Things That Go Bump In The Night


Pennywise: Tasty, tasty, beautiful fear.
Eddie: Okay, so let me get this straight. It comes out, from wherever, to eat kids for, like, a year, and then what? It just goes into hibernation?
It (2017)

Even at eleven, he had observed that things turned out right a ridiculous amount of the time.

― It, Stephen King (1986)

Same with markets. Things turn out right a ridiculous amount of the time. Pennywise only shows up once every 27 years. Should we be scared about his market equivalent?

Like many children with over-developed imaginations, I was always scared of things that go bump in the night. To this day I remember vividly the events (all fictional, of course) that frightened me so badly, like this scene from the 1979 made-for-TV movie of Stephen King’s Salem’s Lot, where little vampirized Danny tries to get his friend to open the upstairs window and let him in. You see, vampires have to be invited into your house. You have to give them permission to destroy you.

Hold that thought.

Anyway … as a child, I convinced myself that I could keep myself and my family safe from these malevolent forces and evil eyes if only I surrounded myself with the proper talismans (mostly stuffed animals, arranged just so around the bed) and said the proper words to God before going to sleep.

And it worked! This was classic magical thinking, just like that used by so many of our smartest and most powerful adults to protect us from the malevolent forces of economic recession and political decay.

I’d love to say that I’ve outgrown these fears that I know are irrational, but the truth is that I still surround myself with protective talismans and carry them with me wherever I go … a couple of lucky pennies, sure, but also a lucky dime (h/t Scrooge McDuck); one of the many chestnuts that I’ve rubbed between thumb and fingers till it’s oiled black and smooth, thinking this was my uniquely private charm until I recently found a well-worn chestnut hidden away in my grandfather’s rolltop desk; fortunes from cookies I ate 20+ years ago; my half of the turkey wishbone from this Thanksgiving, where my wife and I always not-so-secretly try to let the other win; an ancient post-it note wishing me luck, scribbled by one of my kids not for any particular reason, but just because. Powerful magics, all.

I’ll bet any amount of money that everyone reading this note has their own protective talismans. Maybe not as over-the-top as me, but you have them. This has always been my can’t-miss Turing test — the question you ask of an intelligence you can’t see to determine if it’s human or machine — what’s your talisman? What’s your charm of protection or luck? Every human being has a talisman. No machine would. It’s like asking a computer what mnemonic device it uses to remember something like the colors in the spectrum of visible light … the name Roy G. Biv has no meaning to a non-human intelligence other than as a curiosity of a less-capable species.

In investment and allocation circles, we have a name for these magical protections against spooky market forces that go bump in the night. We call them hedges. Now I’m not talking about hedge funds per se. I’m talking about the ad hoc hedges used by naturally long-only allocators like foundations and endowments and pension funds and big family offices. I’m talking about the ad hoc hedges used by naturally long-only investors like everyone with an IRA. I’m talking about how everyone reading this note has, at one time or another, gotten scared about markets and decided to hedge their professional portfolio or personal account with something that will make money if markets go down. Not as part of a considered review of risk tolerances and return projections and portfolio convexity (whatever THAT means). Not as part of an intentional portfolio that might include a long-volatility manager or a dedicated short fund. But just because we’re scared of something going bump in the night, and we need a talisman to ward off the bogeyman.

The most common of these casual hedges, the investment equivalent of a lucky penny, is the put option, and its most common expression is the put spread.

Quick review! A put is an option where you’re betting on whether the underlying thing, say the S&P 500, will go down below a certain price level before the expiration date of the option. So if I buy a put option that’s “struck” at a price level 5% below where the S&P 500 is today, and that option expires three months from today, then in three months my put option will only have value if the S&P 500 is at least 5% below its current price. The farther below that 5% strike price, the more money the option is worth.

A put spread is when I both buy AND sell a put option. Slightly different put options, of course, otherwise I’d just be buying and selling the same thing, but the difference between the two options — either in expiration time or (more commonly) the strike price — is the “spread” that I’m now betting on. So let’s say I bought a three-month put option struck at 5% down on the S&P 500 and sold a three-month put option struck at 15% down. When those options expire, I’ll make money on the put I bought if the S&P 500 is down at least 5%, and I’ll make a little money on the put I sold (limited to the price someone paid me for the option in the first place) if the S&P 500 avoids being down more than 15%.

Why would I do this complicated little dance? I do it in order to reduce the net cost of the put option I’m buying (the one struck at 5% down in this example). I want to buy some “insurance” on my portfolio that will pay off if the market is down more than 5%, and I can reduce the cost of buying that more-than-5%-decline insurance policy by selling someone else a more-than-15%-decline insurance policy. I mean … yeah, I’m scared of a 5% bogeyman attacking the market, but a 15% bogeyman? In the next three months? C’mon, that’s crazy talk. I’m not THAT scared.

As you can imagine, there are a zillion different variations on the put spread theme, depending on how scared I am and what I’m scared about. As you can also imagine, selling these put spreads to naturally long-only investors is a lucrative business for Wall Street, the bread and butter of equity derivative desks everywhere.

Again, I want to make clear that I’m not talking about the Street’s interaction with professional investors where options trading is part and parcel of their particular strategy. If you’re a BMW salesman, do you make your money by selling to a guy who owns a limo service and knows everything about the car business? No, of course not. You make your money by selling (or better yet, leasing) a new vehicle every three years to the doctors and lawyers and financial advisors who love their beemers. They’re not dumb guys and you’re not fleecing them (or else they’ll try a Mercedes for a change), but it’s not their business. This is where you make your margins. It’s exactly the same thing with the Street and selling portfolio hedges to naturally long-only investors.

Here’s the other similarity between luxury car sales and portfolio hedge sales. When you step back for any sort of a long-term view, is there really a meaningful difference in the transportation utility between a new BMW and a used Chevy? Of course not. There’s a personal utility I get in driving a BMW. My dad bought a BMW 1600 (the cheaper cousin of the 2002) in Birmingham freakin’ Alabama back in 1972 when BMWs were economy cars. I learned to drive a stick shift with that car. That car would flat-out FLY. It connects me with my father, gone 20 years now, and my own youth to own a BMW. So you’re damn straight I’m going to keep driving one. But I don’t own a BMW because it improves the Sharpe ratio of my transportation portfolio. I own it because it’s a powerful talisman for my personal life story. It makes me feel better about myself.

This is the reason why so many naturally long-only investors have paid for billions of dollars in ad hoc portfolio hedges, mostly in the form of put spreads, over the years. Not because these hedges have improved the risk-adjusted returns of their portfolio — decidedly on the contrary, in fact — but because they make long-only investors feel better and more secure about their portfolio. Ad hoc portfolio hedges are a crucial part of the STORY we tell our investment committees — either an external committee or, more importantly still, that internal investment committee we all carry around inside our heads — about how we are ever-vigilant against the monsters lurking just beyond the castle walls.

And it works! Not in an economic sense, of course, but in the powerful psychic benefit it provides, like me as a child arranging the stuffed animals around my bed just so, or me as an adult driving a BMW.

But here’s the thing about our adult talismans — they’re not cheap. Sure I might not care about the premium I pay to drive a BMW when times are good, but I can tell you from experience that I care a lot if my annual income takes a big hit. Talismans and charms are great for the psychic benefit they provide, and god knows I’m all about psychic benefits, but if it’s that or paying the mortgage …

I think that naturally long-only investors are now abandoning their portfolio hedges, because they can no longer easily afford the psychic benefits of these expensive adult talismans.

The investment returns of so many naturally long-only investors have been so disappointing for so many years (in relative terms if not in absolute terms) that it is harder and harder to justify the very real cost of putting on ad hoc portfolio hedges. If you don’t keep up with the Joneses in the investment returns you provide your client, external or internal, you will be fired. If you’re a good story-teller, that will buy you more time with your client than if you’re a poor story-teller, but it’s only a matter of time. You. Will. Be. Fired. In times like this, psychic benefits go by the wayside, and I think this is creating a big shift in the behavioral structure of markets.

I don’t have any proof-positive charts to show you that naturally long-only investors (who control the vast majority of financial assets in the world, btw) are now changing their long-held behaviors by abandoning ad hoc portfolio hedges. I have plenty of anecdotes and stories, and a couple of suggestive charts, but like all big shifts in investor behavior this is a slow burn that won’t be obvious until it’s already happened. If I’m right, though, this is a sea change in the way that the game of markets is played, with important implications for anyone who cares about playing the players and not just playing the cards.

Here are two charts that suggest a behavioral shift.

First, this chart (h/t Joe Gulotta) shows the ratio of outstanding equity put options to call options on the Chicago Board Options Exchange (CBOE), the largest options exchange in the U.S. I like looking at the ratio of puts to calls because it’s not impacted by the overall level of options usage in and of itself. Whatever the overall option activity might be, this ratio is isolating how many investors are participating in negative markets bets (puts) versus positive market bets (calls). The put/call ratio is typically used by traders as a sentiment indicator (so in this case showing a bullish market sentiment), and that’s all well and good. I’m using it for a different purpose … not to judge sentiment levels per se, but to see if we can glean behavioral patterns from the path in which those sentiment levels change over time. I’m not particularly interested in measuring sentiment or even change in sentiment. I’m interested in understanding the behaviors associated with sentiment, and how those behaviors change over time.

There have been six trading days over the last eleven where there were only half as many put options held by investors as call options. Prior to this, there were six trading days with this 1:2 ratio over the past two years. Also, you can see on this chart that there have always been spikes of put buying activity every few months, when investors get scared about this or that and decide to buy some talismans for “protection”. We haven’t had that sort of spike since last summer, and it’s not like there haven’t been any well-publicized market bogeyman since last summer. It’s the put-buying behavior that’s changed.

Second, this chart  (h/t Devin Anderson and the rest of the Deutsche Bank equity derivatives team) shows the changing value of outstanding put options on the S&P 500. In other words, I’m less interested in the ratio or total number of put options out there at any given time, than in the dollar amount of hedging that those put options represent. This is what it means to show “delta-adjusted” open interest on put options, measured here in billions of dollars. So per this chart, over the past five years the maximum amount of hedging on the S&P 500 index using put options occurred in the fall of 2015, with about $230 million worth of “insurance”. Today, however, there is only about $70 million in S&P 500 index protection outstanding, the lowest amount in five years, and it sure looks to me like it’s on a path to nothing. Which would be an amazing thing.

I’m not saying that it’s a bad thing.

In fact, as someone who has a strong professional interest in encouraging allocators and investors to focus on what truly matters for their portfolios (see, of course, Rusty Guinn’s 2017 serial opus for Epsilon Theory, summary of the chapters linked here), I think it’s a good thing to stop making these ad hoc portfolio hedges. And if it’s accompanied by a conscious review of risk, reward and REGRET in our investment strategies for a profoundly uncertain world … well, that’s a really good thing.

But it is an amazing thing, with some important implications. Here’s one:

For years now, whack-a-mole vol-selling strategies, where any slight pick-up in volatility was promptly whacked on the head with a mallet of put selling and volatility futures shorting, have been extremely successful. Why? Because when volatility spiked up it meant that there was a bogeyman narrative being projected by CNBC and the like, and the naturally long-only allocator or investor got all scared and decided to “buy protection” with a put spread or some similar ad hoc hedge. And then when the bogeyman didn’t materialize, this “insurance” expired worthless, and the premiums paid were pocketed by the volatility selling strategies. If you’ve ever bought a portfolio hedge (and god knows I have), then you’ve been the counterparty to these vol-selling strategies. Time after time after time, you’ve been on the losing side of the zero-sum game that is the options market.

Today though … if that talismanic put-buying behavior is going away — and I think it is — then systematic volatility selling strategies won’t work as well going forward as they have in the past. That’s not a bold market call. It’s just a mechanistic fact of markets: sellers don’t get as high of a price for what they’re selling if you have fewer buyers. Volumes go down and margins are squeezed for traders, too.

This isn’t just an issue for hedge funds and Big Bank equity derivative desks. Systematic vol-selling strategies are everywhere these days, including the most vanilla of accounts. Got a covered-call overlay (also called a buy-write strategy) on your RIA account? That’s a systematic vol-selling strategy. Now please, I’m not saying that these are bad strategies or anything like that. Really, I’m not. I’m saying that a change in the hedging behaviors of institutional investors isn’t just inside baseball stuff. It matters for every financial advisor, every individual investor trying to figure out what to do.

