The Zeitgeist | 1.24.2019

This is our feature of the 10 most on-narrative (i.e. interconnected, highly similar) stories in financial media. It’s not a list of best articles, or articles we think are most interesting, or articles we agree with. But if you’re going to read 5-10 stories when you start your day, these are the ones that are most connected to the financial news that got published today.

Waters has banks, Wall Street, Trump in crosshairs

Technology Business Decisions Can Require Courage

Fed examines Deutsche’s Danske role; Wells loses another executive

China, After Years of Market Meddling, Tries a Lighter Touch

The tax cut investment ‘boom’ is already over. Some say it never really started

DealBook Briefing: Trade Concerns Rise on Report of Canceled Meeting

Davos 2019: What global elites said on Modi, market & macros

CNBC Interview with Standard Chartered CEO, Bill Winters, from the World Economic Forum 2019

Texas Instruments Rises After Beating Earnings Estimates, Missing Guidance

The Zeitgeist | 1.23.2019

This is our feature of the 10 most on-narrative (i.e. interconnected, highly similar) stories in financial media. It’s not a list of best articles, or articles we think are most interesting, or articles we agree with. But if you’re going to read 5-10 stories when you start your day, these are the ones that are most connected to the financial news that got published today.

Econometric methods for fractional response variables with an application to 401(k) plan participation rates (Ed note: Sounds like a fun read)

Global trust in ‘my employer’ hits new high

Why sovereign wealth funds are adding economic development to their mandates

Shutdown’s Economic Impact Is A Forceful Reminder Of Why Government Matters

Robotics adoption: The SMB guide to industrial automation

We may be talking our way into a recession

Economists aren’t the only ones worried about a recession. Investors are, too

United Technologies Rises as Fourth-Quarter Earnings Smash Estimates

Housing market’s fundamentals actually turning brighter

The Zeitgeist | 1.22.2019

This is our feature of the 10 most on-narrative (i.e. interconnected, highly similar) stories in financial media. It’s not a list of best articles, or articles we think are most interesting, or articles we agree with. But if you’re going to read 5-10 stories when you start your day, these are the ones that are most connected to the financial news that got published today.

Backed by a 200 Million Investor Blockchain-powered Investment Platform, Roobee Is Launching Service with $10 Investment Threshold

Insiders say that Google’s new cloud boss is likely to make some very large acquisitions

2019 Is The Year Of The Corporate Debt Diet

Things Could Get Much Worse for Apple When It Reports Earnings

Earnings Preview: What To Expect From IBM On Tuesday

‘Cypress Semi’s CEO Talks Cars, Smart Homes and Industry M&A With TheStreet

Trump two years in: The dealmaker who can’t seem to make a deal

Nissan CEO says new capital ties with Renault not discussed

As global recession fears grow, calls escalate for Trump to end shutdown and trade war

Schrödinger’s Staredown

Friends, the gyre has widened. Again.

In September, Ben wrote a Brief called Schrödinger’s Senate Hearing. It explored the effect of the widening gyre on our conscious intellectual processes – on our capacity to effectively reason. Presenting the Kavanaugh confirmation in terms of Schrödinger’s Cat, Ben showed how political polarization makes it nearly impossible for us to entertain, much less maintain, a probabilistic framework for understanding the world. The widening gyre is an environment in which we must adopt a deterministic framework, in which we must auto-tune our views to one of several discrete possible values.

Just over a month later, in November, I wrote a Brief called Hey, Maybe It’s the Needle. It was an exploration of the Jim Acosta microphone affair – remember that? – and what it could teach us about the influence of the widening gyre on something as fundamental as our senses. As absurd as it still sounds, it demonstrated that two perfectly reasonable, perfectly intelligent, perfectly decent people could watch the same video and come away with entirely different conclusions about what took place.

During that time – and much further back – we’ve written ad nauseam about the acts of political missionaries (President Trump chief among them) and the media missionaries who seek to tell us how to think about events and issues. To our peril, those missionary statements are so often clothed in the finery of facts and information, but with an implicit or explicit underlying aim to conflate those facts and information with subjective ideas through the use of powerful symbols and memes.

If it hasn’t happened already, in the next day or so you will probably be forced to open Schrödinger’s Box once again. Instead of Brett Kavanaugh or Jim Acosta, however, this time the box will contain at once the many possible explanations for the confrontation that took place in front of the Lincoln Memorial this weekend. But as with the prior such events, missionaries of each side have crafted narratives that make it nearly impossible to think clearly and independently about what took place. The result is that two otherwise perfectly reasonable, perfectly intelligent, perfectly decent people will watch the same videos and come away with one of these two interpretations of the events in it:

Choice A: A group of smirking teens in MAGA hats harassed, mocked and were disrespectful in multiple ways to a veteran and native American elder. This is really yet another story about what Trump’s cozy attitude toward white nationalism and open racism is doing to America, and about the millions of Americans who will stand by in silence when vulnerable populations are assaulted.

