Why Hope?


Since we have launched the new Epsilon Theory site, the engagement from our readers has been, without question, the most rewarding part for both me and Ben. I am grateful for the emails and responses to We Were Soldiers Once, And Young. I’m grateful to our member John, who doesn’t let me get away with any bullshit.

I’m also grateful to our member Thomas, who posted an incredibly thoughtful response to one of David Salem’s notes from last week. In this comment, he challenges whether hope is the right response to our present social and political environment. It’s an earnest and entirely reasonable challenge. “Hope”, as Thomas points out in quoting Henry Rollins, “is the last thing a person does before they are defeated.” And so it is. And yet, I’d like to stand again in defense of hope – and duty, its fellow laborer.

I’ve done so before, in a prior piece I called the Two Churchills.  But today I want to talk instead about Two Worlds.

In one world, humans have never been so free to live the life they choose. In this world, diseases are being conquered. Scientific and mathematical breakthroughs are being achieved. Fewer people die in violence, in conflict and in war. Fewer crimes are committed. Fewer children go hungry. Fewer people are imprisoned and killed by their own governments. We are learning to harness new sources of power. We are learning about the stuff we are made of.

This is our world.

Is this world at risk? As it ever was, yes! Our prosperity and fruitfulness appear to have put a strain on our planet’s climate and ecology. The balance between protecting our world and ensuring that we may still be so productive as to offer the poor nations of the world the same promise we took hold of in the last century is delicate. We may face escalating challenges from increasingly resistant pathogens. Many of the technologies we are now exploring – from gene editing and genetic modification of foodstuffs to artificial intelligences – carry immense potential…and uncertainty. And no matter how far our science may advance, we can never bury the road to serfdom brought on by the occasional circumstances in history that have so often compelled societies to vest their power in authoritarian governments.

And yet, on balance the World of Reality is, by any comparison to a world that has existed for human beings, a paradise.

But there is another world, a world which is at once both imaginary and real. It is the World of Abstraction.

The World of Abstraction is a world awash in narratives and memes. It has always existed alongside the World of Reality, because many of those memes are hard-wired into the human brain, or else into human cultures as patterns and heuristics. But in only the last ten years, practically all of humanity has gained near-constant access to the megaphones of always-on news, internet-enabled mobile devices, and broad, multi-layered social media presence. The number of bi-lateral human interactions we have today is a fraction of the interactions we have in front of an audience. When we speak to each other, we speak to each other AND to the crowd of people watching.

The World of Abstraction is The Panopticon. A circular prison with clear glass walls, an invention of Jeremy Bentham to explore prisoner behavior under the conscious influence of the constant, silent knowledge of perfect surveillance. By everyone.

The picture the panopticon presents of the world – what we call common knowledge – isn’t just a fuzzy picture of the World of Reality, shifted slightly by the change in how we communicate knowing that the crowd is watching the crowd. It is something completely changed, affected not only by third- and fourth-level abstractions, but by individuals who recognize how to leverage this panopticon to shape that common knowledge. These are the people we call missionaries. This is how you will know them: they are the ones who tell us what something really means. Some are benevolent, or wish to be. Others are not. When a powerful enough missionary is committed to using this power to create the perception of an existential conflict, our World of Abstraction becomes what we have referred to as a competition game. A stag hunt, as it is referred to in game theory, in which the equilibrium is a bad outcome for everyone. Donald Trump has done this. The US Media has done this. Debating who came first or who is more ‘responsible’ is a vain enterprise, and in the now-typical recursively meta sort of way, part of the conflict itself.

The world’s present travails are not wholly the result of these missionaries and the narratives of which they are the purveyors, nor of the competitive game they spawned. That’s a Pollyannaish delusion, too. Humans have lied, murdered, cheated, stolen and been horribly unhappy for millennia. They will still do those things. We would still disagree with one another in the World of Reality, sometimes vehemently, and would find countless issues for which our differing value systems bring us to an unpleasant impasse. But I am convinced that the specific unhappiness about our current time and our current political environment is not driven so much by the state of the World of Reality, as by the World of Abstraction.

There is good news: the world we truly live in is the World of Reality, friends.

There is also bad news: our brains will do everything to convince us that we live in the World of Abstraction. And in a sense, our brain will be right. A paranoid delusion or a mind beset with depression may cause a person to see and perceive events, people and language other than they truly are, but the actions they take in response will be very real.

So it is for each of us.

Our hope need not be a vain gasp at the end of all things. Our commitment to kindness need not be a futile gesture. In the best case, our hope is a flag in the ground that tells other people, “I am willing to look like a fool in the World of Abstraction. Come look like a fool with me and see the world for what it is.” If enough people rally around the flag and reject the narratives of this competition game, even the ones that feel right to us, even the ones that help our values to win some battle or other, I believe it can be defused. I may be naïve. Or maybe I’m right, and it is possible, but we don’t succeed.

That’s OK. Even then, in the worst case, hope and kindness and a commitment to good faith will be a necessary guide to a functioning civil society, if and when the competitive game causes us to do what competitive games tend to: fall apart.


Inflation Monitor – 10.31.2018

  • After several months of increasing cohesiveness around an inflation-is-coming narrative, attention to the topic has been tapering in early Q4
  • Right now we think this has more to do with the distraction created by declining equity markets, but this could change
  • Employment and unemployment discussions have been increasingly tied to inflation news in Q4, but otherwise the mix of topics has remained fairly consistent
  • Inflation-related topics are being linked much more strongly to financial markets (or at least in more volume) in the US than anywhere else in the world at this time
  • Sentiment is almost always negative for topics like inflation, but we think that the early 2018 “inflation and rate hikes are coming” narratives flipped most of the financial markets-focused media into more consistently negative language. See also Central Bank Omnipotence.

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention

Source: Quid, Epsilon Theory

Fiat News Index

Source: Quid, Epsilon Theory

Sentiment Index

Source: Quid, Epsilon Theory

Key Articles

Bank of Korea’s Tricky Interest Rates Decision Gets Trickier

ETF Investors Are Rewriting the Rules for Interest Rate Hedging

ECB keeps policy unchanged even as growth wanes

Powell Says Fed to Keep Hiking at Gradual Pace Amid Solid Growth

Turkish economy normalizing after ‘attacks’ from abroad: Finance Minster/CNN Turk

U.S. spending rises; income posts smallest gain in over a year


Central Bank Omnipotence Monitor – 10.31.2018

  • The narrative of coordinated global central banking policy has been restrained for an extended period, including most of 2018.
  • After a brief rise along with inflation fears earlier in 2018, we think stories and research have settled into clusters around three active central bank narratives with modest internal cohesion: (1) “US equity and bonds markets expect a gradual pace of rate hikes”, (2) “BOJ and PBOC are concerned about trade but markets expect a light hand of intervention” and (3) “Italy, bad debts and disappointing growth are going to drive policy for the ECB.”
  • Notably, we do not observe a dominating narrative in media that “The Fed Will Save Us” or “The Fed Must Save Us” in the same way that we observed after equity drawdowns in recent years. 
  • After entering the year with a certain indifference to central bank coverage, however, reports became increasingly dour over the course of the year. We think this is primarily a reflection of the generally greater concern by this universe for equity and bond market performance over inflation concerns.
  • We also note that “rates will help savings and attract young people back to traditional banking” stories were surprisingly central and connected to highly varied topics / clusters. This is new and worth monitoring as part of an inevitable financials rotation story from sell-side sources.

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention

Source: Quid, Epsilon Theory

Fiat News Index

Source: Quid, Epsilon Theory

Sentiment Index

Source: Quid, Epsilon Theory

Key Articles

Speculative Edge of Stock Market is Where Rate Angst Could Bite

Global Markets – Shares bound as bulls fight back at end of brutal October

Stock market bears have their best chance in nearly four months to cut into the bulls’ 2018 lead

Student debt can ruin your dreams of being your own boss

ECB’s Coeure Still Sees Need for Stimulus, Seeks Fiscal Reforms

Italy faceoff is not expected to derail the European Central Bank’s message to markets


Trade and Tariffs Monitor – 10.31.2018

  • While it is only a single data point, our October attention measure rose from its very low base over the prior three months. Our aggregate rolling measure of that attention remains low.
  • Similarly, sentiment and language in articles about Trade and Tariffs have continued to be very negative in comparison to more benign and technocratic coverage of the issue in late 2017 and early 2018.
  • The sub-themes that are being most attached to markets, positioning and stocks are also the ones that have emerged with the strongest connectivity to all other themes: National Security. We think this is important. By attaching trade and tariff issues with China to territorial disputes, IP and cybersecurity, narratives here could take on a lot more influence in the minds of allocators and investors.
  • While our measures of fiat language and advocacy journalism rose in the February/March concern about tariffs, we have not yet observed that in the most recent uptick. 

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention

Source: Quid, Epsilon Theory

Fiat News Index

Source: Quid, Epsilon Theory

Sentiment Index

Source: Quid, Epsilon Theory

Key Articles

Asia shares bounce after rout, but sentiment fragile

Harley-Davidson posts largest profit beat in two years, Europe sales rise

Stand together, Britain’s May calls for unity on Brexit

Wall St. cuts losses as investors snap up shares

Powell: U.S. outlook “remarkably positive” with low unemployment, tame inflation

Trade retaliations against the U.S. hit Canada farmers, too

America’s global trade war finally arrives at the WTO as members dispute US tariffs


US Fiscal Policy Monitor – 10.31.2018

  • After climbing as usual (and, we think, in more muted fashion) in connection with mid-term elections, attention to US Fiscal Policy narratives ticked down modestly in October.
  • We are not observing higher than usual fiat news or advocacy journalism effects, although we note that the aggregate level of fiat news for fiscal policy topics is very often much – between double and triple – that of similar topics we track. 
  • The tone and sentiment of topics has continued to plummet in the lead-up to elections, which we anecdotally attribute to coverage of political rhetoric, attack advertisements and the like. We expect this to recover following elections, but would be focused on potential import if sentiment remained as negative as it is today. 
  • While attention is high for the elections – stories are reporting many of the same themes – if anything, the narratives around US Fiscal Policy appear to be anti-austerity rather than anti-deficit. The most central topics are not market debt fears or spending levels, but rather inequality and funding of education, health care and disaster services at the federal level. 

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention

Source: Quid, Epsilon Theory

Fiat News Index

Source: Quid, Epsilon Theory

Sentiment Index

Source: Quid, Epsilon Theory

Key Articles

Lower For Longer Is No Longer Certain

The Credit Cycle is On the Turn

The Credit Crunch Cometh

Are Republicans seeking to get rid of Medicare, Medicaid and Social Security?

No, Trump’s Tax Cut Isn’t Paying for Itself (as Least Not Yet); News Analysis

The U.S. Economy is Booming. So Why Is The Federal Deficit as its Highest Level Since 2012?


Credit Cycle Monitor – 10.31.2018

  • While articles including key credit terms continued to rise in October, their internal coherence continued to fall. This means that stories tended to cover individual countries, regulators, companies or debt markets without explicitly or implicitly identifying connections between them. 
  • Even within similar topics, articles varied between reviews of compressing spreads and strong lending markets and a new group of articles exploring potential risks for these funds going forward, especially in CLOs and leveraged loan topics. 
  • While it is a narrow data point, we have seen a small up-tick in fiat news and advocacy journalism in a topic that is already fairly well-populated by such pieces. 

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention

Source: Quid, Epsilon Theory

Fiat News Index

Source: Quid, Epsilon Theory

Sentiment Index

Source: Quid, Epsilon Theory

Key Articles

More house prices falls look likely unless regulators intervene

IL&FS fallout: Finance firms face fund crunch

Italian banks caught in vicious circle as bond spreads hit danger threshold

There is a new IMF in town and it’s called China

Ameritech Financial: Could Almost Half of Student Loan Borrowers Be in Default by 2023?

Asset Gatherer versus Asset Manager: What Happens When a Core Bond Strategy Gets Too Big?


Stalking Horse

Livre de Chasse (1387)
Neel Kashkari

That illustration above is from one of the most influential books in the world, Livre de Chasse (Book of the Hunt), constructed by Gaston III, Count of Foix between 1387 and 1389. Gaston, more popularly known as Phoebus, was the preeminent hunter of his day, and this illustrated manuscript, presented with great acclaim to Philip the Bold, is an amazing compendium of every hunting technique that man has developed over the thousands of years we have hunted beasts.

This illustration shows the hunting technique of the stalking horse.

That photograph of the rather intense young man is a 2006 picture of Neel Kashkari, who was then the Assistant Secretary of the Treasury under Hank Paulson, and who is today the President of the Federal Reserve Bank of Minneapolis. Kashkari recently wrote a well-publicized opinion piece in the Wall Street Journal, calling for the Fed to stand down from its program of interest rate hikes.

Neel Kashkari IS a stalking horse.

What is this hunting technique? I’ll let Jeremiah Johnson and Bear Claw explain.

[Jeremiah and Bear Claw hunt a big elk buck]

Jeremiah:  Wind’s right, but he’ll just run soon as we step out of these trees.

Bear Claw:  Trick to it. Walk out on this side of your horse.

Jeremiah: What if he sees our feet?

Bear Claw:  Elk don’t know how many feet a horse has!

– “Jeremiah Johnson” (1972)

Elk don’t know how many feet a horse has. 

Neither do we.

Or for a different sort of example, I’ll Let Vito Corleone explain.

“Tattaglia is a pimp. He never could have outfought Santino. But I didn’t know until this day that it was Barzini all along.”

Tattaglia was a stalking horse. Barzini was the hunter standing behind him.

A stalking horse is a familiar presence that a hunter hides behind in order to get close to his prey. And when WE are the prey, the stalking horse is almost always a familiar Narrative or Abstraction, to use the Clear Eyes, Full Hearts lingo, presented by a familiar Missionary

Just as the elk is hard-wired to trust a horse standing in a field no matter how many legs it has, so are we hard-wired to trust, say, Kevin O’Leary appearing on CNBC no matter how many conflicts of interest he has.

I mean … we all know that it’s weird that CNBC has Kevin O’Leary on to talk about everything under the sun. It doesn’t feel quite right to us elk. And yet there he is again. Hmm. I guess I’ll listen to what he’s saying. Hmm. Well, I guess that certainly sounds convincing. He certainly says it with confidence and conviction.

You know what my number one tell is when I’m trying to figure out if a financial advisor is actually just an elk dressed up in human clothes?

CNBC is playing non-stop from the TV hanging in the corner of his office.

And yes, it’s always a him.

Every Missionary – meaning every famous politician or central banker or investor who appears on CNBC or CNN or Fox – understands perfectly well how we are hard-wired like elk.

And every status quo institution – meaning every large corporation or political party or government bureaucracy – they know it, too. They stand behind their Missionaries and their familiar-sounding words and messages in order to hunt down their true quarry without spooking anyone. And by anyone I mean us. This is how the Nudging State and the Nudging Oligarchy work.

How is Neel Kashkari a stalking horse?

He’s a familiar Missionary presenting a familiar narrative. The Fed’s monetary policy is all about helping Main Street. The Fed should pause on any more interest rate hikes “to allow as many Americans as possible to participate in the recovery.” If the Fed continues “tapping the brakes”, then the primary impact will be “restraining wage growth.” 

This is not a lie.

But it is not the truth. It’s not even a half-truth. It is a cartoon of populism broadcast as a promoted opinion piece in the freakin’ Wall Street Journal. It is a constructed one-tenth truth in service to the interests of two of the most powerful hunters on earth – Wall Street and the White House.

Why are Wall Street and the White House freaked out over the Fed’s interest rate hikes? Because they’re worried about getting “as many Americans as possible to participate in the recovery”? Bwahahahahahahaha!

NO. They’re worried about the stock market going down. Period. Full stop.

The most direct threat to rising financial asset prices is the Fed and their interest rate hikes. It’s the most obvious Horseman of the Investment Semi-Apocalypse, and it’s what Wall Street and the White House desperately want to stop. But they can’t just come out and say, “hey, c’mon guys, we need to juice the stock market here before we have an election and year-end bonuses!” because that would be … you know, an unpopular thing to say. So let’s get good old old Neel Kashkari, who for all I know actually believes that this one-tenth truth he’s writing is the whole truth, and let’s put him out front as our stalking horse. I mean, it wouldn’t be the first time that Neel Kashkari has been a stalking horse (cough, cough … Hank Paulson and TARP). Or the second time (cough, cough … PIMCO and equity mutual funds). Or the third time (cough, cough … California Republican Party and the 2014 governor’s race).

