When the Story Breaks

The Three Types of Fear:
  • The Gross-out: the sight of a severed head tumbling down a flight of stairs. It’s when the lights go out and something green and slimy splatters against your arm.
  • The Horror: the unnatural, spiders the size of bears, the dead waking up and walking around. It’s when the lights go out and something with claws grabs you by the arm.
  • And the last and worst one: Terror, when you come home and notice everything you own has been taken away and replaced by an exact substitute. It’s when the lights go out and you feel something behind you, you hear it, you feel its breath against your ear, but when you turn around, there’s nothing there.

Stephen King

Brody: You’re gonna need a bigger boat.

“Jaws” (1975)

Back in my portfolio manager days, I was a really good short seller. I say that as a factual observation, not a brag, as it’s not a skill set that’s driven by some great intellectual or character virtue. On the contrary, most short sellers are, like me, highly suspicious of all received wisdom (even when it is, in fact, wise) and have weirdly over-developed egos that feed on the notion of “I’m right even though the world says I’m wrong”. But what set me apart as a short seller were two accidents of experience. First, I didn’t come out of Wall Street, so I wasn’t infected with the long-bias required of those business models. Second, my professional career prior to investing was all about studying mass behaviors and the informational flows that drive those behaviors.

Here’s why that’s important. The biggest difference between shorting and going long is that shorts tend to work in a punctuated fashion. One day I’ll write a full note on the Information Theory basis for this market fact, but the intuition is pretty simple. There’s a constant flow of positive information around both individual stocks (driven by corporate management) and the market as a whole (driven by the sell-side), and as a result the natural tendency of prices is a slow grind up. But occasionally you’ll receive an informational shock, which is almost always a negative, and the price of a stock or the overall market will take a sharp, punctuated decline. The hardest decision for a short seller is what to do when you get this punctuated decline. Do you cover the short, pocket a modest gain, and look to re-establish the position once it grinds higher, as it typically does? Or do you press the short on this informational validation for your original negative thesis? It’s an entirely different mindset than that of most long-only investors, who – because they have the luxury of both time and informational flow on their side – not only tend to add to their positions when the stock is working (my thesis is right, and I’m raising my target price!) but also tend to add when it’s not working (my thesis is right, and this stock is on sale!).

Solving the short seller’s dilemma requires answering one simple question: is the story broken?Is the informational shock sufficient to force long-only investors to doubt not just their facts, but – much more crucially – their beliefs, thus turning them into sellers, too? The facts of the informational shock are almost immaterial in resolving the short seller’s dilemma. Your personal beliefs about those facts are certainly immaterial. The only thing that matters is whether or not the river of information coming out of the sell-side has shifted course in a way that swamps the old belief structures and establishes new Common Knowledge.

The China growth story is now broken. To be clear, I am NOT saying that China’s economy is broken. On the contrary, I’m a China bull. What I’m saying is that what everyone believes that everyone believes about Chinese growth – the Common Knowledge about Chinese growth – has now shifted dramatically for the worse. What I’m also saying is that China-related stocks and markets are going to have a very hard time working until the investors who believed in the China growth story are replaced by investors who believe in a different China story, probably a China value story. That can take a long time and it can be a very painful transition, as any value investor who ever bought a mega-cap tech stock can attest. But it will happen, and that’s a very powerful – and ultimately positive – transformation. Ditto for Emerging Markets in general.

In the meantime, what we’ve been experiencing in markets is the plain and simple fear that always accompanies a broken story. The human reaction to a broken story is an emotional response akin to a sudden loss of faith. It’s a muted form of what Stephen King defined as Terror … the sudden realization that the helpful moorings you took for granted are actually not supporting you at all, but are at best absent and at worst have been replaced by invisible forces with ill intent. The antidote to Terror? Call the boogeyman by his proper name. It’s the end of the China growth story, one of the most powerful investment Narratives of the past 20 years. And that’s very painful, as the end of something big and powerful always is. It will require investors to adapt and adjust if they want to thrive. But it’s not MORE than that. It’s not a sign of the investment apocalypse. It’s the end of one investable story, soon to be replaced with another investable story. Because that’s what we humans do.

Here’s a great illustration of what fear looks like in markets, courtesy of Salient’s Deputy CIO and all-around brilliant guy, Rusty Guinn.


These are the cumulative pro forma (i.e., purely hypothetical) returns generated by selling (shorting) the high volatility S&P 500 stocks and buying an off-setting amount of the low volatility stocks (0% net exposure, 200% gross exposure). The factor is up 10% YTD and 15% from the lows in May. Now just to be clear, this is not an actual investment strategy, but is simply a tool we use to identify what factors are working in the market at any point in time. There are any number of ways to construct this indicator, but they all show the same thing – investors have been embracing low volatility (low risk) stocks ever since Greece started to break the European stability story this summer, and that dynamic has continued with the complete breakdown of the China growth story. This is what a flight to safety looks like when you don’t trust bonds because you think the Fed is poised for “lift-off”. This is the fear factor.

