A Cycle of Addiction


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Requiem for a Dream (2000)

A 35-year Secular Trend

Two of the world’s major central banks – namely the Bank of Japan (BOJ) and the European Central Bank (ECB) – have created what is akin to a cycle of addiction to negative interest rates. Moreover, even those developed economies with positive rates appear addicted to near-zero rates. Without them, developed market economies seemingly begin to slip back into growth malaise. [1] Ben Bernanke’s 1999 critique of the Japanese central bank’s failure to act aggressively enough to stop their ‘lost decade’ is arguably one of the first seeds of the ‘do whatever it takes’ mantras now so common amongst global central bankers. [2]  These mantras’ tools include quantitative easing (QE) – also known as Large Scale Asset Purchases (LSAPs) or Permanent Open Market Operations (POMOs) – which have ultimately forced long-rates negative in much of Europe and Japan. This suppression has far longer-lasting effects on capital allocation decisions and investor behavior than traditional rates policy using temporary open market operations (TOMOs). [3]

Step-by-step and slowly over time, the BoJ and ECB followed the Swedes and eventually arrived at negative interest rates policy (NIRP). This policy was not just limited to deposit rates but QE allowed its application to longer duration risk-free (as well as to risky) assets. Similarly, over the past 35-years, the Fed also has been on a march towards zero interest rate policy (ZIRP). However, the U.S. has the luxury of far better demographics than Europe and Japan. The U.S. also has the benefit of fiscal unity, which Europe lacks, and the U.S. has the benefit of possessing the world’s reserve currency. The structural impediments to growth in Japan and Europe have arguably necessitated more aggressive monetary policy. Not all within the central bank community agree with this approach. Former BOJ Governor Masaaki Shirakawa has identified what he calls the global ‘Japanification’ of monetary policy; importantly, he argues it has failed. [4] While Ben Bernanke has since recanted the severity of his 1999 critique, it has mattered little. Once socialized, central bankers seized upon it as an excuse to become even more active economic influencers.

An Anachronism

Traditional monetary policy models are anachronistic. Despite aggressive policy measures, inflation has not met central bank targets in the U.S., Europe or Japan. The closed and static monetary policy models of the past fail to recognize that the Fed is no longer the only large policy actor. They generally assume economies are closed and not reflexively adaptive (i.e. – dynamic). To the contrary, rates markets are open systems subject to cross-border capital flows. For example, negative rates in Europe and Japan have important impacts on U.S. rates. Figure 1 shows how the U.S. 10-year regresses against the Bund (the German 10-year). The repression of long-rates in those geographies has anchored rates here. [5] Lastly, QE killed the traditional relationships between inflation and rates, and it also murdered the Philips curve. In fact, QE has created the unintended consequence of overinvestment, overcapacity and consequent lack of pricing power. Thus, the low rates QE produced have arguably caused the low inflation central banks intended it to cure.

The most extreme deployment of QE results in prolonged periods of negative long-rates, as we currently observe in Europe and Japan. The concept of negative real rates should not be offensive on its face. Negative real rates may occur when inflation exceeds the nominal interest rate. By the Fisher identity, nominal rates = real rates + inflation; thus, real rates = nominal rates – inflation. Real rates have gone negative in the past at various periods in time, and it is one reason why the Fed or other central banks have generally chosen to hike when inflation gets too high relative to the policy rate. Traditional theory holds that negative rates are inflationary. Proponents may argue that because negative real rates have historically required central banks to raise policy benchmarks to prevent inflation (as in the Volker era) that the converse is true. That is, they may argue that the use of negative rates now will create inflation later.  We disagree. Currently, in Germany, real rates = [-.3% – .9%] = -1.1%. These deeply negative rates suggest that the ECB may be profoundly concerned about renewed deflation – ironically, we believe their prescription is producing precisely the opposite of the desired result.

Figure 1: Bunds Regressed against U.S. 10-year

While exacerbated by the trade war, the slowdowns in Europe and Japan are largely structural. If negative rates in the developed world outside the U.S. – especially long-rates – remain pervasive, the bid for U.S. duration should continue. We think low growth and the potential for capital loss will require persistently low rates. Therefore, it is our view that long rates in Europe and Japan will continue to anchor U.S. long-rates, which will trend towards zero longer-term. Over the next three to six months, we forecast the U.S. 10-year yield will approach 1.25%. [6] This likely coaxes the Fed to cut the funds rate more aggressively in 2020, as it will desire to prevent a prolonged yield curve inversion and its impact on banks. We doubt that nominal U.S. rates ever go negative as there appears to be resistance within the Fed, but we posit that real rates most certainly will. Indeed, it seems as if a Lagarde ECB might not be quite as committed to negative rates as a Draghi ECB, but she may have no choice but to force rates more negative given the capital loss that less negative rates will create. [7]


We believe QE has created an addiction to more QE (in both low-rate and negative-rate economies). Negative rates, in particular, necessitate yet more negative rates; they lock central banks and the economies they serve into a cycle of addiction to negative rate policies. [8] An addiction to low or negative rates can occur for several reasons. In order for a firm to invest in a new project, it must believe that low or negative rates will be persistent enough to limit refinancing risk. In the extreme example of negatively yielding debt, holders must also believe that rates will become more negative because they own these securities for capital appreciation rather than yield! Europe exemplifies this problem. These two behaviors are how the addiction to low rates forms.

Negative rates (whether real or nominal) are effectively a tax on capital providers – i.e. on savers. Capital providers that should receive a return for the privilege of a borrower providing stewardship of their capital are instead charged for it. This tax creates unintended consequences and incentives, just as fiscal tax policy often does. Indeed, we’d go a step further and suggest that negative rates are social policy clothed in the guise of monetary policy. Rates policy wasn’t always this way, but the world is here now and the voting public ought to pay as much attention to it as it does to fiscal policy. Democracies are based on the idea that a country’s citizens should determine a government’s decisions to tax, spend and redistribute wealth. Monetary policy has no such constraints, yet it has similar consequences for the redistribution of wealth from savers to consumers.

The costs of persistently low or negative rates may ultimately be far too high. For firms, they promote inefficient capital allocation decisions – specifically, they lead to overinvestment. Importantly, QE distorts perceptions about what rates of return an investment must produce over the long-term. For context, TOMOs distorted (lowered) capital costs for only short duration bonds. Therefore, the impact of lower short-rates was mostly to create a pull forward in demand (i.e. – an intertemporal demand impact) with only minimal impact on firms’ long-term investment decisions. As POMOs suppress term premia, the impact is also to pull forward investment (rather than just demand), as firms now have lower long-term hurdle rates. This appears to have created global overcapacity and oversupply. When industries have excess capacity, firms lose pricing power and inflation becomes difficult to achieve.

Disinflation is not the only risk to low or negative rates. It is particularly important to understand risks to a system where negative yields are common. Currently, there are about $15 trillion in negatively yielding securities. Most of those are in Europe and the rest in Japan. First, bank profitability suffers. Eventually banks pass those costs through to the real economy in the form of potentially higher lending rates (relative to the negative benchmark) and less lending. [9] Figure 2 shows that negative deposit rates are not passed along to borrowers. [10] Market participants ought to be painfully aware that the costs of negative rates may ultimately be borne by European taxpayers when Europe’s banks need to recapitalize. Because the financial system is global, a European bank recapitulation would have important implications for global market liquidity (not unlike in 2011) and the global economy. [11]

The impact of negative rates extends far beyond the banks. Negative real deposit or other policy rates force investors, especially captive audiences like pension funds and insurance companies, to take unwarranted duration or credit risk. For investors like these funds, when purchasing negatively yielding securities, they must receive the benefit of price appreciation to make up for the negative yield. It is the only inducement for such a purchase. In order to induce the purchase, central banks must implicitly guarantee they are committed to such policies. [12] This creates a self-reinforcing cycle that pushes the neutral rate to zero across the entire curve. It becomes a trap from which the central bank can’t escape. This can be said of low rates, but it is particularly true of negative rates. Negative rates necessitate more of the same.

Figure 2: Policy rate in Sweden vs. rates to individuals and corporations


The distortions QE has created (especially where QE produced negative rates) will be difficult to unwind. It is important to remember that the balance sheet expansion needed to execute on QE policies ultimately works through the suppression of term or risk premia. It is not through a quantity of money mechanism. Little firepower is left in most of the developed world for QE to have more impact, and we conclude more harm than good has already been done through negative rates policy. Overall, there are few levers left for central banks short of moving to purchases of equities (as in Japan). That leaves fiscal policy, which is notoriously inefficient and has empirically disappointed as a stimulant to growth when compared to good old fashioned productivity gains. These gains are harder to achieve when low rates keep zombie companies afloat. The seeds of aggressive rates policy and negative rates were sown in the late 1990s, and they have sprung into large dogmatic trees, which should soon be cut down.

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[1] The need for a quick policy reversal here in the U.S. when the Fed funds effective rate hit 2.5% and the U.S. 10-year hit 3.25% is anecdotal evidence of this. Now, we think 2% on UST 10-year yields is the new 3%.

[2] The Swiss actually pioneered the practice back in the 1970s to keep their safe-haven currency from over-appreciating.

[3] For a discussion of the difference between temporary and permanent operations please see https://www.federalreserve.gov/monetarypolicy/bst_openmarketops.htm. Temporary open market operation suppress short rates while permanent operations suppress long rates (QE).

