Ireland Event Follow-up: Shockwave

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Yesterday the CDC held a press conference and released an analysis showing that they expected the more virulent UK-variant strain (B117) to account for 50% of Covid cases in the United States by the end of February. I’ve attached the CDC analysis here, and you can read a summary of the findings in this WSJ article: https://www.wsj.com/articles/u-k-covid-19-variant-likely-to-become-dominant-u-s-strain-in-march-cdc-says-11610733600?page=1.

For reference on our work on this topic, you can read the full ET note here: https://www.epsilontheory.com/the-ireland-event-2/. We’ve also released a podcast on our work, available on the ET website https://www.epsilontheory.com/et-podcast-3-the-ireland-event/ , and on Spotify and iTunes.

While on the one hand it’s gratifying that the CDC is validating what I wrote you last weekend, on the other hand it’s pretty scary to contemplate the consequences of the B117 UK-variant virus accounting for 50% of all US cases 45 days from now. That’s what this email is focused on – the consequences – because they are sorely underplayed in the WSJ article summarizing the CDC report.

Consequence #1: if B117 is the dominant US strain, vaccination will need to reach 80%+ Americans for effective control of the Covid pandemic. That’s at least 10% higher than current vaccination policy contemplates, meaning that not only will 35 million additional doses need to be sourced, distributed and administered, but also the finish line in this race between an exponential process (B117 spread) and a linear process (vaccine delivery) just got pushed back. That’s extremely bad news for the linear process.

Consequence #2: if B117 is the dominant US strain by the end of Feb, the daily number of new Covid cases by the end of Feb will be MUCH higher than today. This is the point that was completely missed in the WSJ article. B117 doesn’t become the dominant strain because it “defeats” the baseline strain. This isn’t a football game. B117 becomes the dominant strain by spreading even faster than the current fast-spreading baseline virus. The math here is as inexorable as it is sobering.

I don’t believe that ANY of this is priced into markets. I don’t believe that ANY of this is contemplated by the most popular trades and investment narratives du jour – “dollar debasement”, “reflation”, “number go up” (Bitcoin), “commodity supercycle beginning”, “cyclical recovery”, “earnings recovery”, “pent-up consumer spending”, etc. etc. – all of which are based on the core narrative of “Whew! The path to recovery may be bumpy, but it is assured.”

If B117 becomes the dominant SARS-CoV-2 strain in the United States, that is a profoundly deflationary, risk-off, dollar higher, flight to safety event.

Will markets ultimately look through that event, particularly if the Fed says all the right things (which they will) and particularly if we get the JNJ vaccine in wide distribution soon (fingers crossed)? Sure. Absolutely, markets will ultimately look through the B117 threat.

But between today and that ultimate look-through, I believe there is a significant narrative shock coming to markets. You can’t jawbone the virus. You can’t declare by fiat or by narrative that B117 isn’t happening. This IS happening, and the common knowledge that this IS happening will hit every risk asset like a ton of bricks.

When does that narrative shock occur? What creates the B117 common knowledge that hits markets like a ton of bricks? I think it’s whenever we get news of the first cluster of B117 cases in the US. Right now we’re still in the case, case, case phase of the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! cycle of exponential spread. You can still close your eyes and pretend B117 isn’t happening in the case, case, case phase. But once that first cluster hits the news … well, you can’t ignore that. That’s when B117 becomes common knowledge. That’s when every market missionary starts talking about it. That’s when everyone knows that everyone knows that our glidepath to recovery is not assured.

When do we hear about the first B117 cluster in the US? No idea. And the longer it takes, the less the impact on markets. But the cluster IS coming. As the kids would say, it’s just math.


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ET Podcast #3 – The Ireland Event

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The Epsilon Theory podcast is free for everyone to access. You can grab the mp3 file below, or you can subscribe at:

Spotify: https://open.spotify.com/show/3ZXOnreiGGiUtuGHzbin6d

Apple: https://podcasts.apple.com/us/podcast/epsilon-theory-podcast/id1107682538



In episode #3 of the Epsilon Theory podcast, Rusty and I discuss the dramatic spike in Covid cases in Ireland over the last two weeks of December, and the risk of seeing a similar “Ireland Event” here in the US.

Unfortunately, once it becomes apparent that an Ireland event is occurring, it’s too late to stop it.

The time to act is NOW, not with indiscriminate lockdowns, but with strong restrictions on international and domestic air travel to contain the UK-variant virus while we accelerate vaccine delivery.


ET Podcast #3 – The Ireland Event

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The Ireland Event

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Daily reported new Covid cases, Ireland, through Jan. 7, 2021

For the past year, I’ve been consumed with how Covid numbers are used/manipulated to create political narratives. From China to WHO to don’t-test-don’t-tell to Covid Trutherism in all its forms … that’s been the windmill I’ve tilted at for almost 12 months now.

Last week I became consumed by a new twist on all this – Covid numbers that were being largely ignored. Insane infection numbers coming out of UK and Ireland, apparently driven by a new virus strain, that we acknowledged over here but didn’t seem to be too mussed about.

It reminded me of the Covid numbers coming out of Italy last February. Was Europe once again our crystal ball? Were we once again going to ignore THAT?