Look, I’m not saying that we can be anything other than elk. We’re not going to change the power dynamics of the hunter and the hunted. But we can be wary elk. We can be survivor elk.

We can see our world differently, looking through the familiar narratives and abstractions to see the powerful interests hiding behind those narratives and abstractions.

Clear eyes, friends. Clear eyes.


It’s Twue, it’s Twue!


We are rapidly accelerating toward mid-term elections that will be described as the most important in our lifetimes (until the next election, that is), and the ones that will decide whether our Democracy lives or dies (until we miraculously survive until the next one, that is). What that means, of course, is that we should all expect to be subject to peak fiat news. For the uninitiated, fiat news is a term we use at Epsilon Theory to describe news which does not include incorrect facts (i.e. we aren’t talking about fake news), but which treats statements, analysis and conclusions as facts themselves, usually because they were derived from those facts.

In short, it’s news that tells you how to think about something, instead of giving you the tools to make up your own damn mind.

Reuters, a good service and not the one I would usually peg for this kind of thing, published a textbook, innocent-looking example of what we mean by fiat news this morning. The headline is just glorious: “Elections could put Wall Street’s favorite lawmaker in top finance role.” Now, typically I’d counsel withholding judgment on the story itself until you read it. After all, headline writers looking for clicks (and their bosses badgering them for clickworthy headlines) can be a bit overzealous. But I’ll spoil the surprise: The lede uses the same language.

Let’s be fair. There is obviously nothing inherently wrong about using the term Wall Street. It can be a loaded term, but it is also a useful term. It’s more specific than “the financial services industry” and also has a more expansive definition that can go beyond specific companies and individuals to convey its lobby, its government influence and the like. Furthermore, assuming that people have the same understanding as we do of a loaded term is a recipe for counterproductive interactions. Full Hearts.

But the context for a loaded, pointed and intentional use of the expression “Wall Street’s favorite lawmaker” is compelling. Mr. Luetkemeyer’s sources of campaign funding are the focus of the article. They are linked (along with the potentially loaded language), to his rise to the Chairmanship of the Financial Services Committee and to his policy views. Congresswoman Waters, on the other hand, is referred to as a “vocal Wall Street critic”, with little in the way of exploration of any funding-related inducements that might guide that view. On this basis alone, it doesn’t seem at all unreasonable to guess that “Wall Street’s favorite lawmaker” was consciously or subconsciously used as a pejorative – and expression of opinion as fact.

When pressed, I suspect that the authors would contest that, and defend the assertion as being exactly that: a fact. After all, look at what the Center for Responsive Politics data says about donations from commercial banks. It’s true, it’s true! Maybe there’s a bit of poetic license here in calling this candidate ‘Wall Street’s favorite lawmaker’ just because commercial banks gave him the most money this cycle, but is that so bad? No. It’s worse. The problem is that CRP’s definition of ‘Commercial Banks’ isn’t ‘Wall Street’, something Reuters and the authors – both of whom are actually quite effective journalists who have written some dazzlingly good pieces – know quite well. It doesn’t take much digging to start calling the narrative here into question. Five minutes at the CRP website is enough. I wonder what it would say if we started with the CRP industry categorization that best aligns with what most people on Wall Street would call ‘Wall Street’: Securities and Investment Firms.

Oh. OH. That’s not the right story. OK, change the channel, change the channel. HEDGE FUNDS!

“(Annoyed Grunt)” What I meant to say was Venture Capital!

No, I didn’t say “Venture Capital!” I said “Bend your cap a little.” The flat bill look is way too Gen Z. What I really meant to say was Investment Management Companies and Private Equity. I’m just SURE he’ll show up here, in the category I really meant. 

Hey, would you look at the time?

First of all, people’s definitions of ‘Wall Street’ differ, but basing the central narrative of a news story on a cherry-picked definition that didn’t include at least the firms in CRP’s Securities & Investment category is complete nonsense. Not including the other categories is more or less forgivable depending on your perspective. Part of the Full Hearts responsibility for all of us means recognizing that this could have been an honest mistake. The people who wrote this story are good journalists. One of them covers the financial regulator beat as well as anyone. But when we are reading financial news, it is imperative that we look at loaded words like “Wall Street’s favorite lawmaker” with Clear Eyes and Full Hearts. Clear Eyes to understand that intentional and unintentional bias creep into articles that would tell us how to think about an issue. Full Hearts to recognize that sometimes words are just words, and that we’ve got to have some grace for the natural way in which each our subjective views creep into analysis that we would like to present as objective.

If you’re following along at home, this is our running guide to fiat news and how to spot it:

  1. Ask “Why am I reading this NOW?”
  2. Look for the tells of fiat news: “but, because, therefore”
  3. Be on guard for overdetermination and overconfident attribution of causality.
  4. Look at loaded words with Clear Eyes and Full Hearts

An Ocean of Indifference


If I tried to imagine the public as a particular person…I should perhaps think of one of the Roman emperors, a large well-fed figure, suffering from boredom, looking only for the sensual intoxication of laughter.

Søren Kierkegaard in The Present Age (1846)

From time to time, readers point out to us that when we explore individual stocks and investments, we tend to focus on stocks that are more obviously in the news. Mea culpa. In our defense, it’s usually more interesting, and it helps us to demonstrate narrative patterns more clearly. It is also true that not all stocks and investments are equally influenced by narrative. But even that can be useful to know. Especially for those of us more attuned to value investing.

As always, the reason it is useful relates to investor behavior. We think that the absence of clear narrative is often indicative of complacency or conditioning. When a stock has performed consistently well or poorly over an extended period of time, it is natural for the attention paid to the drivers of the company’s returns and results to wane.  The missionary’s job is done, so to speak. When the owners of a positively trending stock become complacent, the logic goes, bad news is often shrugged off and ignored more than it would be for a comparable stock. Likewise, for a stock or company stuck in a long-term rut, investors may become so conditioned to a continued stream of lousy news that green shoots pass by with a corresponding kind of under-reaction effect.

To value-with-a-catalyst investors, these are archetypal opportunities: companies which have regained some operating momentum, but for which active price setters in the market are too conditioned to malaise to update their views as much as they ought to. Figuring out the catalyst is its own challenge, but identifying the signs of conditioning and malaise? Here’s what they look like in narrative space:  

Source: Quid, Epsilon Theory

You can probably guess which company this from the tags, but in case it isn’t familiar, this is the narrative map from the last 3 months for General Electric. Folks, this is what an ocean of indifference looks like.

Like many industrial conglomerates (which it still is, even if less conglomerated than it once was), GE has products and businesses in far-flung markets. In addition, as you might expect, market research and consulting firms constantly publish commentary and discussions of those segments, products and businesses. So while there are people – wonks and people trying to sell slides for decks to banks and competitors, mostly – who care deeply about what General Electric is doing, the Financial media are not among them.

When financial media has written about General Electric lately, the central focus of the articles has been ‘the turnaround’, language used in almost every piece. Those articles include the kinds of things you’d expect in a turnaround: write-downs, cash flow questions and one-time charges. For obvious reasons, these ‘turnaround’ articles also bear a lot of similarities to articles about the recent change in CEO. And while there is a bit of humor to be had in how the tone of the articles about Larry Culp changed after a brief pop in the stock, the new CEO stories and the turnaround stories are part of one narrative, and really the only narrative being told about the stock right now. Both of these topics are, understandably, linked to GE’s languishing but critical GE Power business, struggling to deal with gas turbine demand that is far outstripped by global manufacturing supply. It is a big part of the mess Culp was charged with fixing.

But this is a surprisingly narrow set of topics for a company like GE. Tellingly, even the financial media reports that incorporate changes in ownership, or sell-side / buy-side participants talking about their opinions, are completely untethered to the fairly disinterested turnaround narrative. Aviation, healthcare, renewables, oil & gas and transportation are all pictured outside the frame. It isn’t that the sentiment attached to all of these topics is profoundly negative or anything. People just don’t seem to care. Beyond telling me that people have just given up and gotten bored, what else would this tell me?

  • I think it tells me we’ve now got a universe of investors who are well and truly conditioned to perma-turnaround GE.
  • I think now is the time I’d be looking more closely for signs of underreaction to good news on things I believed were potential positive catalysts…I mean, if they ever have any.
  • If and until that happens, the narratives strike me as being conducive to the current trend.

As a more general observation, we think that behaviorally oriented investors in a Three-Body Market would do well to more actively incorporate complacency and conditioning of market participants into their thinking. Price and market structure analysis can give investors some sense of those things. We think an understanding of narrative helps fill out much of the rest.


Oh, hell, Martha, go ahead and burn yourself if you want to.


It’s a famous story in Hunt family lore. 

Scene: The dining room of Ben Hunt (my grandfather) in Scottsboro, Alabama, circa 1939. Miz Hunt (my great-grandmother) actually rules the roost, of course, with Grace Hunt (my grandmother) learning the art and science of imperious Southern control from the wings. My aunt Martha (8 years old) is the definition of hell-on-wheels, and my father, Bud (5 years old), is Le Petit Prince.

Yes, this is the Scottsboro of Scottsboro Boys infamy, where 9 African-American teenagers were falsely accused and convicted of raping two white women in 1931. I never knew this was a thing until I went to college. See “Letter From a Birmingham Museum” for more thoughts on that thread.

I wasn’t around for the Miz Hunt dinners, of course, but I doubt much changed from 1939 to 1979 and the dinners I remember. Multiple courses. Most of the day to prepare. Always in the big dining room with the leaves in the table and the tall chairs that had to be placed back up against the wall during the day. My grandmother, and I’m sure my great-grandmother before that, smoking her cigarettes and drinking a highball while cooking in that kitchen, standing in the dining room doorway while we ate, never sitting down herself until the very end of dinner.

Apparently, however, for this particular dinner in 1939, all of the adult Hunts and a few family friends were, in fact, sitting down at the table. There was some sort of baked dessert in the oven, and someone needed to go fetch it.

My grandmother Grace decided to send her daughter Martha to bring the dessert in for the table, admonishing her to be VERY, VERY careful because the oven was EXTREMELY hot.

Miz Hunt, who I imagine was more than a little perturbed that her daughter-in-law had taken it upon herself to send Martha to bring in the dessert, nevertheless relented, but repeated the warning. “Martha! You must be very careful. Do NOT burn yourself.”

Now my aunt Martha was … how to put this … a person who enjoyed the bright light of attention. No shrinking violet, she. So naturally what transpired was a back-and-forth routine where Martha would shout out from the kitchen how scared she was, and her mother and grandmother would shout back that she must be VERY careful and whatever she did, she MUST NOT burn herself.

At which point my grandfather, a large man who may or may not have had a glass of rye or three by this point in the evening, growled loudly, “Oh, hell, Martha, go ahead and burn yourself if you want to.”

Dessert was then served.

I have often thought about this story over the course of raising four daughters of my own, and I thought about it again when I received this email from a young ET pack member.

Hello Dr. Hunt,

I’ve been following your blog for about a year now and your writing and ways of viewing the world have really clicked with me. Thank you for providing all of this writing to me for free for so long, and I have recently decided to subscribe to the paid version for this month.

I do have a question for you that might seem a little strange since I think I’m a bit younger than your usual audience, (Second year in college)

You started my interest in investing and last summer and I interned at a fund doing quantitative research, which was fun and interesting but I still feel like I don’t have any discernible direction where I can commit to doing something for the rest of my life. I also spent many years before college working 40 hours a week while in school to be able to afford it so I don’t like the idea of me wasting that by spending so much time not knowing what I’m trying to get out of it.

Coming into college I wanted to work in politics, policy research or something similar and that led me to study political science and statistics, with an initial plan to go to law school if I could find a way to afford it but I go back and forth on these ideas all the time and realize that I have very little clue. And while I enjoy the math and political science I learn, things like Epsilon Theory expose me to so many interesting things going on in the world that I have a hard time focusing on any one thing. So to sum it all up I am curious if you’ve ever written something that might relate to figuring out how you want to spend your life, or have any advice you could offer.

Thank you!


I could have written this exact same letter in my second year at college!

Seriously, word for word, that was pretty much me. And unfortunately for M., I no more have Answers for his questions now than I did for my questions then. Like everyone else in this world, I stumbled and bumbled my way through.

Looking back, though, I do have some strong views on a PROCESS to guide any younger person’s stumbling and bumbling through life. It’s a variation on the Clear Eyes, Full Hearts process, of course, but it’s more prescriptive and (appropriately, I think) avuncular. It’s also a good example of what a regret minimization strategy (as opposed to a reward maximization strategy) looks like.

In order, it’s this:

  • Build your intellectual capital.  I’ve known so many people in my life who have enormous intellectual horsepower, but who were in such a ferocious hurry to get somewhere that they never built their intellectual capital. So when they got to wherever they were hurrying … they had nothing to say beyond the narrow confines of their day job. And they knew it. It’s one of the most disappointing outcomes in life – to be very successful in your chosen field, but to find it AND yourself to be oddly empty. Can you catch up? Can you be a late-in-life learner? Sure. But just like losing 20 pounds on a diet gets exponentially harder the older you get, so does adding meaningfully to your intellectual capital. Build it NOW.  
  • Get your passport stamped. We live in a world of credentials. I’m not saying that’s a good thing or a bad thing. I’m just saying that it IS. The most important credential you can have today is some sort of degree from an elite university. It doesn’t matter if it’s an undergraduate or graduate degree, and I’m not going to argue with anyone about whether a school is “elite” or not. The second most important credential for a young person is a 2+ year stint with an elite institution in an elite city. Again, don’t @ me. There are work-arounds and effective substitutes for both of these credentialing mechanisms. But your path will be immeasurably easier if you get your Team Elite passport stamped NOW.
  • Train your voice. And use it. Again, it’s one of the most disappointing outcomes in life – to know that you’re a creative person, to have something Important that’s going to burn you up inside if you don’t share it with the world … but to lack the words or the music or the art to do so. In my experience, the unhappiest people in the world are mute creatives. To paraphrase Langston Hughes, sometimes they shrivel. Sometimes they fester. And sometimes they explode.
    Every creative person should start a blog to express and develop their art. Do not distribute it. Do not publicize it. Do not play the ego-driven Game of You. Erase it all every six months if that’s what you need to do, because odds are you have nothing interesting to say! But start training your voice NOW, because one day you will. 

And then there’s a fourth instruction – the most important instruction of all – which you can probably already guess from the set-up of this note. See, I can tell M. and I can tell my daughters what NOT to do until I’m blue in the face. Because I’ve burned myself on lots of stoves, personally and professionally, and I’d love to prevent M. and my daughters from making the exact same mistakes that I made. 

But they’re never going to be the exact same mistakes.

Burning yourself on a stove because you made a bad decision in the immediate game is getting the Answer wrong. It is an idiosyncratic event error specific to your life. There may be surface similarities to the node mistakes that I have made, and certainly we feel the pain of the burn in the same way. But my burns are my burns. Your burns are your burns. And that’s exactly how it should be. We all need some burns. But they have to be OUR burns.

Ending up in a less than satisfying life because you made a bad decision in the metagame is getting the Process wrong. It is not idiosyncratic to your life, but has been shared and endured by unsatisfied humans for thousands of years. It is not an event error. It is a category error.

Getting the Process wrong leads to an entirely different sort of regret than getting the Answer wrong. It creates profound regret, a regret that can’t easily be fixed without damaging yourself and damaging others.

I can’t advise you on the Answers. I won’t advise you on the Answers. But I will advise you on the Process. Because that’s what we do for our fellow pack members.

So hell, Martha, go ahead and burn yourself if you want to.

And you will want to. And that’s a good thing.


Innocent Monsters


“Another such victory over the Romans, and we are undone.”

Pyrrhus, from Plutarch’s Apophthegms of Kings and Great Commanders

 “What strange phenomena we find in a great city, all we need do is stroll about with our eyes open. Life swarms with innocent monsters.”

The Parisian Prowler, by Charles Beaudelaire (1864)

Ben and I have both been challenged by what to write about the events of the last week.

Writing about any of this in context of narratives can feel cheap, especially because of those who use the term to dismiss something as ‘a story that doesn’t fit my pre-existing views.’ There are eleven people dead in Pittsburgh at the hands of an anti-Semitic white nationalist. Two are dead near Louisville in an apparently racially motivated attack. At a nearby predominantly black church, there are many who now live knowing that the murderer was after them. There are political leaders and citizens, and hundreds of people who work for them, who now live their lives a little less freely, knowing they could have been caught up in the attempted pipe bombings. No one needs to read anything we have to write more than they need to sit in empathy for these people and their families.