Choice B: A group of Black Hebrew Israelites shouted homophobic and racist taunts at a group of Catholic kids waiting on their parents. A drummer from an indigenous people’s group came between them and started banging a drum in the face of one of the kids. The kid didn’t know what to do and stood still. This is really just another story about the media crafting a narrative, calling it fact, and inciting doxxing and violence from the ‘tolerant left.’

It’s a brutal pair of choices, but those dueling narratives become clear in NLP analysis. Here are the stories from Saturday, January 19th. They are completely one-dimensional, and offer one explanation. On this day, 74% of the articles discussing the event expressed enough confidence in the facts of the events to use the fairly loaded words “mock” or “taunt.” Around 57% thought it important to reference “MAGA hats.” Just over 41% used the word “hate.” None of us is invulnerable to this type of single-narrative missionary activity. I know that I wasn’t.

Source: Epsilon Theory, Quid

By late Saturday into Sunday morning, longer videos of the entire event emerged. At that point, the narrative didn’t change. It split. There was now a coherent narrative of highly similar language and imagery describing the event as MAGA Hat Harassment, and a completely separate counter-narrative based on the interpretation of the more complete video and additional eyewitness accounts. In the narrative map of news articles from January 20th below, you can see the former on the left, and the latter on the bottom right.

Source: Epsilon Theory, Quid

When you closely examine the terms and phrases used in each of these two dominant narratives, you notice something else: In less than one day, the authors within each cluster are hard at work to find connections to other issues of broader significance. For people slotted by the widening gyre into Choice A, this was no longer a single ugly event. It was another seminal moment in the history of privilege and hate. It was another 1960 Woolworth’s Lunch Counter, another Little Rock Nine. It revealed the real hearts of those behind pro-life march and religious schools. It was a symbol of how Trump and his supporters have tacitly enabled hatred of all kinds. It was a symbol of all those smirking children of privilege.

For those forced into Choice B, the event wasn’t about the kids or the elder at all. It was now a symbol of the unchecked bias of media elites. It was a symbol of Trump Derangement Syndrome. It was a symbol of how the political left ignores homophobia and hate if it serves their political purposes. It was a symbol of how far people would go to thwart Trump and conservatives, like celebrities, politicians and members of the media openly campaigning to ruin the lives of teenagers before all the facts were available, and then refusing to walk back their words when they were.

The Competition Game is our Zeitgeist.

In a Competition Game, the gyre continues to widen because both the cause and effect of each widening event – its abstraction into existential memetic symbols – are the same. A chain of linked engagements. This is another skirmish on the battlefield that has defined every event that has shaped this widening gyre. On the one hand are those whose Greater Truth is the existential importance of protecting historically marginalized people from institutionalized sources of power. On the other hand are those whose Greater Truth is the existential threat of a left-wing monoculture in media, entertainment and academic institutions that control all of our cultural narratives. You don’t have to think that these things are equivalent in importance (I don’t) to believe that they represent good-faith fears and honest desires (I do). But like all existential fears, when the Zeitgeist becomes a Competition Game, they come to define our divisions. This wasn’t the first such skirmish. It won’t be the last. Each will leave us more divided.

But there’s something in this event in particular that worries me: Our machinery for translating any kind of event into an existential crisis that requires us to abandon a humble, probabilistic view of the world has evolved into something truly exquisite. It now takes that machinery less than a single day to extrapolate the meaning of an event into Common Knowledge – something that everybody knows that everybody knows. It takes only hours to marshal us all into defense of issues of existential importance to our Greater Truth.

Under these circumstances, it’s hard to have clear eyes about any of our priors or how those priors are influencing our interpretation of reality. It’s a rotten state of affairs for our civil society, but it’s a really rotten state of affairs for any fact-based process or profession.

So what do we do, that is, if we’re not willing to settle for rank nihilism? Now more than ever, I think we’ve got to look for people of varying philosophical views and circumstances with whom we can come to a mutual agreement: to hold one another accountable and to trust one another’s expressed motives. People who will wait and think with us, who will understand that our hesitance to jump into the fray isn’t evidence of a lack of principle or conviction, but respect for the empirical observation that our judgment will inevitably be clouded by the Zeitgeist.

Around here we call that a pack. If you haven’t found one, do it now, before this widening gyre makes it impossible.