And when I say “insane infection numbers” I mean a 30x spike in Covid cases in Ireland over the span of two weeks in late December, where the R number – the basic reproductive rate of the disease – went from something around 1.2 to something around 3. Where you suddenly went from a few hundred new Covid cases every day to more than six thousand cases every day. All in a country the size of Alabama (which, btw, currently has about 4 thousand cases every day).

So I’ve been trying to figure out what happened in Ireland, and whether it could happen here.

To do that I had to research this new UK-variant of the virus. I had to research the way in which Covid is explosively spreading in Ireland, and whether that was similar or different to US. I had to research what it MEANS to have an R-number go from 1.2 to 3.  And finally I had to dig into why this ‘Ireland Event’ was not being discussed by US Covid missionaries (to use an Epsilon Theory term) like Scott Gottlieb or Tony Fauci.

I’ll start with the conclusion.

I believe there is a non-trivial chance that the United States will experience a rolling series of “Ireland events” over the next 30-45 days, where the Covid effective reproductive number (Re not R0) reaches a value between 2.4 and 3.0 in states and regions where a) the more infectious UK-variant (or similar) Covid strain has been introduced, and b) Covid fatigue has led to deterioration in social distancing behaviors.

A single Ireland event is a disaster. A series of Ireland events on the scale of the United States is catastrophic. If this were to occur, I’d expect to see a doubling of new Covid cases/day from current levels in the aggregate (today’s 7-day average is 240k/day), peaking somewhere around 500,000 new daily cases before draconian economic shutdowns (more severe than anything we’ve seen to date) would occur in every impacted major metro area. Hospital systems across the country would be placed under enormous additional strain, leading to meaningfully higher case fatality ratios (CFRs) as medical care was rationed. Most critically, this new infection rate would far outpace our current vaccine distribution capacity and policy. Assuming that vaccines are preferentially administered to the elderly, aggregate infection fatality ratios (IFRs) should decrease, but the overall burden of severe outcomes (death, long-term health consequences) would shift to younger demographics.

Current US government policy rejects the possibility of an Ireland event, largely because of what I believe is a politically-motivated analysis by the CDC that models more than 100 million Americans already possessing Covid antibodies, prior to any vaccination effort. Using data from flu monitoring programs in prior years, the CDC models project that 70 MILLION Americans have already gotten sick with symptomatic Covid, but decided to just write it off as a bad cold and never got tested. I am not making this up. Add in another 10 million or so Americans who the CDC models as having already had asymptomatic Covid, add in the 23 million Americans who we know have had Covid, and voila! – per the CDC, one-third of the American population is already effectively immunized against getting Covid in the future. And obviously enough, if >30% of Americans are already effectively immunized against Covid because they’ve already gotten sick, then it’s very difficult to hit the Re numbers of 2.4 – 3.0 that Ireland is currently experiencing.

I think this model is wrong, and I think the CDC knows that it’s wrong.

I think it’s wrong because the 2021 behavior of someone who thinks they might have Covid is very different from the 2015 behavior of someone who thought they might have had the flu, but the CDC assumes it is the same in their models. You don’t ignore Covid. You don’t just brush it off. I’d say that no one just brushes off Covid symptoms the way they might have brushed off flu symptoms in the past, but of course that’s not true. I’m sure there are millions of Americans who have, in fact, had symptomatic Covid and ignored it, particularly in spring and early summer when our national testing capability was pathetic. But 70 MILLION Americans? Twenty percent of ALL Americans? More than three times the number of known Covid cases? C’mon, man.

I think the CDC knows this model is wrong because if it were true – if they actually thought that one-third of Americans were already effectively immunized by having Covid antibodies – this would be an ENORMOUS factor in determining vaccination policy. Otherwise, you are going to be wasting one-third of your precious supply of vaccines on people who don’t need it.

I think the CDC knows this model is wrong because if it were true, how do you make sense of Covid hospitalization rates?

Again, were there millions of undiagnosed and “brushed-off” Covid cases in the spring and early summer when Covid testing was ridiculously sparse? Absolutely. But unless you’re prepared to say that either the SARS-CoV-2 virus is much more dangerous today than it was in the spring or that hospital Covid admission policies are much more lenient today than they were in the spring, I think it is impossible to reconcile actual Covid hospitalization data on 23 million symptomatic-and-diagnosed Covid cases with a model of 70 million symptomatic-but-undiagnosed Covid cases.

So yes, I think this model is nuts. I think this was a politically-motivated Trump Administration exercise to “prove” that the US infection fatality rate (IFR) is really tiny and you’ve got nothing to worry about. One of many such politically-motivated efforts across many institutions to minimize the risk and impact of Covid-19.

But this CDC model is why prominent Covid missionaries like Scott Gottlieb and Tony Fauci have said that they expect daily case numbers to decline from here on out, not accelerate, and this is why I think a potential Ireland event is NOT priced into any mainstream market expectations or political expectations for 2021.

Unfortunately, once it becomes apparent that an Ireland event is occurring, it’s too late to stop it.

In our human-scale, linear world, we experience exponential growth like this: nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! But by the time we start to really pay attention to an exponential growth process – typically at the cluster stage – the process is already too entrenched to stop it, absent incredibly harsh social measures like you see China reinstating today in Shijiazhuang, a city of 11 million. No government in the West is prepared to even talk about these measures, much less implement them. So we’re always surprised by the BOOM. If an Ireland event occurs here, it will be no exception.