[4] World has learned wrong lessons from ‘Japanification’

[5] While alternate causes for the move in U.S. long rates may be a lack of above trend growth and inflation in the U.S., the move in 10-year yields versus the Bund and 10-year JGB is observable.

[6] It remains our view that European and Japanese negative yields will persist for at least the next eighteen months (and likely for much longer) because global growth will fail to turn. After the recent backup in yields, we foresee Bund yields once again below -50bps by year-end. The secular challenges to growth in Europe and Japan simply will not go away.

[7] The Philips Curve at the ECB. Those cataclysmic results include massive capital loss at pension funds and insurance companies that have purchased negatively yielding securities.

[8] Any withdrawal from these policies is likely to be a painful process for which few policy makers have the stomach. Perhaps, with a new ECB chief at the helm, a policy ‘mistake’ that allows European rates to become less negative too quickly will be the undoing of global risk-on.

[9] The impact of negative rates on banks may be summarized as follows:

  1. negative interest rates destroy NIMs;
  2. upon dipping below the ZLB (zero lower bound), banks no longer pass through negative yield to borrowers but in fact increase lending rates as a way to offset the cost of paying Central Banks for safely storing currency, and
  3. loan volumes may actually decline as rates rise because of the pass-through the costs.

[10] Negative nominal interest rates and the bank lending channel

[11] Tiering is one way the ECB has elected to attempt to ameliorate the negative impact on banks.

[12] The impact on pension fund returns is potentially catastrophic. This is where the duration and credit risk is most concentrated and could easily evolve into systemic risk.


The Rent Is Too Damn Low


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My favorite part of the Jimmy McMillan ouevre is the gloves.

And while I completely agree with McMillan that the rent is too damn high when it comes to urban apartments, I’m not talking about housing rents in this Zeitgeist note. I’m talking about the rental price of money. I’m talking about interest rates.

The problem with money is that the rent is too damn low.

Fed Repo Action Oversubscribed in Clamor for Year-End Funds   [Bloomberg]

“The Federal Reserve Bank of New York’s operation to inject cash into the financial system over the end of the year was oversubscribed on Monday, indicating a thirst for year-end funding.”

“Market participants submitted $49.05 billion in bids for the Fed’s 42-day term repo operation, which matures Jan. 6, 2020. That was more than the $25 billion on offer. This was the first of three term operations to provide funding past the year-end period. The others will be held in the coming weeks.”

“Even with the Fed’s commitment to continue providing liquidity to the financial system around year-end, the market is still showing concerns. This is due to banks’ year-end balance-sheet constraints related to capital surcharges and other regulatory requirements.

This $25 billion in term loans is in addition to the overnight repo facility, btw, which clocked in at something like $60 billion or thereabouts.

But, hey, it’s all good, people!

This is due to banks’ year-end balance-sheet constraints related to capital surcharges and other regulatory requirements.

WHY are the Fed repo operations a never-ending garbage fire? WHY is the Fed facing an apparently insatiable demand for cash and very short-term liquidity?

Because the banks are over-regulated, that’s why.

Jamie Dimon wants you to know that if only our Too Big To Fail banking institutions were “unleashed” from those awful post-GFC capital requirements, why then, by golly, JP Morgan and all the other primary dealers would be only too happy to step into the breach and provide more short-term liquidity from their reserves. They’d be doing that right now if not for those pesky capital requirements!


Look, you can’t blame Jamie Dimon for taking advantage of the Fed’s impossible position in order to push for rolling back capital requirements and freeing up more cash to “return to shareholders”. You can’t blame Jamie Dimon for his Jamie Dimon-ness. It’s his nature.

After all, Jamie Dimon is the rake.

No, I can’t blame Jamie Dimon for trying the ole “awkshually, the problem is too much government regulation” line. But I can sure blame everyone else for parroting it.

It’s just another variation on the trickle-down economics song, that if only you’d use government policy to improve the heaping portion of profitability on a giant private enterprise’s plate, then enough crumbs will fall off that plate so that everyone eats a little better.

“Yay, crumbs!”

Yep, this is “capitalism” in the Long Now, where a government agency makes the money and sets the price of money and then sells it to a government-selected banking oligopoly that resells it for a profit. And then complains about their cut.

Money is a completely rent-controlled market. It’s Jimmy McMillan’s dream world, where the rents are never too damn high but are always so damn low.

And just like all rent-controlled markets, it’s the rich and the well-connected who make out like bandits.

But everyone who would throw an unholy temper tantrum at – gasp! – rent-controlled apartments is just fine with the manager of that banking oligopoly being a billionaire and his chief lieutenant managers being centimillionaires and a gazillion of his sub-lieutenant managers being decamillionaires.

Everyone is just fine with the manager of that government agency being a centimillionaire and his predecessors being decamillionaires.

Everyone is just fine with the current President being a billionaire and his predecessor doing everything in his power to become a billionaire and now two more billionaires deciding to run for President.

What’s the problem for the Fed and its repo operations?

The rent-controlled price of money is too damn low.

What’s the problem for American citizens and our democracy?

We sold our birthright for a mess of pottage, and we don’t even see that we were taken.


By Our Own Petard


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For ’tis the sport to have the enginer
Hoist with his own petard; and ’t shall go hard
But I will delve one yard below their mines
And blow them at the moon. O, ’tis most sweet
When in one line two crafts directly meet.

Hamlet, Act 3, Scene 4, by William Shakespeare
Image result for office space the bobs

Peter Gibbons: It’s a problem of motivation, all right? Now, if I work my ass off and Initech ships a few extra units, I don’t see another dime. So where’s the motivation? And here’s another thing, Bob. I have eight different bosses right now!

Bob Slydell: I beg your pardon?

Peter: Eight bosses.

Bob: Eight?

Peter: Eight, Bob. So that means when I make a mistake, I have eight different people coming by to tell me about it. That’s my real motivation – is not to be hassled. That and the fear of losing my job, but y’know, Bob, it will only make someone work hard enough not to get fired.

Office Space (1999)

I would like to start, as every good essay ought to do, by offering you a heuristic I have pulled completely out of my ass. Or out of a career dedicated to understanding the behaviors of the people who allocate to investment managers, which basically amounts to the same thing:

Ask the novice adviser or allocator what matters most, and their answer can usually be reduced to historical performance.

Ask the journeyman, and the answer you receive will be reducible to the identification of #edge.

Ask the master, and they will tell you about alignment.

I don’t mean this to be condescending. Truly, I don’t. I also don’t mean it to be dismissive of any methodology or philosophy for the selection of professional investment advisers and managers. But the incredible degree of difficulty (read: mathematical impossibility) of achieving results consistently worth the fees paid to external advisers, coupled with the tendency of the math to bang that reality into our heads over the course of a career, is almost tautologically geared to this intellectual progression in the evaluation of investment strategies:

Induction -> Deduction -> Deconstruction

Scientism -> Kinda-Sorta Empiricism -> Evo Psych

Historical Performance -> Analysis of Edge -> Alignment

The inevitable final form of the professional allocator or adviser is not so much the nihilist as the practitioner of serendipity. They recognize that randomness reigns and control what they can control. In a perfect world, they control what they can control by leaning on lasting, demonstrable, biologically determined human behavioral traits to try to guide someone they think is talented and process-oriented to results that will benefit both principal and agent alike. It is a stoic, right-sounding, eminently reasonable, perfectly justifiable framework. There’s just one problem. A tiny, insignificant problem that I almost hesitate to mention:

We will never – can never – be aligned with our agents.

As citizens, shareholders and investors, we worry with good reason that the agents working on our behalf – our political representatives, corporate management teams and the investment consultants, advisers and managers we rely on, respectively – actually will work on our behalf. Preferably for a reason that goes somewhat beyond ‘not going to jail’ or ‘because they seem like someone you could have a beer with.’ We want them to feel like they have skin in the game. Like we both win if either of us wins.

When we, as a principal, select an agent, we have every reason to shout “Yay, alignment!” from the rafters.

And because we have every reason to shout “Yay, alignment!”, our agents have every reason to sell us compensation structures which permit them to extract undeserved economic rents by demonstrating the superficial trappings of alignment. This job is made a hell of a lot easier by the fact that we investment professionals – nominally principals in the relationship – are often ourselves agents of some other party. We are using delegated authority to act on behalf of a client, a family, an institution, a board. People to whom we need to demonstrate alignment.

Necessity being the mother of invention and all, our need for a story that will make us or our own charges shout “Yay, alignment!” makes us vulnerable to structures and features from our agents which don’t deliver anything of the sort – but seem to.

Hoisted by our own petard, as it were.

And here’s how it happens.

Let’s start with what has long been Common Knowledge – what everyone knows everyone knows – about alignment in our little corner of the world:

Commission-based models are bad.

What we all know that we all know is that fixed commission-based compensation models represent poor alignment of incentives because the adviser who is paid on commissions has an incentive to generate commissions by executing trades. Even Chuck here, who is nearly a deca-billionaire because of the decades he charged clients commissions, knows that the tide is going out on him. He wants to re-cast himself on the right side of history.

Charles Schwab

Just so we are 100% clear about this, the single human being who may have built the greatest personal wealth by charging clients commissions is now shaking his finger at us to tell us how much he hates them, and how we ought to think about them. Just marvelous.