What Gang Aft Agley

But, Mousie, thou art no thy-lane,

In proving foresight may be vain;

The best-laid schemes o’ mice an’ men

Gang aft agley,

An’ lea’e us nought but grief an’ pain,

For promis’d joy!

To a Mouse, on Turning Her Up in Her Nest With the Plough, by Robert Burns (1785)

It’ll be Burns Night this Friday, which in my house merits a dram or two more than the usual end-of-week celebration. It will involve no more haggis than the usual, which is to say, none. Most of all it will mean a great deal of poetry – Burns poetry – which is written in a way that all but forces you to try your hand at a Scottish accent. One of the great joys of marrying a theatre scholar is her shocking facility with such dialects, the result of studying under one of the best voice coaches in the world. My own attempts are less impressive.

All the same, bad accent or not, I’ll drink a toast to Burns. But a Burns Supper isn’t just whisky, haggis and poetry. It’s a meal of joy, melancholy and respectful remembrance of times and people now departed. In this house, this year’s will also be a Bogle Supper. On Friday, we will drink a toast to Jack, a genuine treasure who did more to make markets work for the individual investor than any person. Ever. He wasn’t just someone who was in the first place at the right time to capitalize on an inevitable idea. He made something happen that wouldn’t have happened otherwise, perhaps for many years.

It’s an achievement that none of us will equal.

So remarkable was Bogle’s role in the advent of low-cost investing that commentators and media have run out of things to say. And when we run out of things to say, we usually start saying some rather silly things, too. One of these silly things I’ve read several times this week is that the ‘truly great’ achievement wasn’t massively reducing the cost of investing (yes, it was), but the operation of Vanguard as a client-owned enterprise (no, it wasn’t).

It isn’t that client ownership of the firm isn’t a really cool idea. It is. It’s an admirable idea. It also works for Vanguard and the culture that they sought to build. It isn’t perfect – Vanguard employees aren’t angels, and they want to make more money and have more prestigious jobs, too. But it’s pretty damn close, especially for a passive investment firm that isn’t selling that it’s got a better strategy than the next firm over. To the extent you believe that there are necessary investment strategies and forms of advice where results will vary across practitioners, however, most of us would say that an approach that limits the financial rewards of success probably doesn’t create all the right incentives. That’s part of the reason why lower fees have changed the world, and client ownership of investment firms hasn’t. 

Still, none of this has stopped us from inventing countless ways to solve the alignment problem between asset owners and asset managers. Not one of those methods truly achieves it – not fully, anyway. Not even Vanguard’s. So why do all these best-laid schemes gang aft agley?

Because we cannot scheme away the principal-agent problem.

As allocators, we first learn to hate fixed management fees – not necessarily from the justifiable hatred of paying excessive amounts for strategies with no hope of producing the alpha that would justify such a fee – but under the belief that it creates the wrong incentive. Management fees exist to keep the lights on, we reason, and if a fund company or financial adviser takes in more than this, their greatest incentive may become to avoid losing the business. There’s no denying this. It’s true. Then the inevitable bout of volatility hits. Then come the headcount reductions. Then the adversely selected departures of a couple of their brightest analysts. Then, as allocators, we start wondering about the stability of the business. We really have so many options, and it’s really not worth taking a risk…

Then we learn to hate incentive fees. The fund had a banner year the year we invested, you see, and we (happily) paid through the teeth for it. Then two brutal years followed, and washed away all the alpha. Somehow we didn’t get our money back for all those incentive fees we paid in the first year. Are we going to stay to let them earn it back and to lower our effective fee? Or do we call it a sunk cost and move on?

Then we focus on related alignment questions. To be most aligned with us, shouldn’t the portfolio manager invest a significant portion of his or her own wealth in the same product? Some skin in the game? And then, in the depths of a draw-down for that product, when we’re comforted by our own diversification, the portfolio manager we applauded for the 80% of their wealth they invested in their long/short biotech fund is acting very strangely. Panicked. I wonder if that’s why they’re doing so poorly. Maybe they’re having a mental breakdown. Might be time to redeem.

Then we realize, come to think of it, that if we were going to be truly aligned, the alignment can’t come through the fees or our investment in the product. We should own part of the firm. After all, it’s our commitment that keeps them in business, and if we own a portion of it then we can be sure that we are maximizing what we get out of every dollar we invest. The fund manager won’t be able to focus on growing the business over investment quality without us participating in that upside. Then, over time we discover the extent to which many of the conflicts with our interests occur not at the company level, but at the employee level, where all of the self-interested behaviors and conflicts with us as principals continue unabated regardless of our ownership. When that sharing of ownership is less voluntary than it was with, say, Vanguard, we allocators soon recognize how much our interest is also resented over time by those who now reason that they could have achieved the same without us.

