilon-theory-best-of-list-september-26-2014.pdf (74KB)


Finest Worksong


Take your instinct by the reins
You'd better best to rearrange
What we want and what we need
Has been confused, been confused
– REM, “Finest Worksong” (1987)

The politics of dancing
The politics of oooh feeling good
– Re-flex, “The Politics of Dancing” (1983)

The fault, dear Brutus, is not in our stars, but in ourselves.
– William Shakespeare, “Julius Caesar” (1599)

In theory there is no difference between theory and practice. In practice there is.
– Yogi Berra, (b. 1925)

Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. …

Indeed, the IMF’s expectation for long-run global growth is now a full percentage point below what it was immediately before the Global Financial Crisis. …

But it is also possible that the underperformance reflects a more structural, longer-term, shift in the global economy, with less growth in underlying supply factors. 

– Fed Vice Chairman Stanley Fischer, “The Great Recession: Moving Ahead”, August 11, 2014

There is one great mystery in the high falutin’ circles of the Fed, ECB, and IMF today. Why is global growth so disappointing? There are different variations on this theme – why aren’t businesses investing more? why aren’t banks lending more? – but it’s all one basic question. First the Fed, then the BOJ, and now the ECB have taken superheroic efforts to inflate financial asset prices in order to bridge the gap between the output shock of 2008 and a resumption of normal economic growth. They’ve done their part. Why hasn’t the rest of the world joined the party?

The thinking was that leaving capital markets to their own devices in the aftermath of the Great Recession could result in a deflationary equilibrium, which is macroeconomic-speak for falling into a well, breaking your leg, at night, alone. It’s the worst possible outcome. So the decision was made to buy trillions of dollars in assets, forcing all of us to take on more risk with our money than we would otherwise prefer, and to jawbone the markets (excuse me … “employ communication policy”) to leverage those trillions still further. All this in order to buy time for the global economic engine to rev back up and allow private investment activity to take over for temporary government investment activity.

It was a brilliant plan, and as emergency intervention it worked like a charm. QE1 (and even more importantly TLGP) saved the world. The intended behavioral effect on markets and market participants succeeded beyond Bernanke et al’s wildest dreams, such that now the Fed finds itself in the odd position of trying to talk down the dominant Narrative of Central Bank Omnipotence. But for some reason the global economic engine never kicked back in. The answer? We must do more. We must try harder. And so we got QE2. And QE3. And Abenomics. And now Draghinomics. We got what we always get in the aftermath of a global economic crisis – a temporary government policy intervention transformed into a permanent government social insurance program.

But the engine still hasn’t kicked in.

So now villains must be found. Now we must root out the counter-revolutionaries and Trotskyites and Lin Biao-ists and assorted enemies of progress. Because if the plan is brilliant but it’s not working, then obviously someone is blocking the plan. The structural villains per Stanley Fischer (who is rapidly becoming a more powerful Narrative voice and Missionary than Janet Yellen): housing, fiscal policy, and the European economic slow-down. Or if you’ll allow me to translate the Fed-speak: consumers, Republicans, and Germany. These are the counter-revolutionaries per the central bank apparatchiks. If only everyone would just spend more, why then our theories would succeed grandly. 

Hmm. Maybe. Or maybe what we want and what we need has been confused. Maybe the thin veneer of ebullient hollow markets has been confused for the real activity of real companies. Maybe the theatre of a Wise Man with an Answer has been confused for intellectually honest leadership. Maybe theoretical certainty has been confused for practical humility. Maybe the fault, dear Brutus, is not in external forces like Republicans or Germans (or Democrats or Central Bankers), but in ourselves. 

Let me suggest a different answer to the mystery of missing global growth, a political answer, an answer that puts hyper-accommodative monetary policy in its proper place: a nice-to-have for vibrant global growth rather than a must-have. The problem with sparking renewed economic growth in the West is that domestic politics in the West do not depend on economic growth. What we have in the US today, and even more so in Europe (ex-Germany), are not the politics of growth but rather the politics of identity. At the turn of the 20th century the meaning of being a Democrat or a Republican was all about specific economic policies … monetary policies, believe it or not. You could vote for Republican McKinley and ride on a golden coin to Prosperity for all, or you could vote for Democrat Bryan and support silver coinage to avoid being “crucified on a cross of gold.”