Whether Chuck’s come-to-Jesus is authentic or not, we are now all in on the joke. The natural incentive implied by commission-based compensation is to take actions which would harm the client. Simple enough. Fair. Some will make the ‘Yes, but if I don’t make good trades I’ll lose the client and I don’t want to do that, etc.’ argument, but I feel confident that even those folks get the basic criticism. Full-hearted FAs can absolutely deliver good client outcomes under a commission structure. But their incentive is not to do that. It isn’t complicated.

I also think most people understand intuitively the disconnect between paying a transactional fee for something and expecting that person to want to do a better job on that thing. We structure many of our commercial relationships around the introduction of performance-based variability. In America, anyway, we pay restaurant and bar service professionals primarily through variable compensation: tips. We structure our companies’ compensation around bonuses (which, truth be told, almost universally tend to vary around corporate results far more than personal performance). In significant swaths of the legal profession (excluding corporate law, where the goal is to find lawyers we can pay enough to offload the career risk of a botched deal structure), we pay on contingency.

If an agent’s primary incentive is to get you to do a specific deal – and that is very frequently the case with those paid on functionally fixed commission – it’s easy to see how that doesn’t satisfy our desire for alignment. The cases where high, fixed, transactional fees for one-off services are still the norm are accordingly almost always industries protected by forms of occupational licensing. In some cases, like, say, medicine, those licenses and the fixed compensation models they contemplate seem legitimate. To me anyway. Feels a bit unseemly to pay someone a bonus for doing an especially good job removing a cancerous mass. In other cases the fees are simply the result of lobby-protected oligopolistic behavior. Classic rent-seeking. Real estate agents, we are all looking square at you and your patently absurd 6%.

(And yes, if you send me a bulleted explanation of why that 6% is justified, straight out of some brochure given to new agents by the National Association of Realtors, there is a 100% chance it will be reprinted on these pages with all sorts of friendly annotations from yours truly.)

In almost all of those cases, and certainly in the investment industry, the next step in our evolution toward Yay, alignment! was to move to a relationship-driven, asset-based fee or fee-for-service model. This form of better alignment is the rallying cry of the independent registered investment adviser and investment adviser representatives against their brethren at banks, wirehouses and independent brokerages.

So is this industry-wide move from commission-based to fee-based advisers good? Did it actually move us in the direction of better alignment?

Of course it did.

But not nearly as far as we all want to pretend.

Asset-based fees, management fees, advisory fees – whatever term of art your corner of the industry wants to use – eliminate the incentive to churn, but aligned? Come on. And in case you were wondering, this is absolutely a trope that is marketed to you to exploit the Yay, alignment! meme. For example, before Fisher Investments professionals were festively describing to conference-goers how selling to individual investors was like ‘getting into a girl’s pants’ (no, really, this is an actual thing that happened), they were spooning out hot garbage like this advertisement below.

Remember this?

The name of the ad spot is, “We do better when you do better.” This is the Yay, alignment! hook as she appears in the wild. I guarantee you the script to this thing recommended casting a substantially taller guy with an unbuttoned suit as the Fisher guy. In practice, some 90% of the amount of any asset-based fee without a fulcrum structure in a given year is going to be driven by whatever capital you gave the adviser to manage to start the year, and the lion’s share of the remaining difference will be driven by market returns outside of the adviser’s control. For an average balanced portfolio, the amount of the asset-based fee that reflects the job that was done? Maybe 2%, if you’ve got someone generating some tracking error by overweighting value indexes and emerging market stocks a little bit.

So, yes, the Fisher ad is bad and they should feel bad. Still, even if advisers don’t really do better when you do better in any real way that measures up to the meme, surely whatever incentive replaced the incentive to sell whatever you could sell is better.

What, then, IS the incentive for the fund manager, adviser or consultant in an asset-based fee framework?

To keep clipping coupons on your account.

In our heart of hearts – that is, when we aren’t justifying to someone else why people in our industry should be paid what we all get paid – we know that working hard enough to not get fired isn’t alignment, Bob. Not even close. But we’ve all perfected the tortured way in which we pretend that it is. The best part is that we get to summon the Yay, alignment! meme in a particularly special way while we do it. And what an empowering message it is: ‘If the client isn’t happy with the results, we don’t get paid. What could be more aligned than putting all the power in the hands of the client?’

See how easily bullshit rolls off the tongue when it’s wrapped in these seductive memes?

Don’t get me wrong. We can wish that paying people in this industry weren’t so expensive, or that accessing the circa-1987 technology in a Bloomberg terminal didn’t hit our P&Ls to the tune of a new Camry every year, but wishing won’t make it so. You’ve got to charge management fees. We do too. And doing so is usually going to put us in better alignment than commission-based compensation. But let’s drop the theatrics, people.

Paying asset-based fees won’t align you with your agents.

Except most of us rather like the theatrics.

So instead of dropping them, we double down. No, that’s not right. We lever it up ten times and call it super-aligned. How? By looking for and preferring equity ownership on the part of fund managers and financial advisers.

And look, I get why this is such a good-sounding thing. There is such a native appeal to the narrative of the guy-with-his-name-on-the-door who has real skin in the game, who would never let any of his clients be mistreated, lest his good name be besmirched. I get it. But the idea that this is the primary incentive created by equity ownership strains credulity. Take an honest look at what’s happening in the RIA space. Record number of M&A deals in 2016. We broke that record in 2017. Then we broke that record again in 2018. Similar consolidation cycles in many segments of the asset management space, too.

Folks, if you do business with an investment company that charges you an asset-based fee, there is a spreadsheet somewhere on their network drive with your name in Column A, your most recent AUM in Column B, your effective annual fee rate in Column C, and the number 10 (12 for people who hire aggressive bankers with shady comps) in Column D. In Column E is the amount of money they take off the table by selling your account to somebody. Buyers don’t pay very much for performance fees, and they aren’t crazy about things they perceive as being one-time in nature, like financial planning fees or estate planning fees. But recurring asset-based fees? Money in the bank.

Incentives don’t follow a direct path to behavior, of course. They pass through all sorts of work ethic, moral and process layers on their way, and so a decent human being with bad incentives may end up producing better results than a real jerk who ought to know where his bread is buttered. But find me an RIA principal thinking about selling his firm in the next 18-24 months, and I’ll find you a guy who doesn’t say no as often as he should to his clients’ insane IPO requests, who hews to US stocks and vanilla high-grade laddered munis, who wouldn’t give a thought to working to identify that higher volatility source of diversification for you. There are few incentives which I have observed having as direct an influence on realized behavior as an interest in the capitalized value of a management fee stream.

Now again, the point here isn’t to say that these aren’t things you should accept, or that they are Very, Very Bad. They aren’t. For better or worse, this is how our industry works right now. But if your diligence guidelines describe how you think equity ownership aligns an investment professional with long-term financial prudence and fiduciary principles and blah blah blah, you are deluding yourself. Sorry. I should know. I deluded myself on this point for a very long time. It aligns them with not pissing you off until they can get someone to pay them 10x against the run-rate revenue on your account.

This incentive not to piss you off doesn’t make them evil. It doesn’t make it worse than other bad forms of alignment.

But it also doesn’t make them aligned with you.

Most of us get this. Grudgingly, perhaps, but as long as someone isn’t trying to get us to agree to this in context of an argument about the level of compensation in the investment industry, we will usually go along with it. And if the SEC didn’t make it nearly impossible to charge performance or pseudo-performance fee structures (e.g. fulcrum fees, etc.) for retail investors or in the most common retail vehicles, I think many of us would do more than go along with it. We’d put our money where our mouth was and slap performance-based fees on everything.

Except, well, it’s probably performance fees that sing the most seductive Yay, alignment! song.

On the surface, it is hard to imagine anything more aligned than performance-based fees. You pay when you get performance. You don’t pay when you don’t.

Except that, like, you do.

There are two reasons why this is true. The first is well-trod, and so I won’t dwell on it too much. I will, however, say this: anyone who is paying performance-based fees for beta in 2019 is a sucker, and anyone who is charging performance-based fees for beta in 2019 is a raccoon. While there are blessedly fewer than there were a decade ago, there are still long/short equity and credit managers with persistent net exposures of 40-60% who argue that their net is not really beta but the outcome of an alpha process. It’s a garbage argument. They know it. You know it. And no matter how confident we might be in their edge or alpha generation potential, the odds against that ever realistically measuring up to 15-20% of that 40-60% beta exposure are astronomical. A performance-based fee on functionally static beta is a management fee. Again, this wouldn’t have been a novel observation even 10 years ago, but in the interest of completeness, a client paying performance-based fees on beta is in no way aligned with their manager.

There is a second issue, however, which consistently and structurally favors the chargers of performance-based fees against the payer: we systematically understate the experienced asymmetry of realized performance fees as a percentage of gross portfolio returns.

Here’s what I mean.

Let us say that you are an asset allocator with the opportunity to invest with a hedge fund charging a 20% performance fee. Let us be generous and presume that you would be likely to terminate this manager only if they (1) lost more than 10% in absolute terms since inception or (2) experienced a drawdown of more than 20%. Now let us assume that this manager has absolutely zero skill. A real Greenwich special.

Over a five year period, how much do you think you would pay in performance fees? Our analysis is too path-dependent for a closed-form solution, so let’s play it out 100,000 times for various levels of portfolio volatility. We are examining the realized fees that would be paid annually as a percentage of assets, making certain (pretty realistic) assumptions about when we would probably fire the manager. Each point on the below chart is the average from those 100,000 simulations for each level of volatility.