It is also challenging to write about events like this for logistical reasons. We write about narratives, but narrative in our parlance is the cultivation of common knowledge, where a large group of people knows that they all know something. More often than not, that something is some several layers of abstraction away from what the thing actually is, or was. Establishing the existence of something like this takes time, and the events are fresh. But the seeds of those abstractions are there, and we are watching them grow in real-time. They aren’t pretty.

We are further challenged by the fact that the immediate aftermath of events like this exacerbates our emotional sensitivity. All of us. No matter how we write about this topic, some will think we are simply joining the fray when we should be above it. Others will think – a topic that will come up again – that by expressing a view, we make ourselves complicit in some tragedy. Fortunately, both of those views are bullshit and I don’t care. I’m going to do my best to tell you what I’m observing and how someone who believes in adopting Clear Eyes and a Full Heart ought to respond. So what am I observing?

The widening gyre is transforming all of us into innocent monsters.

I know this is a heavy charge. For posterity’s sake, let’s take a look at a network of the articles written about the mail bomber between the 24th and the 27th. We define this as news articles referring to ‘bomb’ and any one of the words ‘pipe’, ‘mail’, ‘Clinton’, ‘Obama’, ‘DeNiro’ or ‘Biden.’ Cluster names are mine.

Source: Quid, Epsilon Theory

The first thing that stands out is that – and this is common when examining evolving news over short periods of time – the stories cluster strongly on a time dimension. The colors in the chart above reflect when they were published, starting from blue hues on the 24th to red hues on the 27th.  The reason for this is intuitive: stories released at a particular time reference the events that have taken place so far, and include the statements and comments made by officials, victims and others recently. For this reason, it is almost – not completely, but almost – possible to simply read this network as beginning in the upper right on Wednesday and cascading around to the upper left by Saturday.

You don’t need the raw adjacency data here to see the center of this network, the topic that permeates and connects to nearly every other cluster. You can see it right now. False Flags, a cluster of both conspiracy theories and responses to them. Only slightly behind this cluster is the network of articles linked by statements by Hillary Clinton and Barack Obama telling Americans “to elect candidates who will try to [bring our country together]” and that the “character of our country is on the ballot”, respectively.

The gravity of this entire topic is formed around abstractions.

What do I mean by that? I mean the process by which we use things to stand in for other things even when the facts and a logical process don’t exactly allow us to make those intellectual leaps.

For many – maybe even most – on the political right, the story ceased to be about the story almost immediately. The story, you see, was really about the lengths to which shady left-wing political operatives would go to promote their cause and make Republicans look bad. It was really about the unbalanced treatment of left-wing and right-wing violence by a biased press. Even among conservatives who didn’t come out directly and embrace the false flag theory, most news outlets, pundits and commentators were on the defensive against any attempt to use the events to imply that this had anything to do with conservatives or Donald Trump.

For those on the political left, a story about mail bombs was just as quickly really about Donald Trump and what he had done to inflame people toward hatred and violence. Then it was about the MAGA movement. And then, in the wake of a further tragedy in Pittsburgh, we were three layers of abstraction deep, with noteworthy personalities from the political left not only implying, but directly attributing ongoing responsibility for all violent tragedies to anyone who would dare to vote for Republicans. Sure, we can pretend that isn’t really what Dan Rather is saying here, but everyone knows that everyone knows it is what Dan Rather is saying here.

This week’s events have provided a perfect synopsis of what I believe is the primary source of our widening gyre: a narrative from the political left that the members of the political right are irredeemably committed to an ‘environment of hate’, and a narrative from the political right that the media and academy are committed to a ‘maliciously dishonest’ scheme to influence how citizens think about social and political issues. These are the narratives that will govern all future engagements.  

These two narratives have incredible meta-stability and incredible polarizing power, because almost any conceivable event serves to strengthen each side’s priors. When we posit the existence of an ‘environment of hate’, every act of violence or threat, every policy that can be seen to harm one party or another, regardless of its true relationship to Trump, conservative policies or the broad conservative masses, will be attributed to them by those attached to that narrative. When we posit the existence of a ‘maliciously dishonest media’, every report with tilted language, every news report sprinkled with obvious opinions, every columnist who tries to attach every regular guy with conservative principles to psychopaths of the far right, will be seen to confirm its existence.

The two narratives will continue to reinforce each other. We will want to believe – and we will be told to believe – that speaking truth to power! or the next election, the most important in our lives! will be the solution. Sometimes they are. This time they aren’t. The more every party tries to ‘win’ this Competition Game, the deeper and wider this gyre will grow. Even when we are right, we innocent monsters will make things worse. There is no Answer to this, but there is a process:

Clear Eyes and Full Hearts. Clear Eyes to recognize and grapple with underlying truths that lie beneath the layers of our opponents’ narrative about us. Full Hearts to hold our own narratives in abeyance while we engage one another in good faith.

Good faith doesn’t mean not arguing or debating. It doesn’t mean believing both sides are always equal. It doesn’t mean not holding people, policies or parties accountable. It doesn’t mean not being angry. Furious, even. It doesn’t mean not campaigning, and doesn’t mean avoiding acts of civil disobedience. It means a longsuffering willingness to believe what other people say about their intentions. Don’t get me wrong – good faith is a terrible electoral strategy. It is, much as we might like to pretend otherwise, also a terrible way to win in the court of public opinion. But if you think, like I do, that regaining a functioning civil society is more important than the likely tangible differences in any short-term political outcome, it’s our only way there.


Getting Out: A Godfather Story


“Just when I thought I was out, they pull me back in!”

It’s one of the most famous quotes in movies, as Michael Corleone rages in Godfather III over the assassination he narrowly avoided and his inability to steer the family into legit businesses.

Michael is what I like to call a coyote, someone who is VERY smart and VERY strategic. Actually, too smart and too strategic for his own good, what a Brit would call too clever by half.

That’s in sharp contrast to his father, Vito Corleone, who is no less smart and no less strategic, but is somehow far less conniving and far more beloved.

You see this difference in character most clearly in the deaths of Vito and Michael.

How does Vito Corleone die? Playing in his vegetable garden with his grandson. At home. Surrounded by life and laughter and plenty of bottles of Chianti.

Vito got out.

How does Michael Corleone die? Sitting in a stony Sicilian courtyard as two skinny dogs scurry around. Struggling to peel an orange. All dressed up and no place to go. Alone. Utterly alone.

For all his smarts and strategy and cleverness, Michael NEVER got out.

How did Vito get out, while Michael failed? I think it’s the whole too-clever-by-half coyote thing. Michael never trusted ANYONE in the way that Vito did. Michael was obsessed with finding the Answer, an impossibility in the game of organized crime. Or the game of markets. 

Michael was a maximizer.

Which is another way of saying that, like most coyotes, he wasn’t very good at the metagame.

Do you want OUT from the game of markets?

I do.  

Am I good at the game? Yeah. Do I enjoy it? Not really. I used to. But ever since Lehman it’s been mostly a drag. And that’s okay! The game of markets is a means to an end. It’s a really big, important game, but it’s only one of several big important games within the larger metagame of life and doing.

My goal in doing is to have a happy ending. I want the Vito ending, not the Michael ending.

How do we get there? We keep our eye on the prize – the happy ending – and we work backwards. We maintain our vision on the metagame and its outcome even while we play the immediate game.

My goal as an investor is NOT to maximize my investment returns or to maximize my personal wealth. That’s myopic thinking. That’s coyote thinking. That’s the sort of thinking that ruined Michael.

My goal as an investor is to minimize my maximum regret in the metagame. What is that maximum regret? Dying alone. Failing to protect and sustain my pack, both at the most personal level of family and the broadest level of humanity. Minimizing the risk of THAT is what drives my doing, in both politics and in markets. I want enough wealth to avoid the bad ending, not the most wealth I can possibly achieve, because going for the most wealth I can possibly achieve actually increases the chances of the bad ending.

You will NEVER get out of the immediate game, whether it’s the mafia game or the markets game, if you play that game as a maximizer. You will ALWAYS be pulled back in.

And yet, all of our dominant ideas about financial advice – ALL OF THEM – are based on the assumption that we are maximizers. Every bit of Modern Portfolio Theory – ALL OF IT – is based on assumptions of maximization. All of those Big Bank model portfolios that are handed down from on high every month – ALL OF THEM – are based on the assumption that we are maximizers. Worse, all of these ideas about economics and investing aren’t just based on the assumption that we ARE maximizers. All of these core ideas about financial advice are based on the narrative that we SHOULD BE maximizers.

The business of financial advice is hurting. We all know that. It’s hurting for its practitioners and it’s hurting for its clients. I think it’s hurting because the narrative of maximization, in both its descriptive and its normative forms, gives particularly poor outcomes when Things Fall Apart. It gives particularly poor outcomes when the gravity of a Three-Body System makes the ground beneath our feet quiver and shake.

In order to survive … in order to do better for clients … the business of financial advice needs a new narrative, one based on what truly matters for practitioners and clients alike in a world of profound uncertainty.

What is the new narrative for financial advice?

I think it’s regret minimization in the metagame rather than reward maximization in the immediate game.

I think it’s Clear Eyes and Full Hearts.

A new narrative isn’t just possible. It’s necessary. And it’s happening.


Notes from the Diamond #3: Everything Has Its Price


Trivia question #3 of 108: From how many ballgames was former Baltimore Orioles manager Earl Weaver ejected before the first pitch had been thrown?  Answer in main text.  

“Baseball has everything” – a former Yale baseballer (identified below) who sank into politics

Off the Wagon.  By all accounts, Paul “Big Poison” Waner was one tough sumbitch.  Like his younger brother Lloyd — known as “Little Poison” — Paul was also a fine ballplayer, despite or perhaps because of his heavy drinking.  In fact, Big Poison boozed so habitually that the team for which he played for most of his 20 years in the big leagues, the Pittsburgh Pirates, included an abstinence clause in Waner’s contract one year — a clause the team waived proactively within weeks of its adoption when Waner’s slumping performance suggested he played better off the wagon than on it.  Big Poison’s interests having been realigned with those of his employer, he went on to complete a playing career that landed him in baseball’s Hall of Fame.  Little Poison made the Hall of Fame too, having smacked enough hits that, when combined with his brother’s, put the Waners atop the list of siblings with the most total career hits, the most accomplished trios in major league baseball (MLB) history — the Alous and DiMaggios — not excepted.[1]

Paul and Lloyd Waner in 1932

Extremely Difficult.  Why didn’t Pirates management foresee that inducements aimed at enhancing Big Poison’s play would have the opposite effect?  Perhaps it should have.  But those of us who’ve spent substantial time negotiating performance-based incentives (PBIs) — as principals, agents or both — are perhaps more inclined than others to give Waner’s misguided overlords a break: excepting only rare cases in which principals and those working for them wield both uniform metrics for gauging success and uniform time horizons for assessing its pursuit, devising effective bonus schemes for highly trained professionals is extremely difficult.  Indeed, relative to other purely cerebral challenges in both money management and baseball, structuring incentives for such pros that do more good than harm on balance is the administrative equivalent of what the ballplayer who did it more reliably well than anyone in his own time or since (Ted Williams) called “the single most difficult thing to do in professional sports”: using a bat to hit baseballs thrown by major league pitchers.

To help younger players do at least passably well what he himself had done so expertly, Williams devised the colorful graphic shown here for his classic how-to book The Science of Hitting — essentially a payoff table denoting the probability that a skilled batsman like himself would notch a hit when swinging at a ball pitched into each of the 77 discrete positions comprising the strike zone for a batter of his size (i.e., seven balls wide, eleven balls high).  Beyond simply wanting to introduce this intriguing chart to readers who’ve not seen it before, I’ve included it here because the logic underlying it has aided my own work as an allocator over the years, informing decisions respecting the deployment of both human and financial capital as well as corollary choices respecting incentives for investment pros to whom I’ve entrusted clients’ capital or my own.  

Immutable Conditions. What lessons about incentivizing highly trained pros have I learned along the way?  Among others, I’ve learned that it’s essential to keep personality traits plus other immutable boundary conditions governing a given principal-agent relationship foremost in mind when structuring it, adjusting not merely tactics but strategies to suit such conditions.  Williams did precisely this in determining not merely how to apply his bat to a given pitch but whether to swing at all.[2] Of course, Teddy Ballgame (as Williams was known) didn’t publish the aforementioned bible for batters until after his playing career ended, either because he felt he was learning important new lessons about hitting even as his career wound down, or because Williams wanted to maximize his competitive edge until he hung up his cleats, or perhaps both.  Dunno.  What I do know is that I myself still have lots to learn about the art and science of structuring effective principal-agent relationships in money management; and I hope without knowing for sure that I’ll be engaged in such work for many years to come — if not until the anticipated Hall of Fame induction of the current Bosox player whom Williams likely would have most enjoyed mentoring, then at least through the end of what’ll hopefully be a storied MLB career for the player in question, a 26-year old wunderkind whose parents deliberately and presciently gave him the initials MLB.

How many more years will devotees of MLB (the game if not also the man) have the pleasure of watching Marcus Lynn “Mookie” Betts play before the mandatory five-year waiting period for his election to baseball’s Hall of Fame commences?  Again, dunno, nor does anyone, MLB the man not excepted.  More to the point of this note, to what extent has Mookie’s Williams-esque dominance of statistical measures of big leaguers’ output been the product of specific contractual incentives aimed at eliciting such results? I doknow the answer to that question, and reveal it below, after revealing a few (for now) of the things I’ve learned about the use and abuse of PBIs as a longtime student of both money management and baseball.

Readers looking for additional (or alternate!) sources of wisdom or experience on contractual arrangements in money management will find well-crafted papers on it by academics here, here and here, and by practicing accountants or attorneys here, here and here.

Thing 1 — Don’t Whip A Winning Mount.  Of the countless available photos of Hall of Famer Joe Torre — the only major leaguer to achieve both 2,000 hits and 2,000 wins as a manager — I chose the one included here for two reasons: (1) Torre appears not in the uniform he wore while leading the New York Yankees to the playoffs in 12 consecutive seasons but rather in the uniform he donned after telling the Yankees to take a hike; and (2) conveniently for me, Torre appears alongside another gifted manager on whom my second thingy (below) focuses.  Why did Torre swap Yankee pinstripes for Dodger blue in 2008?  He did so for several reasons, the decisive one arguably being Yankee management’s insistence that he swap a material portion of his base pay for the opportunity to earn certain performance-based bonuses: so many dollars each for winning divisional or league titles, or the World Series, were he to continue piloting the Yanks. Perfectly sensible, no? 

Try senselessTorre having already guided the team to nine divisional titles, six league titles and four World Series crowns as their manager, without any such discrete incentives having comprised part of his compensation.  In short, not only didn’t Torre neither want nor need such PBIs to do his best work, the mere suggestion that they form part of his contract insulted him to the point that he took his talents elsewhere, ultimately guiding the Dodgers to divisional titles in 2008 and 2009 en route to his 2,326th and final career win as a manager in October 2010.

The lesson for capital allocators in the Torre-centric tale just told?  Don’t assume money managers who prefer more stable pay constructs over those entailing potentially sizable but contingent bonuses lack the right stuff, with the latter defined broadly to include both the ability to do stellar work and innate confidence in their capacity to do so.  Believe it or not, some of the most skilled and trustworthy investment pros with whom I’ve worked and continue to partner are quite content to earn relatively stable incomes financed solely via asset-based fees, relatively being highlighted to acknowledge that asset-based fees on portfolios comprising volatile assets can fluctuate materially, especially if the capital being deployed emanates from clients with dispositions as volatile as the late Earl Weaver’s.  In his 2,540 games as manager of the Baltimore Orioles over 17 seasons (1968 – 82 and 1986), Weaver evinced enough angst about the proceedings to get himself ejected 91 times, including ejections from both games of a doubleheader three times and from two games before they’d even started.  I don’t know who had the privilege of managing The Earl of Baltimore’s money, but I don’t regret that I wasn’t part of what was likely a long and ever-changing line of such cats.      

Thing 2 — Don’t Underestimate Primal Needs.  Readers clued into the 2018 MLB playoffs now unfolding will be familiar with the neo-modern strategy known as bullpenning: reducing the edge that batters typically gain when facing a given pitcher multiple times by rotating hurlers more frequently than the typical 20th century manager or indeed 21st century starting pitcher would cotton.  I’ve labeled bullpenning “neo-modern” because no less a baseball sage than Hall of Fame manager Tony LaRussa deduced the merits of strict pitch counts a quarter century ago, putting them into practice as skipper of the Oakland Athletics in 1993.  Alas, as is true of many pioneers in money management as well as baseball, LaRussa was so early with his innovation —and so deficient in anticipating its corrosive effect on the karma of the players whose performance he sought to boost — that he was compelled to abandon bullpenning after a handful or so of games. 