A full-blown Ireland event is driven by both the more virulent UK-strain AND a deterioration in social distancing behaviors. Either taken alone is bad enough. It’s the combination, though, that creates a regional superspreader event. Irish health authorities estimate that their starting point for Covid Re was something between 1.1 and 1.3 (meaning that, on average, one person infected with the SARS-CoV-2 virus would pass it along to 1.1 – 1.3 new people). They blame deteriorating masking/social distancing for the majority of their “event” (say, a 0.9 – 1.1 increase in the Re number), and the UK-variant for the balance (say, a 0.5 – 0.7 increase in Re). This is very much in line with the latest research from Public Health England, which estimates that the UK-variant Covid virus is approximately 40% more infectious than the baseline virus. Notably, the UK-variant shows an even greater increase in infectiousness for “close contacts” (not necessarily face-to-face, never touching and perhaps up to 2 meters apart) rather than “direct contacts”, meaning that the UK-variant virus is particularly successful at bridging the air gap between strangers or short-duration contacts in an indoor space. This is … ummm … troubling. As lax as we all have gotten with our mask wearing and our social distancing outside of the home, the UK-variant virus dramatically reduces the margin of error we have with mask wearing and social distancing outside of the home.

For the same reasons that we humans typically don’t recognize an exponential growth process prior to the cluster, cluster, cluster stage, we have an even harder time appreciating the impact of even a small increase in the effective reproduction rate of Covid. A 40% increase in Re has an enormous impact on how many people will be infected by Covid. For example, let’s assume that the current Re for the United States is something like 1.4 (I think it’s probably higher than that in areas like SoCal, and going up everywhere as Covid fatigue takes hold). With a 5-day infection cycle (assume you pass along the virus to 1.4 new people within 5 days of contracting the virus yourself, i.e. before you become symptomatic), a single Covid case will result in a grand total of 2,296 Covid infections over a 100-day period. Now let’s increase that Re by 40%, so that it’s not 1.4 but is 2.0 … now that single Covid case will result in more than 2 MILLION total Covid infections over a 100-day period.

This is the power of exponential growth. The numbers get silly … I mean, take that Re up to 3.0 (the high end of the current Ireland estimate), and a single Covid case will result in 5.2 BILLION total cases over a 100-day period, about 60% of the entire human population on the planet. Obviously our social behaviors around the disease would change dramatically well before we got to that point. But the real challenge of all this from a social behavior perspective is the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! nature of any exponential growth process.

That Re of 2.0 that results in 2 million total infections from a single Covid case over 100 days? On Day 30 there are only 127 total cases. Not noticeable at all. On Day 50 there are just over 2,000 total cases. Barely noticeable. Let’s say you’re an elected political leader. Are you really going to take the steps that are necessary to stop this process – like shutting down domestic travel to and from an infected area, like physically quarantining entire cities – over a few hundred cases? Not a chance. Even if you’re right … even if you prevent a catastrophic outcome through your actions on Day 30 or Day 50 … your voters will never know that you were right. They will only experience the lockdown pain, and they will never credit you for the catastrophe averted.

I think we’re already at Day 30 in a dozen states. I suspect we’re already at Day 50 in a few.

So look, maybe I’m wrong about all this. Maybe we’re already well along the path to herd immunity, and one-third of Americans currently have Covid antibodies through prior exposure, just like the CDC models say. Maybe we’ll all rediscover that old-time religion when it comes to mask wearing and social distancing outside of the home. Maybe governors and the new Administration will focus on containing the UK-variant through domestic travel restrictions. Maybe we’ll wake up tomorrow with a new urgency about vaccine distribution.

Maybe.

But my spidey-sense is really tingling on this one.


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Reap the Whirlwind

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Image: Congress Holds Joint Session To Ratify 2020 Presidential Election

The dirty little secret of every riot and protest and looting that ever existed in the history of mankind … IT’S FUN.

Lucifer’s Hammer on Epsilon Theory, August 31, 2020

During the summer of 2020, as widespread non-violent protests for racial justice gave way to steadily creeping violence and property destruction, we published our concerns on these pages that there was practically zero political will – and zero political incentive – by either party to do what was necessary to reduce that violence.

Republicans and Donald Trump believed that the violence at a number of BLM-related events would be framed alongside deeply unpopular “defund the police” narratives as long as they continued. They believed, I think, that this framing would be electorally helpful. However perverse, from a purely electoral perspective I believe they were right on both counts. They did not win the presidency, of course, but on most ballots the GOP outperformed very low expectations. I think antipathy toward the events of the summer played a significant role.

Still, if he wished to do so, Donald Trump possessed and did not exercise meaningful power to de-escalate and reduce this violence at multiple points.

Democratic leaders at state and local levels had even more power, I would argue. They also largely elected not to exercise that power, if for very different reasons. In their case, I think there was genuine concern that calling in resources like the National Guard to maintain order would be seen as a betrayal of the very arguments about the nature of state power deployed against black communities being made by those protesting. More practically, I think they believed that this action would have the effect of increasing voter apathy for an already moderate-looking slate. More perversely, I think they felt some confidence that generally sympathetic national media would be very unlikely to pay very close attention to what was happening at some of these rallies, lest doing so unduly influence the electorate to make a Wrong Decision. I think the Democrats were right about each of these things.

No, they weren’t right. They were correct. They – and the GOP – were correct in their evaluation of optimal electoral strategy under the conditions of a competition game. But there was nothing right about allowing the destructive LARPing that took place in the late summer by activists and counter-activists alike to continue unabated.