The gray line shows across each of those simulations how much, on average, you should expect to pay in performance fees per annum during years in which you are invested. Remember, this manager has zero skill. You have no expectation of long-term alpha.

In other words, for any realistic expectation of the life-cycle of an invested relationship with a manager that charges performance-based fees, you might expect to pay roughly 80% of the manager’s annualized volatility (multiplied by whatever the performance fee rate is) in performance-based fees every year FROM SHEER RANDOMNESS WITH ZERO EXPECTATION OF REAL ALPHA.

That is the power of the asymmetry of paying performance-based fees when they are earned, but almost never recouping them when that performance is lost. Now, it may be hard to visualize some of the most egregious scenarios that roll up into these aggregates, so let us now take a look at the distribution of fees paid against gross returns generated at a particular volatility level. Let us consider a hypothetical skill-less manager with 8% volatility.

Again, what we’re doing here is randomly generating returns for an 8% volatility manager for each of 5 years. We pay fees at 20% of alpha at the end of each year above the high-water mark, and we terminate the manager if they have lost more than 10% absolute since inception or if they have experienced a drawdown of 20% from their high-water mark. Each dot below shows one of the simulation outcomes over that five year period, where the X-Axis represents the cumulative (non-annualized) gross return and the Y-Axis represents the percentage of assets that have been paid in fees over the corresponding period.

It should be intuitive that the slope of the diagonal line reaching upward to the right at the edge of the dots is 0.2, or 20%, the performance fee rate. Perhaps less intuitive for those of us who haven’t accustomed ourselves to thinking about performance-based fees in a path-dependent way is that a huge share of the outcomes end up with us paying way, way more than 20%, at times with seemingly no real relationship to the amount of value added. Remember, these are simulations of the outcomes for a pretty normal investment manager with ZERO SKILL.

See everything to the left of the blue edge sloping at 0.2x, or the 20% performance fee rate you sold to your board? Those are cases where you paid more than 20% in the aggregate over a five-year period. See everything to the left of the sloped black line? Those are cases where you paid this no-talent clown more in performance fees than the total gross performance they generated. In around 57-58% of these cases, your manager produced negative cumulative returns by the time you canned them. In about 47% of those cases, you still paid them a performance fee. In about 60% of those cases, that fee was more than 1%.

Friends, this is the water in which your incentive alignment structure swims. This is the bogey, the noise against whatever signal exists in your manager’s alpha/performance fee relationship must compete for us to consider it true alignment.

In any realistic path-dependent analysis, performance-based fees are far too noisy to align you with your managers.

So why do these fees exist?

Maybe because they can occasionally be structured to truly reflect a shared set of interests. Truly. It does happen.

Maybe because for some rare sources of alpha, even the likely elevated realized performance fee experience will be worth it.

But really? They exist because people who can charge these fees know that asset owners have boards that feel better and are less concerned about paying fees in particular periods where the returns are very good. They know that when we present funds for approval, we all show the linear scenarios of fees paid in different return scenarios, and that we heavily sell the downside scenarios where we don’t pay as much as we would under a management fee heavy structure. They know that we never, ever show the path dependent scenarios in which we pay fees early, hit a drawdown and terminate, and they know that no one ever, ever asks to see that illustration – even though it may be among the most inevitable outcomes in all of finance.

There is bigger game afoot here, too. In a very real way, by embracing the Yay, alignment! meme so wholeheartedly, we have institutionalized the ability of a class of individuals to extract mathematically inevitable rents from the act of doing nothing other than taking risk with our money and the money of our fiduciary charges.

So what do we do? If most of what we call alignment are right-sounding cartoons which enable massive compensation schemes, how do we achieve real alignment with our financial advisers, fund managers and consultants?

Simple. We don’t.

Sorry, were you expecting a panacea? There isn’t one. You cannot structure away principal-agent problems. And that’s the point. The manipulation of the meme of Yay, alignment! is designed to make you believe that it is possible to do so in order to agree to compensation schemes and arguments for ‘alignment’ of incentives which do absolutely nothing of the sort.

But here’s what we can do:

  1. We can demand beta hurdles: Guys. It’s 2019. Friends don’t let friends pay fees for beta. Stop doing it and stop explaining it away. When they tell you their consistent 40-60% net long exposure is an outcome of their alpha process and not really a beta, tell them they are full of it, and move on if you can’t move them off it. Seriously. You should already be skeptical about alpha. If you are paying 15-20% on a static 0.4-0.6 beta AND paying the volatility tax, the hurdle on your alpha expectations will be insurmountably high for just about any fund manager in the world.
  2. We can look more favorably on multi-year crystallization fee structures: These were all the rage a few years back, especially among more long-biased equity funds. Still, some liquid markets managers have and continue to offer multi-year crystallization on incentive fees in exchange for lockups on capital. My view is that the price you should demand for illiquidity is nearly always dwarfed by the benefit you gain from functional clawbacks on performance fees that would have been moot with shorter horizon fee crystallization.
  3. We can more eagerly pursue cross-fund netting: As allocators, we feel inclined to spread capital around to specialists. It feels right. It feels sophisticated. It feels like we’re doing the work we are paid to do. But the path-dependent power of getting to net the performance-based fees of multiple funds from a single investment partner with multiple investment capabilities often exceeds whatever “uniqueness” benefit we typically get from spreading assets around to smaller, less capacity-constrained, more ‘hungry’ boutiques. Sorry. I know that’s going to be an unpopular view. But asymmetry is a curse. Not nearly enough large, influential allocators take advantage of this.
  4. We can start paying more attention to our advisers/managers’ incentives to sell their firms: There is little more destabilizing to our simple point-in-time estimates of incentive alignment than the hidden calculus of how much an investment firm is worth. We can spend less time thinking about how much someone’s name on the door will make them act honorably, and more time thinking about how much a 10x multiple slapped on our account will make them act irresponsibly with our money.
  5. We can be very careful about the volatility tax we pay on our own behavior when hiring higher volatility managers with incentive fees: As we start to become more selective in our use of alternatives, we will often – appropriately – drift toward higher volatility, higher leverage or higher tracking error strategies to make better use of our various budgets. But take care: the bogey that we are charged in practice on the asymmetry of performance-based fees becomes particularly egregious on higher volatility strategies. If we must go this direction, relying more heavily on systematic managers who more explicitly track, target and limit risk seems prudent.

But most importantly, we can stop thinking that we can and will ever be aligned with our agents. We can’t. We won’t. And the sooner we realize that, the sooner we will also realize that anything being sold to us under the meme of Yay, alignment! ought to be seen with Clear Eyes. Not dismissed. Not rejected. But understood for what it is, lest those we hire to represent our interests hoist us by our own petard of ‘alignment.’

PDF Download (Paid Subscription Required): By Our Own Petard


Sneak Preview


I was invited by the Financial Times to write a guest post on my recent windmill-tilting exercise of calling attention to how corporate management is using increasingly large stock buybacks to mask increasingly large stock-based comp packages issued to themselves. That post should appear in the Market Insights column online next Monday and on the back page of the paper next Tuesday (possibly this Friday), but I thought I would give you all a sneak preview today!

I think (hope) that it’s the sort of article that can create a bit of a stir on its own, so I’ve toned down some of my more incendiary language on stock buybacks that I might use on Twitter. At the bottom of the piece, I’ve also appended my notes to the FT editor so that you can see the math behind the “Lycroloft” example. MSFT 10-K available for download here.

If you’ve missed any of the notes I’ve written to date on the topic, here are the links:

Yeah, It’s Still Water (Texas Instruments)

When Was I Radicalized? (Boeing)

The Rake (JP Morgan)

OK, Boomer (FedEx … not directly on this topic, but of somewhat related interest)

As always, I’m keen to get your take on this. And if you happen to run through your favorite company’s 10-K and find something interesting to relate, I’m all ears! – Ben


In poker, the rake is the cut that the casino dealer takes out of every pot. It’s usually a couple of dollars per hand … barely noticeable, certainly not to a donkey poker player like me.

But what if the dealer started taking 10% out of every pot? Would you notice then? How about 20%? How about 70%?

That’s what many large public companies are doing today, taking a rake of anywhere between 10% and 70% from the “pot” of stock buybacks – the hundreds of billions of dollars that these corporations make as a “return of shareholder capital” every year.

And no one is noticing.

This is the agency problem, a classic conundrum of economics, where shareholders’ agents – corporate management – find ways to enrich themselves at the expense of shareholders by gaming the system.

How does this latest incarnation of the agency problem work? Through massive stock issuance programs, masked and sterilized by even more massive stock buyback programs.

When a company issues new shares to employees with one hand (at a low price) and buys back those shares on the open market with the other hand (at a higher price), that price difference multiplied by the number of wash-traded shares equals value that never reaches shareholders at all, but is entirely captured by the recipients of the new shares. Please note that this value is lost to shareholders and captured by the employees whether or not their new shares are sold back to the company in the open market buyback operation. It’s an accounting identity. As the “Yay, stock buybacks!” crew likes to say, it’s just math.

For example, let’s say a company whose name rhymes with Lycroloft trumpets a big stock buyback program in their year-end earnings call, where they “returned capital to shareholders” in the prior 12 months by spending $16.8 billion to buy back 150 million shares of common stock on the open market. Sounds great, right? Very shareholder friendly!