My career has been split into equal thirds: a third spent buying stakes in fund managers, a third spent allocating an institution’s capital, and a third spent leading a fund management business. What I have learned from being on each side of the table is this: the reason most asset owners fail to achieve alignment is that they focus entirely upon rigidly engineering the incentives of their agents, and because they focus not at all upon constraining their own behaviors in ways that will exert much larger influence on the incentives of the agent. Said another way, we have adopted such a short-sighted and perverse view of what it means to be a fiduciary that we are hell-bent on squeezing every bit of apparent advantage we can out of our prestige, asset size and credibility, ultimately to our own harm and that of our charges.

What do I mean? I mean that our heavily negotiated fee structure with an active manager will have a paltry influence on our adviser’s or manager’s behavior relative to their fear of being terminated or kicked off our approved list after a bad quarter or year. I mean that the incentive effects of an ingenious incentive fee structure that calculates alpha over some rolling set of regression-calculated betas will be nothing compared to the manager’s knowledge that we’ll put them in the penalty box if they terminate those two underperforming analysts and exceed our headcount change threshold during our annual diligence meeting. The incentive to waste time on clever visualizations, the incentive to memorize useless facts about companies with no import on the investment thesis to prepare for ‘knowledgeable’ stock chats with clients – these are the kind of things that we justify as demands because we deserve everything that’s coming to us as fiduciaries or principals, even if getting what we demanded ultimately harms us.

A long-time friend and business relationship asked me and Ben the other day, “What is the single most important thing you look for in a portfolio manager or adviser?” The answer is alignment! But I don’t mean alignment between them and us, as agent and principal. That is almost always a kind of fool’s gold, the kind of thing that you can never find by looking for it – which lea’e us nought but grief an’ pain for promis’d joy. No, I mean alignment between the temperament and circumstances of the portfolio manager or adviser on the one hand, and the investment strategy employed and the commercial terms for that relationship on the other.

It’s a nuanced difference, but an important one. If we want an aligned relationship with a passive manager that isn’t selling specialized expertise, Jack Bogle and Vanguard went most of the way toward showing us what that should look like. But what if we want an aligned relationship with our financial adviser or active fund manager? If our oversight structure permits it, instead of beginning with the cartoon version of ‘fiduciary’ that requires us to squeeze every basis point out of them, we can instead ask them these four questions:

  1. What worries you about your existing client relationships?
  2. What do you think your clients are too focused on? Give me some examples.
  3. In a perfect world, what would you change about your existing relationships, like how you meet, what you talk about, and how the investments are structured?
  4. How could we structure our relationship so that these issues occupy less of your mind?

In the end, as allocators we don’t have to do any of those things. There may be a poor alignment between their strategy, their fears and a commercial arrangement that will work for us. That’s OK. We really can move on. But if we really mean alignment when we talk about the term, and not just squeezing every possible commercial term we can out of the negotiation process, we will do much better by understanding not only explicit financial incentives, but the implicit incentives embedded in the nature of our relationships with our agents.

If you want to read some thoughtful exploration of what this can look like in practice, I highly recommend our friend David Salem’s contribution from a few weeks back: Everything Has Its Price.

The Zeitgeist | 1.18.2019

This is our feature of the 10 most on-narrative (i.e. interconnected, highly similar) stories in financial media. It’s not a list of best articles, or articles we think are most interesting, or articles we agree with. But if you’re going to read 5-10 stories when you start your day, these are the ones that are most connected to the financial news that got published today.

Morgan Stanley’s Worst-on-Street Bond Trading Sends Stock Lower

An Improving Interest Rate Outlook

The major bank earnings reports are all in and Morgan Stanley was the biggest loser

Fiserv to buy First Data for $22 billion to boost payments business

NeuroMetrix CEO reflects on the art of AI in the art of healing

Basmati Rice prices to rise further on export demand, low carryover stock

How to Trade ‘Too Big to Fail’ Banks Post Earnings

‘Welfare reform cushion’ millions unspent

LSE’s ‘Companies To Inspire Africa 2019’ Report Shows 46% CAGR Revenue

Jeffrey Vinik Thinks He Can Beat the Stock-Picking Bots

The Zeitgeist | 1.17.2019

This is our feature of the 10 most on-narrative (i.e. interconnected, highly similar) stories in financial media. It’s not a list of best articles, or articles we think are most interesting, or articles we agree with. But if you’re going to read 5-10 stories when you start your day, these are the ones that are most connected to the financial news that got published today.