Why did LaRussa’s strategy fail?  Because the 50-pitch limit it entailed made it nigh impossible for starting pitchers to meet MLB’s five-inning threshold for notching wins.  To be sure, as the analytics-laden execs inhabiting most MLB front offices and indeed dugouts these days would readily attest, LaRussa’s strategy indisputably enhanced his team’s odds of achieving its cardinal goal of winning as many games as possible.  But this same strategy conflicted squarely with the cardinal goal of the very people on whom its successful execution most relied: pitchers whose longer-term earnings prospects depended heavily on the number of wins they personally racked up.

Today’s Starting Pitchers Almost Never
Complete What They Begin

Why didn’t LaRussa have the As’ front office rework his pitchers’ contracts to achieve fuller if not perfect alignment of their interests with those of the ballclub for which they labored?  Prior to the sea change in labor relations in pro baseball unleashed by the de facto repeal of MLB’s so-called reserve clause in 1975, the As might have attempted if not actually executed such a paradigm shift, big leaguers being essentially beholden to the teams that employed them unless and until a team chose to trade a player for other talent and/or cash.  Since the advent of free agency for most major leaguers in 1975, however, a preponderance of such players and especially those lacking the 6+ years of MLB service on which unfettered free agency is preconditioned have focused less on dollars actually received under their current contracts than on dollars potentially received from their next contract, and the one after that (if there is one), and the one after that (ditto), ad libitum, until they hang up their cleats a final time.

It doesn’t take someone as bright as the Oakland pitcher who objected perhaps most strenuously to LaRussa’s platooning scheme, former Yale star and current MLB broadcaster Ron Darling, to understand why a preponderance of big leaguers — assumedly those below the MLB average age of 29 years plus older guys who sense their playing abilities are peaking — focus more on putting up stats that’ll impress potential future employers than on doing things that’ll merely help their current ballclubs win: in present value terms, earnings derived from contracts not yet signed typically dwarf those derived from current arrangements, an increasing fraction of which have so-called opt out provisions that enable players who perform especially well over a given interval to shift voluntarily from one team to another willing to pay them bigger bucks.

Thing 3 — Don’t Confuse Skill and Luck.  Why don’t MLB teams mitigate the misalignment of interests just described via baseball-oriented analogues to the two-part fee structures that institutional investors use so commonly to apportion financial risk between managers they employ and themselves?  Two and twenty, anyone?  C’mon now, if you owned the Red Sox (to pick a major league team at random) and could pay ace Bosox pitcher David Price $2 mill (sic) in base pay plus $20k for every strike he throws in regular season games in 2019, wouldn’t you prefer that gamble to paying Price the flat $31 mill his current contract specifies?  Inked in late 2015, that contract is the richest in baseball history for a pitcher, paying Price $217 million for seven seasons’ work, with an opt-out for Price after the 2018 playoffs wrap up.  Given Price’s generally strong but somewhat uneven performance since executing his current contract, it’s unlikely he’ll exercise his opt-out, and unlikely too that he’ll pitch well enough in 2019 to make him wish he’d negotiated the 2 and 20 scheme hypothesized above.  To be precise, if such a scheme were to be implemented for 2019, Price would have to toss 1,450 strikes to earn $31 million.  Possible?  Sure, Price having thrown 1,765 strikes in 2018.  Probable?  I’d take the under on that bet, fully aware that if our hypothetical “2 and 20” scheme were in place and Price were to throw the same number of strikes in 2019 as he did in 2018, he’d earn $37.3 million or 20% more than the $31 million the Bosox are legally obliged to pay him.     

In theory, as with contracts governing investment advisory services, there are countless ways of apportioning risks in MLB player contracts, the dollars to be paid on a guaranteed or contingent basis being infinitely adjustable and the metrics used to compute contingent bonuses being limited only by the imaginations of the parties involved or quant jocks employed by them.  In reality, however, just as parties to money management contracts are constrained by laws and regulations from apportioning risks as they might ideally wish, MLB players and teams are constrained in contract negotiations by an even thicker patchwork of constraints, including especially a Collective Bargaining Agreement (CBA) that prohibits player bonuses based on statistical measures of on-field achievements.

Interestingly and perhaps shockingly to some readers, such prohibited measures include not only traditional and familiar “stats” like a pitcher’s wins or earned run average (ERA), or a batter’s home runs or runs batted in (RBIs), but most elements of the large and growing universe of “advanced” stats that baseball wonks like yours truly enjoy tracking.  (See the table of selected stats for David Price below to get a general sense of how wonky this stuff can get.)  Why does MLB’s current CBA prohibit player bonuses based on statistical measures of on-field achievements?  It does so because bonuses of that sort would be highly susceptible to gaming — by team owners no less than players, teams being subject to salary caps that some owners sought to evade via bonus schemes so artfully drawn that MLB owners as a group adopted strict limits on such hijinks several years ago.  Of course, performance-based bonuses in money management are also highly susceptible to gaming, mostly by money managers as distinct from clients, the latter having few tools at hand to mess up incentive fee schemes outside of too-frequent calls and emails about recent returns that bring managers’ worst behavioral tendencies to the fore.

2008 Rays (A+) 4 0 0 6 6 34.2 9.61 1.82 0.00 0.311 80.0% 49.4% 0.0% 1.82 1.67 2.26  
2008 Rays (AA) 7 0 0 9 9 57.0 8.68 2.53 1.11 0.247 93.9% 57.7% 15.9% 1.89 3.98 3.19  
2008 Rays (AAA) 1 1 0 4 4 18.0 8.50 4.50 0.00 0.393 67.7% 52.7% 0.0% 4.5 2.93 3.76  
2008 Rays 0 0 0 5 1 14.0 7.71 2.57 0.64 0.205 79.4% 50.0% 6.7% 1.93 3.42 3.9 0.2
2009 Rays (AAA) 1 4 0 8 8 34.1 9.17 4.72 1.31 0.261 67.5% 42.0% 18.5% 3.93 4.66 3.57  
2009 Rays 10 7 0 23 23 128.1 7.15 3.79 1.19 0.268 68.5% 41.5% 11.1% 4.42 4.59 4.43 1.3
2010 Rays 19 6 0 32 31 208.2 8.11 3.41 0.65 0.270 78.5% 43.7% 6.5% 2.72 3.42 3.83 4.2
2011 Rays 12 13 0 34 34 224.1 8.75 2.53 0.88 0.281 73.3% 44.3% 9.7% 3.49 3.32 3.32 4.4
2012 Rays 20 5 0 31 31 211.0 8.74 2.52 0.68 0.285 81.1% 53.1% 10.5% 2.56 3.05 3.12 5.0
2013 Rays (A+) 1 0 0 2 2 7.1 14.73 3.68 0.00 0.267 71.4% 57.1% 0.0% 1.23 1.2 1.48  
2013 Rays 10 8 0 27 27 186.2 7.28 1.30 0.77 0.298 70.0% 44.9% 8.6% 3.33 3.03 3.27 4.4
2014 2 Teams 15 12 0 34 34 248.1 9.82 1.38 0.91 0.306 72.7% 41.2% 9.7% 3.26 2.78 2.76 6.0
2015 2 Teams 18 5 0 32 32 220.1 9.19 1.92 0.69 0.290 78.6% 40.4% 7.8% 2.45 2.78 3.24 6.5
2016 Red Sox 17 9 0 35 35 230.0 8.92 1.96 1.17 0.310 73.6% 43.7% 13.5% 3.99 3.6 3.52 4.5
2017 Red Sox (AAA) 0 0 0 2 2 5.2 12.71 3.18 1.59 0.524 39.7% 23.8% 11.1% 9.53 3.87 3.52  
2017 Red Sox 6 3 0 16 11 74.2 9.16 2.89 0.96 0.278 77.0% 39.9% 9.8% 3.38 3.64 4.2 1.6
2018 Red Sox 16 7 0 30 30 176.0 9.05 2.56 1.28 0.274 77.3% 40.1% 13.2% 3.58 4.02 3.95 2.7
Total   143 75 0 299 289 1922.1 8.68 2.32 0.90 0.287 75.2% 43.6% 9.9% 3.25 3.34 3.46 40.7

Selected Advanced Stats for MLB Pitcher David Price (courtesy of FanGraphs)

Wait: with so many well-schooled pros plying their trades in the money management arena, why haven’t the best among them devised bonus schemes not susceptible of gaming to an extent intolerable to any interested parties?  They have, I’d suggest, and will discuss such schemes in later notes.  That said, I’d also suggest that even well-engineered schemes tend to do more harm than good from a principal’s or client’s perspective when the metrics on which bonuses are based are ill-conceived.  The next note in this series will focus on such misconceptions, looking at them through the prism of the ongoing and unwarranted efforts by the world’s largest educational endowment to produce returns rivaling those produced by Ron Darling’s collegiate alma mater.  As we’ll see, if the powers-that-be at Harvard want to hold their own feet as well as those of the endowment’s hired guns to the fire in a manner that’ll truly advance the university’s long-term interests, they’d adopt metrics different if not radically different from those they’ve customarily employed to assess the endowment’s evolving performance. 

Room for Improvement.  Speaking as we just were of unconventional metrics, if one were designing an optimal bonus scheme for a big league pitcher like David Price and weren’t subject to the constraints on player contracts imposed by the aforementioned CBA, one would almost surely not use an imperfect measure like pitches hitting the strike zone as the sole metric on which bonus payments depend.  (Revisit the graphic at page 2 to imagine the pounding a big league pitcher might undergo if he hurled pitches only into the sub-zone framed by dotted red lines.)  Just as there are sounder metrics for assessing the evolving performance of Harvard’s endowment and indeed most institutional funds than the metrics currently favored by such funds’ overseers, so too are there sounder metrics than such familiar stats as wins or ERAs for measuring a pitcher’s skillfulness. 

Note that our focus here is skill or the lack thereof, as distinct from results per se, the latter obviously reflecting — in baseball no less than in money management — factors beyond the control of the performer being judged.  Interestingly and perhaps unsurprisingly given plummeting IT costs and the “big data” revolution they’ve helped spawn, baseball-obsessed statisticians have worked up in recent years a host of “defense independent” measures of pitching prowess, including some shown in the accompanying table dissecting David Price’s exertions (e.g., FIP and xFIP).[3]

Could analogous metrics be devised to help allocators do a better job of distinguishing skill from luck in money management?  Some investment pros would argue that they’re already being judged and indeed compensated via such enlightened metrics, e.g., the manager of a sector-focused hedge fund whose carry or incentive fee is based on the fund’s performance relative to a sector-specific benchmark, or the CIO of an endowment whose bonus depends on her fund’s performance relative to an agreed-upon “peer” group of institutional funds.  I don’t think such arguments are entirely without merit.  But there’s almost as much room for improvement in the methods used to evaluate investment pros circa 2018as there was for improvement in the methods used to evaluate baseball pros when the Sabermetrics revolution began in the 1970s.

Open Question.  We’ll leave open here a crucial question that later notes will address, namely whether and to what extent methods of evaluating investment talent superior to those most widely employed today might usefully focus on qualitative rather than quantitative factors.  Advanced analytics like those depicted above having become table stakes for MLB franchises since the 2004 World Champion Red Sox showed the world how powerful such methods can be, baseball’s best minds including perhaps most conspicuously former Bosox general manager (2002-2011) and future Hall of Famer Theo Epstein are increasingly focused on qualitative attributes when assessing players’ bona fides.  I mention this in closing by way of encouraging readers who find baseball stats unexciting to hang in there with these notes.  As much as I enjoy diving into such stats, I enjoy the game’s unquantifiable aspects even more.  And there are plenty of the latter, just as there are in money management.  In fact, I wouldn’t have pledged to crank out 105 more of these notes if what one lover of my chief avocation said about it didn’t apply equally to my chosen profession: “Baseball,” a former Yale baseball captain named George H.W. Bush once smilingly observed, “has everything.”     

On deck: the use and abuse of peer group comparisons in money management and baseball

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[1] Paul and Lloyd Waner notched 3,152 and 2,459 hits, respectively, for a total of 5,611.  The Alous racked up 5,094 hits in total: 2,101 for Felipe, 1,777 for Matty and 1,216 for Jesus.  The corresponding figures for the DiMaggios were 4,853 hits in total: 2,214 for Joe, 1,660 for Dom and 959 for Vince.

[2] Later notes in this series will explore the divergent ways in which the competitive edges of skilled pros in baseball and money management tend to evolve as their active careers in each arena unfold, with superstars in money management tending to enjoy the “magic of compounding” to a more pronounced and prolonged extent than superstars in the more physically demanding domain of pro baseball.  That Williams benefited from such “compounding” to a considerable and hence logical extent is borne out anecdotally as well as statistically, no more convincingly than with the tale of what unfolded after Williams walked on four straight pitches during a game against Detroit late in his career.  “Bill,” Detroit catcher Joe Ginsberg complained to home plate ump Bill Summers.  “Don’t you think that last ball was a strike?” “Mr. Ginsberg,” Summers replied.  “Mr. Williams will let you know when it’s a strike.”

[3] FIP stands for Fielding Independent Pitching, a stat as intuitively appealing to baseball junkies like me as it is needlessly complex to casual observers of the game.  Ditto for xFIP, which is shorthand for Expected FIP.  Wanna know more about such arcana?  I didn’t think so.  But if insomnia strikes and safer cures for it aren’t available, click into the Glossary section of FanGraphs and master as many equations as you can before your game gets called due to darkness.


Never Give Up Hope


I was re-reading Ben Hunt’s superb series Things Fall Apart in the midst of research for my own contributions to Epsilon Theory (Notes From the Diamond) and was struck by a potentially encouraging contrast between Ben’s dire appraisal of contemporary politics on the one hand and famed incidents in baseball’s past on the other: incidents suggesting that seemingly irreconcilable differences between the bitterest of foes can not only be overcome but inevitably are — often sooner than the persons (or “tribes”) involved could possibly have imagined.

Consider perhaps the ugliest on-field example of tribalism in major league baseball (MLB) history: San Francisco Giant Juan Marichal’s clubbing of Los Angeles Dodgers catcher John Roseboro during an August 1965 game between two teams whose respective fan bases loathed each other almost as much as did the warring parties in the Dominican Civil War raging in Marichal’s home country at the time.  Though hardly an excuse for the violence Marichal unleashed on Roseboro after the Dodgers catcher whistled a ball being returned to pitcher Sandy Koufax too close to his ear for Marichal’s comfort, Marichal’s extreme angst over the uncertain fate of loved ones back in the Dominican made him especially testy the afternoon he assaulted Roseboro. 

Marichal having another go at Roseboro as a horrified Koufax (far left) arrives 

For better or worse — and it admittedly took a while for the incident’s redeeming virtues to become manifest — another future Hall of Famer at San Francisco’s Candlestick Park that afternoon, Giants superstar Willie Mays, assumed immediately the role of peacemaker (“centrist” in Hunt-speak) after Marichal clubbed Roseboro, shielding the Dodgers catcher during the melee that Marichal’s assault unleashed and escorting a profusely bleeding Roseboro off the field to the Dodgers dugout for medical treatment.  Mays underwent pretty ferocious criticism from Giants partisans following the incident, as did Roseboro, of course, albeit not as ferocious as the scorn cast upon Marichal — by Dodgers fans and the broader public generally — for clubbing Roseboro.  Interestingly, and importantly for our purposes here, Roseboro as well as Mays ended up playing pivotal and supportive roles in Marichal’s eventual election to baseball’s Hall of Fame in 1983, three years after his initial appearance on a Hall of Fame ballot, and four and eleven years, respectively, after Mays and Koufax took their rightful places in Cooperstown during their first years of eligibility for the Hall. 

Willie Mays escorting John Roseboro to the Dodgers dugout

George Brett is a baseball Hall of Famer too, remembered by all serious students of the game as one of the greatest hitters ever — he’s the only MLB player in history to win batting titles in three different decades — and by even casual observers of the game as the chief protagonist in an on-field incident that ripened into an off-field battle involving two characters who fairly exemplify the anti-centrism that Ben critiques in Things Fall Apart.  The incident involved Brett’s bashing of a ninth inning home run off future Hall of Famer Richard “Goose” Gossage that seemingly gave Brett’s Kansas City Royals a 5-4 win over their bitter rivals at the time, the New York Yankees, in July 1983. 