But let’s also say that same company issued 116 million brand new shares to employees over those same 12 months as a result of employees exercising their stock options or vesting their previously restricted stock units (RSUs). The company receives some cash from their employees as these options are exercised and RSUs are vested (about $1.1 billion in this case), but obviously these new shares are being issued to employees at a dramatically lower average price than the average price of the same year’s open market buyback activity.

As a result, more than 60% of the total buyback “pot” that we donkey investors thought was coming to us as shareholders, close to $12 billion for this one company in this one year, is actually being raked by management to distribute among themselves.

Is this rake widely distributed among corporate employees? There’s no clean data on this, as – quelle surprise! – companies provide next to zero detail on the recipients of new stock issuance in their 10-Ks. What’s clear, however, from even a cursory review of the stock holdings of “insiders” at any big public company (Form 4 in SEC-speak), is that senior managers have done particularly well in this new regime of more stock issuance sterilized by more stock buybacks.

It’s not only CEO billionaires like Jamie Dimon, who owns more than 7 million shares of JP Morgan stock, or near billionaires like Tim Cook, who sold $114 million of freshly granted Apple stock just this August. It’s not only independent directors like Al Gore, who was issued 80,000 shares of Apple stock over the past two years, worth $21 million, after selling $38 million worth of stock in 2017. It’s the centimillionaire COOs and CFOs. It’s the legion of decamillionaire vice presidents and business line managers.

I think it’s a historic wealth transfer from shareholders to the managerial class. Not to founders or entrepreneurs or risk-takers. To managers.

What’s to be done? Here are three suggestions to start changing the incentives of rake-taking dealers.

  1. Separate the CEO and Chair positions of publicly traded companies. When the Chair of JP Morgan, Jamie Dimon, says in his 60 Minutes interview that the board independently sets the salary of the CEO of JP Morgan, also Jamie Dimon, we may be forgiven our incredulity. Let’s remove this obvious vehicle for the agency problem.
  2. No stock-based compensation for independent directors. Cash only. Let’s not give guardians of the shareholder hen-house any fox-like incentives.
  3. No exercise of stock-based compensation by ANY directors, independent or not, while they serve on the board. Again, hen-house. Again, fox-like incentives.

We’re never going to eliminate the agency problem, and the dealer deserves a proper rake. But we better start making this casino fairer to shareholders and less of a wealth transfer engine to the managerial 1%. Or someone is going to burn the casino down.


Notes to FT editor …

  1. On Microsoft …  see page 72 of 157 in the PDF (pg 44 of the original doc) for the FY 2019 open-market share repurchase of 150 million shares for $16.8 billion. Note that some sources like Bloomberg show total share repurchases for FY 19 were $19.5 billion, but that includes $2.7 billion that MSFT used to repurchase stock directly from management for tax withholding purposes, NOT open-market buyback operations. The note on the $2.7 billion (as well as more info on the open-market buyback) is on page 132 of 157 in the PDF.
  2. Also on Microsoft … see page 131 of 157 in the PDF (pg 85 of the original doc) for the FY 2019 new share issuance of 116 million shares. The $1.1 billion in funds received for that issuance is on page 85 of 157 in the PDF.
  3. The math on Microsoft is as follows … $16.8 billion spent on open-market buybacks divided by 150 million shares is an average price paid of $112.00 … $1.1 billion received on 116 million shares in an average price received of $9.48 … the difference in price per share paid and price per share received ($102.52), multiplied by the number of wash-traded shares (116 million), is the value received by employees ($11.9 billion). The total buyback “pot” is $19.5 billion ($16.8 b in open-market purchases + $2.7 b in direct-to-mgmt purchases), and $11.9 billion is 61% of that.

OK, Boomer


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How FedEx Cut Its Tax Bill to $0   [New York Times]

“The company, like much of corporate America, has not made good on its promised investment surge from President Trump’s 2017 tax cuts.”

“Nearly two years after the tax law passed, the windfall to corporations like FedEx is becoming clear. A New York Times analysis of data compiled by Capital IQ shows no statistically meaningful relationship between the size of the tax cut that companies and industries received and the investments they made. If anything, the companies that received the biggest tax cuts increased their capital investment by less, on average, than companies that got smaller cuts.”

“FedEx’s financial filings show that the law has so far saved it at least $1.6 billion. Its financial filings show it owed no taxes in the 2018 fiscal year overall. Company officials said FedEx paid $2 billion in total federal income taxes over the past 10 years.”

Fact check: TRUE.

Fact check: ALSO TRUE.

I think FedEx is one of the crown jewels of Western capitalism. This is a company that has invested (and continues to invest) billions of dollars in the US economy, creating (and continuing to create) tens of thousands of jobs.

I think FedEx can spend whatever tax cut windfalls they might receive in whatever way is best for their shareholders. There’s nothing unfair or wrong about that.

I think Fred Smith is one of the crown jewels of Western capitalism, too. His personal story is an inspiring one of risk-taking and patriotism.

I think Fred Smith, entrepreneur and risk-taker, can be as rich as he wants to be, and there’s nothing unfair or wrong about that, either.

But here’s the thing …

If I hear another lecture from Fred Smith and his fellow billionaires on trickle-down tax cuts and the “benefits to the United States economy, especially lower and middle class wage earners”, I’m going to lose it.

If I hear another lecture from Jay Powell and his fellow centimillionaires and decamillionaires at the Fed on trickle-down monetary policy and the “benefits to the United States economy, especially lower and middle class wage earners”, I’m going to lose it.

OK, boomer.

What’s the boomer world?

It’s a world where our current President is an on-the-make billionaire, and our most recent former President seems hell-bent on becoming one. A world where lawyers from Citadel write our securities regulations, and VPs from Boeing run our Defense Dept. A world where corporate managers can become billionaires – not by innovation or risk-taking – but by stock-based comp at scale. A world where asset managers can become billionaires – not by invention or outperformance – but by asset-gathering at scale.

It’s a world that has been systematically hollowed out for decades, through narrative capture of monetary policy, trade policy, antitrust law, mass media and the tax code.

“Yay, trickle-down economics!”

It’s a bipartisan thing. It’s a Zeitgeist thing.

And the 2017 Tax Cuts and (LOL) Jobs Act was just the latest smiley-face punch in the gut.

Worried about losing your freedom to a redistributive State? I think you’ve already lost it.

Just not in the direction you thought.


The Rake


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In a poker game, the rake is the cut that the casino dealer takes out of every pot. It’s usually a couple of dollars per hand … barely noticeable, certainly not noticeable to a casual poker player like me.

But what if the dealer started taking 18-25% out of every pot as his rake? Would you notice then?

That’s what JP Morgan management does with its “return of shareholder capital” through stock buybacks.

Cramer: Jamie Dimon, when questioned about $31 million pay, should have said he’s worth it   [CNBC]

“I would’ve said, ’Look I know you think that I may be overpaid but I do point out that others have shared in the wealth,” the “Mad Money” host says.

In 2018, JP Morgan bought back 181.5 million shares of stock for $20 billion. Also in 2018, JP Morgan issued 32 million new shares to management (18% of buyback). Those newly issued shares were worth $3.5 billion then, and are worth $4.2 billion today.

In 2017, JP Morgan bought back 166.6 million shares of stock for $15.4 billion. Also in 2017, JP Morgan issued 31 million new shares to management (18% of buyback). Those newly issued shares were worth $2.9 billion then, and are worth $4.03 billion today.

In 2016, JP Morgan bought back 140.4 million shares of stock for $9.1 billion. Also in 2016, JP Morgan issued 38 million new shares to management (27% of buyback). Those newly issued shares were worth $2.5 billion then, and are worth $4.94 billion today.

Were these newly issued shares spread evenly throughout the company, perhaps as part of an employee stock ownership program (ESOP)?

No. In each year, there were fewer than 1 million shares issued for the JP Morgan ESOP program, less than 3% of the dilutive issuance. Senior management received more than 97% of the newly issued shares.

Today, Jamie Dimon owns more than 7.8 million shares of JP Morgan, worth more than $1 billion. Some of these shares were purchased by Dimon on the open market. Most of them were not.

There are several JP Morgan senior executives listed on Form 4 who are centimillionaires from their stock holdings. More than a dozen are decamillionaires, most several times over.

One day we will recognize the defining Zeitgeist of the Obama/Trump years for what it is: an unparalleled transfer of wealth to the managerial class.

Not founders. Not entrepreneurs. Not visionaries.

Nope … managers.





Here’s JP Morgan’s stock performance over these three years.

Not bad. Up 48% over the three years versus the S&P 500 up 23%. On a total return basis – which includes dividends (a true return of capital to investors IMO) reinvested in JPM – it looks even better … up 59% versus the S&P 500 up 30%.

Are Jamie Dimon and team good managers?

I think you’d have to say yes, although it’s also … difficult … to overlook the various felony charges and billions in civil settlements that have been assessed against JP Morgan during Dimon’s long tenure.

Did you know that Jamie Dimon and team are taking an 18-27% rake from the multi-billion dollar stock buybacks that JP Morgan announces every year?

I bet you didn’t. And no, it wasn’t always this way.

Are Jamie Dimon and team worth the 18-27% rake they take from the multi-billion dollar stock buybacks that JP Morgan announces every year?

I don’t think so. I think it’s obscene.

I think the way in which corporate management teams like JP Morgan’s have captured their compensation plans to enrich themselves at the expense of shareholders is a micro-version of the way in which Oligarchs have captured monetary policy and tax policy and trade policy and antitrust policy and securities policy to enrich themselves at the expense of citizens.