China Must Adjust To Some New Realities – But Will It?

EMERGING MARKETS-Emerging market stocks dip, S.African rand soft ahead of rate meet

Inflation Is Nowhere in Sight

Medicine Man Technologies, Inc. announces launch of direct operator division of licensed cannabis operations

A $1.8 trillion investor says US stock rally has years to run

Tyranny of the algorithm: how Uber replaced one exploitative boss with another

Aussie house prices drop expected to be worst in the world

Corporate Earnings May Still Trip on Lower Bar

Why investors should fear ‘fallen angels’

5 Pieces of Advice from John Bogle

Navigating the Discovery Map

One of our subscribers pointed out that the Discovery Map can be a bit daunting – so many articles, so many nodes. Fair enough! So he (and we) thought it would be helpful to provide you with some of the best starting points to give you a push on your own self-sovereign discovery of self-sovereign discovery.

I think that there are probably two ways to go about this, and it may just depend on your mood. Here are our top three ideas for each of these two paths of discovery. If you want to know where you can click on the map to get started, the image below highlights the location of the Rabbit Hole pieces by numbers in yellow text, and the Bridge pieces in green text.

  • The Rabbit Holes: Navigating the neighbors of these articles will give you our deepest explorations of certain topics. They are the most connected to one another, and as such, the most influential on the overall structure of the narrative map. Here are the deepest rabbit holes:
    1. Things Fall Apart, Pt. 3 (Politics): Connected to a range of concepts and a series in itself, this is among the most connected notes to the widest range of Epsilon Theory concepts.
    2. Whom Fortune Favors: The first note in a series covering some overarching views on what matters and does not matter to portfolio management. This is, despite not being explicitly narrative-focused, is actually the most connected note of the entire map.
    3. Surely You Can’t Be Serious: A short and sweet note from 2014 which shows you how the Golden Age of the Central Banker launched Epsilon Theory – and acts as a present reminder of how the Narrative of Central Bank Omnipotence behaves when it holds sway.
  • The Bridges: Perhaps just as interestingly, you might start your journey with the articles that stand out not for how similar they are to a great many articles, but for their cross-cluster connectivity. If you want to see how Epsilon Theory content connects across different topics, and how it all fits together, this is where you might start.
    1. The Wages of Fear: The most centrally connected of all notes, The Wages of Fear reaches across topical central bank omnipotence threads, individual sovereignty threads, discussions of missionaries and common knowledge, and even our discussions of civics and the widening gyre.
    2. Flatland: One of the most direct notes relating central banking communication policy to game theoretic and information theory concepts, it is a classic note to start exploring these intersections.
    3. My Passion is PuppetryA central note connecting the tools of the widening gyre and financial abstraction in a practical investment context. One of my all-time favorites.
Source: Epsilon Theory, Quid

Settle in and find one of those nodes below to begin your exploration.

Shikaka!

Fulton Greenwall: The chief says that unless the sacred bat is returned before the marriage of the princess, the Wachati tribe will meet their death.

Ace Ventura: What type of bat are we talking about?

Fulton Greenwall: The great white bat, of course.

Ace Ventura: Crepuscular Chiroptera?

Fulton Greenwall: Yes. But to the natives: Shikaka!

Ace Ventura: Shikaka. SHEEKKAAKAHH. Shikasha! Uh…shishkebab…Shawshank Redemption…Chicaaago! Alright, you’re out of there. Go on, you’re gone.

Ace Venture: When Nature Calls (1995)

Back before Jim Carrey completed his transition into a slightly unhinged version of my grandmother, he really was very funny – one of our country’s better physical/slapstick comedians. It’s a tremendously difficult style to pull off as long as Carrey, Benny Hill and Jerry Lewis were able. The short shelf life isn’t really a hazard of the trade, although Belushi and Farley did both die from drug overdoses (of the same drug, as it happens) in their prime. The more typical problem is that slapstick must adapt more quickly than other forms of humor if it is to stay fresh. It shocks, it sparkles, and then it bores.

The Ace Ventura movies haven’t aged especially well in this regard. If you didn’t watch them at the time, and perhaps if you weren’t the 13-year old demographic for whom they reached their nirvana, you’ll struggle through them today. But for the modern political observer, they have everything: symbols! Opposing factions exploiting those symbols! Sophisticated outsiders expertly manipulating those symbols to create conflict! A man literally talking out of his ass!

In the last two weeks, US political observers will have seen the powerful emergence of two great white bats. Both have the dog whistle and obedience collar features Ben discussed in his classic note, Always Go to the Funeral, and the rage and mirroring engagements in A Game of You. Both issues are almost completely without substance.