Today’s elections almost never hinge on any specific policy, much less anything to do with something as arcane as monetary policy. No, today’s elections are all about social identification with like-minded citizens around amorphous concepts like “justice” or “freedom” … words that communicate aspirational values and speak in code about a wide range of social issues. Don’t get me wrong. There’s nothing inherently bad or underhanded about all this. I think Shepard Fairey’s “HOPE” poster is absolute genius, rivaled only by the Obama campaign’s genius in recognizing its power. Nor am I saying that economic issues are unimportant in elections. On the contrary, James Carville is mostly right when he says, “It’s the economy, stupid.” What I am saying is that modern political communications use neither the language nor the substance of economic policy in any meaningful way. Words like “taxes” and “jobs” are bandied about, but only as totems, as signifiers useful in assuming or accusing an identity. Candidates seek to be identified as a “job creator” or a “tax cutter” (or accuse their opponent of being a “job destroyer” or a “tax raiser”) because these are powerful linguistic themes that connect on an emotional level with well-defined subsets of voters on a range of dimensions, not because they want to actually campaign on issues of economic growth. Candidates have learned that while voters certainly care about the economy and their economic situation, the only time they make a voting decision based primarily on specific economic policy rather than shared identity is when the decision is explicitly framed as a binary policy outcome – a referendum. Even there, if you look at the ballot referendums over the past several decades (Howard Jarvis and Proposition 13 happened almost 40 years ago! how’s that for making you feel old?), the shift from economic to social issues is obvious.

Both the Republican and the Democratic Party have entirely embraced identity politics, because it works. It works to maintain two status quo political parties that have gerrymandered their respective identity bases into a wonderfully stable equilibrium. The last thing either party wants is a defining economic policy question that would cut across identity lines. But until the terms of debate change such that an electoral mandate emerges around macroeconomic policy … until voters care enough about Growth Policy A vs. Growth Policy B to vote the pertinent rascals in or out, despite the inertia of value affinity … we’re going to be stuck in a low-growth economy despite all the Fed’s yeoman work. I know, I know … what blasphemy to suggest that monetary policy is not the end-all and be-all for creating economic growth! But there you go. At the very moment that elections hinge on the question of economic growth, we will get it. But until that moment, we won’t, no matter what the Fed does or doesn’t do.

What reshapes the electoral landscape such that an over-riding policy issue takes over? Historically speaking, it’s a huge external shock, like a war or a natural disaster, accompanied by a huge political shock, like the emergence of a new political party or charismatic leader that triggers an electoral realignment. In the US I think that the emerging appeal of national Libertarian candidates (all of whom, so far anyway, have the last name Paul) is pretty interesting. The 2016 election has the potential to be a watershed event and set up a realignment, if not in 2016 then in 2020, which hasn’t happened in the US since Ronald Reagan transformed the US electoral map in 1980. And yes, I know that the conventional wisdom is that a viable Libertarian candidate is wonderful news for the Democratic party, and maybe that will be the case, but both status quo parties today are so dynastic, so ossified, that I think everyone could be in for a rude awakening. It’s a long shot, to be sure, mainly because the US economy isn’t doing so poorly as to plant the seeds for a reshuffling of the electoral deck, but definitely interesting to watch.

What’s not a long shot – and why I think Draghi’s recently announced ABS purchase is a bridge too far – is a realigning election in Italy. 

I like to look at aggregate GDP when I’m thinking about the strategic interactions of international politics, but for questions of domestic politics I think per capita GDP gives more insight into what’s going on. Per capita GDP gives a sense of what the economy “feels like” to the average citizen. It addresses Reagan’s famous question in the 1980 campaign with Jimmy Carter: are you better off today than you were four years ago? It’s a very blunt indicator to be sure, as it completely ignores the distribution of economic goodies (something I’m going to write a lot about in future notes), but it’s a good first cut at the data all the same. Here’s a chart of per capita GDP levels for the three big Western economies: the US, Europe, and Japan.

Source: World Bank. For illustrative purposes only.

The Great Recession hit everyone like a ton of bricks, creating an output shock roughly equal to the impact of losing a medium-sized war, but the US and Japan have rebounded to set new highs. Europe … not so much.

Let’s look at Europe more closely. Here’s a chart of the big three continental European economies: Germany, France, and Italy.

Source: World Bank. For illustrative purposes only.

Germany off to the races, France moribund, and Italy looking like it just lost World War III. I mean … wow. More than any other chart, this one shows why I think the Euro is structurally challenged.

First, why in the world would Germany change anything about the current Euro system? The system works for Germany, and how. Alone among major Western powers, the politics of growth are alive and well in Germany. “But Germany, unless you lighten up and embrace your common European identity, maybe this sweet deal for you evaporates.” Ummm … yeah, right. The history books are just chock-full of self-interested creditors with sweet deals that unilaterally made large concessions before the very last second (and often not even then).