What is rent-seeking?

It’s setting the RULES – in big ways like tax policy and in small ways like compensation policy – to benefit the rule-setters over the people the rules are supposed to benefit.

And because it’s the RULES … well, you don’t even notice it.

Particularly if it’s masked by a compelling narrative like “Yay, Stock Buybacks!”.

What is rent-seeking?

It’s the rake.

I think these obscene rakes should be stopped and rolled back. Sadly, I think these obscene rakes are so ingrained in our economy and our politics that they are immune to incremental policy measures. Sadly, I think we have to take a flamethrower to these rakes to change any of this.

But that’s just me.

I understand and appreciate that you may feel differently about both the appropriate level of compensation for corporate management and – even if you agree with me about its obscenity – you may disagree with me about what actions should be taken to address this, and by whom. For example, Rusty and I disagree about a LOT of this on the policy/regulatory intervention side. Amazingly enough, we can disagree on this without accusing the other of lacking basic math skills. Yes, this is a subtweet.

Recognizing that well-meaning people can disagree on the urgency of the problem and how to redress it, I want to suggest three non-flamethrower policies that I think (hope) can get wide agreement. They all stem from this quote by Jamie Dimon in last Sunday’s 60 Minutes interview, when Leslie Stahl asked him if he thought his compensation was “appropriate”:

The Board sets my pay. I have nothing to do with it.

The Chairman of the JP Morgan board of directors is … Jamie Dimon.

And don’t @ me about independent directors and compensation sub-committees and all that. Just don’t. Don’t even start. Because you KNOW that’s bullshit. And so does Jamie Dimon.

So here are my three non-flamethrower policy proposals. These can all be legislated or regulated into existence tomorrow if there were political will to do so.

1) Require by law that the board Chair of publicly traded companies may not also be the CEO. [and if you really want to get serious about this, require that the board Chair be an independent director]

2) Require by law that board directors may only receive cash compensation for their services and are not eligible for any form of stock-based compensation.

3) Require by law that board directors may not exercise any form of previously granted stock-based compensation while they serve on the board.

Do these proposals go far enough? I don’t think so.

But they’re a start.


Silly Season


There’s something weird happening in narrative-world, and I’ve been trying to figure out what it means since we published our monthly Narrative Monitors update last week (attached to this email). I still can’t figure it out, but instead of continuing to wrestle in silence, I’m going to tell you what I find odd and ask what you think it means … if anything. It’s entirely possible that I’m just too much in my head on this.

First I’ll report on what we saw in the Monitors from October’s financial media.

Inflation – “Inflation narratives faded in both cohesion and attention in October. Any inflation narrative exists almost wholly within political worldas opposed to market world.”

Central Bank Omnipotence – “the level of attention on central bank narratives has faded rapidly: common knowledge has emerged that other investors are more focused on trade, IPO market/growth issues and election politics.”

Trade and Tariffs – “the attention on Trade War narratives has ticked down from our maximum level for the first time in months.”

US Recession – “US recession commentary drifted downward in both cohesion and attention in October.”

US Fiscal Policy – “there is no Fiscal Policy, Deficit or Austerity narrative, at least as it concerns markets.”

Individually, none of these Monitor reports is that odd. Taken together, though … well, that’s the weird part. Our measures of attention (drumbeating on an issue in financial media relative to all other issues) fell in October for ALL of these market-impacting macro narratives. Yes, Trade & Tariffs is still garnering a lot of attention, clearly the most of any of these standing issues. But even there we saw a noticeable decline in both the number of articles published in financial media on the topic and – much more importantly for our research – the centrality or “gravity” of those articles relative to other topics.

What took the place of these core macro factors? Well, we saw a ton of articles about politics … both impeachment and “how a Warren Presidency would destroy markets as we know them” articles. We also saw a lot of “OMG, WeWork” articles. I doubt that the spate of WeWork articles persists, although the Street really needs a good IPO to take the stench out … so we’ll probably get just that.

But I think we’re just getting started on the dominance of political narratives in financial media.

In fact, if you look at the Monitor narratives in terms of political-world rather than market-world, both Inflation and US Fiscal Policy are pretty darn robust in their attention scores. That is, “people are talking” about prices and taxes and spending as it impacts politics. People are not talking AT ALL about prices and taxes and spending as it impacts markets.

Or market prices.

Which leads me to the big question I have … and it’s the big question I don’t have an answer for:

At what point, if ever, do political narratives about Inflation and Fiscal Policy become market narratives about Inflation and Fiscal Policy?

Because right now they’re not, so we gravitate to new market high after new market high. And it is entirely conceivable to me that they never do – become market narratives, that is – and we continue to live in this, the best of all possible worlds. But I’m trying to figure out what might make that transition happen. Is it just time and getting closer to the election? Is it something else? That’s the weirdness that I’m wrestling with. As always, I’d love to hear your thoughts.


Bye, Alexa…


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Leave aside the question of whether you care about wealth concentration or believe in any socially deleterious effects it might have. Ignore whether you believe that Amazon or any other Big Tech company is really an anti-competitive monopoly. Do you disagree with Ben about wealth taxes? Hold that in abeyance, too.

Why? Because what we personally believe about each of these things isn’t the same thing as what we all believe we all believe, or what we all know that we all know – a thing which we call Common Knowledge. And it is Common Knowledge, rather than the sum total of all of our deeply held personal beliefs, which usually shapes our culture and our politics.

The more we glance at the top of the Zeitgeist, our daily collection of the most linguistically connected articles in financial news, the more often we see common threads with our Election Index. In many ways, the framing of all news through the lens of income inequality, monopoly power and the influence of Big Tech IS the zeitgeist.

It shouldn’t be surprising, then, that this article about the apparent attempts by Amazon and Bezos to steer the outcome of a local city council election ranks so highly.

Amazon’s $1.5 million political gambit backfires in Seattle City Council election [Reuters]

To date – and it’s true with this article and its neighbors, too – the most powerful connections between finance and markets articles have been phrases like ‘socialist’, ‘billionaire class’ and ‘unprecedented spending’. Still, it’s hard not to observe a subtle transition happening here. Here the main event isn’t just income inequality or power and influence per se, but the framing of Amazon’s use of wealth to generate political power as ‘backfiring‘ and ‘repudiated.’ I think that similar language in coverage of Bloomberg’s primary bid and the related Howard Schultz retrospectives probably contributed to that. So maybe this is anecdotal.

But if we’re not looking ahead to consider what else we might all know that we all know through these lenses, that’s a failure of imagination on our part.


The Age of the High-Functioning Sociopath


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I’m old enough to remember when Donald Trump, the President-elect of the United States, and Masayoshi Son, CEO of Softbank, had an impromptu press conference in the Trump Tower lobby to trumpet the FIFTY THOUSAND JOBS and FIFTY BILLION DOLLAR INVESTMENT that Softbank would be bringing to the US.

As the articles covering this “incredible and historic” meeting pointed out, “Mr. Trump took credit for the investment, saying his November victory spurred SoftBank’s decision.”

When Billionaires Meet: $50 Billion Pledge From SoftBank to Trump   [Wall Street Journal]

Masayoshi Son, the brash billionaire who controls Sprint Corp., said Tuesday he would invest $50 billion in the U.S. and create 50,000 new jobs, following a 45-minute private meeting with President-elect Donald Trump.

The telecom mogul, who made his fortune in Japan with SoftBank GroupCorp., announced his investment plans in the lobby of Trump Tower, though he didn’t provide details. Mr. Trump took credit for the investment, saying his November victory spurred SoftBank’s decision.

The focal point of Son’s meeting with Trump was a three or four slide powerpoint deck that they both initialed. I have no idea what it means to say “$50bn + $7bn” and “50k + 50k new jobs”, but what the hell.

I thought about that Trump Tower deck when I saw the most recent Softbank and Vision Fund investor deck, presented in the aftermath of the WeWork IPO debacle and Softbank’s subsequent refinancing of the company.

That deck, apparently meant to “reassure” investors, was chock-full of slides like the ones I’m going to present without comment below. Honestly, when I first saw these slides on social media, I was certain that they were photoshopped. I was certain they were a put-on.

They’re not.

At some point, I expect this deck will be lost to the sands of time, so to preserve it for posterity I’ve saved a copy on our servers. You can download the Softbank Investor Deck here, if you like.

In the immortal words of transcendentalist poet Walt Whitman,

You just can’t make this shit up.

Haha, JK. Walt Whitman never said that.

But then again … maybe he did! How do you know for sure he didn’t? Maybe he muttered it to himself after a series of fishing mishaps out there on Walden Pond.

What’s that you say? … it was Thoreau who lived on Walden Pond, not Whitman? Are you sure about that, friend? Are you sure that Walt Whitman never visited Henry Thoreau and went fishing and lost a couple of hooks and said this?

Because lots of people are saying that it’s possible he did.

Because apparently I can say ANYTHING in an SEC-compliant investor presentation if I just put some 3-point font disclaimers at the bottom of a slide and say it’s possible.

Why should we play by the rules when raccoons like Donald Trump and Masayoshi Son not only break them with impunity and ludicrous intent, but are celebrated and made rich for breaking them?

Why should we care about anything when nothing matters?

Because you’re not a sociopath.

Because you care about your Pack.