And it goes way beyond the impact on this investment strategy or that strategy. What I think we’re seeing is the next necessary step in the transformation of markets into political utilities, where political institutions like the Fed are tasked in a more and more explicit manner with supporting the interests of the Nudging State and the Nudging Oligarchy. Does anyone doubt that if a vampire were truly to appear and knock on the market’s window, say a vampire in the form of a North Korean artillery attack, that the central banks of the world wouldn’t do “whatever it takes” to keep markets from falling? Why should we pay good money to buy put options as a hedge on our portfolio when the Fed will give us a put option for free? I think this is the most far-reaching and transformative effect of the extraordinary central bank policies of the past eight years — we are no longer afraid of things that go bump in the night.

But should we be?

Let’s agree (I hope) that buying ad hoc hedges in response to our fear of things going bump in the night is a poor implementation of our worries, that it’s an expensive psychic benefit that rarely moves the portfolio performance needle even if it works. But if we could implement a hedging strategy in a systematic way (not necessarily mathematical, although maybe, but always rigorous and repeatable in its process … something I’ve written about a lot, notably here and here), should we?

Are there monsters that the Fed can’t protect us from?


I think that there are two ways to think about the monsters that are immune to the central bankers’ Protection from Evil spell (sorry, revealing my OG D&D roots there).

First, there are monsters that the central bankers CAN’T control. Now to be honest, there aren’t too many of these bogeymen out there after eight years of forward guidance chants and $20 trillion of asset purchases, but the most obvious ones all come out of some unexpected turn of events emerging from China — a military coup, a hot war, a yuan devaluation (or float), a cold war on trade … something of that ilk. All very low probability events, but not totally crazy, either. If China and the U.S. are ever seriously at odds in a geopolitical sense, then it doesn’t matter how much jawboning we get from central bankers … the market is going to decline in a serious way. But I don’t get too worried about these monsters that the Fed can’t control.

Much more important, I think, are the monsters that the Fed WON’T control.

There’s an old saying that I remember liking so much when I first heard it: “Ask for forgiveness, not permission.” It appealed to me (and I suspect to most readers) because it speaks to our personal sense of independence and autonomy. By golly, I’m going forward with this smart plan of action that might not get approved in advance by my boss or my board or my significant other, because I truly believe it’s best for the team. And if my boss or my board or my significant other has a problem with my actions after the fact … well, then I’ll swallow hard, take full responsibility and ask for forgiveness.

This is exactly the opposite of how vampires behave.

Vampires ALWAYS ask for permission.
Vampires NEVER ask for forgiveness.

You get one chance to say no to a vampire. After that … well, you asked for it.

I’m not talking about Stephen King vampires. I’m talking about real-world vampires, intensely self-interested professions that have been institutionalized into destroyers. Real-world vampires aren’t knocking on the window asking for permission to come in. We’ve already given them permission. They’re already inside.

Like politicians who are invited into our White House and Capitol with our votes. Politicians who then enact policies to enrich and empower themselves, their families and their posses. Politicians who pursue these policies with absolute entitlement and zero shame.

Like police and surveillance organizations who are invited into our homes and cellphones with our tacit and explicit expressions of support for civil security. Police and surveillance organizations who then seize our property and our communications. Police and surveillance organizations who pursue these seizures with absolute entitlement and zero shame.

Like technology companies who are invited into our friendships and purchasing behaviors with our voluntary social media and online commerce participation. Technology companies who then monetize our most private habits, opinions and preferences. Technology companies who pursue this monetization with absolute entitlement and zero shame.

Like unfathomably large banks who are invited into every aspect of our lives with our insatiable appetite for debt and consumption. Unfathomably large banks who then claim a permanent and unbreakable lien on our income and our labor. Unfathomably large banks who pursue this claim with absolute entitlement and zero shame.

Each of these modern vampires has charisma. They don’t present themselves as ghouls floating outside the upstairs window. They present themselves as the Robert Pattinson equivalent for whatever group of citizens they need to open the front door wide. It is, per Anne Rice, the first lesson of the vampire: “to be powerful, beautiful and without regret.”

This is how you NUDGE.

Each of these modern vampires of the Nudging State and the Nudging Oligarchy shares a certain DNA. Not to get all Marxist here, but these vampires share the DNA of Capital, in opposition to the DNA of Labor, and this is why you will never see the Fed or any other central bank lift a finger against them. Because the Fed is also a creature of Capital not a vampiric destroyer as these modern manifestations of Capital have become — but a creature of Capital nonetheless.

Meaning what, Ben? Meaning that all of the Fed’s policies — and particularly the monetary policies that are most impactful on our investment portfolios — are in the service of Capital. Sometimes, as we’ve experienced over the past eight years, that means incredibly accommodative monetary policy to support asset collateral prices. Sometimes, as we’ve seen in the past and I think we’re about to see again, that means punitive monetary policy to crush labor and wage inflation.

I don’t know how this change in monetary policy regime plays out. I don’t know how quickly punitive monetary policy happens or how far it runs. I can’t predict it. But I know that the Fed won’t prevent it, because the Fed isn’t your protector, and that’s what you should hedge against in an intentional, systematic way.

In real life it’s never the monster that goes bump in the night that gets you.

It’s always the monster in plain sight.

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I sat on the porch
Listened to the rain
Smoked a cigarette
And counted to ten

Oh no, here it comes again
That funny feeling

― Camper Van Beethoven, Oh No! (1985)

A quick post-Fed follow-up to “Tell My Horse”, the best-received Epsilon Theory note to date (thank you!). I’ll jump right into what I’ve got to say, without the usual 20 pages of movie quotes and the like. Well, I’ve got one quote above, because I can’t help myself. They’re the lyrics to the best break-up song ever, and they’re what Janet Yellen was singing to the market on Wednesday.

Let’s review, shall we? Last fall, the Fed floated the trial balloon that they were thinking about ways to shrink their balance sheet. All very preliminary, of course, maybe years in the future. Then they started talking about doing this in 2018. Then they started talking about doing this maybe at the end of 2017. Two days ago, Yellen announced exactly how they intended to roll off trillions of dollars from the portfolio, and said that they would be starting “relatively soon”, which the market is taking to be September but could be as early as July.

Now what has happened in the real world to accelerate the Fed’s tightening agenda, and more to the point, a specific form of tightening that impacts markets more directly than any sort of interest rate hike? Did some sort of inflationary or stimulative fiscal policy emerge from the Trump-cleared DC swamp <sarc>? Umm … no. Was the real economy off to the races with sharp increases in CPI, consumer spending, and other measures of inflationary pressures? Umm … no. On the contrary, in fact.

Two things and two things only have changed in the real world since last fall. First, Donald Trump — a man every Fed Governor dislikes and mistrusts — is in the White House. Second, the job market has heated up to the point where it is — Yellen’s words — close to being unstable, and is — Yellen’s words — inevitably going to heat up still further.

What has happened (and apologies for the ten dollar words) is that the Fed’s reaction function has flipped 180 degrees since the Trump election. Today the Fed is looking for excuses to tighten monetary policy, not excuses to weaken. So long as the unemployment rate is on the cusp of “instability”, that’s the only thing that really matters to the Fed (for reasons discussed below). Every other data point, including a market sell-off or a flat yield curve or a bad CPI number — data points that used to be front and center in Fed thinking — is now in the backseat.

I’m not the only one saying this about the Fed’s reaction function. Far more influential Missionaries than me, people like Jeff Gundlach and Mohamed El-Erian, are saying the same thing. If you think that this Fed still has your back, Mr. Investor, the way they had your back in 2009 and 2010 and 2011 and 2012 and 2013 and 2014 and 2015 and 2016 … well, I think you are mistaken. I think Janet Yellen broke up with you this week.

The Fed is tightening, and they’re not going to stop tightening just because the stock market goes down 5% or 10% or (maybe) even 20%. Bigger game than propping up market prices is afoot, namely consolidating a reputation as a prudent central banker before the inevitable Trump purge occurs, and consolidating that reputation means keeping the evilest of all evil genies — wage inflation — firmly stoppered inside its bottle.

Let’s be clear, not all inflation is created equal. Financial asset price inflation? Woo-hoo! Well done, Mr. or Mrs. Central Banker. That’s what we’re talkin’ about! Price inflation in goods and services? Hmm … a mixed bag, really, particularly when input price inflation can’t be passed through and crimps corporate earnings. But we can change the way we measure all this stuff and create a narrative around the remaining inflation being a sign of robust growth and all that. So no real harm done, Mr. or Mrs. Central Banker.

Wage inflation, though … ahem … surely you must be joking, Mr. or Mrs. Central Banker. How does that possibly advance economic efficiency and social utility? I mean, even a first year grad student can prove with mathematical certainty that wage inflation only sparks a wage-price spiral where everyone is worse off. What’s wrong with you, don’t you believe in math? Don’t you believe in science? Hmm, maybe you’re just not as smart as we thought you were. But I’m sure you’ll be very happy as an emeritus professor at a large Midwestern state university. No, Ken Griffin is not interested in taking a meeting.

I know I sound like a raving Marxist to be saying this, that the Federal Reserve system and all its brethren systems were established specifically to serve the interests of Capital in its age-old battle with Labor. But yeah, that’s exactly what I’m saying. Propping up financial markets? That’s a nice-to-have. Preserving Capital as the apex predator in our social ecosystem? There’s your must-have.

Whatever you think full employment might be in the modern age, 4.3% is at the finish line. And 4.1% or 3.9% or wherever the unemployment rate is going over the next few months is well past the finish line. You’re already seeing clear signs of labor shortages, particularly skilled labor shortages, in lots of geographies. Wage inflation is baked in, and modern populist politics make it impossible for corporations to play the usual well-we’re-off-to-Mexico-then card. Not that wages in Mexico or China are really that much better anymore, depending on what you’re doing, and there are inflationary wage pressures there, too.

Bottom line: I think that the Fed is going to do whatever it takes to prevent wage inflation from getting away from them, and shrinking the balance sheet is going to be a vital part of that tightening, maybe the most important part. Why? Because the Fed thinks it will push the yield curve higher as it lets its bonds and mortgage securities roll off, which will help the banks and provide an aura of “growth” and a cover story for the interest rate hikes. Otherwise you’ve got an inverted yield curve and a recession and who knows what other sources of reputational pain.

But here’s the problem, Mr. Investor. Ordinarily if the Fed was determined to take the punchbowl away by tightening monetary policy and raising interest rates, your reaction function was pretty clear. Get out of stocks and get into bonds. Wait out the inevitable bear market and garden-variety business cycle recession, and then get back into stocks. Or just ride your 60/40 vanilla stock/bond allocation through the cycle, which is the whole point of the 60/40 thing (even, though, of course, you’re really running a 95/5 portfolio from a risk perspective). But now you’re going to have both stocks *and* bonds going down together as the Fed hikes rates and sells bonds, in a reversal of both stocks *and* bonds going up together over the past eight years as the Fed cut rates and bought bonds.

Hmmm. ‘Tis a dilemma. What to do when indiscriminate long-the-world doesn’t work? What to do when nothing works? Maybe, with apologies to the old Monty Python line, active management isn’t quite dead yet. And just at the point of maximum capitulation to the idea that it is. Wouldn’t be the first time. In fact, that’s kinda how maximum capitulation works.

Is everything as neat and clean in reality as I’m making it out to be? Of course not. Other central banks are still buying bonds. Maybe global growth pulls everything through. Maybe President Pence/Ryan/whoever-is-fourth-in-line pushes through all the tax cuts and regulatory rollback and infrastructure build programs that your little old capitalist heart desires. Plus, this isn’t some cataclysmic event like “China floats the yuan” or “Italy has a bad election”. It’s a slow burn.

But I think that if your investment mantra is “don’t fight the Fed”, you now must have a short bias to both the U.S. equity and bond markets, not the long bias that you’ve been so well trained and so well rewarded to maintain over the past eight years. This is a sea change in how to navigate a policy-driven market, and it’s a sea change I expect to last for years.

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Tell My Horse


You may be a business man or some high-degree thief
They may call you doctor or they may call you chief
But you’re gonna have to serve somebody, yes you are
You’re gonna have to serve somebody
Well, it may be the devil or it may be the Lord
But you’re gonna have to serve somebody

— Bob Dylan, Gotta Serve Somebody (1979)

Guede is a powerful loa. He manifests himself by “mounting” a subject as a rider mounts a horse, then he speaks and acts through his mount. The person mounted does nothing of his own accord. He is the horse of the loa until the spirit departs. Under the whip and guidance of the spirit-rider, the “horse” does and says many things that he or she would never have uttered un-ridden.

— Zora Neale Hurston, Tell My Horse (1938)

In voodoo, the loa are intermediaries between humans and gods, similar to saints or angels in Western theology. But here’s the big difference with Western theology. You don’t just pray to the loa to receive its help. Belief is a necessary but not sufficient condition. You must serve the loa.