Second, why in the world would Italy accept anything about the current Euro system? The system fails Italy, and how. The system fails other countries, too, like Spain, Portugal, and Greece, but these countries are in the Euro by necessity. Their economies are far too small to go it alone. Italy, on the other hand, is in the Euro by choice. Its economy is plenty big enough to stand on its own, and with a vibrant export potential, an independent and devalued lira is just what the doctor ordered to get the economic growth engine revved up. Short term pain, long term gain.

Why doesn’t Italy bolt? Lots of reasons, most of them identity related. Also, let’s not underestimate the power of cheap money to keep the puppet-masters of the Italian State in a Germany-centric system. The system may fail Italy as a whole, but if you’re pulling the strings of the State and can borrow 10-year money at 2.5% to keep your vita nice and dolce … well, let’s keep dancing.

Still, nothing focuses the electoral mind like the economic equivalent of losing a major war. At some point in the not so distant future there will be an anti-Euro realigning election in Italy. 

And that will wake the Red King.

In the meantime, Draghi will go forward with his ABS purchase scheme, a brilliant theory that will deliver frustratingly slim results quarter after quarter after quarter. Until the politics of growth are embraced outside of Germany, European banks will remain reticent to lend growth capital to small and medium enterprises. Until the politics of growth are embraced outside of Germany, large enterprises with plenty of cash and access to cheap loans will remain reticent to invest growth capital. Maybe a little M&A, sure, but no new factories, no organic expansion, no grand hiring plans. The thing is, Draghi knows that he’s pushing on a string with the ABS program and that growth won’t return until the fundamental political dynamic changes in France in Italy, which is why he is calling both countries out by name to institute “structural reforms”. But in typical European fashion this entire debate is Mandarin vs. Mandarin, with almost all of the proposals focused on regulatory reform rather than something that must be hashed out through popular legislation. So long as economic policy reform is imposed from above … so long as we are engaged in modern-day analogs of Soviet Five-Year Plans … I believe we will remain stuck in what I call the Entropic Ending – a long gray slog of disappointing but not catastrophic aggregate economic growth. That’s not a terrible environment for stocks, certainly not for bonds, and the alternative – economic reform based on the hurly-burly of popular politics, is almost certain to be a wild ride that markets hate. But to get back to what we need (real growth) rather than what we want (higher stock prices) this is what it’s going to take. Elections always matter, but in the Golden Age of the Central Banker they matter even more.

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The Game of Thrones and the Game of Markets


Two items for the mid-week.

First, an invitation to attend a Salient Webinar I’ll be presenting next Thursday, September 18th at 2pm ET, titled: “The Game of Thrones and the Game of Markets”. I’ll be tying together various threads from past Epsilon Theory notes, with the goal of showing how to listen to financial news and analysts to detect Narratives. Please note that the presentation is geared for financial advisors, brokers, and investment professionals, and it qualifies for one hour of CFP/CIMA®, CIMC®, or CPWA® CE credit if you care about such things. Invitation attached and registration link here.

Second, a few brief thoughts on an Epsilon Theory connection between modern capital markets and the NFL (and between Central Bankers and Roger Goodell). The connection is solipsism – a pathological egocentrism where reality is defined by an individual’s mental perceptions and constructs.

For individuals like Goodell and Yellen we’re talking about good old-fashioned individual solipsism. These are people who have never been proven wrong about anything in their professional lives. I know that sounds weird to professional investors and allocators, because we are demonstrably wrong about something every single freaking day, and it’s a hard concept to describe effectively to someone who’s never lived within a sheltered organization where empirical outcomes are either pre-ordained or immaterial. But both Goodell and Yellen have spent their entire professional careers as the modern equivalents of cloistered monks or nuns, the former within the Holy Order of the National Football League and the latter within the High Church of UC Berkeley. It’s wonderfully pleasant to live within these worlds without external consequence, where your mental constructs and pronouncements receive constant positive reinforcement, but the inevitable result is that you begin to believe that your mental constructs ARE reality. Roger Goodell truly believes that everything he has done and announced, most recently his appointment of an “independent” investigator, is obviously the right and correct course of action, and he has no idea why these actions and announcements are being questioned. He has no idea why his world is crumbling. Similarly, Janet Yellen is not being disingenuous when she talks about her ability to control “macroprudential” outcomes. In her mind (and in the minds of everyone else in today’s academic Fed), these theories ARE reality. Drain the $5 trillion in banking system reserves without market consequence? Sure, we’ve got a theory for that. No problem. As Yul Brynner would have put it in Cecil B. DeMille’s “The Ten Commandments”: So let it be written. So let it be done.