Yes, this is the Age of the High-Functioning Sociopath. Yes, this is the Age of Sheep Logic. Yes, this the age where scale and mass distribution are ends in themselves, where the supercilious State knows what’s best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery.

Stipulated. What, did you think this was going to be easy?

These clowns don’t deserve us. And it will take decades of a persistent, bottom-up social movement that rejects and negs and ridicules them … ALL OF THEM … before we have the opportunity to reclaim our world.

The Age of the High-Functioning Sociopath will never change on a single point of failure like an election. Or a “suicide”. Or an impeachment. Or a busted IPO.

But a MILLION points of failure? A MILLION points of rejection and negging and ridicule?

Yeah, that can work.

So let’s get started.


US Recession Monitor – 10.31.2019


Access the Powerpoint slides of this month’s ET Pro monitors here.

Access the PDF version of the ET Pro monitor slides here.

Access the underlying Excel data here.

  • US recession commentary drifted downward in both cohesion and attention in October.
  • As with other narratives, we believe this took place in part because of general distraction on multiple macro risks. Still, it is our judgment that this is also in part a result of growing Common Knowledge that the recession bullet (in the US anyway) that recession risks have largely been dodged (or will be addressed in market space through aggressive CB policy).
  • Also similar to other topics, recession coverage is intensely intertwined with Trade/Tariffs (the common knowledge proximate cause) and broad common knowledge of the need for, inevitability of and market efficacy of stimulus.
  • Everyone knows that everyone knows that the Fed and tariff tweets will determine asset prices for now, not economic fundamentals.
  • Sentiment is still negative enough to highlight that the economy remains a political talking point, so we wouldn’t call this a complacent narrative structure.
  • Still, we believe rapidly falling attention is often accompanied by increased magnitude of surprise to any negative events.

Narrative Map

Narrative Attention Map

Narrative Attention

Narrative Cohesion

Fiat News Index

Narrative Sentiment

Key Articles

Trump May Abandon Toughest China Trade Demands, Says Private Equity Chief [Bloomberg]

Fed to cut rates again, but other economic concerns are emerging ahead of election [CNBC]

Markets drop another week on signs of economic weakness [Washington Post]

Trump and China Have a “Phase One Deal” The World Economy Is Still at Risk. [NY Times]

Federal government has dramatically expanded exposure to risky mortgages [Washington Post]


US Fiscal Policy Monitor – 10.31.2019


Access the Powerpoint slides of this month’s ET Pro monitors here.

Access the PDF version of the ET Pro monitor slides here.

Access the underlying Excel data here.

  • No change in October: there is no Fiscal Policy, Deficit or Austerity narrative, at least as it concerns markets.
  • Sentiment on these topics has rebounded slightly, but it still remains deeply negative.
  • As with inflation, we believe that is because of narratives in political world. There, we do observe an emerging language about US debt levels, deficits and spending. It exists purely in political and wonkish debates, and has been almost completely untethered from financial markets discussion.
  • We have said that the monetary narrative in 2019 is that it means nothing in the real world and everything in the world of asset prices. Is common knowledge about deficits the opposite? Irrelevant to markets, but meaningful to the real economy?
  • Not yet. But as we argued in our September report, it does imply a complacency about the issue in markets.

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention Map

Source: Quid, Epsilon Theory

Narrative Cohesion

Fiat News Index

Narrative Sentiment

Key Articles

Federal Budget Deficit Swelled to Nearly $1 Trillion in 2019 [NY Times]

The Finance 202: Trump team drops push for key economic reform from Chinese [Washington Post]

Expect Bigger Deficits and Energy Unease Under a Trudeau Minority [Bloomberg]

Japan Raises Taxes on Its Spenders Despite Growth Worries [NY Times]

Are Congressional oil sales risking an oil price spike? [Houston Chronicle]


Trade and Tariffs Monitor – 10.31.2019


Access the Powerpoint slides of this month’s ET Pro monitors here.

Access the PDF version of the ET Pro monitor slides here.

Access the underlying Excel data here.

  • It is Common Knowledge that the China Trade War remains the most important risk/event to other investors.
  • The emergence of and resulting distraction form two additional core market topics, however, has meant that the attention on Trade War narratives has ticked down from our maximum level for the first time in month (see additional attention graphs below)
    • 2020 Election Politics and Impeachment; and
    • The Implications of a Failing IPO Market.
  • Our core view remains the same: this is an unpredictable Game of Chicken that warrants very little use of investors’ respective risk budgets. • • The fall in attention and stabilizing sentiment also leaves us concerned that many investors may be somewhat complacent about how risky assets would react to a return to negative trade news or political escalation.

Narrative Map

Narrative Attention Map

Supplemental Attention Maps

Narrative Attention

Narrative Cohesion

Fiat News Index

Narrative Sentiment

Key Articles

No Joy at the Factory on National Manufacturing Day [Bloomberg]

Nomura Says Hedge Funds Appear Bullish on Asia Before Trade Talks [Bloomberg]

Agriculture Funds Aim to Harvest Profit, Along With Corn and Wheat [NY Times]

U.S. markets tepid as trade uncertainty dampens a banner week for stocks [Washington Post]

U.K. Election Looms as Johnson Accepts Extension: Brexit Update [Bloomberg]


Central Bank Omnipotence Monitor – 10.31.2019


Access the Powerpoint slides of this month’s ET Pro monitors here.

Access the PDF version of the ET Pro monitor slides here.

Access the underlying Excel data here.

  • As we noted last month, the cohesiveness around a “Fed must continue to act” narrative remains at moderate levels.
  • We also think the common knowledge of excessively slow rate cuts by the Fed – again, not the personal intellectual belief in the mistake, but a belief that the market believes that the market believes it – continues to exist:
    • We think the sharp drop in sentiment attached to this coverage is partially reflective of the language expressing this view.
    • We also think from the language of some articles that it reflects a growing common knowledge of the limited real-world impact of this stimulus.
  • Importantly, however, the level of attention on central bank narratives has faded rapidly:
    • Common knowledge has emerged that other investors are more focused on trade, IPO market/growth issues and election politics.
    • We think this means that any negative surprise on continued easing expectations could have a more dramatic impact than investors / markets have discounted.

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention Map

Source: Quid, Epsilon Theory

Narrative Attention

Narrative Cohesion

Fiat News Index

Narrative Sentiment

Key Articles

The Longer-Term Lessons of the Repo Turmoil [Bloomberg]

Morgan Stanley Tells Stock Bulls Not to Kid Themselves on Trade [Bloomberg]

Pension Obligation Bonds May Soon Have Their Moment [Bloomberg]

Wage inequality is surging in California – and not just on the coast. Here’s why [LA Times]

Markets now see a 90% chance Fed will cut rates this month after weak services data [CNBC]


Inflation Monitor – 10.31.2019


Access the Powerpoint slides of this month’s ET Pro monitors here.

Access the PDF version of the ET Pro monitor slides here.

Access the underlying Excel data here.

  • Similarly to every other major topic we consider, Inflation narratives faded in both cohesion and attention in October.
  • Any inflation narrative exists almost wholly within political world as opposed to market world – for example, we continue to see election season-related rhetoric surrounding health care, housing and education inflation which continues to have only tangential relationship to market discussions.
  • The continued decline in sentiment appears to be related to these political inflation discussions.
  • Still, our conclusion from last month remains: a low attention narrative structure with very high fiat news and historically negative sentiment strikes us as one with higher than average asymmetry – especially in context of the strong common knowledge around central bank omnipotence.

Narrative Map

Source: Quid, Epsilon Theory

Narrative Attention Map

Source: Quid, Epsilon Theory

Narrative Attention

Narrative Cohesion

Fiat News Index

Narrative Sentiment

Key Articles

Wall Street faces a tough earnings season: ‘Caution probably makes sense right now’ [CNBC]

Secretive Chinese Tycoon Once in Short Sellers’ Crosshairs Dies [Bloomberg]

Trump’s Trade War Escalation Will Exact Economic Pain, Adviser Says [NY Times]

It’s America First and Forever at This Rate [Reuters]

Income inequality on the rise in Texas [Houston Chronicle]


When Was I Radicalized? (Boeing edition)


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Dick Fuld

That’s Dick “Gorilla” Fuld, former CEO of Lehman Brothers, who oversaw a criminal fraud conspiracy that went by the name of Repo 105.

Dick Fuld never saw a courtroom, much less a jail cell.

When was I radicalized?

When Dick Fuld walked away scot-free from Lehman with half a billion dollars in cash comp and stock sales during his tenure.

I thought of Dick Fuld today when I saw this picture and read this article.

Prosecutors Face Complex Path to Charging Boeing Over 737 MAX   [Wall Street Journal]

To bring a successful criminal case against Boeing itself, prosecutors would have to show that executives repeatedly concealed or ignored the 737 MAX’s engineering problems, experts said.

And there is a larger economic and political component: A corporate indictment and potentially huge sanctions must be balanced against the economic and national-security risks of incapacitating the country’s second-biggest defense contractor.

That’s Boeing CEO Dennis Muilenburg, about to testify before Congress about the 737 MAX.

The article is correct, of course. There’s no way that the Justice Dept. will ever bring a criminal case against Boeing, not one that hits top management or really shackles the company.

And I know that Boeing said today that Muilenburg won’t get a bonus or (more) stock grants until the 737 MAX is flying again, but this article got Radical Me thinking …

I wonder how much money Muilenburg and his management team and his board of directors have pocketed since he took over as CEO in 2015 and Chairman in 2016?