Three final Narrative-related points…

First, while the breakdown in the China growth story has reached a tipping point over the past week, this is just the culmination in what has been a two year deterioration of the entire Emerging Market growth story. The belief system around EM’s has been crumbling ever since the Taper Tantrum in the summer of 2013, and it’s the subject of one of the most popular Epsilon Theory notes, “It Was Barzini All Along”. Everything I wrote then is even more applicable today.

Second, I see very little weakness in either the US growth story (best house in a bad neighborhood, mediocre growth but zero chance of recession) or the Narrative of Central Bank Omnipotence. Do I think that the Fed is being stymied in its desire to raise short rates in order to reload its monetary policy gun with conventional ammo? Yes, absolutely. Do I see a significant diminution in the overwhelming investor belief that the Fed and the ECB control market outcomes? No, I don’t. Trust me, I’m keeping my eyes peeled (see “When Does the Story Break?”), because in many respects this is the only question that matters. If this story breaks, then in the immortal words of Chief Brody when he first saw the shark, “You’re gonna need a bigger boat.”

Third, while I’m relatively sanguine about the China growth story breaking down, as I’m confident that there’s a value story waiting in the wings here, I’ll be much more nervous if the China political competence story continues to deteriorate. This is a completely different Narrative than the growth story, and it’s the story that one-party States rely on to prevent even the thought of a viable political opposition. In highly authoritarian one-party nations – like Saddam’s Iraq or the Shah’s Iran – you’ll typically see the competence Narrative focused on the omnipresent secret police apparatus. In less authoritarian one-party nations – like Lee Kuan Yew’s Singapore or Deng Xiaoping’s China – the competence Narrative is more often based on delivering positive economic outcomes to a wide swath of citizens (not that these regimes are a slouch in the secret police department, of course). From a political perspective, this competence Narrative is THE source of legitimacy and stability for a one-party State. In a multi-party system, you can vote the incompetents (or far more likely, the perceived incompetents) out of office and replace them peacefully with another regime. That’s not an option in a one-party State, and if the competency story breaks the result is always a very dicey and usually a violent power transition. I am seeing more and more trial balloons being floated in the Western media (usually with some sort of Murdoch provenance) that indicate “dissatisfaction” with this or that cadre. And it’s not just a markets story any more, as grumblings over the Tianjin fire disaster appear to me to have grown louder over the past week. I haven’t seen this sort of signaling coming out of China in 20 years, and it certainly bears close watching.

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Breaking Bad

Jesse: And why’d you go and tell her I was selling you weed?
Walt: Because somehow it seemed preferable to admitting that I cook crystal meth and killed a man.

“Breaking Bad” (2008)

Meadow: Are you in the Mafia?
Tony: Am I in the what?
Meadow: Whatever you want to call it. Organized crime.
Tony: Who told you that?
Meadow: Dad, I’ve lived in the house all my life. I’ve seen the police come with warrants. I’ve seen you going out at three in the morning.
Tony: So you never seen Doc Cusamano going out at three in the morning on a call?
Meadow: Did the Cusamano kids ever find $50,000 in Krugerrands and a .45 automatic while they were hunting for Easter eggs?
Tony: I’m in the waste business. Everybody immediately assumes you’re mobbed up. It’s a stereotype. And it’s offensive. And you’re the last person I would want to perpetuate it. There is no mafia.
Meadow: Fine.
Tony: [pause] Alright…look, Mead, you’re a grown woman, almost. Some of my money…comes from illegal gambling and whatnot. How does that make you feel?
Meadow: At least you don’t keep denying it, like Mom.

– “The Sopranos” (1999)

Jane: You’re lying! Now I know why Ed’s been calling every half hour. You’ve been back on the case, haven’t you?
Frank: No! I swear it’s another woman!

“Naked Gun 33 1/3: The Final Insult” (1994)

Always confess to a small crime if you want to hide the big stuff. I remember reading this in a Robert Heinlein sci-fi novel when I was a kid, and it’s stuck with me ever since. Once you start looking for this trope you see it everywhere, and even if it goes a little over the top at times in scripted media (anyone remember the “24” season where Jack Bauer tortures his own brother, who gives up a partial truth to hide their father’s role as an arch-villain of treason?), I’m always on the look-out for it in the Narrative construction of our unscripted investment news media.

The problem in mass Narrative construction is not (or at least is very rarely) an issue of intentional misdirection through selective confession. But you don’t need intentionality for this dynamic to take root and misdirect all the same. Much more commonly, it’s the spreading of an easy to understand revelation of old fashioned greed that generates such a sense of outrage among all of us that regulators and policy makers mobilize to “crack down” on a few obvious bad guys while leaving the underlying flawed system intact. The result is that the flawed system often gets a new lease on life, as both the popular and regulatory attitude becomes “Oh … well, I guess so long as you’re not doing THAT, then I suppose we’ve got nothing to worry about.”