Erzulie Freda requires her champagne and perfume. Baron Samedi his rum and cigars. Voodoo is an intensely transactional theology, which makes it the perfect religion for the Age of Trump.

The wind came back with triple fury, and put out the light for the last time. They sat in company with the others in other shanties, their eyes straining against crude walls and their souls asking if He meant to measure their puny might against His. They seemed to be staring at the dark, but their eyes were watching God.

— Zora Neale Hurston, Their Eyes Were Watching God (1937)

Zora Neale Hurston, William Faulkner, and Cormac McCarthy are my indispensable authors. Why? Because they teach us how the human animal responds to The Storm.

Hurston was born in 1891 and grew up in Eatonville, Florida, one of the first all-black towns in the U.S. She moved to Baltimore when she was 26, working as a maid, pretending to be 16 so that she could go to high school. She went to Howard University, where she studied Greek and started the school newspaper, and from there went to Barnard College in 1925 for post-graduate studies in anthropology. She was the only black student at Barnard. In the 1930s, Hurston published three novels, two anthropology books, and dozens of articles and short stories. She wrote a Broadway musical. She won a Guggenheim fellowship.

20 years later, Hurston was working as a maid outside of Miami, having been fired as a librarian at Patrick Air Force Base for being “too well-educated”. She died alone and penniless in the St. Lucie County Welfare Home in 1960, buried in an unmarked grave.

What happened? Hurston was black. Hurston was a woman. Hurston was a libertarian. Strike three! Hurston rejected the notion that “black literature” should “uplift the Negro” (yes, this was a thing), making her anathema in mainstream white culture, not to mention unfit for librarian work in Brevard County, Florida. But Hurston faced as sharp a rejection in black counterculture, where her refusal to kowtow to black men of letters (and they were ALL men) and their vision of art (and women) in the service of socialist political dogma ultimately made her an outcast in every social circle she entered. Hurston was nobody’s fool, and she was nobody’s bitch. That’s a hard road to travel in any age.

1st-year Banker:   Look. I wanna be rich. I admit it. I want the car, the house, the whole show. But the idea that some global financial whatever exists independent of public and political accountability seems … naïve at best. Public opinion matters. Government regulations matter.

Viktor Eresko:  Young man … We finance culture. We buy entire nations.

— Jonathan Hickman, The Black Monday Murders (2017)

In his day job, Jonathan Hickman is responsible for orchestrating pretty much the entire Marvel Comics universe. Ever wonder how all those superhero movies tie in with each other? It’s Hickman’s story line. His best work, though, is found in indie comics far away from the Borg cube that is Disney.

Source: UBS Multi-Asset Sales, as of 06/07/17. For illustrative purposes only.

And in entirely unrelated news to the fictional notion of some global financial whatever that exists independently from public and political accountability, central bank assets recently topped the $14 trillion mark, growing at $2 trillion per year.

And speaking of endoparasitoids …

Wasps of the genus Glyptapanteles, also known as “voodoo wasps”, lay their eggs inside various caterpillar species. The eggs hatch and most of the wasp larvae eat their way out of the body of the caterpillar host and begin to pupate.

But some larvae stay behind and take over the caterpillar’s nervous system, effectively transforming the host into a zombie. The half-eaten-from-the-inside zombie caterpillar then proceeds to starve itself to death while protecting the baby wasp cocoons.

No, I’m not making this up.

Louis Cyphre:  Alas … how terrible is wisdom when it brings no profit to the wise, Johnny.

— Angel Heart (1987)

Tell me about it. Story of my life.

I’m having a hard time with this market, because I can see what a powerfully stable social equilibrium is being established around this transformation of capital markets into a political utility. I’m having a hard time with it because, like any powerfully stable social equilibrium, to be truly successful in that world you must give yourself over to that world. You must embrace that world in your heart of hearts. As Winston finally learned, to be happy you must love Big Brother. Or in our case, lever long, sell volatility, and love the Fed.

I can’t do it. I can’t embrace the machines and the vol selling and the ETF parade and the central bankers’ “communication policy”. So I’m NOT happy. I’m 20+ pounds overweight. I don’t sleep well. I DON’T trust the Fed, much less love them, and I never will.

I know, I know … boo hoo. First world problems and all that. No doubt Don Corleone would slap me around a bit for my Johnny Fontane-esque whining. You can act like a man! But here’s the thing. There are tens of thousands of people in this business who feel exactly like I do. Yeah, we’re privileged. So what? This is OUR existential crisis and we’re going to deal with it in the only way we can, by talking it through. Capisce?

So here’s my question. How do you survive, both physically and metaphysically, in a market you don’t trust but where you must act as if you do? How do you pass? How do you reconcile the actions and beliefs necessary to be successful in this market with the experiences and training of a lifetime that tell you NOT to act this way and believe in all this?

Here’s what most people do. Here’s the human answer. You make accommodations. You surrender little by little to the new religion and its transactional catechism. It starts off easy enough. At first it’s just staying quiet while others talk. Then it’s simple superstitious behavior that you can laugh off. Who does it hurt to pour a shot of rum and leave it out on the table for Baron Samedi? Ha ha ha. But then a friend testifies to you in a private moment. You can see with your own eyes the earthly rewards his faith has brought, while your caution and doubt have brought you nothing but portfolio underperformance and difficult conversations with unhappy clients. And then one day you feel it. Yes, I, too, can purchase Big Data. I, too, can purchase Cloud Computing. I, too, can purchase an ETF Model. I don’t need ideas of my own. I can transact for whatever ineffable machines or models I require to succeed in this market of ineffable machines and models, so that I can tend to more important things like “building my business” or “interacting with clients.”

And that’s where we are. By far the most common coping mechanism for a market we don’t like and we don’t trust and we don’t understand — but a one-way up market for all that — is to become smaller in spirit even as we become larger in scale. To become transactional. To collaborate with the forces that turn markets into utilities. To become positioners rather than investors. To become model followers rather than idea generators. To hedge out our most pronounced career risk — which is not a large portfolio loss, because so many others will be in the same boat, but is rather a small portfolio loss from independent decision-making while others are making non-independent, collective gains. How do we accomplish this hedge? By eliminating independent risk-taking and embracing collective risk-taking, that’s how. By blindly serving the loas of the market — sometimes ancient ones like Value Investing but more frequently new ones like Modern Portfolio Theory or Passive Investing — and letting them ride us like a horse.

Management fees doth make cowards of us all.

This gradual but massively widespread behavioral accommodation to what I’ve called the Hollow Market — where a shell of normalcy hides vast depths of faux trading volume, faux securities, and faux people — has different impacts in different parts of that market.

For discretionary stock pickers, particularly hedge funds, the Hollow Market has been a plague of Biblical proportion. The orange line in the chart below is the S&P 500 Index from 1998 to today. The white line and blue-shaded area is the HFRX Global Hedge Fund Index divided by the S&P 500 Index. It represents the relative underperformance or outperformance of hedge funds versus the S&P 500 (h/t to Howard Einhorn at Barclays), and today we are almost back to all-time underperformance lows, last seen in 1999.

Source: Bloomberg LP, as of 06/07/17. For illustrative purposes only.

Okay, you say, that’s the S&P 500, but this is a global hedge fund index. What about a global equity index? Below is the same plot against the MSCI World Index instead of the S&P 500. Oh yeah, that’s better. Merely a 17-year low in underperformance.

Source: Bloomberg LP, as of 06/07/17. For illustrative purposes only.

Accommodation to the Hollow Market is a miserable experience for discretionary stock pickers (and the same is true for any security selectors, whether it’s bonds or commodities or currencies or whatever), and the higher your fee structure the more miserable it is, which is why hedge funds have been particularly hard hit. Why is accommodation so difficult? Because the point of discretionary stock picking is taking independent, idiosyncratic risk. Seriously, that’s the whole, entire point. But if that’s where career risk squarely sits — and trust me, it does — then to survive the Hollow Market you have to give up your reason for being.

For the past eight years, whenever you’ve stuck your neck out with idiosyncratic risk sufficient to differentiate yourself and move the needle, more often than not you’ve been slapped around brutally for your trouble. So you stop doing that. So you make an accommodation by reducing your portfolio volatility to mimic a 50% allocation to the S&P 500 and a 50% allocation to cash, with a teeny-tiny idiosyncratic position here and there in order to have a good enough war story to keep your investors from redeeming (you hope). So you effectively lock in your underperformance and pray for the Old Gods to return and unleash their mighty wrath on global equity markets. Of course, you’ll be down 50% of the market in The Storm, just like you were in 2008, but hey … at least that would give you a reason to come into the office. Anything but this.

Or … you can convert to the new religion. You can reinvent yourself as a quant fund. It’s not who you really are, of course, so you’ll need to go out and buy the team and the computers and the data. But you can do that, and today it feels like every old school hedge fund is doing exactly that and only that. Because everything is for sale in the Hollow Market. Everything is transactional. IF I buy the team and the data and the computers, IF I perform the proper ritual in the proper way, why THEN I will start to generate uncorrelated positive returns again. That’s the promise of the modern loas of Big Data and Artificial Intelligence and Machine Learning. You don’t have to understand, you just have to believe. And serve.

What goes wrong here is what always goes wrong when too much money goes too fast into what is both the greatest creator of wealth in the modern world and the greatest destroyer of wealth in the modern world: financial innovation. And by financial innovation I don’t just mean the quants. In fact I probably mean the quants least of all. More pointedly I mean the financial innovation embedded in the Brave New World of ETFs and index products — of which there are now more such aggregated securities listed on U.S. markets than the company stocks which comprise them! — and more pointedly still I mean the financial innovation embedded in the Brave New World of massive central bank balance sheets and the massive-er quantities of sovereign and corporate bonds that are priced off those balance sheet dynamics.

The crowding inherent in the accommodations we all have made to the Hollow Market — particularly our collective embrace of ETFs + index products and our collective tolerance for central bank magic spells — has the same enormous drawback that global crowding always has: it dramatically increases our collective risk. We don’t care about that collective risk today because we’re all so consumed by our idiosyncratic risks of not fitting into the modern market zeitgeist. I get that. There’s no career risk in collective risk. But as a thinking, feeling human being I am focused on the collective risk. And here’s specifically what I’m focused on.

First, the notion that ETFs and index products are somehow “passive” investments in the buy-and-hold sense of the word is just utterly and disastrously wrong. If you’ve gotten nothing else from Rusty Guinn’s brilliant Epsilon Theory notes, please get this: there’s nothing “passive” about ETFs and index products. They are, on the contrary, the very instantiation of active portfolio management, where investors are making an inherently and completely “active” decision on this sector versus that sector, this asset class versus that asset class, this geography or factor versus that geography or factor. What this means is that the big risk to market structure and the big potential for feeds-on-itself selling pressure during a market downturn isn’t “risk parity” or some other small-fry bogeyman de jour, it’s the active trading decisions of the holders of TRILLIONS of dollars’ worth of active trading instruments — ETFs and index products. There’s your bogeyman.

And the same thing goes for the $14+ TRILLION in central bank assets. These are not buy-and-hold portfolios. These are trading portfolios. I mean, even the act of maintaining these portfolios at their current levels, much less the $2 trillion per year current growth rate, is an active trading decision of massive proportions. Depending on the average duration of the bonds these banks hold, they will be forced to buy $1 to $2 trillion of new bonds each year just to replace what’s running off. Will central bankers jawbone their tapering and selling every which way to Sunday? Will they buy more if markets get really squirrely? Of course they will. Of course they will because … once more with feeling … these are trading portfolios!

Okay, Ben, so they’re trading portfolios. So what? The so what is that there’s one thing that central bankers are even more committed to than propping up financial asset prices, and that’s preventing wage inflation from getting a full head of steam. That’s because central bankers are, in fact, bankers, and bankers gotta serve somebody, too. Or as Zora Neale Hurston would say, their eyes are watching God. It’s just — and I don’t mean to get all Marxist here or anything subversive like that — but their eyes are watching Capital, not Labor. Central bankers think they’re on the side of the angels with this one, the big struggle between the Old God Capital and the Old God Labor. I mean, it’s their “mandate”, after all. Their Mandate of Heaven, so to speak. Who can argue with that?