So of course both are just about the only things anyone wants to talk about.

I’m talking, of course, about The Wall and the 70% Tax.

The fundamental substance of The Wall as an issue – the reality – is really quite boring. Border fences and walls are not uncommon. They are not inherently hateful. They are also not particularly effective. Border control is pretty clearly within the mandate of the government, so there’s not much jurisdictional debate. There are no data indicating much change, or any new crisis in illegal immigration, except data that would indicate a decline. There does appear to be a sharp rise in asylum cases and a lack of resources to handle them, but that is a different issue. The cost of a wall is meaningful, but a rounding error in context of the federal budget. In short, it’s a fringe issue that should be consigned to policy wonks.

The fundamental substance of a 70% Marginal Tax as an issue – the reality – is similarly boring. It won’t raise much new revenue. It really won’t change the effective tax rate of almost anyone, since it will just cause the creation of new deductions and loopholes and exceptions, as such tax rates have since the beginning of time. There’s reason for concern in that the wealthy are not equally well-equipped to access such loopholes, which ironically means that the plan would have little impact on well-entrenched asset owners and more impact on lower asset, higher income creators of new wealth. The net effect of all this is that it would have practically no impact on income inequality. Still, in substance, this is an issue for tax and budget wonks.

Except it isn’t the wall. It’s a meme of The Wall! It isn’t a proposal of a higher marginal tax rate. It’s a meme of The 70% Tax! Each is a symbol meant as obedience collar for its native audience and as provocative dog whistle for the opposition.  

To a Trump-supporting conservative, The Wall! is an obedience collar and an opportunity for mirroring engagement. It stands for a willingness to defend our borders and the integrity of our nation in the way prior presidents have not been willing. It stands for a commitment to the rule of law and enforcement of existing statutes. It stands for putting the interests of tax-paying American citizens first. And yes, for some it stands for keeping a (white) America from changing too quickly. But more than anything, it stands for standing by Trump in the face of constant opposition from the media and opposing politicians who just want to see him lose at any cost.

To the Trump opponent, The Wall! is a rage engagement. It stands for white nationalism and nativism. It stands for hatred and mistrust of foreigners, and an abdication of America’s founding principles. It stands for unjust anti-immigrant policy and sentiment more broadly. Most importantly, it stands for Trump, and the one thing he said most confidently and frequently that he would do during his presidency.

Now, a wall isn’t really any of those things. It’s some cement bound together with more cement and water, or in this case, it’s a row of steel slats, I guess. They’re really normal and boring things for countries to build that cost a bit of money, don’t hurt anybody, and don’t work very well. The abstractions from this boring reality are not inherent features of it, except inasmuch as some topics inherently permit memes to be more easily conjured. They are constructs of the widening gyre of our politics.  

Same with the 70% Tax! meme. To the progressive, especially one looking to move our society much further left, it stands for a willingness to finally do something about wealth inequality. It stands for the belief that the poorest in our society shouldn’t be struggling to get by while the wealthiest select new layouts for the galley in their yacht. It stands for workers. It stands for single parents. It stands for funding the policies and programs that would support them. It stands for equality and fairness. And yes, to some, it stands for sticking it to some rich people we don’t especially like.

To the opposition, the 70% Tax! meme is about encroaching influence of central planners and socialists. It is about those who would take economic freedom from us to implement their own idealized view of the world. It is about institutionalized hatred of the rich and successful. It is about crippling economic growth, creativity and the entrepreneurial spirit in favor of making everyone poorer, if more equal.

Except it isn’t really either of those things. It’s a policy that isn’t going to happen. Even if by some miracle/nightmare it did, it’s a marginal tax that doesn’t raise much money, which after new and existing deductions probably won’t end up costing rich people anything, which won’t fund a single program, which won’t stop a single new venture from being formed, and which won’t change a thing about wealth inequality.

Like The Wall!, the 70% Tax! is an abstraction and a symbol. It is important to realize, even if you care about the underlying issue, that the debate isn’t about the thing. It’s about the abstraction, about all the things that we are being told that each policy supposedly stands for. Those things will feel very real to us, because that’s what the widening gyre does to our brains. It drives us toward the beacon of Good and Right Policy and away from the cesspool of Evil and Wrong-Headed Policy.

What to do?

Clear Eyes. Mind how our side’s obedience collars are calling us to the defense of principles not really under attack. See how the other side playfully shouts “Shikaka!” to raise our hackles and diminish us. Be honest about whether some of the abstractions we find ourselves attracted to are, in fact, unjust or hateful.