Bad things happen when the equilibrium state of national politics is to be nearly always correct and nearly never right.

Or, in the words we published in August:

They are both sowing the wind.

And they will both reap the whirlwind.

Neither the Democratic party nor the Republican party survives a defeat this November in anything close to their current form. I think several people are starting to think about that.

But here’s what’s also true:

Neither the Democratic party nor the Republican party survives a victory this November.

And no one is thinking about that.

Luficer’s Hammer on Epsilon Theory, August 31, 2020

The GOP is reaping the whirlwind today.

The sowing of militaristic language and existential Flight 93 Election rhetoric by the political right led directly to one of the most embarrassing days in the history of our Republic. No, I don’t think those Clown Putsch buffoons attempted to stage a coup. But a crowd of 330 million just watched a crowd of 330 million watch thousands of pastors, pipefitters, engineers, Q activists and business owners together wrap themselves in Trump flags and parade through the halls of the US Capitol. They watched them charge into the chambers with plastic cuffs and Tazers. They heard the “hang Mike Pence” chants. They saw a mob with thin blue line flags literally try to beat Capitol Police officers with them.

And then those 330 million saw lockstep claims by some half of sitting GOP representatives and most of their favored news anchors that these were the actions of Antifa. Without evidence. And without apology.

If you think the media purposefully made less of the violence this summer than an institution less transparently politically invested in the defeat of Donald Trump might have done, I think you are correct. If you think that what happened on 1/6 will ever be seen by a country that watched last week’s images in real time in the same category as the events of the summer, I think you are insane.

As Ben wrote before, the Republican party probably does not survive this in anything close to its previous form.

But make no mistake about it: The sowing of affinity for The Right Kind of Violence we saw in the summer and affinity for The Right Kind of Concentrated Power that we are seeing manifest today on the political left will have lasting results, too. The collective and collusive de-platforming of individuals and app developers happening over the last few days is, by any reasonable account, entirely within the legal rights afforded to Twitter, Facebook, Apple, Google, Amazon and scores of associated service providers under current law. In the very short run (i.e. over the period of a week), I think it is very likely that these actions could reduce the potential for violence.

In the long run?

Friends, the political forces that galvanized support for Trumpism were built on the foundations of a belief that conservatives are not given a fair shake in media, a belief that Big Tech firms run by wealthy, liberal, elites seek to control the lives of hard-working American families, and a belief that a coordinated political-technological infrastructure has led directly to their political marginalization. You can think they are incorrect. You can even think that they are wrong. But if you think that these actions will reduce the influence of Trumpism, political division, polarization and willingness to do violence, so are you.

There is substantial territory that exists between flaccid permissiveness toward the people who committed, sought to commit or directly incited violence to influence the outcome of an election on the one hand, and gleefully instituting widespread political purges that will exacerbate the long-term consequences in exchange for warm justice fuzzies today on the other.

There is a brief window where I think we have the opportunity to commit to building a common national identity together. Seizing this opportunity will mean a lot of us demonstrating corporate humility for actions we may not have taken ourselves, actions of which we bristle at being called guilty, but which in our heart of hearts we know we could have spoken up or taken more action to help prevent. Seizing this opportunity will mean a lot of us leaving a wellspring of anger we will feel is entirely justified at the door.

Not seizing it, I fear, will mean that we all reap the whirlwind.

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The Ireland Event

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Daily reported new Covid cases, Ireland, through Jan. 7, 2021

I’ll start with the conclusion. I believe there is a non-trivial chance that the United States will experience a rolling series of “Ireland events” over the next 30-45 days, where the Covid effective reproductive number (Re not R0) reaches a value between 2.4 and 3.0 in states and regions where a) the more infectious UK-variant (or similar) Covid strain has been introduced, and b) Covid fatigue has led to deterioration in social distancing behaviors.

A single Ireland event is a disaster. A series of Ireland events on the scale of the United States is catastrophic. In the aggregate, I’d expect to see a doubling of new Covid cases/day from current levels (today’s 7-day average is 240k/day), peaking somewhere around 500,000 new daily cases before draconian economic shutdowns (more severe than anything we’ve seen to date) would occur in every impacted major metro area. Hospital systems across the country would be placed under enormous additional strain, leading to meaningfully higher case fatality ratios (CFRs) as medical care was rationed. Most critically, this new infection rate would far outpace our current vaccine distribution capacity and policy. Assuming that vaccines are preferentially administered to the elderly, aggregate infection fatality ratios (IFRs) should decrease, but the overall burden of severe outcomes (death, long-term health consequences) will shift to younger demographics.

Current US gov’t policy rejects the possibility of an Ireland event, largely because of what I believe is a politically-motivated “analysis” by the CDC that models more than 100 million Americans already possessing Covid antibodies, prior to any vaccination effort. Using data from flu monitoring programs in prior years, the CDC models project that 70 million Americans have already gotten sick with symptomatic Covid, but decided to just write it off as a bad cold and never got tested! I am not making this up. Obviously enough, if >30% of Americans are already effectively immunized against Covid because they’ve already gotten sick, then it’s very difficult to hit the Re numbers of 2.4 – 3.0 that Ireland is currently experiencing. I think this is nonsense, because NO ONE brushes off Covid symptoms the way they might have brushed off flu symptoms in the past. But this CDC model is why prominent Covid missionaries (to use an Epsilon Theory term) like Gottlieb and Fauci have said that they expect daily case numbers to decline from here on out, not accelerate, and this is why I think a potential Ireland event is NOT priced into any mainstream market expectations or political expectations for 2021.