George Brett tussling with umpires after his “pine tar” homer was nullified

As became clear during hearings conducted by American League president Lee McPhail that led ultimately to Brett’s acquittal (if you will), the bat that Brett used to take Gossage deep had more pine tar on its handle than MLB rules at the time permitted — a fact trumpeted endlessly by the attorney who represented the Yankees in a transparently frivolous lawsuit brought by Yankees fans upset that they’d been deprived of the privilege of watching the pine tar game’s final half-inning.  (The umps on the day had ruled Brett’s homer invalid and awarded the Yankees a win, thus ending the game — temporarily as it turned out — after the visiting Royals had “completed” their ninth inning at-bats.)  The attorney?  Roy Cohn — the rapaciously divisive lawyer who served as chief counsel to Joseph McCarthy during his ignominious witch hunt for Communists in US government in the 1950s and later as a key advisor to (gulp) Donald Trump.  Who was the other infamously divisive coot who played an important role in whipping up partisan emotions over the pine tar incident?  The Royals’ director of promotions at the time: Rush Limbaugh.  Perhaps unsurprisingly, Brett and Limbaugh remain on friendly terms, or so it is said.  It is said too that Brett and Gossage have become close friends since wrapping up their MLB playing careers (in 1993 and 1994, respectively).

How long will it take for partisans on both sides of the latest headline-grabbing incident in major league baseball to either reconcile their views of the incident’s fundamental properties or, at a minimum, agree to disagree agreeably (sic)?  I have no idea.  But I do have strongly held views of what happened when Red Sox outfielder Mookie Betts tried to snag a fly ball hit by Houston Astros star Jose Altuve during Game 4 of this year’s American League Championship Series (ALCS).  Obviously, fans interfered with Betts, and the umps involved were unarguably correct to rule the unlucky Altuve ”out” on the play (Ed Note: David’s views may not reflect the views of Epsilon Theory or its other writers).  Just as obviously, having been born as close to Boston’s Fenway Park as one could in the year of my birth (or indeed today) and still take one’s first breath in a well-equipped hospital, I’m rooting for my home town team to supplement its indisputably well-deserved ALCS triumph over the Astros with a win over the Dodgers in the World Series that commenced earlier this week.  I’m rooting too for the divisiveness in American politics and culture that Ben discusses in Things Fall Apart to fade, if not as rapidly nor as completely as did the enmity between John Roseboro and Juan Marichal following their famed encounter in 1965, then soon enough to keep the “center” from splintering wholly and irretrievably.

Fans interfering (sic) with Red Sox right fielder Mookie Betts during Game 1 of 2018 ALCS

Things Fall Apart (Part 3)


Download a PDF of Things Fall Apart (Part 3).

Listen to an audio recording of Things Fall Apart (Part 3).

Viktor Vasnetsov, “Four Horsemen of the Apocalypse” (1887)

Our story so far …

Things Fall Apart (Part 1) – in politics we have what Yeats called a widening gyre, where a steady stream of extremist candidates, each very attractive to their party base, pulls all voters into a greater and greater state of polarization, leaving a center that does not and cannot hold.

Things Fall Apart (Part 2) – in markets we have a black hole, where the massive performance gravity of passively managed U.S. large cap stocks pulls all investors into its clutches over time, subverting both the reality of and the faith in portfolio diversification.

But the polarized electorate and the monolithic market are not stable. We are governed by the Three-Body Problem, where multiple bodies that act on each other – like stars and their gravity or humans and their strategic interaction – form a system that has no general closed-form solution. There is no algorithm, no Answer with a capital A, that solves the Three-Body Problem.

Clear Eyes, Full Hearts, Can’t Lose – we may not have an Answer to predict what’s next, but we do have a Process to succeed with whatever comes next.

For every stock you buy and every vote you cast, the Process requires that you ask yourself:

  • What are the Narratives (story arcs) I am being told?
  • What are the Abstractions (categorizations) presented to me?
  • What are the Metagames (big picture games) I am playing?
  • What are the Estimations (the roles of chance) shaping outcomes here?
  • Am I acting to promote Reciprocity (potentially cooperative gameplay)?
  • Am I acting in a way that reflects my Identity (autonomy of mind)?

Ummm … hi, Ben, I’m not asking you to tell me what candidate to vote for or what stock to buy. But I AM asking you to show me how to apply this process to my real-world political participation and my real-world market participation, because that’s by no means obvious here.

It’s a simple question, Ben. WHAT DO WE DO?


In this conclusion to the Things Fall Apart series, I’m going to share with you what I’m doing with with MY political participation and MY market participation. You can decide if my application of the Clear Eyes, Full Hearts process makes sense for you, and in what ways. It’s a lot to describe, so I’m going to divide it up into two notes. This note will be about what-to-do in investing, and my next note will be about what-to-do in politics.

Okay … what-to-do in investing.

To set the stage for this I’m going to use a comic book quote. I know, I know … quelle surprise.

In the Sandman comics by Neil Gaiman, Dream of the Endless must play the Oldest Game with a demon Archduke of Hell to recover some items that were stolen from him. What is the Oldest Game? It’s a battle of wits and words. You see it all the time in mythology as a challenge of riddles; Gaiman depicts it as a battle of verbal imagery and metaphors.

Here’s the money quote from Gaiman:

“There are many ways to lose the Oldest Game. Failure of nerve, hesitation, being unable to shift into a defensive shape. Lack of imagination.”

I love this. It is exactly how one loses ANY game, including the games of politics and the games of investing … including the metagames of life. This isn’t just a partial list of how you lose any truly important game, it is a complete and exhaustive list. This is the full set of game-losing flaws.

  • Failure of nerve.
  • Hesitation.
  • Being unable to shift into a defensive shape.
  • Lack of imagination.

Of these four, lack of imagination is the most damaging. And the most common.

Neil Gaiman, “Preludes & Nocturnes” (1989)

In the comic, Dream and the demon Choronzon go through an escalating series of metaphors for physically powerful entities, culminating with Choronzon’s verbal imagery of all-encompassing entropy and Anti-life. Dream counters by imagining a totally different dimension to the contest thus far, by making the identity statement, “I am hope.” Choronzon lacks the imagination to shift over to this new dimension and loses the game, at which point he’s wrapped up in barbed wire for an eternity of torment.

What’s the point? The greatest investment risk I must minimize is not something that has already been imagined. It’s not a recession or a Eurozone crisis or a trade war or a bear market. No, my greatest risk is a failure of imagination in understanding how the game might fundamentally change.

So let’s put some meat on those bones. Here are the three great already-imagined investment risks that dominate today’s game of markets. Let’s call them the Three Horsemen of the Investing Semi-Apocalypse.

The Three Horsemen of the Investing Semi-Apocalypse

  • The Fed keeps on raising interest rates and shrinking its balance sheet, ultimately causing a nasty recession in the US and an outright depression in emerging markets.
  • China drops a trade war atom bomb by letting the yuan devalue sharply, sparking a global credit freeze that makes the 1997 Asian crisis look like a mild autumn day.
  • Italy and its populist government play hardball with Germany and the ECB in a way that Greece could not, leading to a Euro crisis that dwarfs the 2012 crisis.

Are each of these risks a clear and present danger for markets? YES.

Have I written A LOT about each of these risks? YES.

Will I write a lot more in future notes? YES.

Can you take steps to protect your portfolio from each of these risks? YES.

Should you take steps to protect your portfolio from each of these risks? MAYBE.

If any of these risks come to fruition, would you likely see a 20% decline in US equity markets? YES.

Would you be happy about that? NO.

Should you change your basic investment philosophy if any of these risks occur? NO.

That’s right. Even if the Fed or China or Italy totally blows up our cozy market, you don’t have to change anything in your fundamental investment philosophy. You can keep your 60/40 allocation. You can keep praying to the great god of diversification. You can keep your consultant. You can keep reading the same sell-side pablum. You can keep listening to CNBC blame “risk parity” for every down day. You can keep rejoicing at the big up days when central bankers save the day with their jawboning. You can keep your job, because everyone else will be just as smacked around as you are.

Why don’t you have to change your basic investment philosophy? Because these are VERY well-known and VERY well-discussed event risks. These are anticipatable event risks. There will be a light at the end of the (maybe very long) tunnel. Will it feel like hell? Yes, it will. But as the old saying has it, if you’re going through hell … don’t stop. Whatever you’ve been doing? Keep doing it. With enough time (and that’s the driving consideration for how much you must do to hedge or prepare for these Three Horsemen), you will survive the semi-apocalypse and come out fine on the other end.

Seeing the Three Horsemen of the Investment Semi-Apocalypse ride into town is not your maximum regret. You’ll live. 

But there is a Fourth Horseman. And it WILL require you to change your basic investment philosophy, because it IS your maximum regret as an investor.

There is a future that today’s common knowledge deems impossible, but I think is a distinct possibility. The Fourth Horseman doesn’t (necessarily) come with a 20% market decline. It may not be as directly painful as any of its three junior partners. But it will change EVERYTHING about investing.

The Fourth Horseman of the Investing Apocalypse

  • Inflation is not a cyclical blip and inflationary expectations are not “controllable” by the Fed without taking politically suicidal actions. They don’t commit political suicide, and the world enters a new inflationary regime.

It’s the only question that long-term investors MUST get right in order to minimize their maximum regret. You don’t have to get it right immediately. You don’t have to track and turn with every small perturbation in its path. But you MUST get this question roughly right.

Am I in an inflationary world or a deflationary world?

For the past 30+ years, we have been in a non-inflationary world. For the past 10 years, we have been in a deflationary world. I don’t mean that prices in lots of things haven’t gone up. I don’t mean that inflation hasn’t been a monster in many places. What I mean is that inflation expectations have been declining for 30+ years, and they have been rock-bottom for the past ten. What I mean is that for a decade now, all of our investment behaviors – and by all of us I mean everyone from the smallest individual investor to the Chair of the Federal Reserve – have been predicated on the belief that a) there’s no chance of future inflation for bad reasons (a currency that has lost the confidence of the world), and b) there’s no chance of future inflation for good reasons (robust economic growth). Instead, the most pervasive and powerful piece of common knowledge in investing is simply this: we are on a long gray slog to Nowheresville, a future of too much debt and not enough growth, a pleasant enough if thoroughly meh world.

Each of the Three Horsemen of the Investing Semi-Apocalypse will create a severe deflationary shock.

That’s why you don’t have to change your investment playbook for a Fed-created recession, a China-created credit freeze, or an Italy-created Euro crisis. You already know the deflationary playbook. It’s what you’ve been doing (or should have been doing) for the past ten years. Just keep doing THAT.

But if we enter an inflationary world, something that very few investors alive today have EVER experienced … well, everything you’ve been doing for the past ten years will be a mess. Your prayers to the great god of diversification, at least as that god is manifested today as the Holy Long Bond, will go unanswered. Your embrace of the cult of Vanguard, at least as that cult is expressed today as the worship of passive index funds, will give you pain rather than comfort. The very language that you use today to speak with other investors about core abstractions like Value and Growth will turn into gobbledygook.

Today’s common knowledge rejects this Fourth Horseman of inflationary regime change. But, but … demographics!, you hear. Don’t you understand that Demographics is Destiny™, that we are getting older and having fewer children, dooming us to the long gray slog? But, but … technology!, you hear. Don’t you understand that robots and AI are going to replace all us mere humans, creating a world where our bread and circuses just get cheaper and cheaper? Yeah, I understand. I hear these narratives and memes, too.

But that’s my point. We believe that we are in a deflationary world because we are TOLD that we are in a deflationary world. That’s the common knowledge. Everyone knows that everyone knows that inflation is dead and gone, that it’s a long gray slog going forward, forever and ever amen.

It’s hard to imagine when you’re immersed in it, but common knowledge can change.

That includes common knowledge of the fundamental inflationary/deflationary nature of our world.

I think it’s happening. I could be wrong. But that’s what I’m trying to imagine.

Here’s why I think we are witnessing the start of a sea change in our economic world.

Reason #1. Like I said, the Three Horsemen of the Investing Semi-Apocalypse are hugely deflationary in nature. Yet despite these well known and quite pregnant deflationary risks, inflation expectations are rising nonetheless. Want to imagine something? Imagine if one of these deflationary risks is resolved in a market-friendly way. Imagine what happens to inflation expectations and long-term bond yields then!

And these Three Horsemen WILL be resolved. One way or another, these event shocks always are. They may be resolved in a market-friendly way, or they may be resolved in a decidedly market-unfriendly way. It may be a miserable year or two or three for markets if any of these guys comes galloping through. But one way or another, this, too, shall pass. And what you need to be thinking about is … what then?

Reason #2. The three major narrative Missionaries for markets – the Fed, the White House, and Wall Street – are each beating the drums for inflation. They’ve all got their reasons. The Fed desperately wants to declare victory in its decade-long insistence that they can dispel the deflationary boogeyman, the White House desperately wants to grease the skids for a 2020 campaign by boosting asset price inflation and wage inflation any possible way they can, and Wall Street desperately wants both general asset price inflation and a good story about something to sell, what’s called a rotation trade.

I’ve written a lot about how we can use Natural Language Processing (NLP) technology to actually measure this beating of the drums, to actually create a visual presentation of the narrative and sentiment dynamics of markets. It’s what I call the Narrative Machine, and it’s at the heart of how we see the world at Second Foundation Partners.

I won’t repeat everything I wrote in April about the narrative dynamics of Inflation! in The Narrative Giveth and The Narrative Taketh Away, but I will give an update. The skinny of that note is that the narrative intensity in financial media accelerated dramatically in the 12 months ending April 2018 from the 12 months ending April 2017, that the narrative network map went from this:

Inflation Narrative April 2016 – April 2017
Source: Quid, Inc. For illustrative purposes only. Software used under license. 

to this:

Inflation Narrative April 2017 – April 2018
Source: Quid, Inc. For illustrative purposes only. Software used under license.   

Each of the thousands of dots in these narrative maps is a separate unique article from Bloomberg that contains the word “inflation”, filtered to eliminate articles specifically about inflation outside the US. The articles are clustered by the NLP AI on the basis of similarity in word choice and structure, and they’re colored by time of publication (blue is earlier, red is more recent). Like I say, to read more about the methodology you should start with this note or check out the Quid website, but the point here is pretty obvious: the frequency, centrality and intensity of the Inflation! narrative has picked up dramatically in the financial media sources that serve as the megaphone for common knowledge creation.

So here’s an update for the 12 months ending October 21, 2018, capturing the six months since the maps above were generated.

Inflation Narrative October 2017 – October 2018
Source: Quid, Inc. For illustrative purposes only. Software used under license. 

We’ve come down slightly over the past 6 months in narrative intensity for Inflation!, mostly because the narratives of Trade War! and Midterms! have gotten louder and have soaked up our finite attention, but this is still a drum-banging map, for sure.

Reason #3. As strong and as resurgent as the Inflation! narrative is today, the Budget Deficit! narrative is just as weak and fading. I’m going to present this narrative map without comment. It’s the sum total of the unique Bloomberg articles published over the past 12 months that contain the words “budget deficit” and have anything to do with the US government.

Budget Deficit Narrative October 2017 – October 2018
Source: Quid, Inc. For illustrative purposes only. Software used under license. 

Okay, a bit of a comment. 25 articles talking about the federal budget deficit versus 2,200 talking about inflation over the same 12 month period from the same financial media source. I am not making this up. There is ZERO narrative creation around austerity in the United States. ZERO. And as long as that’s the case, the political dynamic for inflationary debt-be-damned policies is unstoppable.

Reason #4. In exactly the same way that the Fed (and the ECB and the BOJ) spurred deflation with their zero interest rate policies, even though they thought they would accomplish just the opposite, so will central banks spur inflation now that they are raising interest rates, even though they think they will accomplish just the opposite. Why? Because it’s exactly the same driver for the “we got deflation when we thought we’d get inflation” phenomenon when the Fed was easing and the “we got inflation when we thought we’d get deflation” phenomenon that I expect now that the Fed is tightening.

The Fed’s singular goal in all of its extraordinary monetary policy decisions since the Great Financial Crisis has been to spur risk-taking from both investors (in the form of buying riskier assets than they otherwise would) and from corporations (in the form of investing more in plant, equipment and technology than they otherwise would). This is not a secret goal. This is the avowed purpose of quantitative easing and large-scale asset purchases and all that jazz. Of the two goals, spurring corporate risk-taking is far more important for our fundamental economic health and the Fed’s “control” of real-world inflation – either to get it moving or to slow it down. But this far more important goal of spurring corporate risk-taking DID NOT HAPPEN as the Fed created the most accommodative financial conditions in the history of man, because the Fed never imagined what the real-world response of corporate management would be.