For social constructions like markets or professional sports leagues or any self-contained social world, we’re talking about a different version of solipsism – collective solipsism. I’ve written about this idea in the Epsilon Theory note “A Dogmatic Slumber”, so I won’t repeat all that here. Collective solipsism is what overwhelming Common Knowledge looks like. It’s the annihilation of an individual’s perception of reality in favor of a group perception of reality. It’s an entirely natural reaction of the human social animal to certain strategic interactions, i.e., games. It’s what I mean when I say that we are at an asymptotic peak in the social influence of the Narrative of Central Bank Omnipotence. 

When does collective solipsism fail? When does the story break? When it comes into conflict with a larger external social structure, with a larger strategic interaction. The collective solipsism of the NFL crumbles when it runs headlong into the larger political and social structure of the United States, which – amazingly enough – has 300+ million citizens who don’t play Fantasy Football, who have no idea who Ray Rice is, who listen to owners Bob Kraft or John Mara and think they’re from Mars, and who don’t hang on every word of THE Commissioner. But they’ve all seen or heard about the video. They all care about the larger issue of domestic violence. They all think they’re being lied to. And there are powerful political and economic interests in the larger game who see this conflict as working to their advantage. That’s when the story breaks.

The collective solipsism of modern markets is a much bigger game still, and will require a much larger shock and external social structure to unwind the Common Knowledge structure at the heart of all this. I can’t tell you when any of this will happen, but there are only a few social structures large enough to fit the bill. There is no more important task for risk management than monitoring those structures, and that’s what I’m trying to do with Epsilon Theory.

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The Ministry of Markets


Actual conversation as I left a client meeting with a Salient colleague last Friday and we checked our phones…

Colleague: Wow, looks like the jobs number was pretty terrible.
Me: Hey, that’s great.
Colleague: Yep, stocks and bonds are rocking.

Subtitle for this week’s email: “At This Point You Just Have to Laugh”. In every important respect, the Fed and the ECB and their brethren are no longer central banks at all. They are Ministries of Markets, no different from a Ministry of Industry or – even more eerily similar – the Ministry of Culture you would find in most European governments.

I spent the past week in Switzerland, meeting with old friends and making some new ones, and just like my recent travels in the US there was one overwhelming sentiment. No one doubts the omnipotence of central banks. No one doubts that market outcomes are fully determined by central bank policy. No one doubts that central banks are large and in charge. No one doubts that central banks can and will inflate financial asset prices. And everyone hates it.

Among those investors and allocators with the freedom to flee public markets, the interest in private market opportunities has never been greater. Among those investors and allocators trapped by mandate diktat in the Alice in Wonderland world of public markets, the resigned desperation has never been worse. It’s a quiet desperation in Zurich – a Teutonic stare at the floor and a wrinkling of the mouth – more obvious in Geneva with a Gallic shrug and a full-faced grimace. But’s it’s all the same emotional response to the Bizarro markets in this, the Golden Age of the Central Banker.

At this point the Narrative hegemony is complete. There’s no longer even a cursory bow to the idea that fundamentals matter. Earnings seasons come and go in the financial press with hardly a murmur. Over the past six months I can count on the fingers of one hand the financial press headlines that recapped the market day by saying that stocks went up or down “because” of company fundamentals. Six months ago I was writing in insurgent fashion about the “New Goldilocks Economy” constructed not on actual fundamental data but on how that data was interpreted through the lens of central bank policy. Today it’s a so-what-else-is-new article in the WSJ. A year ago I would meet with the occasional true believer in the power of central bank Narratives and the poverty of fundamental analysis in an environment of profound political uncertainty, but it was always against a dominant backdrop of “synchronized global growth” or “stock-picking is going to work again, just you wait and see”. Now everyone is a convert to the Narrative of Central Bank Omnipotence. Wherever I go, anywhere in the world, I am preaching to the choir when I deliver my sermon. 

So I’m calling a top. Not a top in markets, because I honestly have no idea what’s going to happen next. But I’m calling a top in the Narrative of Central Bank Omnipotence because it has, in fact, reached its asymptotic limit of influence and belief.