Unfortunately, once it becomes apparent that an Ireland event is occurring, it’s too late to stop it.

In our human-scale, linear world, we experience exponential growth like this: nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! But by the time we start to really pay attention to an exponential growth process – typically at the cluster stage – the process is already too entrenched to stop it, absent incredibly harsh social measures like you see being reinstated (!) in China. No government in the West is prepared to even talk about these measures, much less implement them. So we’re always surprised by the BOOM. If an Ireland event occurs here, it will be no exception.

A full-blown Ireland event is driven by both the more virulent UK-strain AND a deterioration in social distancing behaviors. Either taken alone is bad enough. It’s the combination, though, that’s catastrophic. Irish health authorities estimate that their starting point for Covid Re was something between 1.1 and 1.4 (meaning that, on average, one person infected with the SARS-CoV-2 virus would pass it along to 1.1 – 1.4 new people). They blame deteriorating masking/social distancing for the majority of their “event” (say, a 0.9 – 1.1 increase in the Re number), and the UK-variant for the balance (say, a 0.5 – 0.7 increase in Re). This is very much in line with the latest research from Public Health England, which estimates that the UK-variant Covid virus is approximately 40% more infectious than the baseline virus. Notably, the UK-variant is, relatively speaking, significantly more infectious than the baseline virus for “close contacts” (not face-to-face, up to 2 meters apart) rather than “direct contacts”, meaning that the UK-variant virus is particularly successful at bridging the air gap between strangers or short-duration contacts in an indoor space. This is … ummm … troubling. As lax as we all have gotten with our mask wearing and our social distancing outside of the home, the UK-variant dramatically reduces the margin of error we have with mask wearing and social distancing outside of the home.

For the same reasons that we humans typically don’t recognize an exponential growth process prior to the cluster, cluster, cluster stage, we have an even harder time appreciating the impact of even a small increase in the effective reproduction rate of Covid. A 40% increase in Re has an enormous impact on how many people will be infected by Covid. For example, let’s assume that the current Re for the United States is something like 1.4 (I think it’s probably higher than that in areas like SoCal, and going up everywhere as Covid fatigue takes hold). With a 5-day infection cycle (assume you pass along the virus to 1.4 new people within 5 days of contracting the virus yourself, i.e. before you become symptomatic), a single Covid case will result in a grand total of 2,296 Covid infections over a 100-day period. Now let’s increase that Re by 40%, so that it’s not 1.4 but is 2.0 … now that single Covid case will result in more than 2 MILLION total Covid infections over a 100-day period.

This is the power of exponential growth.The numbers get silly … I mean, take that Re up to 3.0 (the high end of the current Ireland estimate), and a single Covid case will result in 5.2 BILLION total cases over a 100-day period, about 60% of the entire human population on the planet … and obviously our social behaviors around the disease would change dramatically well before we got to that point. But the real challenge of all this from a social behavior perspective is the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! nature of any exponential growth process. That Re of 2.0 that results in 2 million total infections from a single Covid case over 100 days? On Day 30 there are only 127 total cases. Not noticeable at all. On Day 50 there are just over 2,000 total cases. Barely noticeable. Let’s say you’re an elected political leader. Are you really going to take the steps that are necessary to stop this process – like shutting down domestic travel to and from an infected area, like physically quarantining entire cities – over a few hundred cases? Not a chance. Even if you’re right … even if you prevent a catastrophic outcome through your actions on Day 30 or Day 50 … your voters will never know that you were right. They will only experience the lockdown pain, and they will never credit you for the catastrophe averted.

I think we’re already at Day 30 in a dozen states. I suspect we’re already at Day 50 in a few.

So look, maybe I’m wrong about all this. Maybe we’re already well along the path to herd immunity, and one-third of Americans currently have Covid antibodies through prior exposure or vaccination. Maybe we’ll all rediscover that old-time religion when it comes to mask wearing and social distancing outside of the home. Maybe governors and the new Administration will focus on containing the UK-variant through domestic travel restrictions. Maybe we’ll wake up tomorrow with a new urgency about vaccine distribution.

Maybe. But my spidey-sense is really tingling on this one.


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Just a Fantasy

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This piece is written by a third party because we think highly of the author and their perspective. It may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.


Is this the real life?
Is this just fantasy?
Caught in a landslide
No escape from reality
Open your eyes
Look up to the skies and see
I’m just a poor boy, I need no sympathy
Because I’m easy come, easy go
A little high, little low
Anyway the wind blows, doesn’t really matter to me, to me