The Fed suffered a failure of imagination, and as a result they are now risking their maximum regret – a world where they do not “control” inflation.

I wrote about this in July 2017 in Gradually and Then Suddenly, when the Fed was just starting its efforts to turn the monetary policy barge around from easing to tightening, and I wouldn’t change a word today. The money quote:

The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? Why in the world would management take the risk — and it’s definitely a risk — of investing for GAAP earnings when they are so awash in easy money that they can hit their pro forma narrative guidance by simply buying profitless revenue? Why in the world would companies take any risk at all when the Fed has eliminated any and all negative consequences for playing it safe? It’s like going to a college where grade inflation makes an A- the average grade. Sure, I could bust a gut to get that A, but why would I do that?

In the Bizarro-world that central bankers have created over the past eight years, raising rates isn’t going to have the same inflation-dampening effect that it’s had in past tightening cycles, at least not until you get to much higher rates than you have today. It’s going to accelerate inflation by forcing risk-taking in the real world, which means that the barge is going to have to move faster and faster the more it moves at all. I think that today’s head-scratcher for the world’s central banks — why haven’t our easy money policies created inflation in the real world? — will soon be replaced by a new head-scratcher — why haven’t our tighter money policies tamed inflation in the real world?

Okay, Ben, let’s say I believe you that the biggest risk to my investment goals is the risk that no one is currently imagining, and that a change in the inflation regime could well be that unimagined risk.

My question still holds. WHAT DO WE DO?

Here’s the trick. We’re trying to figure out a way to be responsive to our very real concerns about the Three Horsemen of the Investing Semi-Apocalypse, each of which is a severe but short-to-medium duration deflationary shock if it happens, against a backdrop of a potential long-term change in the fundamental fabric of our investing world, which is what happens if the inflationary Fourth Horseman comes to town.

To pull off this trick we need to think about the nature of time and the exclusivity (or not) of states of the world. We need to think really carefully about the path that our portfolios will take in a probabilistic world, and our inability to predict the outcome of a Three-Body System.

To pull off this trick we need to differentiate between the analysis we should use for questions of risk and the analysis we should use for questions of uncertainty.

A risk is something where we can assign some sort of reasonable probability to its occurrence AND some sort of reasonable assessment of its potential impact, so that we can calculate what’s called an “expected utility” … in English, so that we can talk meaningfully about risk versus reward of some action or decision. Of course we’re not 100% sure about these probabilities and assessment. Of course we can’t predict what’s going to happen in the future. But we can estimate the short-term future probabilities and we can constantly adapt to those changing estimations, if that’s what we want to do. To use Donald Rumsfeld’s oft-maligned but in-truth brilliant characterization, a risk is a “known unknown”.

An uncertainty is something where we either cannot assign a reasonable probability of occurrence OR its potential impact is so great that thinking in terms of probabilities and expected utilities and risk versus reward doesn’t make much sense. In Rumsfeldian terms, uncertainty is an “unknown unknown”, and historically the classic example of an uncertainty was whether or not you’d win or lose a major war. In modern times, the classic example of an uncertainty is global climate change. Hold that thought.

Modern financial analysis and modern financial advice is very proficient when it comes to decision-making under risk. In fact, that’s all it is. Everything that your consultant tells you is based on decision-making under risk. Everything that your Big Bank model portfolio tells you is based on decision-making under risk. Everything that Modern Portfolio Theory tells you is based on decision-making under risk. It’s all an exercise in maximization – maximizing your expected return over a series of risk vs. reward decisions – and that works out perfectly well if you have stable historical data and well-defined current risks. Less well if you have unstable historical data and poorly defined current risks. Cough, cough.

On the other hand, modern financial analysis and modern financial advice is useless when it comes to decision-making under uncertainty. Worse than useless, really, because you will get actively bad recommendations from an expected utility maximization machine (which is what modern financial analysis really is) when you apply it to questions of uncertainty. It’s like using a saw when you need a hammer. Not only do you have no chance of driving in that nail, but you’re going to damage the wood.

The Three Horsemen of the Investment Semi-Apocalypse are RISKS.

They’re poorly defined risks, and we’re going to talk about that, but a Fed-driven recession, a China-driven global credit freeze, and an Italy-led Euro crisis are, in essential form, risks rather than uncertainties. That means that the right tool kit for figuring out how to prepare and deal with them is basically the same tool kit that every advisor and investor has been using for the past 30+ years. You diversify your portfolio with long-dated government bonds, you pay a lot of attention to taxes and fees, and most importantly, you don’t lose your nerve. You don’t lose your nerve at the top by levering up, and you don’t lose your nerve at the bottom by selling out. You stay invested in markets with a steady level of risk, which is why I’m a fan of the investment philosophy that underpins volatility-adjusted cross-asset investment strategies … you know, what the witch hunter crowd calls Risk Parity.

What this means in practice for many investors, maybe most investors, is that the right thing to do to hedge their portfolio against the Three Horsemen is … NOTHING.

I know, I know … I’m talking against my self-interest here, but my strong belief is that almost all investors, especially investors with a long time horizon, are making a mistake if they actively hedge their portfolios in advance against poorly defined yet well known event risks. This, too, shall pass, or maybe it never even happens, or maybe it doesn’t happen the way everyone thought it would. I’ve seen waaaay too many investors (civilians and professionals alike) zig when they should zag, close the barn door after the horse is out, overpay for insurance, tie themselves into knots … I’ve got a thousand metaphors for misplaying prospective event risk with portfolio hedges.

Now what I DO think is advisable, though, is to react to event risk once it actually happens. What I DO think is advisable is to have a plan for what to sell and what to buy. What I DO think is advisable is to measure the dynamics of event risk as it happens and is converted into market-moving narrative, and use that as the trigger for the plan.

This is very similar to what a risk parity strategy does, which is why I like its philosophy so much. Risk parity reacts to a persistent event shock by selling the portfolio down as the realized risks go up. It’s not trying to predict what’s next. It’s not trying to create “alpha”. It’s trying to keep you in the game while also trying to keep you from being carried out. Endorsed! I think it’s the right investment philosophy for dealing with these poorly defined yet well known event risks, albeit in a (too) systematic and (too) blunt form. I think it’s possible to marry the reactive and profoundly agnostic investment stance of a risk parity strategy with narrative analysis and discretionary management.

That’s what I want to do with MY market participation.

What do you do about the Three Horsemen? You don’t hedge your portfolio in advance. You wait until the Horsemen actually ride into town. And then you play the Oldest Game.

  • You keep your nerve and embrace the game, because you are prepared.
  • You don’t hesitate to sell (or buy), because you have a plan.
  • You’re flexible enough to get defensive, because you know the game may go against you.
  • Most importantly, you can imagine what’s next, because you’re watching the market-moving narratives develop in real time.

This is our game for the next year or so, while preparing for the Fourth Horseman.

The Fourth Horseman of the Investment Apocalypse is an UNCERTAINTY.

And that requires a completely different tool kit, a completely different state of mind.

There’s an urgency to an uncertainty, if you believe it exists, that doesn’t pertain to a risk. The consequences of an uncertainty coming to pass in a bad form … well, that’s the maximum regret. That’s the path we MUST avoid. That’s the probability we MUST minimize.

I mentioned earlier that the best modern example of an uncertainty is global climate change, and I love the direct comparison to global inflation regime change. Both are unfalsifiable because neither generates any experimental hypotheses, both are unprovable in any sort of classical scientific fashion, and both are, in my opinion, true and real. I’ve found that reactions to one are predictive of reactions to the other. If you’re resistant to the circumstantial evidence for global climate change, I bet you’re resistant to the circumstantial evidence for global inflation regime change. I get that. It’s okay.

Both are BIG. I don’t think anyone rejects the stakes here. And that actually makes my task of suggesting what-to-do a lot easier. Because unlike global climate change and the policies put forward to slow down or reverse it, I’m not trying to reverse anything with global inflation regime change. I’m not suggesting big macro policies to prevent this, I’m suggesting personal investment policies to survive this! So long as you accept the potential stakes of an inflation regime change, I think it’s easier to contemplate the merits of taking steps to minimize the really bad ending.

Easier, but not easy.

Here’s what preparing your portfolio for an intrinsically inflationary world requires:

  • Your long-dated government bonds will no longer be an effective diversifier. They’ll just be a drag. I bet they’re a big portion of your portfolio today.
  • Highly abstracted market securities will be very disappointing. Even somewhat abstracted securities (ETFs) won’t work nearly as well as they have. You’ll need to get closer to real-world cash flows, and that goes against every bit of financial “innovation” over the past ten years.
  • Real assets will matter a lot, but in a modern context. Meaning that I’d rather have a fractional ownership share in intellectual property with powerful licensing potential than farm land.
  • The top three considerations of fundamental analysis in an inflationary world: pricing power, pricing power, and pricing power. I could keep writing that for the top ten considerations. No one analyzes companies for pricing power any more.
  • When everyone has nominal revenue growth, business models based on profitless revenue growth won’t get the same valuation multiple. At all. More generally, every business model that looks so enticing in a world of nominal growth scarcity will suddenly look like poop.
  • Part and parcel of a global inflation regime change will be social policies like Universal Basic Income. I have no idea how policies like that will impact the investment world. But they will.
  • Perhaps most importantly, the Narrative of Central Bank Omnipotence will be broken. Central Banks will still be the most powerful force in markets, able to unleash trillions of dollars in purchases. But the common knowledge will change. The ability to jawbone markets will diminish. We will miss that. Because the alternative is a market world where NO ONE is in charge, where NO ONE is in control. And that will be scary as hell after 10+ years of total dependence.
  • God help us, but there’s an argument for Bitcoin here.
Matthias Gerung, “Four Horsemen of the Apocalypse” (ca. 1530)

In practical terms, the greatest conflict between the portfolio you have today, the portfolio you’ll want if any of the Three Horsemen come around, and the portfolio you’ll want if the Fourth Horseman appears is in one particular asset class: long-dated government bonds. You have them today – a lot of them if you’re an institutional investor – and they’ve been great for you. You’re a little nervous about them today, but they haven’t killed you. You’ll be happy to have them if we get a deflationary shock from one of the Three Horsemen, very happy. But if the Fourth Horseman arrives, your long-dated government bond holdings will absolutely kill you.

How do we reconcile all this? Partly through time, partly through planning, mostly through a state of mind. Meaning this:

Today, your long-dated government bonds are a core holding. They should become a tactical holding.

I don’t mean that you sell them tomorrow. I don’t mean that you sell them next week or next month or next year. In fact, if we get a deflationary shock from a Fed-driven recession, a China-driven global credit freeze or an Italy-led Euro crisis, you’re going to want to buy more. This “tactical holding” will be a very large chunk of your portfolio. But make it a tactical holding. Make it something that you are willing to sell. Without hesitation. Without losing your nerve.

Henry Temple, aka Lord Palmerston, directed British foreign policy throughout the mid-19th century, when Britain was at the peak of its imperial power. Here’s his great quote:

Nations have no permanent friends or allies, they only have permanent interests. We have no eternal allies, and we have no perpetual enemies. Our interests are eternal and perpetual, and these interests it is our duty to follow.

It’s easy to mistake the ideas and the investments that have worked for us for 30 years to be permanent allies. They’re not. It’s easy to lose our imagination in considering what might work best for our interests, to cement allocations or asset classes as somehow sacrosanct to our portfolio. They’re not. It’s easy to confuse an event for a regime change. It’s easy to confuse a risk for an uncertainty. They’re not.

A change is coming, friends. It always is. But with clear eyes and full hearts we can achieve the ending we deserve. Or at least minimize the chances of the ending we don’t.




The dancers on stage are flopping around, dancing awkwardly in the absence of any music. They look uncomfortable as the Emperor Joseph II enters the rehearsal for the first performance of Mozart’s The Marriage of Figaro.

Emperor Joseph II: What is this? I don’t understand. Is it modern?

Kappelmeister Bonno: Majesty, the Herr Director, he has removed a balleto that would have occurred at this place.

Joseph: Why?

Count Orsini-Rosenberg: It is your regulation, Sire. No ballet in your opera.

Joseph:  Do you like this, Salieri?

Antonio Salieri: It is not a question of liking, Your Majesty. Your own law decrees it, I’m afraid.

Joseph:  Well, LOOK at them! No, no, no! This is nonsense. Let me hear the scene with the music.

Amadeus (1984)

Of all the investment strategies that force investors to hold their noses and take their medicine, we are most uncomfortable with those based on historical price movements. We know that they work, up to a point. And so we balance in our heads the ideas of participating in trends with some vague notion that we will make enough money doing so to compensate us for it all blowing up in our face one day. Alternatively we hope that we will be able to buck the trend before it reverses, whether through a contrarian analysis of price movements or some statistical model of investor behavior. Even when the models work, it can feel unsettling, like dancing a ballet without music.

Music’s exclusive function is to structure the flow of time and keep order in it.

Igor Stravinsky, as quoted by Geza Szamosi in The Twin Dimensions: Inventing Time and Space

In a Three-Body Market, narratives are the music. Understanding how they influence the structure and flow of price-trending behaviors is not a cure-all. But it can be a useful tool.

If you would dance, my pretty Count, I’ll play the tune on my little guitar. If you will come to my dancing school I’ll gladly teach you the capriole. I’ll know how; but soft, every dark secret I’ll discover better by pretending. Sharpening my skill, and using it, pricking with this one, playing with that one, all of your schemes I’ll turn inside out.   Se vuol ballare, signor contino, il chitarrino le suonerò, sì, se vuol venire nella mia scuola, la capriola le insegnerò, sì. Saprò, saprò, ma piano, meglio ogni arcano dissimulando scoprir potrò. L’arte schermendo, l’arte adoprando, di qua pungendo, di là scherzando, tutte le macchine rovescerò.
  • The Marriage of Figaro, by Wolfgang Amadeus Mozart from a libretto by Lorenzo da Ponte (1796)

If narratives are the music, we must be conscious of the musicians.

This is Part 4 of the multi-part Three-Body Alpha series, introduced in the Investing with Icarus note. The Series seeks to explore how the increasing transformation of fundamental and economic data into abstractions may influence strategies for investing – and how it should influence investors accessing them. 

  Economic Models Behavioral Models Idiosyncratic Models
Systematic Security Screening Econometric GTAATrend-Following
Value Factor Investing
Statistical Arbitrage
High Frequency  
Discretionary DCF / DDM / Price Target
Credit Work
Growth Equity
Relative Value
Asset Value
Sentiment Value + Catalyst Discretionary Macro
Other Trading Strategies
Activism Distress

Trend-following is an odd little corner of the market.

Well, not little, I suppose. When taken in the aggregate, trend-following strategies – by which I include all strategies which use historical price behavior as a primary component in determining current positioning – account for at least $400 billion, and some multiple of that in exposure. If we included all the momentum-inclusive quant equity strategies and related factor portfolios, too, we’re easily wandering into the trillions.

And yet it still has an uneven reputation.

It wasn’t long ago that the most reputationally aware institutional money (i.e. endowments and foundations) wouldn’t touch anything that looked like it was trading based on price movements. Some still don’t. It was considered this sort of uncouth thing, a place for daytraders and charlatans. The real adults were investors! Value investors, business buyers, participants in the process of setting the proper price of capital! It didn’t help, of course, that many of the go-go momentum shops of the late 90’s were pretty sloppy, or that many so-called trend-following strategies were just some guy drawing dumb lines on a Bloomberg chart. And then later getting a computer to draw dumb lines for him.

Now, the empirical premises of the most basic trend-following strategies are not really all that much in question. They work. The data are pretty clear that they work. Of course, don’t tell that to the professor at Wharton who taught me 18 years ago that technical analysis was only so much superstitious hogwash. And yes, as much as we might protest that the reversal pattern of long-term underperformers that DeBondt and Thaler identified in 1985 or the short-term trend continuation pegged by Jegadeesh and Titman in 1996 are different, it is still technical analysis, y’all.

So yes, it works. But investing because of how the price has moved doesn’t FEEL like investing, and this feeling is a hump that a lot of investors still can’t get over. It’s too simple. As it happens, a lot of professional investors are really uncomfortable telling their clients and boards that they buy things just because they’re going up and sell them just because they’re going down. This is a predictable outcome, given that many of those professional investors have sold themselves to their clients and boards on the basis of, y’know, not being the kind of poor sap who just does what everyone else has been doing.