It’s a top because the cracks are starting to show and widen. A Narrative architecture can sustain amazing structures, much like the flying buttress allows Gothic cathedrals to soar, but ultimately it can only bear so much weight. Draghi’s language last Thursday was sloppy. His pitch was uncharacteristically poor as he sang his lullaby to the Red King. I think he’s bitten off waaaay more than even he can chew, a point I’ll review at length next week. As for the US, the Central Bank Omnipotence Narrative is actually counterproductive for equity market price levels at this point. Because we are such well-trained monkeys, we act by reflex today to buy-buy-buy whenever a headline of Central Bank activism surfaces, but the training starts to work the other way when the tightening starts in earnest and the Fed reserves hang out there unresolved, like the mother of all lead balloons draped around the long end of the curve. Remember what an inverted yield curve looks like? Ain’t a pretty sight. But draining the reserves could look even worse. Damned if you do. Damned if you don’t. And the equity market caught in the middle.

It’s a top because – like a Ministry of Industry or a Ministry of Culture – a Ministry of Markets and its dirigiste control of the human animal’s social behavior ultimately fails. Maybe not a failure in the sense of apocalypse and ruin (although sometimes), but a failure in the sense that The Next Big Thing never comes out of a Ministry. They have their successes, sure … some grand program or triumphant announcement … but they’re only successes because we are TOLD they are successes. Since when has a Ministry of Culture sparked great art? Since when has a Ministry of Industry sparked great commercial advancement? Ministries are well-meaning. Ministries are the darlings of the professional intelligentsia that controls the organs of the State and Media. Ministries are wonderfully effective instruments of social control. But neither art nor commerce nor investment comes well from on high.

It just doesn’t stick. The most powerful ideas in human history always come from below, not from above, and markets (and elections and revolutions) are the transmission mechanism of the idea engine. Watch out above!

An inflection point in the market Narrative doesn’t alter market price levels directly. It alters the informational structure of markets (for a refresher course on what I mean, see “Through the Looking Glass”). It alters the market’s response pattern to future signals and events. That’s why I think it’s silly to predict end of year S&P 500 levels or engage in any such crystal ball gazing, because I have no idea what will happen next. But whatever pops out of the woods next (and somehow I doubt the global economy is walking down a primrose path), I think that using an Epsilon Theory perspective based on information theory and strategic behavior can help me react quickly and appropriately, which is what I mean by Adaptive Investing. 

I don’t know what the catalyst for The Next Big Thing will be, although I have my suspicions. Maybe it’s a realignment election in Italy or the US. Maybe it’s China saying whatever the Mandarin equivalent of no mas might be. Maybe it’s a liquidity seizure in the repo market or some other unanticipated structural market failure. But whatever it is, we’re no longer at a point where additional State intervention can claim additional Narrative firepower. It’s like buying a stock that has no short interest and where all the sell-side analysts are rabidly positive. No thanks! Just as a short seller today is the marginal buyer of your stock tomorrow, so is the skeptic today the convert tomorrow. There are no more skeptics. To update Milton Friedman’s famous quote, we are all Bernankians now. Or rather, we all have to profess our Bernankian faith through our market behaviors even as we privately yearn for the Old Gods of greed and fear and the Old Languages of value and growth. And that’s the inflection point. From here on out I’m a seller of the Central Bank Narrative of Omnipotence and Control, and I’ll be writing about what that means for portfolio construction and risk management here at Epsilon Theory.

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The Name of the Rose


If names be not correct, language is not in accordance with the truth of things. 

― Confucius, “The Analects of Confucius” (551 – 479 BC)


Give me a lever long enough and a fulcrum on which to place it, and I shall  move the world.  

– Archimedes (287 – 212 BC)  


Call him Voldemort, Harry. Always use the proper name for things. Fear of a name increases fear of the thing itself.
– J.K. Rowling, “Harry Potter and the Sorcerer’s Stone” (1997)

Do you know why hurricanes have names instead of numbers? To keep the killing personal. No one cares about a bunch of people killed by a number. ‘200 Dead as Number Three Slams Ashore’ is not nearly as interesting a headline as ‘Charlie kills 200.’ Death is much more satisfying and entertaining if you personalize it. 

Me, I’m still waitin’ for Hurricane Ed. Old Ed wouldn’t hurt ya, would he? Sounds kinda friendly. ‘Hell no, we ain’t evacuatin’. Ed’s comin’!
– George Carlin, “Brain Droppings” (1998)


I have been pronounced by the Holy Office to be vehemently suspected of heresy, that is to say, of having held and believed that the Sun is the center of the world and immovable, and that the earth is not the center and moves.