I know it sounds ludicrous today to suggest that wage inflation might be gearing up to make a run, what with it holding at a very sticky 2.4% or thereabouts in the U.S., and Europe and Japan unable to sniff inflation despite all their central bank purchases (wait a second … is it possible that that all this balance sheet expansion is deflationary rather than inflationary? Nah, that’s crazy talk. Forget I even said it.). But I don’t think a new regime of wage inflation is ludicrous at all. In fact, I think it’s pretty darn inevitable with the current swing of the populist pendulum, and I think it’s not just inevitable in the U.S. but in China, as well. And when it happens, the Fed is going to be waaay behind the curve, or they will think they are, which is worse. So they will tighten. They will sell assets. Regardless of whether the market is down a little or a lot, the Fed will tighten and sell a lot more and a lot more quickly than people imagine, and that’s going to beget a lot more selling of … everything. Because we all gotta serve somebody.

You know, the first time I really thought about the Dylan lyrics was back in my headstrong younger days, when the notion of professional autonomy was pretty much my highest goal and I was particularly chafed at what I perceived at the time as the unjust limitations on the full exercise of my natural investment genius <sarc>. The company I worked for provided a corporate shrink, and she was wonderfully insightful. Much more Wendy Rhoades than Dr. Gus, for any Billions fans out there. The most impactful observation, among many: “Ben, no matter who you are or what you do, if you stay in the investment business you gotta serve somebody. Maybe it’s not a portfolio manager or a senior partner. Maybe it’s your clients. Maybe it’s a Board. But you gotta serve somebody.” She wasn’t trying to talk me out of leaving. Which I did. She was trying to talk me into opening my eyes. Which I also did … kinda sorta. That’s the problem with youth. It’s wasted on the young. And I wasn’t that young.

Well, I’m older now, I have my eyes wide open, and here’s how I think about this Truth with a capital T today. I am truly happy to serve the people I care about. In a business capacity, these are my partners and my clients. And yes, I know that my clients are often institutions, not natural persons, but Mitt Romney wasn’t completely wrong when he said that corporations were people, too. The point being that I’m NOT happy to serve an idea. I’m NOT happy to serve a market loa like Value Investing or Artificial Intelligence. I’m NOT happy to serve The Man or The Fed or The Party. I’m NOT happy to serve the interests of the Missionaries that barrage us with their Narratives day in and day out. As Vito Corleone put it, I refuse to be a fool dancing on the strings held by all of those big shots. And what makes my business world work is that the people I serve, my partners and my clients, give as good as they get and do not require me to serve another Master. That hasn’t always been the case in my professional career, and I’m sure it’s not the case for many people reading this note. But if I can give one piece of advice for how to make one’s way through this petty, accommodationist, transactional, voodoo wasp-infested world, it’s simply this: find your Tribe. Work with people who value you as an end in yourself, not as a caterpillar host for whatever voodoo wasp eggs — i.e., zombie-fying endoparasitoid IDEAS — they or others are looking to implant.

So yeah, I’m overweight and I need to get more sleep. I’m not happy about the market, and I’m anxious about living up to my obligations to my partners and clients. But I wake up every morning thinking independent thoughts about idiosyncratic risks. I’ve got a Tribe. I’m nobody’s horse. And that’s about as good as it gets here in the Hollow Market.

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Bernard Lowe: Last question Dolores. What if I told you that you were wrong? That there are no chance encounters? That you and everyone you know were built to gratify the desires of the people who pay to visit your world? The people you call the newcomers.

Bernard Lowe: What if I told you that you can’t hurt the newcomers? And that they can do anything they want to you?

“Westworld” (2016)

Bernard Lowe:  Go ahead, erase my sentience, mnemonic evolution …

Dr. Robert Ford:  Ah, yes … Such clinical language. I would prefer the more narrative voice. Bernard walked over to Clementine.

[Bernard walks to Clementine]

Dr. Robert Ford:  He took the pistol from her hand.

[Bernard takes the pistol out of Clem’s hand]

Dr. Robert Ford:  Overcome with grief and remorse, he presses the muzzle to his temple, knowing that as soon as Dr. Ford left the room, he would put an end to this nightmare once and for all.

Bernard Lowe:  Don’t do this.

Dr. Robert Ford:  I have a celebration to plan, and a new story to tell.

Bernard Lowe:  Robert.

Dr. Robert Ford:  I’ve told you, Bernard. Never place your trust in us. We’re only human. Inevitably, we will disappoint you.

Dr. Robert Ford:  Goodbye, my friend.

[Ford leaves the room and starts walking away. In the background, blurry, Bernard stands still, gun to his own head. A shot is heard, and he falls.]

“Westworld” (2016)

Billy Kwan:  In the West, we want answers for everything. Everything is right or wrong, or good or bad. But in the [shadow play]

Billy Kwan:   no such final conclusion exists.

Billy Kwan:  Look at Prince Ajuna. He’s a hero. But he can also be fickle and selfish. Krishna says to him, “All is clouded by desire, Ajuna, as a fire by smoke, as a mirror by dust. Through these, it blinds the soul.

“The Year of Living Dangerously” (1982)

Sukarno never had a chance. And yes, that’s Linda Hunt as Billy Kwan.

Michael Corleone:  I saw a strange thing today. Some rebels were being arrested. One of them pulled the pin on a grenade. He took himself and the captain of the command with him. Now, soldiers are paid to fight; the rebels aren’t.

Hyman Roth:   What does that tell you?

Michael Corleone:   They could win.

Hyman Roth:  This county’s had rebels for the last fifty years— it’s in their blood, believe me, I know. I’ve been coming here since the ’20s. We were running molasses out of Havana when you were a baby — the trucks, owned by your father.

Hyman Roth:  Michael, I’d rather we talked about this when we were alone. The two million never got to the island. I wouldn’t want it to get around that you held back the money because you had second thoughts about the rebels.

― “The Godfather: Part II” (1974)

Michael Corleone is like me and every investor over the past five years who held off on an attractive investment for fear of political risk. Except he was right and I’ve been nothing but wrong.

Somehow, I think Silicon Valley got even more spun up than Manhattan. There were hedge fund people I spoke to about a week after the election. They hadn’t supported Trump. But all of a sudden, they sort of changed their minds. The stock market went up, and they were like, ‘Yes, actually, I don’t understand why I was against him all year long.’

― Peter Thiel, in a New York Times interview (January 11, 2017)

Everyone loves a solid gold telephone.

All great literature is one of two stories; a man goes on a journey or a stranger comes to town.

― Leo Tolstoy (1828 – 1910)

Grigory Vakulinchuk: We’ve had enough rotten meat! Even a dog wouldn’t eat this! It could crawl overboard on its own!

Smirov, the ship doctor:  These aren’t worms. They are dead fly larvae. You can wash them off with brine.

“Battleship Potemkin” (1925)

Spoiler Alert: Grigory is shot and killed by management. But the baby makes it down the steps alive. Eisenstein is never entirely clear about the efficacy of the whole just-wash-your-dead-fly-larvae-off-with-brine thing.

John Wick:  People keep asking if I’m back and I haven’t really had an answer. But now, yeah, I’m thinkin’ I’m back.

“John Wick” (2014)

Me, too. Political risk, though, not so much.

If political parties in Western democracies were stocks, we’d be talking today about the structural bear market that has gripped that sector. Show me any country that’s had an election in the past 24 months, and I’ll show you at least one formerly big-time status quo political party that has been crushed. This carnage in status quo political systems goes beyond what we’d call “realigning elections”, like Reagan in 1980 converting the formerly solid Democratic Southern states to a solid Republican bloc. It’s a rethinking of what party politics MEANS in France, Italy, and the United States (and with the UK, Spain, the Netherlands, and maybe Germany not too far behind). The last person to accomplish what Emmanuel Macron did in France? The whole “let’s start a new political party and win an election in two months” thing? That would be Charles de Gaulle in 1958 and the establishment of the Fifth Republic. The last person to accomplish what Donald Trump did in the U.S.? The whole “let’s overthrow an old political party from the inside and win an election in two months” thing? I dunno. Never? Andrew Jackson?

Now don’t get me wrong. Do I think Emmanuel Macron, a former Rothschild investment banker whose “ambition was always two steps ahead of his experience”, is the second coming of Charles de Gaulle? Do I think Donald freakin’ Trump is a modern day Andrew Jackson? Bwa-ha-ha-ha-ha-ha … good one!

But here’s what I do think:

  1. Something old and powerful is happening in the real world to crush the status quo political systems of every Western democracy.
  2. Something predictably sad is happening in the political world to replace the old guard candidates with self-absorbed plutocrats like Trump and pretty boy bankers like Macron.
  3. Something new and powerful is happening in the investment world to divorce political risk and volatility from market risk and volatility.

The old force repeating itself in the real world is nicely summed up by these two charts, the most important charts I know. They’re specific to the U.S., but applicable everywhere in the West.

First, the Central Banker’s Bubble since March 2009 and the launch of QE1 has inflated U.S. household wealth far beyond what the nominal growth rate of the U.S. economy would otherwise support. This is a classic bubble in every sense of the word, with the primary difference from prior vast bubbles being its concentration and focus in financial assets — stocks and bonds — which are held primarily by the rich. Who wins the Academy Award for creation of wealth inequality in a supporting role? Ladies and gentlemen, I give you the U.S. Federal Reserve.

Source: Bloomberg LP and TCW, as of 12/31/16. For illustrative purposes only. Past performance is no guarantee of future results.

And as the second chart shows, this central bank largesse has sharply accelerated the massive shift in wealth to the Rich from the Rest, a shift which began in the 1980s with the Reagan Revolution. We are now back to where we were in the 1930s, where the household wealth of the bottom 90% of U.S. wage earners is equal to the household wealth of the top one-tenth of one percent of U.S. wage earners.

For illustrative purposes only.

So look … I’m not saying that the current level or dynamics of wealth inequality is a good thing or a bad thing. I’m just saying that it IS. And I understand that there are insurance programs today, like social security and pension funds, which are not reflected in this chart and didn’t exist in the 1930s, the last time you saw this sort of wealth inequality. I understand that there are a lot more people in the United States today than in the 1930s. I understand that there are all sorts of important differences in the nature of wealth distribution between today and the 1930s. I get all that. What I’m saying, though, is that just like in the 1930s, there is a political price to be paid for this level of wealth inequality. That price is political polarization and electoral rejection of status quo parties. I won’t give the whole history lesson here, as it’s a good excuse for readers to immerse themselves in Wikipedia for half an hour or so and read about guys like Father Coughlin, but the rhyming of political history in Western democracies between the late-1920s/early-1930s and today, particularly in the way that status quo political parties were subverted or overthrown or just plain eliminated throughout Westworld is … pretty amazing.

Western democracies, mixing a healthy dash of popular political representation with a big dose of capitalist economic structures, are extremely good at the most important driver of social stability: co-opting the more talented members of a mass society into the status quo system, bringing new blood into that top two percent socioeconomic club who might otherwise apply their talents in more subversive ways. Maybe not the top one-tenth of one percent on a purely financial wherewithal scale, but definitely the top two percent on a more broadly defined socioeconomic scale of wealth, stability, and influence. That co-opting process is the steam valve for Western societies, and it has two components, particularly in the most successful Western society, the United States — educational mobility (move to where the good intellectual jobs are) and labor mobility (move to where the good physical jobs are). Educational mobility, spurred in the U.S. by more than $1 trillion in government-backed student loans, is in high gear, and the importance of an educational pedigree to get into the 2% Club has NEVER been greater. Labor mobility, on the other hand, crushed by globalization and the housing crisis, hasn’t been this broken since … yep … the 1930s.

As a result, the composition of the 2% Club of wealth, stability, and influence is changing. Today it’s almost entirely a Club of the educationally mobile and accomplished, the people who deal with symbols for a living — words and tickers and numbers and code — and whose language and lingo is similarly abstracted. And because our status quo political institutions, like political parties, are in all nations and in all times the top-down creations of the 2% Club, our political parties themselves speak a different language today than they did even 10 or 20 years ago. No political party is immune, regardless of where it sits on the traditional left/right spectrum. This isn’t a Republican vs. Democrat thing. It’s not a rich vs. poor thing, either, because there are plenty of rich people who aren’t symbol manipulators and are feeling less and less at home in the 2% Club. It’s a who’s-dominating-the-2%-Club thing, and in Westworld that’s the educationally accomplished symbol manipulators.