And so it is that there are all sorts of stories about why trend-following and momentum strategies work that are meant to lend them credibility. Maybe it’s because dispersion of fundamental information takes time. Maybe it’s because we overextrapolate earnings growth. Maybe it’s because price trends are really just a proxy for intangible business momentum.  I’m sure there are many very bright people who earnestly believe these stories. Hell, they may even be right. But for my money, the simpler explanation – and to be fair, it’s one that is usually recognized by those proposing the other explanations – is the easier one. Things that go up feel better and safer, a natural emotion that we have institutionalized through Morningstar ratings, consultant buy lists, ‘approved lists’ and hyper-frequent portfolio reviews designed under the auspices of weeding out ‘bad investments’, by which we mean ‘investments that have done poorly over the last 12-24 months.’

The problem is that while most of us can get our heads around why price and performance trends ought to continue, we also know that they can’t and don’t continue indefinitely. We also know that, if value investing works, too – and it does – there’s a point at which our view probably ought to shift to an expectation of a contrary relationship between future returns and stocks with strong historical performance. As you might imagine, there are a lot of implementation choices here. In fact, I’m not sure there is a space that provides the potential for as much diversity in signal design as trend-following.

Lest you get too frightened (or excited), no. This isn’t going to be a survey piece. There are great primers available on trend-following, and I’m not going to write a better one. If you’re in the market for a survey course in investment strategies, AQR’s Antti Ilmanen wrote the Bible. I’d also add that if you aren’t following the work by Corey Hoffstein at Newfound Research, you may find it even more useful. He researches implementation questions in the open, and since doing is invariably the best way to learn, I suspect you will gain immeasurably from following along. I have.

If you do want to understand the smorgasbord of strategies which incorporate price as an input, I do have a small number of suggestions, none of which is groundbreaking, and all of which would be a standard part of the arsenal of questions to ask any trend, CTA, managed futures or systematic macro fund manager:

  1. Understand the difference between time-series momentum and cross-sectional momentum, and know which your managers are relying on. They perform more differently than you would expect.
  2. Understand time horizon diversity among the signals being used, and how you might expect those signals to work differently.
  3. Understand how non-price data is being used in models, as primary signals or conditioners.
  4. Understand how positions are sized, and how gross and net exposures are managed.

I’m not making recommendations here, but at their very likely great distress, I’ll also share the names of a few people who, in my experience, are preternaturally good at discussing the hows and whys of these strategies. And this is me suggesting, not them offering, y’all:

  • Ewan Kirk at Cantab Capital, to explain anything trend-following or managed futures.
  • Rob Croce at BNY Mellon (and in full disclosure, a former colleague), to sell you on the religion of pure trend.
  • Jason Beverage at Two Sigma, to explain shockingly complicated quant portfolio construction concepts in ways you will understand.
  • On anything on the shorter end of the time-horizon spectrum (where a lot of mean reversion strategies live), you will never go very wrong by asking your AQR rep for a chat with Michael Mendelson.

But again, the intent behind this piece – as with the rest of the series – isn’t to tell you how and why these strategies work. It is to discuss whether we think a more abstracted market with greater always-on awareness of what other investors are thinking and doing ought to change the way these strategies work. The short answer? Yes. It should also change the way some of the strategies are designed and incorporated into portfolios.

What we are NOT talking about is parsing the news for sentiment. Sure, tone and sentiment are a component of any narrative. But a lot of money has been spent by hedge funds and others over the last decade and a half to mine news for sentiment, first by building huge manual research teams in India, and later by assigning those tasks to computers. Most of those efforts have been huge flops. The relationship between narrative and price trends is different, and I want to show you why.

This foray will necessarily cover the relationship between narrative and trend-following more generally, and not with individual strategies. After all, if we’re going to tell stories about how prices dance to the music of the stories that Wall Street tells, we must hold some things constant. So let me tell you a story about just three companies. They existed over the last 3 years. Conveniently, all of them are called Tesla Motors.

A Ballet in Three Acts, Act I: Resilient Tesla

Since calling them all the same thing will be confusing, let’s call the first of our companies “Resilient Tesla.” Resilient Tesla existed between for six months, from November 2016 to May 2017. In what will be familiar to regular readers, we rely on natural language processing technology from Quid to relate and graph news articles from a very broad universe of sources based on content, context, phrasing and sentiment. We provide some of our own characterizations of the clustered content to aid interpretation.

What did media reports have to say about Resilient Tesla? Well, they didn’t ignore bad things that were going on. Media reported on issues with autopilot, and on reported safety issues. It reported on issues with dealership access in states. But those stories were curiously isolated. With few exceptions, they shared no language or other similarities with the core of the conversations taking place about Tesla.

The center of gravity around which the Resilient Tesla narrative orbitted was management guidance, in particular around Tesla’s desire to raise capital to grow. The stories about management guidance and capital raising were usually also stories about the Model 3 launch. They were also about Tesla taking over as the most valuable carmaker in the US. Importantly, they were also stories about Wall Street positioning, and what big investors and sell side analysts thought about the company. And – for the most part – the tone and sentiment of all of these categories were good and positive. What is more, all of these linked positive topics were things where Tesla was the only game in town. That lent stability to the overall narrative, and that narrative was growth. We need capital, but we need it to launch our exciting new product, to grow our factory production, to expand into exciting Semi and Solar brands. Sure, there were threats, but always on the periphery.

Source: Quid, Epsilon Theory

Resilient Tesla was a positive trending stock. Over all but short bursts over this period, it would have been a long position for most long-, medium- and short-term models. Sure, models and strategies incorporating liquidity, volume, daily price action, large block trade activity or other esoteric anomalies may have had different exposure, but Resilient Tesla was a classic long for most.

Source: Bloomberg, Epsilon Theory. Note: This is not a recommendation to buy or sell any security, or to take any portfolio action. Past performance is not indicative of future results. You cannot invest directly in an index, and we do not invest directly in any individual securities.

A Ballet in Three Acts, Act II: Transitioning Tesla

The stories started changing in summer 2017. Act II tells the story of Transitioning Tesla, a company which existed for three months, from May 2017 through August 2017.

Source: Quid, Epsilon Theory

The overall sentiment and the language used in stories about Transitioning Tesla were still positive. In fact, they were actually slightly more positive than they were for Resilient Tesla. But gone was the center of gravity around management guidance and growth capital. In its place, the cluster of topics permeating most stories about Tesla was now about vehicle deliveries. Articles about Tesla used to be Management says this AND Model 3 is coming AND did you know that Tesla is now the most valuable US carmaker AND here’s Wall Street’s updated buy/sell recommendation stories. For Transitioning Tesla they were The Model 3 launch is exciting AND the performance of these cars is amazing, BUT Tesla is having delivery problems AND can they actually make them AND what does Wall Street think about all this? The narrative was still positive, but it was no longer stable.

In other words, two things happened here:

  • Transitioning Tesla lost control over the narrative. It failed to control its cartoon.
  • The main connectivity among the stories people tell about Tesla became concern about deliveries and production.

We’ve previously described narrative as providing meta-stability to an overall market: the ability to shrug off contrary new facts that are inconsistent with the narrative, and to incorporate new facts that were previously considered tangential. Instead, the excitement about non-Model 3 opportunities like Solar, Gigafactory and Semi moved further to the periphery, less linked to most content about the company. Debt concerns, competition and partnership issues, previously easily shrugged off, were now being mentioned in articles that were ostensibly about something else. This is what it looks like when meta-stability fails. This is what it looks like when the narrative breaks.

You wouldn’t necessarily have sensed a difference in how the Tesla story was being told. It was still positive in tone, still almost universally optimistic. Investors and the public alike were still excited about the vehicles’ uniqueness. They still saw value in the periphery businesses. You probably wouldn’t have thought much of the price performance over these four months, either. Long-term cross-sectional momentum models would have shrugged off the addition of four choppy months of ultimately in-line performance. Time-series models would have scored a still-rising stock.

But it was already broken.

Source: Bloomberg, Epsilon Theory. Note: This is not a recommendation to buy or sell any security, or to take any portfolio action. Past performance is not indicative of future results. You cannot invest directly in an index, and we do not invest directly in any individual securities.

A Ballet in Three Acts, Act III: Broken Tesla

The third Tesla – Broken Tesla – existed between August 2017 and the present.

The growing concern about production and vehicle deliveries entered the nucleus of the narrative about Tesla Motors in late summer 2017 and propagated. The stories about production shortfalls now began to mention canceled reservations. The efforts to increase production also resulted in some quality control issues and employee complaints, all of which started to make their way into those same articles. When stories about suppliers not getting paid were coupled with a failed MBO, writers all too easily related these concepts with the management and oversight of the company. Once writers connect these items, then the previously peripheral issues of autopilot crashes, recalls and union disputes start finding their way in as well.

Now, almost all of these things were obviously very real, very tangible problems. That’s not the point. The point is that there was already broad private knowledge that there were issues with Tesla’s manufacturing process. There was already broad private knowledge that senior finance executives had been leaving the company. There was already broad private knowledge that Elon was eccentric. There was already broad private knowledge about the previously peripheral problems for the company. But none of those things really mattered until they became part of the common knowledge around the stock. Once that happened, a new narrative formed: Tesla is a visionary company, sure, but one that doesn’t seem to have any idea how to (1) make cars, (2) sell cars or (3) run a real company that can make money doing either.

Source: Quid, Epsilon Theory

But that’s all the music. So what is the dance? Well, the performance of the stock in this period is probably familiar. This was a model trade for most trend-followers, especially those with more basic strategies. A long-term positive trend, followed by a flat period to roll off old signals, followed by relatively quick transition to a new trend. The funds incorporating more basic long-term cross-sectional signals only probably got hurt a little in Q3 2017, but have been in the money since then.

Source: Bloomberg, Epsilon Theory. Note: This is not a recommendation to buy or sell any security, or to take any portfolio action. Past performance is not indicative of future results. You cannot invest directly in an index, and we do not invest directly in any individual securities.

The Epilogue

If you’re reading this note on Tuesday, October 23rd, you’ll know that Tesla has moved up its earnings call to tomorrow evening. As of mid-day today, TSLA stock is up about 5.6%. As always, these things are overdetermined, but it’s hard to think that responses to chirps from management about a ‘near-profitable’ quarter and record production and deliveries don’t have something to do with it.

Tesla valuations are built on the basis of phenomenal projected future growth. The idea that anyone is going to update some model assumption after tomorrow’s results and legitimately come up with a massively different valuation is nonsense. And yet. If I were short the stock based on the supportive environment for a continued negative price trend, I’d be looking very closely at the following:

  • Can Elon and team put on a performance that starts to put distance between how media and Wall Street talk about the company in the same breath that they talk about credibility issues for management? Can they stay on-point and look like adults?
  • Will the ‘near-profitability’ story and facts dispel the swirling attachment of debt / cash flow / failed MBO concerns to the principal stories about Tesla?
  • Will they be able to bring the topics that have remained positive (e.g. China production, Panasonic’s progress, even Semi, believe it or not) into the main narrative about the stock?

Perhaps most importantly, can Elon step back into the role of Missionary? Or will he continue to let other people determine his cartoon?

The Story of the Three Acts

Let me address a couple legitimate criticisms of this way of complementing trend-following in advance.

The first is that this all seems very easy to see in retrospect. Would I have seen this in advance? Would you? Not sure. There is predictive power in this, but it is hard. It is also systemizable. It is also a new way of looking at things that requires us to build some new muscles to see clearly – and to avoid the confirmation bias that inevitably creeps into this kind of analysis.

The second criticism – and this one comes up a lot – is that professional investors and analysts don’t make judgments about companies and securities based on the content of news pieces. Assuming that this is a serious observation, I would only respond by recommending that you talk to more fund managers and read more sell side pieces. Still, there is a lot to be gained by understanding how common knowledge and broad private knowledge alike DO differ by and among different groups – from broad media, to specialized media, the sell side, long-only fund managers, hedge fund managers and macro strategists. This is something we are working on expanding as part of our research effort.

The third is skepticism that the existence of what we’re calling narrative can predict the direction of a stock. Well…yeah. I mean, I agree. I’m not at all convinced that it can, and there’s nothing I’ve written here today that should convince us that we could have used this ex ante to bet on or against TSLA. This isn’t about predicting the direction of a stock. It’s about updating our predictions about whether it is an environment more or less conductive to investing with or allocating to various types of trend-following strategies. You may not be able to predict the trend, but you may have some ability to project its stability. It’s about understanding how the music changes the dance. It’s not about the answer, it’s about the process.

What else do we take away from all this? What else do I think?

  • I think allocators should be more actively engaging our trend-following managers to be curious about why their signals work. Ask questions about how they try to develop economic intuition for them. They don’t have to buy into how we are conceptualizing this. But they should be constantly curious.
  • I think I’m more inclined toward simple strategies that are heavy on long-term trend. While abstractions are just as capable of creating choppy periods, I think  conducive environments for long-term trends will be more common. I think the cause will be broader awareness of these tools by CEOs and other missionaries. . That’s pure conjecture on my part. But even if I’m wrong, long-term trend’s traits in major equity market drawdowns are a very nice second prize.
  • I’m less inclined toward the managed futures / CTA behemoths. By definition, I think more adaptable strategies capable of turning off models that aren’t suited for the environment – maybe on similar grounds to what we’re arguing, and maybe on more sophisticated ones – will be the winners. The megashops in this space have created capacity and liquidity through strategy stratification that tether them to relatively more static approaches, or else would force them to significantly reduce risk budgets (which many have already done as they’ve transformed themselves into management fee shops).
  • I think, at the margin, I prefer strategies more heavily driven by absolute time-series momentum vs. cross-sectional strategies, although they are perfectly acceptable complements, as well. Both have a role. But I think the bigger abstractions and narratives will require us to capture beta effects (i.e. I want strategies more capable of making non-offsetting directional bets).
  • As an aside, I think if Elon Musk wants to get this thing back on track, he needs to control his own cartoon and embrace his role as Tesla’s missionary again. Among…uh…a few other things. I’ve never owned the stock and I never will. But unlike most people at this point, I really do want Elon to succeed. Yes, really.
  • Maybe most importantly, we have all intuitively adopted ‘trend-following’ thinking in our normal portfolio construction behaviors. After a pleasant decade for risky assets, most of us have internalized a sense of stability in the trend in something like the S&P 500. It won’t allow you to predict the future. But awareness of narrative stability may help you to understand if and when the narratives supporting the “just keep it simple and buy SPY” heuristics start to break down.

PDF Download (Paid Membership Required): http://www.epsilontheory.com/download/16949/


They ALL Came in Through the Bathroom Window


Revolver usually gets the critical nod, but for my money Abbey Road is the superior album.

The A-side is a discontinuous mélange of styles, a sampler of everything the Beatles had to offer at the peak of their powers. The pressing rock beat of Come Together, John’s apparent anti-Reagan theme song. Something, the second best love song of the 1960s, after the Beach Boys’ God Only Knows, which remains the best love song yet written. After that, it’s a granny song, screaming doo-wop, octopuses and a dragging blues riff that washes out into white noise and then abrupt silence. The A-side of Abbey Road alone would still be in the top 50 rock albums of all time.

The B-side couldn’t be more different. Instead of experimenting with the juxtaposition of a silly Ringo song with a sonically and nominatively heavy bit of John and Yoko-style philosophy, the B-side is a medley of interconnected musical and lyrical vignettes. After the interlude of one of the Beatles’ most richly harmonized and probably most polarizing songs (Because), the rest is a single piece in eight parts. It starts with an overture and carries through various obviously and sometimes less obviously linked little stories, ending with the famous closing karmic line: ‘And in the end, the love you take is equal to the love you make.’ Perfect.

After a brief period of thinking my wife (named Pam) would get a kick out of Polythene Pam that ended when I remembered the rest of the lyrics, I settled on my favorite number in the medley: She Came In Through The Bathroom Window. The reason I was always fascinated by the song, I think, is that of all the stories told on the album, its story was the one that sounded like it had to be true. Like something that really happened.

And it did happen. Sort of. You see, there are all sorts of different claims to being the inspiration for the song.

The Apple Scruff

The most popular version of the story goes that a fan named Diane Ashley – one of the Apple Scruffs who waited around the studio all day for a glimpse of one of the Beatles – found a ladder from the garden up to the bathroom in Paul’s home. Once when he was away from he house, Diane claims to have entered the house and stolen a few things, including a framed picture of Paul’s father that was later returned. This, so Diane’s widely accepted story goes, is the inspiration behind the brilliant line: ‘She could steal, but she could not rob.’  