Queen – My Secret Fantasy

Takeaways

  • Tactical Long. On November 24th in The Merger Is Complete, I wrote: “Buy the bull*&-t for a trade into Christmas on fund flows, but don’t buy into the nonsense narratives permanently. [1]I reiterated this tactically bullish position after Christmas in the Bloomberg What Goes Up podcast with Michael Meyer and Sarah Ponczek (stating it would persist into January).
    • Close It Out. It’s now time to close out that long equities trade, especially in small caps, which in any rational universe are wildly overvalued and technically hyperextended; the small cap reversion to reality should occur regardless of whether the Senate swings Democrat (albeit this would be a more bearish outcome despite the reflation narrative to the contrary). Today’s almost 5% rally in small caps could only happen in a fantasy world of avatars and magical thinking. [2]
  • Real Rates. The rationale that recent new lows in real rates justify yet higher equity prices is misplaced because breakevens are volatile and, more importantly, inflation expectations are coming from the nuances of pandemic impacts and stimulus rather than from organic growth expectations.
  • Deficits. Upward pressure on long yields from deficit issuance will surely continue. Even with the Fed sitting on long yields with QE, it will have much work to do to sop up new issuance. This situation could worsen should the Senate swing to the Democrats (i.e. – more Treasury issuance to fund fiscal largesse). I circle back to the two risks I’ve articulated from months: higher taxes and higher long yields. The latter are particularly troublesome for tech and small caps.
  • Taxes and Yields versus Direct Deposits. Three words come to mind on a Democratic win in both Senate races: taxes, taxes, taxes. Over the next four years, under the Biden administration and even in a split Senate, taxes will certainly go no lower, especially when considering proposals like Senator Wyden’s 2019 proposed tax on unrealized gains in investment assets at the same rates as other income. [3]  Does this sound reflationary? Perhaps its reflationary for equities if money supply from direct deposits continues to find its way into the stock market, but it won’t be reflationary for corporate profits or disposable income for those with the highest propensity to spend. [4]
    • Risk to View. The biggest risk to this view is that new stimulus (supplementary direct deposits) will continue to fuel the speculative bubble in equities despite the substantial economic tradeoffs in the form of higher taxes and rising yields and without regard for hyperextended valuations. It’s certainly a difficult set of vector forces to assess.

Discussion

The idea that low yields – most recently the focus of the narrative has shifted to low real yields – is somehow giving market participants’ confidence that equities will continue their ascent. There are a number of objections to this assessment. First, Figure 1 shows that the breakeven 10-year is relatively volatile. The U.S. breakeven 10-year is the difference between nominal 10-year yields and 10-year TIPS. Simply because the breakeven 10-year sits above 2% does not mean it will remain there. Second, it’s necessary to ask ‘why’ it’s there. Is it really productivity growth that will sustainably drive ’good’ inflation? That’s unlikely. Recent wage inflation has been a function of a change in employment mix and goods inflation a function of supply shortages.

The GDP recovery has largely been a function of stimulus. Market participants seem to be betting on massive pent-up demand, but notwithstanding a higher savings rate, much of that that demand may have already been pulled forward by lower rates and massive fiscal stimulus. In fact, given the historical volatility in breakevens and given the Fed’s inability to do anything to achieve its inflation target, real rates are more likely to rise than fall (i.e. – breakevens will fall). If anything, Figure 1 shows that this is just about as good as it gets for breakevens, which almost always retrace after such an advance. [5] Figure 2 decomposes nominal yields, real yields and the breakeven rate. Nominal and real yields have tended to move in lockstep, so the focus on real yields, while important, adds something less than perceived.

While it has served investors well for over 35 years, the old adage ‘don’t fight the Fed’ is on its last legs. Bill Dudley simplified it relatively well: “The stimulus provided by lower interest rates inevitably wears off. Cutting interest rates boosts the economy by bringing future activity into the present: Easy money encourages people to buy houses and appliances now rather than later. But when the future arrives, that activity is missing. The only way to keep things going is to lower interest rates further — until, that is, they hit their lower bound, which in the U.S. is zero.” [6] (By Bill’s logic, this is yet another reason why inflation isn’t coming.) [7] The incremental benefit from lower rates (whether nominal or real) is extremely limited. Indeed, even if reflation were in the cards, higher long yields would likely lead to an equity market reaction similar to late-2018. Risk-assets, when priced to perfection, tend to be quite sensitive to higher yields. Lastly, because cash flows have been so weak, the probability that the credit cycle is over is low; S&P Global Ratings seems to agree. Its 2021 speculative grade default forecast is about 9%. This level of defaults should impact small caps most.

Figure 3 above shows that the Russell 2000 has tremendous work to do to grow into its elevated multiples, which are unjustified by lower rates. Rates are this low for a reason. I’ve made this argument on many previous occasions, and (other than Mr. Dudley’s quote) I will spare readers of it yet again. What this Figure shows is that elevated multiples often precede Russell 2000 selloffs. It is sometimes true that index multiple expansion precedes rallies, as company earnings recover and grow into multiples, but this interpretation would ignore the fragile state of Russell earnings prior to the pandemic. For all companies (including those without earnings) Russell earnings were down about 15% year-over-year for 2019. Importantly, with 10-year yields creeping up on more deficit spending and the Treasury issuance it requires, smaller capital-cost sensitive companies (like those in the Russell) are increasingly at risk as real rates rise on lower-than-expected inflation or on higher nominal yields (on Treasury supply). [8]