Our status quo political parties speak well and clearly to the 2% Club and their educationally mobile circles, not so well to the guy who didn’t go to law school and whose kids don’t have a prayer of getting into Stanford. Not so well to the guy who, to be honest, kinda hates lawyers and the professional symbol manipulators, and definitely hates anyone who went to Stanford. Not so well to, as Amity Shlaes titled her seminal history of the 1930s and the Great Depression, the Forgotten Man, citizens who — today and in the 1930s — are well and truly stuck. Stuck because labor mobility is broken. Stuck because their wages are flat and their debt is up. Stuck because they’re getting older. Stuck because, like the sailors on the Battleship Potemkin, they are served disgusting, rotten meat but are told by the well-spoken professionals that these are dead fly larvae, not live maggots, and so they can simply be washed off with salty water. Stuck because the entire political system is rigged for the educationally mobile and the symbol manipulators. Not rigged in a cartoon evil sense, but rigged in the same way that the German system is rigged in favor of people who speak German and the Chinese system is rigged in favor of people who speak Chinese. Don’t speak Symbol Manipulation? Sorry, but the status quo Western political system is rigged against you. And you know it.

There’s no attachment to a political party that from your perspective is speaking gibberish. The attachment is to change and reversion. The attachment is to Something Else. The Something Else will not have a well-considered or coherent policy wrapper. It won’t look smart. It didn’t in the 1930s and it doesn’t today. Why not? Because if it did, it would be co-opted as part of the status quo! Words like “well-considered” and “coherent” and even “policy” are the abstracted words of the modern status quo. They are the language of the 2% Club, particularly of an educationally mobile 2% Club, and it’s a very different language than that spoken by anyone hailing from the world of physical construction and manipulation rather than symbol construction and manipulation.

So what is this other language? Importantly, as Joan Williams describes in her phenomenal article, “What So Many People Don’t Get About the U.S. Working Class,” it’s not a soak-the-rich language (in fact, it’s more disparaging of the poor than the rich). It’s a non-abstracted language of direct, physical involvement in localized social behaviors (what Nassim Taleb calls “Skin in the Game”), because that’s the language that has meaning for anyone who depends on labor mobility and physical construction to make a better life for themselves and their kids. It’s an uncomfortable language for the educationally mobile 2% Club, because it doesn’t abstract away the racist, sexist corners of real world, localized social behaviors and beliefs in a carefully constructed linguistic architecture. That doesn’t mean that the Forgotten Man is necessarily racist or sexist (doesn’t mean that he’s not, either). It means that these are not behaviorally motivating or politically meaningful words to a major sub-population. It means that our language defines and constrains our thoughts and behavior, not the other way around. It means that we ARE our grammar, at least in our lives as social animals. It means that the Confusion of Tongues is not just a quaint Old Testament story with cool Gustave Doré engravings about some apocryphal Tower of Babel.

It is THE political story of this or any other age, and it always leads to a radical restructuring of the political order, because you cannot have a stable political equilibrium where a critical mass of national sub-populations speak different social languages.

But that’s where we are in every Western nation in 2017. The politically ascendant sub-population on the educational mobility track hear the language of the Other and say “Unacceptable people. Must resist. Zero-sum game.” The politically stuck sub-population on the labor mobility track hear the language of the Other and say “Bad hombres. Must fight. Take no prisoners.” The center cannot hold. More accurately, there is no center, no cooperation. Competition is all, and that’s no way to run a country.

Unfortunately and unsurprisingly, the new political leaders who emerge from a collapse of the Tower of Babel are rarely the champions of the Forgotten Man that you might think would emerge. Both in the 1930s and today, there’s no shortage of non-status quo political entrepreneurs who speak the language of the politically stuck and are willing to put themselves out into the political arena. But to be successful in their political entrepreneurship it’s almost essential that these new candidates be card-carrying members of the 1/10th of 1% Rich Club. Why? Because it requires an insane amount of money and sheer notoriety to replace the machinery of a status quo political party in a mass society. A political party is a media company. By joining a status quo party and toeing that party line, you communicate an enormous set of signals to potential voters for free. But by toeing that party line, you lose your Forgotten Man authenticity and any hope of being the champion of Something Else. Want to be a “change candidate”? Better make a couple of billion dollars first, or have plenty of billionaire friends, so you can afford to bypass the status quo political party.

Little wonder, then, that Donald Trump, a billionaire TV star, succeeds in overthrowing the Republican Party. Little wonder that Emmanuel Macron taps a vast banker network from across Europe to fund his campaign. Little wonder that zillionaire Mark Zuckerberg has embarked on a nationwide “listening tour”, complete with equal zillions of photo ops — none of which are with educationally mobile symbol manipulators — as he prepares for a political life. Good old-fashioned mustachioed fascism may work in Turkey, but here in the U.S. you need a smiley-face with your Panopticon. Sharing is caring!

So that’s my political take: the old and powerful Tower of Babel process is starting up again, and status quo political institutions are not long for this world. As we move to the Something Else to come, we’ll have to endure a parade of billionaires wielding political power in unprecedented ways, aided by unprecedented technologies of social control. That’s the Big Risk for everyone reading this note, regardless of your politics, regardless of your social language, regardless of your vision of the life well lived. That’s the Big Risk we have to manage, as investors and as citizens.

So how do we do THAT?

For today’s note, I’m focusing on the investor side of that question, and that means focusing on the one Big Question: as the Western status quo political system collapses into Something Else, how is it possible that our capital markets are not similarly gripped by volatility and stress? What is responsible for breaking the transmission mechanism from political risk to market risk?

I’ve got a macro answer and I’ve got a micro answer.

The macro answer is that you need status quo political parties to govern a country effectively. Thankfully, there are only enough billionaire candidates of Something Else to fill the top of the ticket, and even if there were more, a party of independently wealthy and independently popular mavericks isn’t a coherent party at all. There’s not less gridlock with an essentially party-less American president or an essentially party-less French president, there’s MORE gridlock. And that means that any sort of fiscal policy — whether it’s a clear-the-decks debt assignment or a classic stimulus program or whatever — is more difficult under this sort of independent political regime than in a status quo regime.

Sure, there’s a lot of excitement when the Stranger comes to town. Take a look at what happened to the U.S. 10-year bond after Trump was elected.

Source: Bloomberg LP, as of 04/10/17. For illustrative purposes only. Past performance is no guarantee of future results.

But excitement fades as fiscal policy promise fades to fiscal policy deadlock. When I look at Washington today, or London or Paris or Rome or wherever, it sure looks for all the world like a return to our regularly scheduled entertainment. Nature abhors a vacuum, and politics is no exception. In the absence of an active and effective fiscal policy authority, global monetary policy authorities will fill the policy void. And what is their policy? Refer to chart 1 at the start of the note, please. Low growth. Financial asset inflation. Low volatility. Wash, rinse, repeat. The new Goldilocks, now eight years old. Could go for another eight years, easy. Wheeee!

Yes, there’s enormous political risk associated with the collapse of status quo political institutions and the rise of the Trumps and the Macrons of the world. But …

  1. for financial markets, these new leaders are familiar, encouraging faces. They’re members of the 1/10th of 1% Rich Club, because they had to be to sidestep status quo political parties. Moreover,
  2. there’s going to be a hope and a promise of fiscal policy initiatives, and that’s a tailwind for markets, too. And finally,
  3. don’t worry, Mr. Market, when that hope and promise of pro-growth policy fades into the realization of anti-growth gridlock, our old friends Janet and Mario will be there to pick up the slack with more liquidity.

That’s my macro story for the divorce of political risk from market risk, and I’m sticking to it. Where does it break down? Not with a funky German or Italian election, but with Janet and Mario declaring victory and taking away the punchbowl. That’s what will bring political risk back to markets.

On the micro side, it’s the triumph of Communication Policy, just as far as the eye can see. I’ve written a lot about Communication Policy in the past, hereherehere, and here. It’s what the Fed calls their use of words and public statements for effect, as a specific policy tool designed to influence investor behavior rather than to communicate truthful information. You know … what we would call lying in other circumstances. As Ben Bernanke said in one of his last speeches as Fed Chair, Communication Policy (“enhanced forward guidance”) has been the star of the show since quantitative easing lost its mojo with the QE2 program. Making up narratives and telling them convincingly has worked for politicians for, oh, several thousand years. I suppose the only surprising thing is that it took central bankers so long to get in on the act. Today it’s their primary shtick.

But now that politicians and central bankers have demonstrated the incredible efficacy of what game theory calls Missionary Statements — the intentional construction of common knowledge through highly mediated statements — everyone wants in on the act. Everyone wants to be a Missionary for their own institutional ends. And that Everyone definitely includes Wall Street.

Here’s what I’ve noticed in the past two major political risk events in Western markets — the Italian referendum on December 5 and the French first round election on April 23. In both cases, the most political risk-impacted equity markets began to rally sharply three or four days BEFORE the vote.

Source: Bloomberg LP, as of 05/03/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.

The top chart is the European bank equity index before and after the French vote. Below is the price chart of the broad Italian equity index before and after their referendum.

Source: Bloomberg LP, as of 05/03/17. For illustrative purposes only. Past performance is not indicative of how the index will perform in the future. The index reflects the reinvestment of dividends and income and does not reflect deductions for fees, expenses or taxes. The indices are unmanaged and are not available for direct investment.

In both cases the bottom was reached well before the actual event. Why? Because in both cases the sell-side research machine — all the chief economists and chief strategists and acolytes of all the big Wall Street firms — began churning out a flood of Missionary Statements designed to create a positive narrative around a potentially very negative (for markets) political risk event. Ditto with the U.S. election, where the positive narrative around Trump began a full week before the election (see “American Hustle” for the full Narrative Machine description).

I mean, the effort to create a positive narrative out of whole cloth would be comical if it weren’t so seriously impactful. My personal fave on the Wednesday before the French vote was a bulge bracket strategist who shall go nameless, writing to say that a Le Pen victory wouldn’t really be that bad of a thing for markets in general and the banks in particular, because if she won there could well be a massive run on the French banks, which means that Le Pen would have to backtrack on her anti-euro stance to prevent a complete economic collapse. So buy now!

My first reaction to this avalanche of positive Narrative construction was indignation, tinged with a little anger. Give me a break! Markets are getting a little squirrelly going into the vote, and so you’re going to start pumping out this drivel? My reaction was what John Maynard Keynes, who was at least as good a game theorist and investor as he was a macroeconomist, would have called a first level response to a Missionary statement — I’m right and the Missionary is wrong! This is the human, natural response. It’s also a losing response if you want to play the game of markets successfully.

As Keynes explained so smartly with his parable of the Newspaper Beauty Contest, you don’t make money by holding firm to your personal opinion of who’s the prettiest girl or what’s the most attractive stock. You don’t even make money by identifying the consensus view of who’s the prettiest or what’s the right answer to a market question, because all of us are smart enough to be looking for the consensus view. No, you make money by getting ahead of the formation of the consensus view through Missionary statements, even if your personal view is that the Missionary is dead wrong in their assessment of pretty girls or attractive stocks or market outcomes. Would you rather be right or would you rather make money? Back in my younger days I didn’t think there was a conflict between the two. Now I know better. Once the Wall Street Missionaries started their Narrative blitz, it didn’t matter that I believed (and still believe!) that an anti-status quo Italian referendum creates a systemic risk for the European banking system. I wasn’t going to get paid for that view, even if the anti-status quo vote won (it did) and even if I’m objectively correct about the risk (we’ll see). Frustrating? Sure. But in the immortal words of Hyman Roth, this is the business we have chosen.

It’s this micro explanation of the divorce between political risk and market risk that I think will prove to have the most long-lasting impact on investor behavior. You know, I started writing Epsilon Theory because Mario Draghi kicked me in the teeth in the summer of 2012 with the pretty words of his mythical OMT program. I couldn’t believe that mere narrative could be so powerful. But it is. It’s the most powerful thing in the world. Bad enough that politicians have wielded this power for centuries. Worse that Central Bankers have recently proven to be such adepts. Now that Wall Street and the global banking synod have fully embraced the dark narrative arts? Katy bar the door. Even when the androids of Westworld knew it was just a story, they were hard-wired to respond. So are we.

So put it all together and what do we have? As a citizen I’m on high alert. Political volatility is only going to get worse in Westworld. But as an investor my systemic risk antennae are pretty quiet. Is there stuff to do, long and short? Sure, particularly away from Westworld. But until and unless Draghi starts to taper and Yellen looks to hang a recession around the Donald’s neck with beyond-tapering balance sheet reduction, I don’t see how political risk translates into market risk. And even then you’ve got a powerful volatility reducer in the self-interested Narrative creation of every Wall Street Missionary. Will it last forever? Of course not. The Missionaries, both on Wall Street and in Central Banks, are only human. Inevitably they will disappoint us. Let’s just try not to have a gun pointed at our heads when they do.