Full Hearts. Be patient with those who attribute the foul features of the abstractions they have created to us. Be longsuffering in defending our intent, and believing the intents of others.

And God willing, when politicians and other missionaries start talking out of their ass and driving us into the widening gyre by promoting these abstractions, we stop voting for them.

The Alembic



This here badass piece of metal and wood is an old apple mill. When my wife and found it in the barn of the farm we bought last year, our minds were made up. We were going to plant an orchard. We were going to make cider. We were going to make brandy. No more than 100 gallons, of course, and entirely for personal consumption, in keeping with Connecticut General Statute §30-77. After all, anything else would be illegal.

Subtitle this, “Notes from the Barn”, I guess.

Like good little analysts who don’t want to play at macro tourism, we started from the bottom up. We tested and amended the soil where we were going to plant the new orchard. We researched each of the 19 apple varieties we were going to plant, from Ashmead’s Kernel and Binet Rouge to Vilberie and Yarlington Mill. We built a library of quantitative analysis on the acid levels, tannin content, sugars and yields of each. We assembled a matrix of pollination calendars and harvest calendars, mineral requirements and preferences of different rootstocks. We collected qualitative descriptions of the impressions tasters got from the particular mix of phenolic compounds like anthocyanins, phloridzin, rutin and catechin that exist in wildly different quantities across cultivars. We reviewed empirical data on the results of other producers with different varietals.

We were also thinking about portfolios.  You see, a good cider depends on getting the right blend of sugars, acid, bitterness and aromas. A delightful eating apple might make an insipid cider. Your favorite honeycrisp, for example, possesses moderate sweetness, a good bit of acid and practically no bitterness or other aromas. It’ll do as the base for a commercial cider, but it’s not really what we’re talking about when we talk about a hard cider. But then, it is rare that any one apple ever is. Sure, there are balanced apples that can be fermented into a beautiful and curious expression of a single cultivar, but in general, what makes a cider is what is achievable through the combination of a variety of different cultivars with complementary characteristics.

The act of making apple brandy is simply the distillation of cider. Figuratively and literally. In America or England, you’d probably heat up your cider in a copper pot still. In Normandy, you’d probably heat it up in a columnar distillation apparatus called an alembic. When heated, the alcohol in your cider evaporates more readily than the water. Along with the alcohol and some water go esters, fusel oils, methanol and tannins. When you’re done with your distillation (or in the case of a pot still, two!), you’ve got a 130-140 proof spirit that’s ready to take on the character of a wood cask for a few years.

But there is a problem.

Remember that beautiful cider, that expression of acid, sweet and bitter that we built with the help of math, nature, intuition and experience? The mechanics of distillation don’t care about any of that. Once we start applying heat, certain things are going to evaporate and recondense. Others will not, or will do so in lesser quantities. In the alembic, what our cider tasted like doesn’t matter. What matters is what will survive the process of distillation. There is in this an important truth to any process:

The characteristics of a good eating apple are often not the characteristics of a good apple for making cider. The characteristics of a good cider are often not the characteristics of a cider that will be distilled into good brandy. The characteristics of a good asset class portfolio are often not the characteristics of an asset class portfolio that will be combined with others to make the best aggregate portfolio.

That usually doesn’t stop us from trying. One of my first jobs back in my public pension days was to design the framework for – and identify most of the allocations of – an externally managed US small cap equity portfolio. It was something I was going to be judged by professionally. It was a portfolio that would be published and measured against a peer group of US small cap allocations of other institutions. It was a sub-portfolio that would be a benchmark-compared line item in every performance report we sent to the board and our consultants. I had every incentive and every temptation to treat it like The Portfolio. I wanted it to be balanced. I wanted it to be all-weather. I didn’t want it to be dependent on just one factor. I didn’t want there to be any tails that could wag the proverbial dog. Let me tell you – this was going to be some good cider. It’s just too bad it was going to be made into brandy.

Look, I did this to myself, but this also happens at different scales in almost every investment house in the world. We all have strategic portfolio objectives, and we all dole out implementation responsibilities to staff or to third parties. In the interest of measuring these agents – an entirely legitimate aim – we nearly always create incentives for them to smooth out every rough edge of the pool of assets they are charged with overseeing. We prize sub-portfolio Sharpe and Information Ratios when we should be celebrating the marginal impact on the risk efficiency of the aggregate portfolio. The result, very often, is a portfolio which sacrifices conviction for risk reduction that would have been achieved anyway when the portfolio was rolled up.

I cannot tell you how often I see this when we meet with investment firms of every type.