Therefore, desiring to remove from the minds of your Eminences, and of all faithful Christians, this vehement suspicion, justly conceived against me, with sincere heart and unfeigned faith I abjure, curse, and detest the aforesaid errors and heresies, … and I swear that in the future I will never again say or assert, verbally or in writing, anything that might furnish occasion for a similar suspicion regarding me. 
– Galileo Galilei (1564 – 1642)


William of Baskerville:   I, too, was an Inquisitor, but in the early days, when the Inquisition strove to guide, not to punish. And once I had to preside at a trial of a man whose only crime was to have translated a Greek book that conflicted with the Holy Scriptures. Bernardo Gui wanted him condemned as a heretic; I … acquitted the man. Then Bernardo Gui accused *me* of heresy, for having defended him. I appealed to the Pope. I … I was put in prison, tortured, and … and I recanted.
Adso of Melk:
What happened then?
William of Baskerville: The man was burned at the stake and I am still alive.
Adso of Melk: And what was the word you both kept mentioning?
William of Baskerville: Penitenziagite.
Adso of Melk: What does it mean?
William of Baskerville: It means that the hunchback undoubtedly was once a heretic. Penitenziagite was a rallying cry of the Dolcinites.
Adso of Melk: Dolcinites? Who were they, master?
William of Baskerville: Those who believed in the poverty of Christ.
Adso of Melk: So do we Franciscans.
William of Baskerville: But they also declared that everyone must be poor, so they slaughtered the rich. Ha! You see, Adso, the step between ecstatic vision and sinful frenzy is all too brief.

– “The Name of the Rose” (1986)


Every battle against heresy wants only this: to keep the leper as he is.
– Umberto Eco, “The Name of the Rose” (1980)

“The Name of the Rose” was an under-rated movie in the mid-1980’s with an in-his-prime Sean Connery and a young Christian Slater (not to mention some great scene-stealing by Ron Perlman), based on an under-rated novel by one of my favorite authors, Umberto Eco. To be sure, Eco is prone to the occasional bout of overwrought ego-stoking prose (but aren’t we all!), and my take on “The Name of the Rose” is that while Eco intended it as a work of great literature masquerading as a murder mystery, it’s really a great murder mystery masquerading as literature. But as a highly entertaining yet wise examination of the power of ideas, the implacable opposition of status quo institutions to “heresy”, and the role of language in that struggle, “The Name of the Rose” has no equal in my library.

I thought of Eco’s book last week when I read the WSJ’s breathless article about the San Diego County pension fund (SDCERA), Salient Partners, and the use of … gasp! … “leverage” and “derivatives” as part of Salient’s recommended allocation strategy. In terms of public Narrative, the words “leverage” and “derivative” have become so mushy and ill-used that they have lost almost all meaning except as a weapon, as a tool to cast doubt on someone’s motives, competency, and ethics. It’s the modern equivalent of accusing someone of witchcraft or heresy, and it’s what status quo institutions and their apologists have done for centuries with insurgent ideas. They use language – or rather, they intentionally misuse language – to paint the insurgent idea as heretical. It’s like Dana Carvey’s Church Lady interviewing someone on Saturday Night Live, only with the tagline shifted from “Could it be … Satan?” to “Could it be … Leverage?”.


Anyone with public accountability or transparency bears the brunt of this linguistic warfare, particularly the investment board or staff of any public pension plan. In my experience these are almost always very smart people who are “there for the right reasons” to use the catch-phrase of “The Bachelorette”. But like William of Baskerville, they find themselves in an untenable position, where even considering an unorthodox idea, much less defending it, is cause for public attack, ridicule, and excommunication. At least being raked over the coals today is a figurative rather than literal punishment, but frankly I think I might prefer the latter.

Modern torture-by-comment may be more psychological than physical, but it’s no less vicious, and it’s growing exponentially in power and scope. How many of you, like me, go straight to the comment area of an ESPN article? It’s not that I care at all what any single commenter says about Johnny Manziel or Tim Tebow, but I am fascinated by the outpouring of effort, the tens of thousands of voices who apparently believe that others really do care about their opinion. It’s entertainment for me. But imagine that you’re the target of this outpouring of know-nothing vitriol, that you’re a pension board member who hears a virtual mob saying that you’re obviously either an idiot or a criminal to use “leverage” – whatever that means – in your investment strategy. It is very difficult to maintain the courage of your convictions or even an open mind to consider new ideas under the onslaught of this modern day Inquisition, and that’s the real damage that’s done here. William of Baskerville recanted. Galileo recanted. And we expect anything more from public pension officials than CYA?

The unfortunate truth in all this is that, as Eco wrote, “every battle against heresy wants only this: to keep the leper as he is.” There are many status quo institutions – particularly political institutions like parties and media institutions like newspapers, but also more than a few large market institutions – who are delighted to keep public pension funds in this perpetual state of retributive fear and defensive under-performance. It has nothing to do with “keeping them honest” or whatever other bromide is trotted out for public consumption. It has everything to do with maintaining a mute whipping boy for political or economic gain.