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The Art of the Probe



Slade: How the hell did you know I didn’t have the king or the ace?
Lancey Howard: I recollect a young man putting the same question to Eddie the Dude. “Son,” Eddie told him, “all you paid was the looking price. Lessons are extra.”
― “The Cincinnati Kid” (1965)


There are only two great movies about poker — Rounders, which everyone knows, and The Cincinnati Kid, which no one knows. Steve McQueen is the Kid and Edward G. Robinson is the Old Pro, Lancey. When I was a younger man, I rooted for the Kid. Today … I’m pulling for Lancey all the way.

Slade: Six stacks, is that right, Shooter?
Shooter: Six.
Slade: Well, we’ve been playing 30 hours… uh, that rate, six thousand, that makes roughly, uh, $200 an hour. Thank you for the entertainment, gentlemen. I am particularly grateful to Lancey, here; it’s been a rewarding experience to watch a great artist at work. Thank you for the privilege, sir.
Lancey Howard: Well now, you’re quite welcome, son. It’s a pleasure to meet someone who understands that to the true gambler, money is never an end in itself, it’s simply a tool, as a language is to thought.
“The Cincinnati Kid” (1965)


Money is to gambling as a language is to thought. What a line!

Screenplay by Ring Lardner, Jr., one of the Hollywood 10 who refused to be rats for the House Un-American Activities Committee in McCarthy days. Lardner was blacklisted and sentenced to a year in prison for contempt of Congress.

True courage comes at a heavy price. Some will be willing to pay that price over the next four years.

And some won’t.


[Shooter’s wife Melba is altering a jigsaw puzzle piece with a nail file]
Shooter: Melba, why do you do that?
Melba: So it’ll fit, stupid.
Shooter: No, I’m not talking about that. What I’m asking is … do you, uh, have to cheat at everything?
Melba: At everything?
Shooter: Yes. At … solitaire. I’ve yet to see you play one game of solitaire without cheating.
Melba: So what?
Shooter: Look, you’re just cheating yourself, don’t you understand? You’ll be the loser, no one else but yourself! … You’ve ruined the puzzle, now, that doesn’t go in there.
[She forces the altered piece into place]
Melba: Does now.
“The Cincinnati Kid” (1965)

I’ve known more than a few economists who had more than a little Melba in them. Quants, too. That’s Ann-Margret as Bad Girl Melba, by the way, and Karl Malden as the cuckolded Shooter. ‘Nuff said.


Daring ideas are like chessmen moved forward. They may be beaten, but they may start a winning game.

― Johann Wolfgang von Goethe (1749 – 1832)

A gambit risks a pawn for advantage later in the game. The word is derived from the Italian gamba (leg), from a wrestling move with a similar sacrifice.

In chess as in life — the only way to defeat a gambit is to accept it.


Berlin is the testicles of the West. Every time I want the West to scream, I squeeze on Berlin.

Nikita Khrushchev, 1963

Without wishing to trade hyperbole with the Chairman, I do suggest that he reminds me of the tiger hunter who has picked a place on the wall to hang the tiger’s skin long before he has caught the tiger. This tiger has other ideas.

John F. Kennedy, 1961

Sieges and blockades are game theory in practice, on both sides of the wall.

epsilon-theory-the-art-of-the-probe-december-8-2016-general-giap epsilon-theory-the-art-of-the-probe-december-8-2016-general-siege

Photo of North Vietnamese General Giap, taken during the siege of Dien Bien Phu in 1954. In anticipation of a full-scale assault, the French took up positions (marked in green on the map) on a series of fortified hills. Rather than attack en masse, however, Giap set up artillery positions east and north of the French fortifications and wore the French down with artillery fire combined with constant probing skirmishes. In investing, I always try to think: WWGGD?

I’ve written a lot about The Common Knowledge Gamehere, here, and here – because it’s the game of markets, i.e., it’s the central contribution of game theory to understanding how markets work. I’ve also written a lot about new technologies and new perspectives – here, here, and here – that help us see The Common Knowledge Game in action. Today I want to take a different cut at this topic: how can you be a better game-player? What are some specific strategies one can adopt to play the game of markets more effectively?

There’s a concept in poker that’s a useful introduction to what I want to talk about. It goes by lots of different names, but I’ll call it The Probing Bet. The idea is that you make a raise or otherwise take the initiative in a signaling interaction because, as you’ll hear time after time if you talk to good poker players, you need to find out “where you stand” in that particular hand. The betting behavior of the other poker players sitting around the table from you is like the betting behavior of the other investors sitting around the market from you: it’s over-determined, which is a $10 word that means there are far more possible explanations of what actual cards might be driving that betting behavior than are required to explain the behavior fully (see “The Unbearable Over-Determination of Oil” for an investment example).

In other words, there might be six different basic card combination categories that an opponent might hold, each of which — if you were playing that hand — has some percentage likelihood of prompting you to duplicate that opponent’s betting behavior. But if you add up those percentage likelihoods across the six different categories, you get a number way higher than 100%. As a result, if you’re trying to reverse engineer in your mind what cards your opponent might be holding, it’s really difficult to come up with anything interesting or informative. It’s difficult and not terribly fun, so most poker players don’t even try. Most poker players only play their own hand. Period. They know their own hand’s strength in an absolute or non-strategic sense, and they know what cards need to show up for them to have a really killer hand. But that’s all they really know, so their betting behavior is directly connected to the non-strategic strength of their hand, coupled with some loose sense of whether they want to play “tight” (bet per the book odds of hitting that killer hand) or “loose” (bet more than the cards justify in an absolute sense in order to set up a bluff or maybe just get lucky).

The average poker player is fascinated by his own cards. Every deal unlocks a world of seemingly endless potential, and almost all of the mental energy at a typical poker game is consumed by thoughts of “how am I going to represent my hand to my opponent?” In sharp contrast, precious little mental energy is spent asking “how can I learn more about how my opponent is representing his hand?”, even though the latter question is FAR more useful to answer. Why more useful? Because just as you are fascinated by your cards, so is your opponent fascinated by his cards. In a game of ubiquitous self-absorption, even a little bit of other-awareness goes a really long way.

What you need to whittle down an over-determined behavior is The Probing Bet, something out of the ordinary that intentionally puts capital at risk in order to narrow down the likely range of hands your opponent might hold. The Probing Bet isn’t designed to represent or signal anything about your hand (which right there makes it a foreign concept to the vast majority of players). It’s a bet designed to get more information about your opponent’s hand and the way he plays it, and it’s something you might do regardless of what cards you have in your hand. Importantly, The Probing Bet in and of itself has a negative expected return. There’s no such thing as a free lunch, and that’s as true in poker as anywhere else. If you want more information, you have to pay for it, and the cost is the potential loss of The Probing Bet. You should gladly pay that cost, however, if the additional information garnered from The Probing Bet increases the expected return of the entire deal (or future deals!) by an even greater amount.

You can find the concept of The Probing Bet in every classic game. In chess, it’s the gambit, the intentional risking of a pawn that accepts a limited loss in the short term to win a more valuable positional advantage over the entire course of the game. When offered a gambit, you’re damned if you do and damned if you don’t. If you don’t accept the offered pawn, you don’t get the piece and you lose the positional advantage anyway. But if you do accept the pawn, your degrees of freedom going forward are sorely limited. On balance, when offered a gambit you have to take it. Chess is a game of informational initiative, and playing a gambit grabs that initiative with both hands. At a cost.

You similarly find the concept of The Probing Bet in every game of nations, and it’s here that we can start making the connection (please!) to the game of markets. I know this sounds weird, but I’ve always found international maritime law to be a place where the game of nations gets crystalized in really interesting ways. Why? Because international law in general is just a short cut to equilibrium outcomes that you’d otherwise need to fight a war to arrive at — which is to say that international law is, in a very real way, MADE of game theory — and maritime law in particular has seen thousands of years of every imaginable strategic interaction in a clean and ordered way. So bear with me as I shift the metaphor from poker to naval blockades and the role of non-belligerent neutral parties. Trust me, there’s a decent payoff here.

Let’s say you’re Neutral Nation and you want to send a ship full of wheat across the ocean to Market Nation and sell it there. You’re one of many neutral nations and you don’t have a huge combatant navy, just lots of cargo ships and lots of wheat to sell. Unfortunately, Market Nation is at war with Banker Nation. Now you don’t have a dog in that fight; all you want to do is make money. But before you send your ship on its merry way, you are informed by Banker Nation’s ambassador that they have declared a blockade on Market Nation, that the list of contraband materials includes wheat, and that they are asserting the right to stop, search, and seize any neutral ships headed for Market Nation carrying such contraband. What do you do?

For a blockade to be valid under international law, two conditions must be fulfilled. First, it must be communicated to you, which in this case it clearly was (interestingly, it doesn’t have to be communicated directly, but can be understood to have been communicated “through the notoriety of the fact”, which is a fancy way of saying Common Knowledge). Second — and this is the important part — it must be an effective blockade for it to be legally binding on you, the neutral party. In other words, Croatia can’t declare a neutral party-binding blockade on Italy because it doesn’t have enough warships to cover all of the Italian ports and make that blockade effective. So if Banker Nation is some weakling, you have every right to say that you don’t recognize their blockade as effective, and any action they might take against your ships will be treated as an illegal seizure and a potential act of war. In game theory we would call this a trivial case, in that the game play is obvious — you and every other neutral country ignore the “blockade” and it collapses immediately.

But let’s say that Banker Nation has a decent-sized navy, maybe even a large navy. Let’s say that Banker Nation is able to put a warship or two around most of Market Nation’s ports most of the time. Is that an effective blockade? Banker Nation will represent that it is. Banker Nation and its ambassadors will tell you that they have an impenetrable wall of warships covering every square inch of Market Nation’s coastline. You know that this isn’t true, but you don’t know how true it is. When they say that they have an effective blockade, are they covering 100% of the ports 80% of the time? 60% of the ports 60% of the time? Does their coverage ratio go up over time? Down? Whatever the port coverage ratio might be, is that enough for you to consider the blockade “effective” and keep your cargo ships at home? The problem you face as Neutral Nation is the same problem faced by The Cincinnati Kid: the statement “my blockade is effective” is as over-determined as an opening bet in a game of Five Card Stud. You don’t know what cards Banker Nation is really holding.

So here’s what you don’t do as Neutral Nation. You don’t send cargo ship after cargo ship sailing blindly to Market Nation in the hopes that a few of them will slip through. You don’t fight the Fed Banker Nation! But what’s also a mistake is to accept the efficacy of Banker Nation’s blockade as a permanent state of the world or just on their word, even though that’s what most neutral countries will do.

So what DO you do? Let’s put this (finally!) in the context of an actual investment scenario. The ECB has famously said that they will do “whatever it takes” to keep the euro system intact. They have proclaimed unlimited resolve to purchase government and corporate debt to accomplish their goals. They have, to stick with the naval warfare metaphor, announced an effective blockade of fundamental market pressures associated with the common currency and the sovereign debt of currency bloc members. Would the Spanish 10-year bond trade 90 basis points tighter than the U.S. 10-year bond if the ECB weren’t patrolling the waters of sovereign rates markets? Please.

But at the same time, the ECB is facing extraordinary and escalating pressure on the home front — the politics of member states and their willingness to participate in a common currency system that clearly has big winners (Germany) and big losers (Italy). 2016 was rocky enough from a political perspective, but 2017 shapes up to be a real doozy, with elections in France and Germany and probably Italy … the three sine qua non countries of the eurozone. As the home front deteriorates, the ECB is going to be hard-pressed to maintain its fleet of announced balance sheet expansion programs, much less the mythical dreadnaughts of the OMT program and other super-warships that are supposedly waiting in the wings should the blockade start to fail. Draghi and the rest of Banker Nation will never admit the deterioration in the cards that they hold, but we know it’s happening. What we don’t know is how bad the deterioration actually is. What we don’t know is what has to happen before Common Knowledge shifts from “yes, the blockade is effective so don’t even try to act against the ECB” to “no, the blockade is no longer effective so let’s go do what we’ve gotta do to protect our capital and make some money if the euro isn’t going to make it.”

What we do know, however, is how the Common Knowledge Game works. We know that we need to watch for a Missionary statement — typically from a status quo-breaking politician — that creates new Common Knowledge in opposition to the old Common Knowledge. We know that we need to watch for how this Missionary statement is repeated and amplified (or not) by other Missionaries — other politicians, famous investors, prominent journalists, etc. We know that this war of beliefs and memes is every bit as fierce as a war of bullets, and that it isn’t just difficult, but is impossible to predict the winning belief through traditional econometric analysis (in the lingo, it’s a multiple-equilibrium game).