The Moody Blues

Moody Blues keyboardist Mike Pinder says something different. He claims that he, fellow bandmember Ray Thomas, and Paul McCartney were hanging out one day, regaling Paul with the story of a young woman and fan who, ahem, found her way into Thomas’s room through – you guessed it – a bathroom window. Mike says Paul picked up a guitar, started strumming and sang the words, ‘She came in through the bathroom window…’

The Dancer-Thief

More recently, a third story has emerged on the internet. A dancer named Susie Landis – who now goes by Landis Kearnon – claims to have been paid $1,500 to steal the master of A Day in the Life from David Crosby’s house. They climbed through a muddy backyard to (yup) a bathroom window that gave them access. They found the master and drove it across town to their employer, who copied it and engaged them once again to return it. Why did he want the copy? As the story goes, a local radio station (KHJ) paid to be able to air the song, which had been previewed for a number of artists and had developed quite a reputation before its first public airing. Apparently the early airing infuriated Paul, giving him ample cause to pen a song about it.

The story is a bit suspect, perhaps, given the number of dimensions on which the storyteller fits her story to the song. For example, she claims that her father had blackmail material on Crosby, which apparently motivated the ‘protected by her silver spoon’ line. And of course this thief was usually a dancer (‘she said she’d always been a dancer’), and knew a Detective Monday, who called producer Billy Monday, who called Tuesday Weld, who called Paul, about the incident (‘Sunday’s on the phone to Monday, Tuesday’s on the phone to me’). A bit too on-the-nose, but true-sounding details around events that did happen are always enticing.

The Artist

Of course, when it comes to any Paul rumor, you could always count on John to lob in an off-hand comment that confused the whole matter. In a 1980 interview included in David Sheff’s All We Are Saying, Lennon said the following:

That’s Paul’s song. He wrote that when we were in New York announcing Apple, and we first met Linda. Maybe she’s the one that came in the window. I don’t know; somebody came in the window.

The Conspiracy

While not nearly as popular as the Dark Side of the Moon / Wizard of Oz urban legend, some Beatles fans claim that between five and six seconds into the track, after “Oh, Look Out!”, you can hear someone quickly saying “Linda Eastman.” I…don’t hear it. But someone is definitely muttering something, and OK, maybe it sounds a little bit like ‘Eastman.’

Stories like this are interesting enough. They’re more interesting when they tell us about the relationship between narratives and facts. One of the reasons that “but, because, therefore” are such good tells for abstracted, fiat news is that direct strings of causality are extraordinarily hard to identify. When we read a story that seeks to attach facts to an explanation, or which seeks to tell us what those facts mean, or which seeks to tell us why the market or a stock is doing this or that today, we not only subject ourselves to the judgments of the author. We also subject ourselves to the fact that most realities are heavily overdetermined. That’s a $10 word for the kind of thing that is so related to so many different drivers that we could easily use those drivers to explain more than 100% of the thing. And if you’re not careful, you’ll buy into explanations that try to do exactly that.

I would be shocked if at least two of the Bathroom Window theories weren’t at least partially true. I would be shocked if there weren’t several other experiences that influenced the lyrics, too. I would be shocked if half the lyrics weren’t simply the fanciful output of a generation’s best songwriter.

But the lesson adds a bit to our rules for reading financial news:

  • Ask “Why am I reading this now?”
  • Look for the tells of fiat news: “but, therefore, because”
  • Be on guard for overdetermination. Confident attribution of causality is another tell of narrative, and of fiat news.

O God, Make Me Humble


Caesar: What’s under the sheet?

Marcus Vindictus: Sheet? Oh! Oh, the sheet. Yes. To begin with, number one, a beautiful hand-carved alabaster bathing vessel!

Caesar: Nice. Nice. Not thrilling…but nice.

– History of the World, Part I (1981)

There is only one prayer I know which God always answers: ‘O God, make me humble.’

When I was growing up in Minooka, Illinois, I was a nice kid. I was also an insufferable know-it-all. To be fair, I wasn’t the smartest in my school. That honor belonged to Andy Kimble, a math genius who went to USC to study film. He’s now an editor for several television shows. Still, I had a reputation for knowing way more than I ought to have about far too many topics.

There was more than a little bit of small pond effect to this. I have already confessed, after all, to my status as Medium Talent. It’s a big world, and the sooner you realize how many millions of people can think circles around you, the sooner you find your place in it. Ben and I both participate in a fairly competitive online trivia league. Within the hierarchy of the league, I am placed in what is called the “B-rundle”, which is exactly what it sounds like. Nice. Not thrilling…but nice.

My one great recurring memory of being young and in school, however, was the joy with which people responded to discovering that I didn’t know something. My fifth grade teacher. That time I spelled ‘handkerchief’ wrong in a spelling bee in 7th grade. The first time I said the word ‘banal’ out loud. The time I pronounced ‘Mussorgsky’ as ‘Musso-gorsky’ in an orchestra rehearsal, and embarrassingly insisted that it was an accepted alternate way to say it. The scarier thing, of course, was how I responded to all these mostly harmless jokes at my expense. How desperately and successfully I hid the fact that there were a LOT of things I wasn’t understanding, and topics I didn’t completely follow.

At a young age, I found that I enjoyed the idea of being thought of as knowledgeable and intelligent, maybe as much as I enjoyed actually being those things. I also realized with some surprise that the payoffs of the two were usually pretty similar – the tangible payoffs that were immediately evident, anyway. And pursuing the former was a hell of a lot less work.

No self-flagellation here. As it turns out, there’s a growing body of research into how the real and perceived value of ability-signaling is effectively stunting true pursuit of education across the board. Bryan Caplan writes about it a great deal in his recent, provocative book The Case Against Education. Much more recently (i.e. this month), two Harvard researchers and one from Stanford released an NBER working paper on the topic called Signaling, Shame and Silence in Social Learning (h/t @RobinHanson). It’s an academic paper, but it is an interesting read. It will also be useful to anyone more generally interested in the intersection of narrative and metagame playing. But at its core, it seems to confirm that the negative ability-signaling associated with implying that we don’t know something keeps us from asking questions even when we should. This is a major problem of social organization. These people are not acting irrationally. In just about every major social sphere, we have created a system in which it is absolutely in our socioeconomic best interest to maximize our ability-signaling, even at significant cost to the thing we are supposedly signaling.

I have never seen an investment firm that has really solved this problem.

Bridgewater has famously, valiantly tried. They’ve done better than most. ‘Radical transparency’ goes a long way toward addressing the costs and benefits of expertise vs. perceived expertise. So does the embrace of mistakes and the attractive concept of a meritocracy of ideas. But even the Bridgewater code systematizes ability-signaling through ‘believability-weighting’.  If you don’t think managing your reputation – even at the cost of asking questions when you don’t know the answer – is as important on Glendinning Place as it is on Wall Street, you’re kidding yourself.

But at least they’ve tried.

And so must we all. It is critically important. To the extent we incentivize ability-signaling, we impair humility. To the extent we impair humility, we degrade every decision-making process we may have. The problem I described in the Cornelius Effect was one in which, beyond a certain point, increases in talent and expertise of advisers and investment professionals tend not to manifest in better outcomes. This problem is partially external. With a world full of brilliant people, believing we can find the person who can tell us the answer through singularly brilliant insights is a fool’s errand. It is also partially internal. Humility is a necessary precondition for a talented person to make himself or herself part of a process.  

But the prayer required of the organization that would actively stamp out the trappings of ability-signaling – O God, make me humble – is perilous. When you tell everyone about your vision, they will say that it is such a good idea! So long overdue! We love how transparent you are! Break the old patterns of our industry! Twelve months later, when they’re flipping through your deck, it will be different. They’ll read the bios. Hmm…what school is that? I like the strategy, but the PM’s background looks spotty…I haven’t even heard of these firms she worked at. The analyst they introduced us to seemed to be really well connected to the PM’s thinking, but remember that analyst at the other firm? He knew everything about that company! Now that was impressive!

I’m making this up, but we both know that I’m not really making this up. This isn’t an indictment of allocators or decision makers or fund managers or…anyone, really. It’s an indictment of the fact that we built an industry on professionals exploiting the knowledge gaps of their clients. It’s an indictment of the fact that the solutions we created to prevent charlatans and criminals from pursuing that exploitation were prudent man and other standards designed to minimize the appearance of risk instead of minimizing undesirable/uncompensated risk.

It’s time to revisit these standards.

This won’t be the last time we write about this.


Funding Secured

SoftBank CEO Masayoshi Son and Crown Prince MBS in happier times

Can you imagine if Tesla were actually moving forward today with the Saudi sovereign wealth fund in a take-private transaction? Can you imagine the uproar over Elon doing this sort of major deal with the Saudis after the Khashoggi regrettable altercation murder?

Well, no need to imagine. Or at least no need to imagine a unicorn financial transaction caught up in the wake of the Khashoggi events.

SoftBank Group Corp. is in discussions to take a majority stake in WeWork Cos., in what would be a giant bet on the eight-year-old provider of shared office space, according to people familiar with the talks.

The investment could total between $15 billion and $20 billion and would likely come from SoftBank’s Vision Fund, some of the people said. The $92 billion Vision Fund, which is backed largely by Saudi Arabia and Abu Dhabi wealth funds as well as by SoftBank, already owns nearly 20% of WeWork after last year committing $4.4 billion in equity funding at a $20 billion valuation.

Talks are fluid and there is no guarantee there will be a deal, some of the people said.

SoftBank Explores Taking Majority Stake in WeWork,” Wall Street Journal, October 9, 2018

Softbank’s Vision Fund is the largest single private equity fund in the world, with about $100 billion in capital commitments, of which about half comes from Saudi Arabia. Over the past two years, the Vision Fund has transformed Silicon Valley, particularly in the relationship between capital markets and highly valued private tech companies – the so-called unicorns like Uber and Lyft and Palantir and Airbnb. Who needs an IPO for an exit when you’ve got the Vision Fund to write a multi-billion dollar check?

Case in point: the deal that was shadow-announced earlier this month between the Vision Fund and WeWork, a company that SoftBank valued at $20 billion last year despite, ummm, shall we say … questionable business fundamentals to support that number and a subsequent bond raise. I mean, can anyone say “community-adjusted EBITDA” with a straight face? But hey, that was 12 months ago! What do you say we literally double down on that valuation and buy out all of the external investors in WeWork, so that it’s just the Vision Fund and WeWork management that owns the company? How does that work for you?

OMG. If I’m one of those current private equity investors in WeWork, I am building a shrine in honor of Masayoshi Son, the SoftBank founder and Vision Fund frontman. If I am an investor or an employee of any of these other unicorn tech companies, I am lighting a candle and praying for Masayoshi Son’s continued good health. 

The Vision Fund, and more generally the Saudi money behind it, is a classic fin de siecle undertaking. It is The Greatest Fool in a private equity world that must find greater and greater fools for their investment funds to work here at the tail end of a very long and very profitable business cycle. The Vision Fund and its Saudi money isn’t just a lucky break for both the financiers and the entrepreneurs of Silicon Valley. It is an answered prayer.

And here’s the crazy thing … the Khashoggi murder could blow this all up. Not just the WeWork deal. Not just the next mega-fund that SoftBank puts together. But this fund. The Vision Fund.

And if the Vision Fund is no longer viable as a player in Silicon Valley, then I don’t think the unicorn valuations are viable, either.

Why do I think that there is now existential risk for the Vision Fund? Check out these narrative maps before and after news of the Khashoggi murder broke on October 3.

First here’s the narrative map of the 608 unique major-media articles on “SoftBank Vision Fund” for the three months prior to the murder, so July 2 through October 2, 2018. I’ve colored the nodes (each node is a separate article) by sentiment, so green for positive, yellow for neutral, and red for negative.

Source: Quid

As you can see, the core of the Vision Fund narrative is all about the deals it is doing. The Saudi connection is way off in the periphery of the overall narrative. Moreover, the sentiment across the map, including the peripheral Saudi thread, is VERY positive. Only 5% of these articles have a negative sentiment, and those are dominated by a very peripheral cluster of articles on microprocessor IP, stemming from SoftBank’s acquisition of ARM in 2016.

But now look at the narrative map since October 3, consisting of 225 unique major-media articles on the Vision Fund. 

Source: Quid

This is a narrative train wreck. It’s not just that the negative sentiment articles have more than tripled to 18%, and that positive sentiment articles are now less than half of the total (which is AWFUL for the normally rah-rah business press). No, the much more damaging aspect is that Saudi involvement is now at the core of the Vision Fund narrative. There are still more articles being published about the investments that the Vision Fund is making. But that narrative cluster is no longer at the heart of the map. The Vision Fund narrative is now defined by its Saudi funding, and that’s a bell that never gets unrung.

I wrote a brief note last week about how common knowledge regarding the Saudi regime in general and Crown Prince MBS in particular had shifted, about how what everyone knows that everyone knows about MBS had changed. And once common knowledge changes, so does behavior. In many cases, it’s the ONLY thing that can change behaviors.

Well, the common knowledge on SoftBank and the Vision Fund has changed, too. Today, everyone knows that everyone knows that it’s Saudi money behind the fund. And that will absolutely change Silicon Valley’s behavior vis-a-vis the Vision Fund, even if it changes nothing in what Silicon Valley already knew.

Will greed and the answered prayer of The Greatest Fool overcome the narrative stain that associating with the Vision Fund now brings? Maybe. I’d never want to bet against greed! But even more so, I wouldn’t want to bet against the power of narrative.

Bottom line: I think that the MBS-is-a-Bond-villain narrative is now a significant risk to unicorn tech company valuations, through the intermediating narrative of SoftBank’s Vision Fund.

PS – I’d like to give a major h/t to our readers for suggesting that we take a look at SoftBank through the lens of the Narrative Machine. Rusty and I are so fortunate to have found fellow truth-seekers throughout the financial services world. Please keep those cards and letters coming ([email protected]) with any ideas on future notes!


The Tells of Fiat News


I was reminded of an old video this week (h/t author Robert Kroese) featuring two of the most creative people in America: Trey Parker and Matt Stone. They are, uh, pictured on the left and right above, respectively. The creators of South Park and Book of Mormon, Parker and Stone are famously irreverent, productive and capable of creating surprisingly incisive social commentary on 2-3 days’ notice. They have a lot to say about storytelling. At an NYU writing seminar back in 2014, they said a lot.

You can watch the video clip here, but a transcript of the key bit is below:

Trey Parker: Each individual scene has to work as a funny sketch. You don’t want one scene that’s just like, what was the point of that scene? We found out this really simple rule that maybe you guys have all heard before, but it took us a long time to learn it.

We can take these beats, which are basically the beats of your outline, and if the words ‘and then’ belong between those beats, you’re f***ed. Basically. You’ve got something pretty boring.

What should happen between every beat that you’ve written down, is either the word ‘therefore’ or ‘but’. So what I’m saying is that you come up with an idea, and it’s like ‘so this happens’ right? And then this happens,’ no no no no! It should be ‘this happens, and therefore this happens. But this happens, therefore this happens.’

Literally we’ll sometimes write it out to make sure we’re doing it.

We’ll have our beats, and we’ll say, ‘okay this happens, but then this happens’ and that effects this and that does to that, and that’s why you get a show that feels like this to that and this to that but this, here’s the complication, to that.

And there’s so many scripts that we read from new writers and things that we see …

Matt Stone: F*** that. I see movies, f*** man, you see movies where you’re just watching, and it’s like this happens and then this happens, and this happens — that’s when you’re in a movie and you’re going what the f*** am I watching this movie for?. It’s just like: this happened, and then this happened, and then this happens. That’s not a movie. That’s not a story. Like Trey says it’s those two, ‘but’, ‘because’, ‘therefore’ that gives you the causation between each beat, and that’s a story.

This is among the more concise, actionable advice I’ve seen about storytelling and writing, fields which tend to attract uselessly impractical or vague recommendations. But it is also a perfect illustration of how news is transformed into fiat news. News is and ought to be exactly the thing which Parker bemoans – a series of linked ‘and then’ statements. Holding multiple truths in our heads (#AND) in this way is powerful. It is also boring.

But more often than not, too many journalists, so many of whom entered the industry out of a desire to ‘change the world’, now approach a topic having already decided the ‘beat’ toward which they must steer the story. Ideas, principles and conclusions they consider self-evident, powerful or provocative. Important. Instead of descriptions of what took place, stories are connected with ‘but’, ‘because’ and ‘therefore.’

These are the mechanics of effective storytelling. These are the tells of Fiat News.

When you open news, get in the habit of searching for ‘because’, ‘but’, ‘therefore’ and ‘however.’ Search for ‘nonetheless’ and ‘as a result.’ More often than not, it will give you a sense of the underlying intent of the author outside of the facts being presented.