This is why newspaper hacks and political wannabes all over the country lick their chops whenever some new idea is proposed by a public agency, whether it’s a local zoning board in a small town or a multi-billion dollar pension investment board. There is zero downside to making these attacks, no matter how simple-minded or misleading. The target is usually defenseless. The political upside is usually significant. And the economic beneficiaries, of course, other than the stalwart media defenders of orthodoxy, are the entrenched financial service providers.

We’re all familiar with the Indiana Jones knife fight, where a fierce turbaned warrior dressed all in black challenges Harrison Ford with his sword, only for Ford to pull out his gun and shoot the guy cold. Our current political and media system forces public pension funds into the turbaned warrior role.They are competing directly with the most advanced institutional investment firms in the world, firms that have an arsenal of weapons at their disposal. But God forbid that a public pension fund use “leverage” – again, whatever that means – in its investment strategy. Oh no, can’t have that. Better to fail conventionally than to succeed unconventionally. Better to arm yourself with that simple sword and be gunned down before the fight even starts.


Enough. Leverage and derivatives are not inherently demonic and aren’t exclusively the purview of dark wizards. If you say the words out loud I promise you won’t call forth a horde of Deatheaters.

Can leverage, however defined, be used in Voldemort-ian fashion for evil rather than good? Of course. As Eco writes in one of my favorite quotes, “the step between ecstatic vision and sinful frenzy is all too brief”, and as a risk manager that’s certainly something I watch for in any strategy or any investment manager. Can derivatives, however defined, be used as “financial weapons of mass destruction”, to quote Warren Buffett? You bet, although I find this quote mighty odd for a guy who wrote close to $15 billion of equity index puts and credit default swaps in 2006 to help fund Berkshire Hathaway. It all depends on what actual activity is being described by the words “leverage” and “derivatives”. It all depends on calling things by their proper names. To use the same word – “derivative” – for both exchange-traded futures in gigantically deep markets and a bespoke swap on some highly structured mortgage securitization is ludicrous, but that’s exactly what the modern Inquisition does intentionally for its own political and economic interests.

Properly understood – which means properly named – many common uses of leverage and derivatives aren’t that scary. They’re also not inherently instruments of risk creation. On the contrary – and this is the entire point of the risk-balancing “heresy” within the public pension world – using leverage and derivatives wisely can reduce the risk of an unlevered portfolio without reducing its long-term potential return or conversely may increase the long-term potential return of the portfolio without increasing its risk. 

How? By using the age-old investment idea of balance, of not putting all of your eggs in one basket like the stock market. A risk-balancing strategy argues that you should put your money into multiple baskets – stocks, corporate bonds, commodities, and government bonds – and that you should balance between those baskets on the basis of historical risk, not simple dollar amounts. Also, most risk-balancing strategies have some mechanism to adapt to changing market conditions by letting the market tell you when something is working or not working. There, that’s it. Pretty scary, huh?

But you can’t execute a risk-balancing strategy without using leverage (properly defined) and derivatives (properly defined). Three reasons. First, to be adaptive you need to be quick on your feet. Not millisecond fast, but one or two days fast. With the massive amounts of money that pension funds invest today, it’s impossible to be sufficiently nimble if you’re locked into individual stocks and bonds. Second, if you want to put some of your investment eggs into the commodity basket, you have to use leverage and derivatives because that’s the only way to control them directly. Third, to balance out the risk between the baskets, as opposed to simply the dollars, you’re going to need to control a lot more dollars in your bond baskets than in the stock basket. Why? Because the historical risk to bonds, particularly government bonds, is so much less than the historical risk to stocks. To get an equivalent amount of risk you either have to get rid of almost all of your stocks, which would be a mathematically correct but financially ill-advised solution, or you have to control a lot more bonds. I think it’s wise to choose the latter … with limits, within reason, and constantly adapting to changing market conditions.

What a risk-balancing strategy means by “leverage” is the same as Archimedes meant the word 2,500 years ago, or that generals on the battlefield mean the word today: it’s controlling a lot with a little by using a force multiplier. It’s not borrowed money. It’s not “doubling down” or “turbo-charging” or whatever other misleading phrase your local genius columnist or comment troll throws out there as Gospel. It’s buying an exchange-traded, liquid contract that controls a lot of stocks or bonds or commodities for a little bit of money for a defined amount of time. These contracts are necessary because they are by far the most effective way of implementing what I think is an important new twist on an important old idea – balance your investments across several different asset baskets, but balance by risk (not dollars) and adapt to a changing market.