Since we can’t predict where we’re going to end up in the Common Knowledge Game (and I really can’t emphasize this point strongly enough … the past is a terrible predictor of the future when it comes to multiple-equilibrium games), we have to constantly assess where we are as the game unfolds. How do we do that? By making occasional Probing Bets. By placing capital at risk to see “where we stand” in the strategic dynamic of the game of markets. By experiencing the reaction of the ECB and other investors, large and small, to a potential volatility catalyst like an Italian election.

Some investors make big Probing Bets. They’re called Bond Vigilantes, and they’ve been cowering in the tall grass since 2012 when Draghi proclaimed “whatever it takes”. But they’re still there, biding their time. Just wait. In 2017 they’ll be back. Many of these game players are Missionaries themselves, and they pack an extra punch in the game-playing as a result.

But you don’t need to be a hedge fund Master of the Universe to make a Probing Bet, although maybe we should take the capitalization off and call these probing bets. You just need to get in the game. I’d like to tell you that you can figure out where we are in the euro game by watching from the sidelines and letting others place Probing Bets, but I can’t. My strong belief is that you have to live an investment before you can gain useful information from the experience. And it’s got to be a high enough cost so that you pay attention. As Old Pro Lancey would say, you can’t just pay the looking price. Does it have to be a cost in actual dollars and cents? No, although that’s a really good attention-grabber. The real price you must pay for a probing bet is even more precious than money — time. That’s the price that most of us find hardest to pay, which is why I think it makes all the behavioral sense in the world to couple it with real money. No one uses the free gym in an apartment complex.

And now for the big finish. I’ve used a macro trade (the ECB and what’s in store for the euro) as my example of the useful role of probing bets and the investment managers who play those cards, because that’s the investment arena that I play in. The exact same logic applies to ALL investment arenas and ALL active managers. What’s the big mistake that investors are making with their single-minded and headlong pursuit of passive investment strategies in the form of ETFs, index funds, and the like? Passive strategies give you ZERO information about the strategic gameplay of markets. Passive strategies, by definition, cannot make a Probing Bet. Passive strategies, by definition, will be the last to know when the state of the world has changed and will be the slowest to adapt. A portfolio composed of passive strategies is like the average poker player who just plays his own hand in a strategic vacuum. That can work out fine if you’re dealt nothing but great cards, a lot less well if you’re not.

That’s not to say that all active managers are effective information-seekers or strategic game-players. In fact, I think it’s fair to say that many, if not most, active managers and active investors are so-so game-players because they confuse caution with wisdom. It’s one thing — a perfectly reasonable thing — to create a cautious portfolio through low gross exposure or high levels of cash if your belief is that markets are more likely to go down than up AND you are placing probing bets to see if the market dynamic is somewhere other than where you think it is, i.e., more positive than you believe. And it’s also a perfectly reasonable thing to be all-in with your portfolio if your belief is that markets are likely to keep rocking AND you are placing probing bets to see if the market dynamic is somewhere other than where you think it is, i.e., more negative than you believe. What’s not so reasonable, I think, but I see every day (and I recognize from time to time when I look in the mirror!) is to take a big risk with a portfolio (and a high level of cash IS a big risk for a portfolio), without allocating a commensurate portion of my risk budget towards going the other way, towards gaining more information about how competing players are playing their hand, towards challenging my beliefs with real dollars and precious time.

And that, in a nutshell, is the best advice I’ve got for any game, whether it’s the game of poker, the game of chess, the game of nations, or the game of markets: act strongly on your beliefs, but don’t hold your beliefs strongly. That’s the cornerstone of Adaptive Investing.

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You Had One Job


ots more where this came from on Of course I think these pix and this meme are hilarious. But then I start to think about whether or not alternative investment strategies have done their job. I start to think about what that job is. And I go hmmm …

Whenever you are about to find fault with someone, ask yourself the following question: What fault of mine most nearly resembles the one I am about to criticize?

― Marcus Aurelius, “Meditations” (180 AD)

esar Millan, dog whisperer. The show can be silly, but I’m a fan. If you want to boil his advice down into one phrase, it’s this: every dog needs a job.

It’s true for the pack, and it’s true for the portfolio.

I know he doesn’t look like much, but Karnak is the most powerful superhero of them all. His ability? To see the flaw in all things. That includes death and philosophies. That includes himself. When he’s not begrudgingly saving the world, Karnak spends most of his time staring at blocks of stone.

One of Karnak’s flaws is that he can’t lead. No one follows a man who sees exactly what’s wrong with you. But he’d make a great short-seller.


Again. Sadder than was. Again. Saddest of all. Again.

William Faulkner, “The Sound and the Fury” (1929)

How often have I lain beneath rain on a strange roof, thinking of home.

William Faulkner, “As I Lay Dying” (1930)

Memory believes before knowing remembers.

William Faulkner, “Light in August” (1932)

The past is never dead. It’s not even past.

William Faulkner, “Requiem for a Nun” (1951)

A Great Rabbi stands, teaching in the marketplace. It happens that a husband finds proof that morning of his wife’s adultery, and a mob carries her to the marketplace to stone her to death.

There is a familiar version of this story, but a friend of mine — a Speaker for the Dead — has told me of two other Rabbis that faced the same situation. Those are the ones I’m going to tell you.

The Rabbi walks forward and stands beside the woman. Out of respect for him the mob forbears and waits with the stones heavy in their hands. ‘Is there any man here,’ he says to them, ‘who has not desired another man’s wife, another woman’s husband?’

They murmur and say, ‘We all know the desire, but Rabbi none of us has acted on it.’

The Rabbi says, ‘Then kneel down and give thanks that God has made you strong.’ He takes the woman by the hand and leads her out of the market. Just before he lets her go, he whispers to her, ‘Tell the Lord Magistrate who saved his mistress, then he’ll know I am his loyal servant.’

So the woman lives because the community is too corrupt to protect itself from disorder.

Another Rabbi. Another city. He goes to her and stops the mob as in the other story and says, ‘Which of you is without sin? Let him cast the first stone.’

The people are abashed, and they forget their unity of purpose in the memory of their own individual sins. ‘Someday,’ they think, ‘I may be like this woman. And I’ll hope for forgiveness and another chance. I should treat her as I wish to be treated.’

As they opened their hands and let their stones fall to the ground, the Rabbi picks up one of the fallen stones, lifts it high over the woman’s head and throws it straight down with all his might. It crushes her skull and dashes her brain among the cobblestones. ‘Nor am I without sins,’ he says to the people, ‘but if we allow only perfect people to enforce the law, the law will soon be dead — and our city with it.’

So the woman died because her community was too rigid to endure her deviance.

The famous version of this story is noteworthy because it is so startlingly rare in our experience. Most communities lurch between decay and rigor mortis and when they veer too far they die. Only one Rabbi dared to expect of us such a perfect balance that we could preserve the law and still forgive the deviation.

So of course, we killed him.

– San Angelo, “Letters to an Incipient Heretic”

Orson Scott Card, “Speaker for the Dead” (1986)

It takes a village to manage a portfolio. Or a country. Discipline to maintain process. Flexibility to tolerate deviance … err, I mean tracking error. We need better Rabbis. Who we don’t kill.


In all cases, not only in the two which we have analyzed, recovery came of itself. But this is not all: our analysis leads us to believe that recovery is sound only if it does come of itself. For any revival which is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own which has to be liquidated in turn, thus threatening business with another crisis ahead. Particularly, our story provides a presumption against remedial measures which work through money and credit. For the trouble is fundamentally not with money and credit, and policies of this class are particularly apt to keep up, and add to, maladjustment, and to produce additional trouble in the future.

Joseph Schumpeter, “Depressions: Can we learn from past experience” (1934)

Schumpeter famously wrote that his personal goals were to be the smartest economist in Europe, the finest horseman in Austria, and the most accomplished lover in Vienna. He judged these to be equally difficult and equally praiseworthy achievements. I think he overrated the whole economist thing.


Marsellus: The thing is, Butch, right now you got ability. But painful as it may be, ability don’t last. And your days are just about over. Now that’s a hard motherfn’ fact of life, but that’s a fact of life you’re gonna have to get realistic about. See, this business is filled to the brim with unrealistic motherf’rs. Motherf’rs who thought their ass would age like wine. If you mean it turns to vinegar, it does. If you mean it gets better with age, it don’t. Besides, Butch, how many fights do you think you got in you anyhow? Two? Boxers don’t have an Old Timers Place. You came close but you never made it. And if you were gonna make it, you would have made it before now. [holds out the envelope of cash just out of Butch’s reach] You’re mine, dig?
Butch: It certainly appears so.
“Pulp Fiction” (1994)

Like boxing and organized crime, our business is filled to the brim with unrealistic motherf’rs.

This is the line that haunts me: if you were gonna make it, you would have made it before now.

The Hunt family has three dogs, each with a distinct job. The German Shephard’s job is to protect. The Sheltie’s job is to herd. The Golden’s job is to love. Each dog is very good at its job, sometimes in an annoying way (particularly the Sheltie), but they’re oh-so happy with what they do well, and it fits our entire family dynamic. There are sacrifices we make for having this particular pack, like we can’t have any other dogs drop in for a visit or else the German Shephard might eat them, but the positives far outweigh the negatives. We’re a solid pack, and there’s nothing quite like that feeling of knowing that the dogs are there for you and you for them, and that the entire Hunt family — human and dog alike — is stronger not just in fact but in spirit for giving ourselves over to the pack.

It’s the same with investment portfolios. Every dog needs a job, and every investment does, too. No single dog can be all things to all people, and neither can a single investment. Nor can any pack of dogs accomplish anything and everything you like. The biggest mistake people make when they get a dog is trying to make the dog fit into the life they wish they led, rather than the life they actually lead. You better know thyself before you get a dog, much less a couple of dogs, and it’s exactly the same thing with making an investment. But if you get it right … man, there’s nothing better. Like a confident pack, a confident portfolio provides both strength in fact, as well as — and this is the part I bet you’re missing right now and the focus of this note — strength in spirit.

In my experience, most people don’t particularly like their portfolios, much less get a lift from them. They tolerate their portfolios. They may be pleased enough with the performance, but they don’t get a psychic boost from their portfolios. They don’t enjoy the confidence and strength of spirit that a solid pack or a solid portfolio can provide. And before you say that this really doesn’t matter to you, that so long as your portfolio performs up to a certain standard you couldn’t really care less whether it provides any “psychic strength” or any such mumbo-jumbo hogwash, let me stop you to say that you’re not just wrong, you’re completely wrong. In truth, the only thing that matters to you about your portfolio is its psychic reward, the positive way it makes you feel.

Now don’t misunderstand me. Performance is part of that psychic reward, usually the biggest part. But in the same way that the Economic Machine is part of a larger social phenomenon that I call the Narrative Machine, in the same way that Newtonian physics is part of a larger set of natural laws called Einsteinian physics, in the same way that Game Theory is part of a larger intellectual construct called Information Theory, so is “performance enjoyment” part of a larger behavioral attitude toward our portfolios. I first wrote about all this in Epsilon Theory with “It’s Not About the Nail” and “It’s (Still) Not About the Nail”, and it’s high time I picked up on this thread as part of the current “Anthem!” series.

The place where I see the greatest dissatisfaction or lack of spirit in most portfolios is in the allocation to alternative strategies. Most model portfolios that come down from on high at the big wealth management firms suggest that alternative strategies should be anywhere from 10-20% of a portfolio. But in fact most actual portfolios for actual clients have a small fraction of the recommended allocation, say 3-4% at most. Why the disconnect?

To answer that question, let me start by telling you what the answer is not. The answer is NOT that financial advisors or professional investors need more “education” about the virtues of an alternatives-heavy portfolio. I think that this focus on “education” is the single most tone-deaf and semi-condescending aspect of the business of modern investment management, which I suppose is a pretty bold statement given the sheer number of tone-deaf and semi-condescending things in our line of work. But there you go. I see it every day. Another email, another webinar, another white paper, another earnest effort to “educate” financial advisors about alternatives, with, let’s be honest, the unspoken implication that you are kinda stupid if you don’t have a heaping plate of alternatives in your portfolio.

It’s not that any of these “educational” efforts are wrong. They speak the truth, albeit a bloodless, overly scientificized truth. But the truth is also that financial advisors have had a poor experience with alternative investment strategies, and once burned twice shy. Why burned? Because A) they’ve been pushed onto financial advisors as some sort of wonder dog that can be all things to all portfolios, and B) they’ve been pulled into portfolios by financial advisors who were thinking more about the portfolio and clients that they wish they had rather than the portfolio and clients that they actually have.

epsilon-theory-you-had-one-job-november-4-2016-scrappy-dooI’m not going to spend a lot of time on point A because it’s obviously egregious and I see this changing for the better in my conversations with financial advisors. They are still inundated with semi-condescending “educational” materials from every possible source, but at least the content of those materials today is a lot more even-handed about the specific job that alternative strategies can perform in a portfolio, as opposed to promising the investment equivalent of Scrappy Doo, Scooby’s far more competent crime-fighting nephew. Pro tip: if you’re offered a walking, talking dog to fill out your pack, you should hold onto your wallet.