Case in point: the record $20 million fine levied by the SEC last week on ITG for its egregious wrongdoing in management of its trading dark pool. I can say that this was egregious wrongdoing without any fear of contradiction because – in sharp contrast to almost every settlement you’ve ever seen with the SEC, where the defendant “neither admits nor denies” anything – ITG was forced to confess as part of the settlement. You can read the SEC press release here, you can read the Bloomberg take here, and you can read the Wall Street Journal take here and here. As with most things market structure-related, I’ve learned a ton about this case from Sal Arnuk and Joe Saluzzi at Themis Trading, who put out a daily note on market structure that I think is very useful.

What did ITG do? They blatantly traded against the interests of their own clients, by peeking into their order book to buy and sell stock in other venues for their own account a few milliseconds ahead of their client orders. It’s pretty much a textbook case of front running, only in a modern context of dark pools and multiple electronic trading venues. This predatory HFT program traded 1.3 billion shares and (per Arnuk and Saluzzi’s calculations) impacted the pricing and execution of about 130 billion shares by a few pennies per share. That’s billion with a B. My favorite factoid from the SEC docs: ITG ranked their clients by how easy they were to trade against, and – surprise! – tried to do more business with the suckers. Oh, and here’s another shocker – the suckers were always the sell-side; ITG would turn off the program when it faced its buy-side clients. To be clear, this wasn’t a “rogue” operation at ITG, but something that was explicitly approved by their Board … twice.

My concern is NOT that what ITG did is rampant in the trading world. I doubt that any other dark pool operator or independent execution trader is cheating their clients in such an overt, really almost caricaturish fashion. My concern is in the grey area between cheating and edge. My concern is that our market structure is fundamentally flawed – or at least contains unanticipated and uncompensated risks – and that an honest discussion of those flaws will be shunted to the side in favor of easy regulatory posturing against those darn evil-doers. My strong hunch is that a regulatory and media focus on obvious front running will lock in the current market structure, although equally bad for investors would be some sort of witch hunt against all dark pools and all electronic trading venues.

Whichever way it goes, though, the ultimate result will be the same – an accelerated victory of the big bank trading groups over the high-tech trading firms for control of market flow data. HFT liquidity providers and quant-oriented execution shops 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.

A lot of HFT critics are crowing over the ITG confession. You see! HFT is front running, plain and simple! Told you! And HFT defenders are largely silent because … well, you can’t defend the indefensible. I’m in the anti-HFT camp (see “The Adaptive Genius of Rigged Markets”), but I’m not crowing. If history is any guide at all, the existence of a clearly identifiable small-v villain will forestall the unmasking of what I believe is a Big Bad … the subterranean influence, bordering on control, of human investment behaviors by firms controlling advanced inference machines (see “Troy Will Burn – the Big Deal about Big Data”). Market infrastructure is only the first battleground in this war, but it’s a critical one. If even more advanced non-human intelligences owned by even more powerful institutions are allowed even more unmonitored and unregulated access to even more massive order books, this first battle is even more lost than it already is. But that’s exactly where I think we’re headed.

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Actually Maybe Not So Excellent

Everything under heaven is in chaos; the situation is excellent.
― Mao Zedong (1893 – 1976)

A quick email on China’s currency devaluation last night. The news itself is big enough, but it’s the Narrative that’s developing around the devaluation that has my risk antennae quivering like crazy. What do I mean? I mean that initial media efforts to portray the devaluation as a one-time “adjustment” that’s in-line with prior policy have been overrun by stories of “shock” and disjuncture. This is true even within Rupert Murdoch’s various media microphones, which tend strongly to toe the Beijing party line. Moreover, the devaluation is not being described in Western media as Chinese “stimulus”, which it surely is and would send markets higher if portrayed in this light, but as Chinese “currency competition” and as a sign that the growth problems in China are more severe than Western central bankers would like to believe. Or more precisely, would like to have YOU believe.

What’s the Truth with a capital T about Chinese growth, Fed intentions, and the future price of growth-sensitive assets like oil? I have no idea and neither does anyone else. Seriously. But what I do know is that the Common Knowledge about Chinese growth – what everyone thinks that everyone thinks about Chinese growth – is dramatically changed for the worse today, and it’s a change that will accelerate unless the Narrative shifts. That could happen. I still have nightmares about how the Narrative around the ECB’s OMT program shifted from “Draghi’s Blunder” to “Draghi’s Bold Move” within a single day in the pages of the Financial Times in the summer of 2012. But unless and until that Narrative shifts, the path forward for the Fed just got much more perilous. And that’s why the 10-year US Treasury is at 2.12% as I write this note. Unless and until that Narrative shifts, the path forward for oil and any other global growth-sensitive asset or security just got much more perilous. And that’s why oil is at $43 as I write this note.

One last point, focused on what’s next for China. As with everything else here in the Golden Age of the Central Banker, my crystal ball is broken. But I think that I’ve got the right lens for viewing China and its political dynamics, and you can read about it in two Epsilon Theory notes: “The Dude Abides: China in the Golden Age of the Central Banker” and “Rosebud”.

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