I wonder if executive compensation practices have changed over that span since … you know … Boeing started buying back nine billion dollars of stock every year?

Tell you what, I’ll make it easy and I won’t even count the cash compensation of Boeing management since 2016. I’ll just stick to the direct value of the sterilized stock options they exercised and the restricted stock units they were vested. And I won’t count any compensation of any sort here in 2019.

Over the 3-year period 2016 through 2018, Boeing employees received newly issued stock that’s worth $4.9 billion today. There was another $3.5 billion worth of stock issued to the Boeing pension plan, which was immediately sold into the open market.

As a result, $5.4 billion of the $25.2 billion in stock buybacks that you thought was a “return of capital” over that span was actually a USE OF CASH to either buy shares directly from management or mask the dilution of non-management shareholders.

In 2017 alone, the one good stock-performance year Boeing has had in a decade, $3.8 billion in buyback activity went to sterilize new stock issuance. That’s 29% of cashflow from operations for the year. The board totally reconfigured their stock compensation system to accomplish that. You know, the board that Muilenburg took over the year before.

And as they say on Wheel of Fortune, once you buy a prize, it’s yours to keep. There’s no clawback here. There’s no repercussion over the 737 MAX, either civil or criminal, for Muilenburg and crew. The only thing the 737 MAX debacle is going to make more difficult is for these same guys to pocket ANOTHER fortune.

And yes, some portion of this stock-based comp went to rank-and-file Boeing employees … I figure 5-10% is a good rule of thumb for most S&P 500 companies and their employee stock ownership programs (ESOPs). The balance went to employees as part of whatever employment agreement they might have, and the Boeing 10-Ks are silent on the distribution profile of that. But remember, I’m not even counting cash comp here. This is three years of stock comp for the management of an American icon of a company that had two so-so years and one really good year.

Is Muilenburg a billionaire from being a Boeing management lifer?

A guy who says his top management “insights” are:

“React quickly. Events can change everything. So must you.”

“Know your team. What really matters to them, on every scale?”

“Chart the course. What should the next 100 years look like?”

No, he’s not a billionaire. He’s just a centimillionaire CEO of a Too Big To Fail company.


Yeah, It’s Still Water.

It’s the greatest transfer of wealth in 100 years. Not to founders. Not to visionaries. Not to inventors. Not to entrepreneurs. Nope … to managers.

This is the story of every S&P 500 company over the past five years.

Oh yeah, one more thing for the “Yay, Stock Buybacks!” crowd.

Over the past 20 years, Boeing has NOT bought back stock in two of those years. That was way back in 2002 and 2003, back when the top management and board jobs were just a twinkle in Dennis Muilenburg’s eyes.

Wanna guess what the total value of exercised stock options by Boeing management was in the years where they did NOT have stock buybacks to sterilize the issuance and so had straight shareholder dilution?

In 2002, with zero stock buybacks, the total value of exercised stock options was $31 million.

In 2003, with zero stock buybacks, the total value of exercised stock options was $19 million.

It was hundreds of millions in the years before that, when they had stock buybacks.

It was hundreds of millions in the years after that, when they had stock buybacks.

It is BILLIONS of dollars today, as Dennis Muilenburg cranks up the buyback machine to its current record levels.

I believe it is impossible to separate the modern management practice of self-enrichment through massive levels of stock-based comp from the modern management practice of investor placation through massive levels of stock buybacks … without regulating one or the other practice.

But I’m all ears for any ideas.


The Return of the Rotation Missionaries


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One of the things we will be highlighting in our November Epsilon Theory Professional monitors is the emergence of two narratives that have finally managed to marginally peck away at the attention on China Trade War narratives – at least in the short run. One of them is the “Rotation from Profitless Growthnarrative. The other is the “What Would Impeachment (or President Warren) Do to Markets” narrative.

We will have a lot more to say about the growing commentary and missionary behavior here, but if you feel like WeWork’s IPO failure, some disappointments at Amazon and execution successes from the likes of Apple and Microsoft are being sold as a package story about quality, value and cash flow mattering again, you aren’t imagining it. We think a rotation trade IS being promoted by market missionaries, which is not exactly the same thing as the rotation actually happening, and neither of which is necessarily the same thing as trading on that observation being a good idea.

Of course, what people mean by quality and value varies wildly. The only universally accurate definition is “things with traits I like more than other investors do.” Still, when you walk through the zeitgeist, you start to get the picture of what a change in vernacular looks like. For example:

Articles about brands and competitive advantage in grocery store chains rank among the top 5 most linguistically connected articles today.

Kroger memo touts a ‘new brand’ and says ‘all will be revealed soon’ — here’s the full message [BI]

Articles with a lot of value investor-triggering language covering the energy sector do too.

Marathon Petroleum Provides Update On Strategic Review To Enhance Shareholder Value [BI]

What else is in the zeitgeist? Quoting “path to profitability” language anywhere and everywhere as the panacea for anyone who might think your favorite profitless revenue growth company might end up like…well, those other ones.

Looking to Shake Those WeWork-Induced IPO Doldrums? Look Up—Into the Cloud [Forbes]

The missionaries are out there – the missionaries who benefit from your trading activity, in particular – and they are officially pounding the table for rotation.

As always, we’re better at observing than predicting, so if it isn’t obvious exactly what to do with this information, know that it isn’t exactly obvious to us, either. Still, our counsel is Clear Eyes: be especially aware right now that you’re being told how to think about what WeWork and the death of profitless revenue growth as the engine for valuation means. That doesn’t mean that won’t manifest in reality – after all, that’s exactly what other investors are being told, too. But we are creatures with a tendency to auto-tune to common knowledge. Knowing that it’s happening is something, at the very least.


Yeah, It’s Still Water (follow-up)


PDF Download (Paid Subscription Required): Yeah, It’s Still Water

You know, I was a big fan of stock buybacks back when I was running a fund. And I’ve thought (and written) that so much of the anti-buyback fervor we’ve heard over the past year or so, particularly from political candidates, was mostly silly on the merits, even though it was pretty effective as a narrative. I think that’s why it’s been so shocking to me when a few hours work on Texas Instruments in response to a stray tweet turned into a research project that’s threatening to take over my life!

The difference in my views now is that I’m looking at stock buybacks from a micro perspective, not a macro or overall market perspective. And from that perspective, there is no doubt in my mind that stock buybacks have been totally hijacked by corporate management and boards over the past few years to sterilize exercised options and restricted stock units. As a result, this narrative of “returning capital to shareholders” is pretty much a sham, as anywhere from 10% (McDonalds) to 40% (Texas Instruments) to 60% (Microsoft) of the money spent on buybacks never reached shareholders at all, but simply carried out a wash trade where one corporate hand issued new stock on the cheap and the other corporate hand bought it back at a much higher price. Note that the full monetary value of this wash trade goes to the recipients of the newly issued stock whether or not they sell it then and there at the repurchase price. There is ZERO EPS leverage accomplished through these wash sales. There is ZERO benefit to non-management shareholders.

For example, over the past 3 fiscal years Microsoft bought back 419 million shares at an average price of $85 per share, but they also issued 254 million NEW shares to management at an average price of $11.50. So out of the $35 billion that Microsoft supposedly “returned to shareholders” with their buyback program, less than half of that actually went to the benefit of shareholders. More than $18 billion in value went directly to the Microsoft employees and directors who exercised these options and restricted stock units. In addition, Microsoft spent more than $6 billion over the past 3 fiscal years to buy back stock to satisfy the tax withholding requirements of management option grants. That’s more than 20% of Microsoft’s cash flow from operations over that span.

But at least, you say, Microsoft stock outperformed all of its benchmarks over the past 3 years. Fair enough. But that’s one hell of a vig that the casino withheld on your winning bet!

Last Friday we published a note –  “Yeah, It’s Still Water” – about a company that has decidedly NOT outperformed all of its benchmarks, but has comped management and directors with billions regardless. That company is Texas Instruments (note attached).

From 2014 – 2018, 40% of TXN’s stock buybacks went to sterilize the options and restricted stock grants given to senior management and the board, for a direct value transfer of $3.6 billion from shareholders. There’s an additional $2.6 billion in stock-based comp already issued but yet to be exercised. That’s above and beyond a billion or two in cash comp.

For what? Over the same five year period, 2014 – 2018, TXN stock performance matched the Philly Semiconductor Index ETF zig-for-zag. That’s an ETF with a 47 basis point all-in expense ratio, by the way.

One day we’ll get as angry at index-hugging corporate managers who get paid BILLIONS as we do at index-hugging fund managers who get paid a few basis points.
One day we’ll see the Zeitgeist of the Obama/Trump years for what it is: an unparalleled wealth transfer to the managerial class.
What is financialization? THIS.
It’s not illegal or incompetent.
But yeah, this is why our world is burning.

Do I like companies that return unproductive cash to shareholders? YES. So use a special dividend. That’s why they exist. There, fixed it for you.

And one last point. IMO, the most culpable parties in this entire charade are the independent directors of these public company boards. I think they’re bought off by options and RSUs of their own, and I think they’re almost always ex-management or current management of other companies, with all the incestuous baggage that brings.

Okay, I’m off the soapbox. For now. But I am going to keep working through these 10-Ks and compiling my list of the naughty and the nice. That second list is the null set so far.