Asset management executives, do your stakeholders a favor. Ensure that the processes followed by your asset class teams and sub-portfolio managers are integrated into your aggregated risk and strategic asset allocation processes. Take caution when you incentivize staff or third-party managers to smooth out every edge of the portion of the portfolio they are managing. Allocators, develop comfort with asset class portfolios that have persistent structural biases within a balanced broader portfolio. Fight the temptation to systematically reward standalone sub-portfolio risk/reward ratios. Understand the factor loadings, environmental biases, betas, tilts and exposures of your asset class portfolios against whatever benchmark you’re using, but stop optimizing your portfolios at each step of the construction of the aggregate.

Stop forcing your people to make cider that’s going to spoil your brandy.

Run, Run, Pass

Source: Fort Worth Star-Telegram

As you might expect, we get a lot of emails.

Most of them are very nice. A few are nasty. After Ben’s “Lord Make Me Chaste…But Not Yet” brief, I think one reader called us “everything that is wrong with America.”

Tough but fair.

The most common emails by far, however, are from readers cluing us into examples of narratives they have observed in the wild. Only the common usage often isn’t the same thing that we mean by the term. When most people say ‘Narrative’, they mean a story that they perceive to be manufactured or artificial. Usually it is a pejorative, referring to something that is intentionally misleading, something which is decided in advance and attaches facts as convenient. They mean spin. This is…not exactly what we mean when we say it. When you read ‘Narrative’ on Epsilon Theory, you should read it as ‘an abstracted and symbolic representation of reality that replaces that reality as the locus of our thinking about a topic.’  A Narrative may be malicious or benign, but it is always most powerful and relevant to our interests when it becomes Common Knowledge, and especially when it leverages or is itself a Meme.

Why is this important to understand? Because if you are always looking for someone telling a story, you’ll miss the far more common types of narrative abstractions: facts, figures and models that stand in as proxies for the mechanic of reality they seek to model. Ben’s piece last year – Cartoons Against Humanity – is probably our clearest explanation of what we mean by this.

Yes, most narratives aren’t twisted, biased interpretations of facts. They aren’t fiat news. They aren’t overtly manipulative. They are numbers and data, unadorned, presented before you to do with what you will. The narrative’s power lies in our presumption of their sufficiently explanatory power.

We’ve talked about labor numbers and other cartoonified numbers. How about one of the most mind-numbingly obvious examples that still manages to suck us into the cartoon? Now, you may not know what I mean when I say, “run, run, pass,” but we have thousands of subscribers and readers in the Pacific Northwest who will know exactly what I mean. It is the clearest description of the Seattle Seahawks’ offensive gameplan for most of the 2018 season, including their most recent unfortunate playoff loss to my Dallas Cowboys. And why not? Any student of the most basic NFL analytics will tell you that the number of rushing attempts in a game is among the most explanatory variables for the team’s victory. No story there. That’s just a fact. If you ran the ball a lot, you probably won the game. Except, you know, if you ran the ball a lot, it’s usually because you were winning. Teams run when they’re ahead. Remember how I said this was mind-numbingly obvious (if you follow the sport, anyway)?

But as a data point, this idea that establishing the run is how you win is the natural progression in logic from the pure data, and it fuels all sorts of other more traditional story-driven narratives and, yes, common knowledge. Well, it sets up the pass. It sets up the play action. It’s necessary as a threat to keep the opposing alignment and defensive schemes honest and closer to the line of scrimmage. And the fact that all these things are a little bit true make it feel like you’re really on to something, when what you have is a garden variety, underdetermined mess of a model for how to win.

In the same way, we investors conveniently tell ourselves that so many of our models don’t work out-of-sample when they worked perfectly well in-sample because the underlying effect got arbed away, and so we move on to finding some new thing that hopefully won’t get arbed away. We convince ourselves that there’s economic intuition behind our variables, a good practice, as far as it goes. Or we convince ourselves that we’re accessing something that can’t be arbed away because it is a fundamental feature of human nature, which is probably true if our investment horizon is infinite (which it isn’t).

But no matter how accurate it may appear to be, a model is always a model. The moment we start believing that it’s as good as reality is usually the moment we get run over by a Mack truck.

What’s to be done?

In the absence of data to continually improve our estimates, we diversify our models. We take in inputs and mechanics from people with different priors. We ruthlessly evaluate the sensitivity of our models to every assumption we can identify, both explicit and implicit. Not just variables, but the structure of our estimation and prediction frameworks. We love the pieces that the team at Newfound Research have put out on this very topic. The last few posts here are focused on it. I highly recommend reading them. As you do, think about how treating your models and data like fact by not diversifying them is, itself, among the most powerful kinds of stories we tell ourselves.  

And go Cowboys.