From a ‘technical’ standpoint, Figure 4 shows the Russell 2000 overlayed with a ‘power’ regression. The regression prediction is banded by +/- 1-SD in yellow and 2-SD in red. The ‘innovation’ here is the choice of power regression, which fits the price trend extremely well and takes into account an accelerating trend that a linear regression would not. What it shows is that the 2-SD band (red) above the price trend (dotted blue) has served as resistance (as one would expect given the confidence interval). The Russell pulled back significantly at that 2-SD level in 2000, 2007, 2014, late 2015, and again in January 2020. It failed to do so in late 2018 as a rotation narrative took over. Currently, it has also failed to serve as meaningful ‘resistance’ as retail mania is driving a similar rotation on an even more hollow rotation and reflation narrative. However, the Russell did pull back at just over 3-SD above trend in 2018, and that’s where it is again right now. So, even if the price trend is accelerating (changing the regression prediction and making it less accurate), there’s lots of ‘cushion’ to this assessment. Lastly, today’s rally pushes the Russell 2000 into long term uptrend resistance, which began just after the 2009 low, as shown in Figure 5. [9]

There are arguments to be made that the one’s expectations for the performance of the Russell 2000 should change, as its composition has now changed somewhat (over 20% healthcare). What ‘healthcare’ really means is small cap biotech, which has been a darling of the retail crowd as many look to profit on the next Moderna. On the other hand, this might be considered yet another reason to dislike the Russell 2000, as many of these names are highly speculative (i.e. – unprofitable) and have contributed to the overbought and overvalued condition of the index. The bulk of the index still consists of consumer discretionary (~11%), broad financials (18%), materials and industrials (~19%), and real estate (7%). All of these sectors rallied on January 6th with financials and materials outpacing most other sectors. If anything, while the speculative bubble in 1999 was mostly in communications technology, it may now be in biotech, which is dragging along other sectors through ETF buying. The Russell has of late become the posterchild for speculation in biotech – along with the new ETFs ARKK and ARKG.

Conclusion

Todays 4%+ rally in small caps likely isn’t sustainable. They are simply priced to a fantasy world that is unlikely to ever exist. It wouldn’t be the first-time small caps experienced manic highs (or lows). The reflation narrative on a Democratic sweep (more profligate stimulus) ignores the impact of higher taxes and the potential for higher long-yields. Sure, it’s tough to ‘get things done’ in Washington, but you can bet taxation will be the first order of business should a blue wave sweep through Washington. Even without that wave, the reflation narrative makes little sense. Much of the narrative is based on higher breakevens, which are often not predictive of future inflation. This is particularly important to point out on a day when the reflation narrative is being plastered everywhere.

Small caps, in particular, are subject to more extreme swings in sentiment than even technology companies, many of which are now mature cash flow generators. Certainly, the money supply has exploded on fiscal stimulus, which has increased deposits. As I’ve pointed out, those deposits – coupled with easy access to markets through mobile-based trading apps – have found their way directly into equity markets, and especially into the most speculative stocks (i.e. – small caps). As the pandemic begins to abate and money supply begins to contract, despite a modest but determined economic recovery, small caps will once again fall out of favor. Today’s strength is an opportunity to lighten small cap exposures or hedge aggressively versus implicit or explicit long small- cap exposures.


Disclaimer

AlphaOmega Advisors, LLC (AOA) does not conduct “investment research” as defined in the FCA Conduct of Business Sourcebook (COBS) section 12 nor does AOA provide “advice about securities” as defined in the Regulation of Investment Advisors by the U.S. SEC. AOA is not regulated by the SEC or by the FCA or by any other regulatory body. Nothing in this email or any attachment to it shall be deemed to constitute financial or other professional advice, and under no circumstances shall AOA be liable for any direct or indirect losses, costs or expenses that results from the content of this email or any attachment to it. AOA has an internal policy designed to minimize the risk of receiving or misusing confidential or potentially material non-public information. The views and conclusions expressed here may be changed without notice. AOA, its partners and employees make no representation about the completeness or accuracy of the data, calculations, information or opinions included in or attached to this email, is based on information received or developed by AOA as of the date hereof, and AOA shall be under no obligation to provide any notice if such data, calculations, information or opinions expressed in this email or any attachment to it changes. Any such research may not be copied, redistributed, or reproduced in part or whole without AOA’s express written permission. The prices of securities referred to in any research is based on pricing as of the date the research was conducted, may rise or fall at any time thereafter, and past performance and forecasts should not be treated as a reliable indicator of future performance or results. This email and any attachment to it is not directed to you if AOA is barred from doing so in your jurisdiction. This email and any attachment to it is for informational purposes only and does not constitute an offer or solicitation to buy or sell securities or to enter into any investment transaction or use any investment service. AOA is not affiliated with any U.S. or foreign broker dealer. AOA or its principals may own securities discussed herein.


[1] Jeremy Grantham and I remain on the same page with GMO reiterating its bubble warning yesterday. After becoming bullish in March and cautious in late June, I felt the same pain into November.

[2] As of this writing, the Ossoff-Perdue race looks too close to call.

[3] https://www.wsj.com/articles/top-democrat-proposes-annual-tax-on-unrealized-capital-gains-11554217383

[4] https://www.yodlee.com/many-americans-used-part-their-coronavirus-stimulus-check-trade-stocks

[5] As I’ve noted, for many companies, ‘price’ will be difficult to achieve (other than in areas where there are pandemic-related supply disruptions) because of overcapacity. According to Bloomberg, almost 600 corporations of 3,000 of the country’s largest publicly-traded companies no longer have EBIT/Interest > 1. The same companies added almost $1 trillion of debt to their balance sheets since the pandemic began, bringing total obligations to $1.36 trillion. As the article suggests: “But in helping hundreds of ailing companies gain virtually unfettered access to credit markets, policy makers may inadvertently be directing the flow of capital to unproductive firms, depressing employment and growth for years to come.”