Does the use of leverage (properly defined) and derivatives (properly defined) create trading risks that wouldn’t be there if you just bought the Vanguard 60/40 fund and called it a day? Sure. But I believe risk-balancing strategies mitigate far more dangerous risks to a public pension portfolio – particularly an over-reliance on equity markets. Public pensions are complex entities whose liability structures are often many times greater than the size of their investment portfolios. The common practice to resolve this dilemma has been to pursue an equity-dominated asset structure that has greater chances of achieving the required return to make the entire structure work. The problem is that equities are themselves leveraged, but it’s hidden leverage and thus hidden risk.

What does this mean, to say that equities embody hidden leverage? It means that the assets of S&P 500 operating companies are nearly five times as large as the equity that finances them. It means that, by definition, the gulf between assets and equity can only be bridged by various forms of leverage. This is the alchemy that transformed a paltry 3.27% return-on-assets for S&P 500 operating companies in 2013 to an impressive 15.01% return-on-equity. For all the equity enthusiasts out there who shake their heads and tut-tut the idea of a few turns of leverage on a liquid portfolio of government bonds, I’d ask why you’re so confident in a 5x equity leverage on the 3.27% unlevered ROA of the S&P 500, but so fearful of, say, a 2x leverage on the 3.44% average interest paid on 30-year government bonds. That’s not a slam on equities. I love equities. Nor is it to say that there’s no risk in government bonds. My point is simply that as an investor you must take risk to achieve a return that is higher than the risk-free rate. There is no way around this, no free lunch, no way to get something for nothing. The question, at least for an investor like most public pensions, is not how to eliminate risk. The relevant questions are: do you know what risks exist in your portfolio, and which of these risks do you want to embrace? 

Maybe you just don’t like a risk-balancing allocation strategy, for whatever reason. That’s fine. Or maybe you have a concern or an objection to the strategy or its implementation. That’s fine, too, and believe me, there are plenty of reasonable concerns you could raise or I could raise about ANY investment strategy. But don’t just shout out “Leverage!” as if it were a self-evident condemnation of the strategy or its adopters. It’s like the scene in Steve Martin’s wonderful movie Roxanne, where a heckler in a crowded bar shouts out “Big nose!”. Martin’s response? He’s insulted by the triviality of the insult, and proceeds to whip out 20 superior insults that the heckler could have made (my personal fave – “Obscure: whoa! I’d hate to see the grindstone.”). In this case, I would suggest “Looming: if you thought your leverage and derivative exposures were big, just wait till you see your liabilities.” or “Clairvoyant: if you’re so smart, why use diversification at all?”.


I’ll close with two quotes from Will Rogers, who not only never met a man he didn’t like but also had an amazing knack for communicating advanced investment insights without resorting to three syllable words or mathematical equations.


You’ve got to go out on a limb sometimes because that’s where the fruit is.

Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.
– Will Rogers (1879 – 1935)

I love these quotes because they encapsulate why Salient recommends a risk-balancing core allocation strategy. We want to embrace risk as an ally rather than treat it as the Great Satan. We do it for the same reason, as Will Rogers said, that you go out on a limb. Because that’s where the fruit is. Risk and reward are entirely inseparable. They are two sides of an unsplittable coin, and you can’t have one without the other. But you need to think about that relationship between risk and reward smartly. More importantly, you need to think about that relationship wisely. What’s the difference? Smart thinks that he can model the future. Wise knows that she doesn’t know what the future holds. Smart is intellectually sharp. Wise is intellectually honest.

Being wise about risk and reward means you don’t claim to own a magical crystal ball that predicts where risk will be low and reward will be high in the future. It means being intellectually honest enough to say that you don’t know. That’s the hardest thing in the investment world to admit, because there is no shortage of smart people who will tell you that they have just such a crystal ball. And maybe they’re right. If you have that crystal ball or you know someone who does … if you are able, as Will Rogers advised, to avoid buying stocks that don’t go up in the future … then you don’t need a risk balancing strategy. Otherwise, let’s have a conversation, or at least listen in by reading Epsilon Theory.

I’m not suggesting that we have a monopoly on new ideas for investing – we don’t – or that our ideas are right for everyone – they’re not. But we believe we are part of an insurgent movement to change the way investors think about asset allocation, and we are buoyed by a consistent lesson from history. The struggle between status quo and insurgent ideas can take a long time and it’s never an easy road for the truth-seekers caught in the middle, but eventually … the Inquisition always loses. 

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