[6] https://www.bloomberg.com/opinion/articles/2020-10-28/the-federal-reserve-is-really-running-out-of-firepower

[7] Here’s a caveat. His is an incomplete description of how monetary policy works for at least two reasons. First, it fails to convey the intertemporal impact of monetary policy on investment. Second, it fails to appreciate the offsetting impact on the income channel. That is, the benefit to consumers or companies to consume or make capital expenditures because of lower rates is offset (at least in part) by the loss of income to savers. The basic macroeconomic equality that investment is equal to the sum of foreign and domestic savings suggests that a reduction on one ought to be offset by the other. The argument becomes a qualitative one that the income benefit to savers has a lower multiplier than the benefit to consumers or companies. Indeed, some might argue that this means monetary policy is itself no effective at stimulating ‘real’ economic activity, and fiscal policy is the only impactful alternative.

[8] The steeper yield curve won’t be good enough to pull small cap banks (~13% of Russell 2000) out of their malaise. Credit losses for regionals and the impact of higher rates on loan demand will more than offset the positive impact on NIMs.

[9] Unfortunately, implied volatility remains elevated, so it makes sense to sell some options to cheapen up any synthetically constructed short trade on the Russell 2000. This often makes the return profile a bit more linear, but one can still fashion something interesting. The IWM is 1/10 the Russell 2000 index with very little tracking error. One possible way to express the sentiment I articulate would be an IWM ‘put spread collar.’


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What Does Inflation Mean For Your Portfolio?

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We published our January Narrative Monitors earlier this week, which you can grab online here and here (also, if you need a refresher course in how to read these Monitors, don’t forget our webcasts and primers here and here). I’m going to focus on the Central Bank Monitor in this email, because we’re seeing something in this analysis that is unique in our historical dataset.

We think there are five narrative “archetypes” when it comes to central banks in general and the Fed in particular: Fed Put (signal for strongly positive market returns), Inflation (signal for moderately positive market returns), Dovish (signal for weakly positive market returns), Unemployment (signal for moderately negative market returns), and Hawkish (signal for moderately negative market returns). As has been the case for the past 9 months, the Inflation archetype is the strongest among these five. Nothing new or unique there. But …

  1. ALL of the narrative archetypes are now very weak. Inflation is only slightly stronger (meaning more central to the entire financial media conversation) than Hawkish, and all of these archetypes are near all-time lows in terms of the “gravity” they exert on our overall investment narratives.
  1. ALL of the narrative archetypes have absurdly positive sentiment. Meaning that for every possible narrative or sub-narrative scenario, the conclusion is that this is a positive for markets. Inflation about to run rampant? Bullish! Inflation concerns overblown? Bullish! Massive fiscal stimulus on the way to reduce unemployment? Bullish! Meh stimulus on the way and unemployment remains high? Bullish! Fed is on autopilot? Bullish! Fed is highly vigilant? Bullish!
  1. WITHIN these individual narrative archetypes (with the exception of Unemployment), there is almost zero narrative consensus or cohesion. For example, within the Inflation archetype, there are equally strong and extremely disparate (very little shared language) sub-narratives/memes/claims happening simultaneously, from “inflation is already here!” to “inflation is impossible!” to “the Fed won’t respond for years!” to “the Fed will respond now!”. There is no coherence to the Inflation narrative, no narrative agreement on what inflation means today, to a degree that we’ve never seen in the data.

This is what it looks like when common knowledge – what everyone knows that everyone knows – is being formed.

Here’s how it will play out in your own head.

Your first instinct will be to try to figure out on your own what inflation really and truly means for your portfolio. You will read about the history of inflation and think really hard about it. You will have some ideas and, depending on your ego, more or less confidence in those ideas. But then, on reflection, you will decide that you want to understand what everyone else thinks inflation really and truly means for your portfolio. You will do this by watching CNBC and reading Bloomberg Opinion articles and Goldman Sachs research reports and portfolio manager letters and the like. You will call this “doing your research” and “listening to smart people”. Over time you will begin to recognize a common thread running through what you hear and what you read. You will call this common thread an “investment thesis”, and you will find yourself nodding your head by the fourth or fifth time you recognize this common thread on what inflation really and truly means for your portfolio. You will begin to recognize this common thread in more and more of what you hear and read, and you will provide positive feedback in one form or another to the creators of this content. You will congratulate yourself on being smart enough to tease out this common thread from your “research” and you will begin to implement your “investment thesis” in your portfolio. Soon you will have conversations with other smart investors who have similarly identified this investment thesis from their research, and you will take great comfort in that. You will increase your position in the investment thesis.

I am not saying that your investment thesis is wrong. I am not saying that you will lose money with your investment thesis. On the contrary, if you are early with your investment thesis and that thesis evolves into common knowledge, I think you’ll make a lot of money.

I am saying that what you call an investment thesis is a narrative.

I am saying that the business of Wall Street and financial media is to create an investment thesis that makes you nod your head. I am saying that you will always find an investment thesis that makes you nod your head, and that this process of selling you an investment thesis that makes you nod your head is as predictable and as regular as the sun rising in the east and setting in the west.

Right now, Wall Street is trying to identify which inflation narrative will be an investment thesis that makes lots of people nod their heads.

Recognizing THAT – and maybe even trying to get ahead of THAT – is how you play the game of markets successfully.


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