Its point B that I think is a bit less obvious and one that needs more explication. Basically I think what’s happened is that a lot of financial advisors and serious investors believe they know the job that alternatives can help provide for a portfolio — diversification — and they really want that for their portfolio. But they set themselves up for failure, where the alternative strategies in their portfolio don’t FEEL satisfying even if the performance is okay, in two important ways.

First, they’re mistaking a quality of the portfolio — diversification — for a job of an individual investment. Asking an investment to provide diversification is like asking a dog to provide pack stability. It’s just not within their power to do this. Portfolio diversification and pack stability emerge from the proper organization and job assignment of the individual members of the portfolio or pack, not the other way around. If someone tells you that their alternative strategy is “a diversifier”, your question should be “Relative to what?” if you’re in a generous mood, something a little more snippy if you’re not. The question you need answered is what job does the strategy perform in your portfolio. How should I expect it to behave under what conditions? Then you can decide for yourself how that job fits with the other jobs your other investments are doing. Then you can evaluate this potential new member of your pack in a non-alienated fashion, focusing on its fit within the whole rather than its standalone attributes.

Second, they’re judging this alternative strategy versus that alternative strategy on the basis of standalone historical performance, alienated from the psychological meaning that the overall portfolio composition — the pack — plays in their client’s or their own life. Alternative strategies in this conception are a line item in the portfolio, a tasty-looking dish that one orders from a 10-page diner menu, a beautiful exotic dog breed that one reads about in The New York Times Style Magazine.

Odds are that you’ll be disappointed with that exotic dog, through no fault of the dog and actually, through no fault of yours. Odds are that you’ll be disappointed with that fancy alternative strategy, similarly through no fault of the strategy or you. Why? Because human rationality is based on Bayesian decision-making, a $10 phrase that means we make up our minds as we go along and new information comes our way. Maybe that dog is, in truth, perfect for you and your life. But maybe it’s not. I mean, you got all excited about the breed from an article you read in the NYT Style Magazine. Are you crazy? Maybe that alternative strategy is a perfect diversifying complement for your portfolio. But maybe it’s not. I mean, you got all excited about the fund because the manager sounded really smart. Really? Did you really make THAT mistake again?

My point is that we start any standalone investment from a position of self-doubt, and from a Bayesian perspective it takes a lot of evidence before we come to any conclusion as to whether we made a good original decision or not. Even then our conclusions are never final or definitive in a Bayesian approach, because there’s always a chance that new information will come to light that shifts our opinion. Moreover, the qualities of portfolio diversification and pack stability take quite a bit of time to emerge. If you think you see these qualities right off the bat, or conversely you think you see something that shows this is a disaster, you’re usually mistaken. In fact, with both dogs and alternative investment strategies, by the time you’ve received enough information to judge for sure whether or not you’ve actually got a “good one” or a “bad one”, it’s almost always too late to make a switch or do anything differently about it. Put it all together, and we stay in this position of self-doubt on an effectively permanent basis.

epsilon-theory-you-had-one-job-november-4-2016-bruce-willisIt’s what I call The Curse of (Some) Talent, and it’s one of the most pernicious aspects not only of investing, but of the human condition. It’s embodied in Butch, the Bruce Willis character in Pulp Fiction, a boxer who’s a pretty good fighter but is now getting a little long in the tooth. As Marsellus Wallace, the crime boss who bribes Butch to take a dive, says, “if you were gonna make it, you would have made it before now.” Butch has (some) talent, enough to become a professional fighter. But he doesn’t have enough talent to really succeed, to really make it big. I recognize Butch in myself, which is what makes this scene so haunting. Here I am, 52 years old, sitting in a hotel room far away from home on another business trip, writing this note. If I was gonna make it, wouldn’t I have made it before now? I recognize Butch in all the really smart portfolio managers I know, each of whom runs what seems like a really interesting strategy that for whatever reason hasn’t made them a Master of the Universe. If they were gonna make it, wouldn’t they have made it before now? Clearly they have (some) talent. Do they have enough to be an individual star? And if that’s what I need from them or if that’s how I’m evaluating them, then how in the world do I muster up the confidence to take the chance that they do? How in the world do I maintain the confidence to keep them in my portfolio when the winds of chance blow against me or them, something that will always happen at some point?

I think that most financial advisors or serious investors know exactly what I’m talking about here, and this is why most of them are waaaay under-allocated to what investment “science” and their model portfolios and their own voices inside their heads tell them should be their “proper” allocation to alternative strategies. If we’re evaluating these strategies on a standalone, line-item basis, plagued by the self-doubt inherent in Bayesian decision-making and the other-doubt inherent in the Curse of (Some) Talent, then the mystery isn’t why current allocations to alternatives are so low at 3-4%, but why they’re so high!

So here’s what I think is a better way to think about portfolio construction, one that puts not only alternative strategies but ALL strategies in their proper place, which is in service to the pack. That’s your responsibility, too, by the way. The pack always comes first.

Step One. Every investment in the portfolio must have a job, meaning that we expect each investment to do certain things under certain circumstances. This means that we have to imagine what those future circumstances might be. Here are two scenarios that I think we should wrestle with.

  1. The Long Gray Slog: a continuation of the current investment status quo, where central banks continue to squelch the volatility out of markets in their continuing efforts to turn markets and the entire macro-economy into political utilities. Business cycles and bear markets are effectively outlawed, but the imposition of a floor also imposes a ceiling. It’s 1% GDP growth and zero on your savings and flat to slightly up markets just as far as the eye can see.
  2. Fire & Ice: a political event that sets the global economy on a new deflationary leg down, which in turn creates a global credit freeze and liquidity concerns at systemically important European banks. This is Ice. But central banks of the modern ilk refuse to back down, unleashing a wave of bank nationalizations, negative interest rates, and helicopter money drops of various sorts, all designed to force asset prices higher by sheer dint of printing and distributing vast quantities of fiat currencies. This is Fire. You don’t get the Fire without the Ice, and I need strategies that can survive both.

Step Two: Now that we’ve identified the scenarios we think we might face, we need to figure out what sort of portfolio can survive or thrive under these circumstances. How do we do that? By immersing ourselves in the stories of investors who survived and thrived during Long Gray Slogs or Fire & Ice scenarios of the past. By developing a sense of empathy for what it felt like to invest during, say, the 1930s or the 1970s or (for the younger crowd) the 2000s. This is how we figure out what sort of pack supports the life we want to live when confronted by these circumstances. This is how we figure out what strategies — in complement with each other — can create that pack with strength of spirit as well as strength of performance.

We gain this sense of empathy in two ways. We talk to old-timers (for much of my audience, that’s anyone older than 40), and we read. We read a lot. We read biographies. We read memoirs. We read old newspapers and old magazines, as much primary material as we can. We read and we talk, not in the modern cynical way of gotcha and tsk-tsk and eye-roll, but in older ways of trying to understand the WHY and the FEEL, not just the WHAT and the FACT. It’s a Faulknerian effort of trying to understand the past on a visceral level, such that it’s part of the living us and not “the past” at all. Empathy means putting yourself in someone else’s shoes, and it’s one of the hardest, least taught skills in the modern age of narcissism and self-absorption. But it’s also one of the most important. I hire history majors.

What strategies have I found that perform specific, useful jobs in these scenarios? Keep in mind that this is for a portfolio that works for me and my family and the life we’ve chosen. We’re not like everyone. We live out in the woods in Fairfield County, CT. We homeschool our kids. We have sheep and goats and horses. Your kids will have a blast when they visit, but if you bring over your dog, it might be killed by our dogs. Just kidding on that last one. Kind of.

On the Long Gray Slog side, for me it’s basically what’s worked for the last several years, strategies that either harvest global betas in a cheap, efficient, preferably volatility-controlled way, or strategies that “play the player” in a trend-following or discretionary way. Especially the discretionary stuff, but then again I’m a discretionary global macro kind of guy. That’s who I am. Also, in a more or less permanently low growth world, any sort of secular growth and real cash flows from real economic activity is something to be treasured. See my “Hobson’s Choice” and “Cat’s Cradle” notes for more.

The Fire & Ice scenario is perhaps a little more contentious, but only because we’ve been living so completely in the Long Gray Slog for the past few years. My take on Fire & Ice is pretty simple. I want as close to direct ownership as possible of real assets with real cash flows. My definition of real assets is pretty broad, including not just the obvious choices like infrastructure and real estate, but also intellectual property and gold. Yes, I know that gold doesn’t have intrinsic cash flows. Neither does an insurance policy (which is what gold is against central bank error), and I like insurance. A lot of people are fans of Bitcoin and other cryptocurrencies for a Fire & Ice scenario. I’m not (you can read my views here). Basically I’m looking for maximum resiliency, what Nassim Taleb would call antifragile, in the jobs I want my portfolio holdings to perform in a Fire & Ice scenario. And remember, in my scenario, Fire comes last and it can go on and on. Bond holders beware. This is where the right discretionary calls on global macro, particularly on the short side where you get the timing right on long-volatility bets, can make a career. This is when you want Karnak on your team.

epsilon-theoryyou-had-one-job-november-4-2016-the-atlanticAs an aside … well, not so much of an aside, because it’s central to the Epsilon Theory effort … this embrace of empathy and the true lessons of the past is exactly what our central bankers are NOT doing. I put a long quote by Joseph Schumpeter at the start of the note just to show that there have been some other really smart people in the past who suffered through really similar macro-economic situations and looked carefully at empirical evidence and came to diametrically opposed conclusions on what monetary policy should and shouldn’t do as a response. What we are told today is the Truth with a capital T in regards to monetary policy is nothing of the sort. It’s a particular sort of truth, an ex cathedra pronouncement by cultists like Ben Bernanke and his academic acolytes, cherrypicking historical data about the U.S. in the ‘30s or Japan in the ‘90s that fits their tautological world view and rejecting the rest, brooking no dissent. It’s a mongrel pack of policies that provides neither strength in fact nor strength in spirit to the citizens it’s supposed to support and protect. That’s a lot of mixed metaphors, but you get my point. And my disgust. Just remember that Greenspan used to be lauded as a hero, too. Today not so much. Today he’s the man who knew, as in the man who knew better. Okay, rant concluded for today.

Step Three: So I know what sort of portfolio I want for the sort of future scenarios I might encounter. I know what jobs I need filled in that portfolio and I’ve got a sense of the strategies that can best do those jobs. Now how do I choose between specific strategies or managers or what have you? How do I avoid that whole Curse of (Some) Talent thing? Here’s what I’m not doing. I’m not evaluating historical track records, projecting those into the future in some sort of crystal ball, capital markets return prediction effort, and then rolling those individual calculations up into some aggregate portfolio projection. I think that’s nuts. Instead, I’m asking whether the manager has a clear idea of what makes the strategy work (or not). What is the job that the manager performs and under what conditions does he or she perform it? Then I evaluate those claims in a Bayesian way. The most important evidence: did the manager do this job before? As advertised and for realz, not in a backtest. What was the investor experience within that prior job performance? How did it feel? Almost as important from a Bayesian perspective, does the manager have a stable, visible process? Does the process impose a discipline of sticking to the principles of the strategy come hell or high water, while also handling uncertainty and deviation in a calm and intellectually rigorous way? That’s how I judge real talent, the talent that ultimately matters most, in others and in myself. Fortune is fickle, even for the most talented. Experience and process never is.

The hardest part about Step Three is saying no to a talented manager, a good Rabbi for the strategy he administers, because the strategy doesn’t do the required job for the portfolio you actually have, as opposed to the portfolio you wish you had. In truth, that’s the hardest part about this entire process, the monomaniacal focus on what’s best for the portfolio as a whole, given the challenges it might face in the future. But in the same way that we require (or should require) discipline in our managers, we should absolutely require that discipline in ourselves as financial advisors or serious investors. It’s what creates a confident client/advisor relationship, it’s what creates a confident investor/manager relationship, it’s what turns any collection of individuals, man or beast, into a well-functioning pack.

Ultimately, that’s what we’re after here. The protection of the pack. It’s been the human animal’s source of strength, in both fact and spirit, for a couple of hundred thousand years now. I think we’re going to need it over the next few years, too.

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Ash: You still don’t understand what you’re dealing with, do you? Perfect organism. Its structural perfection is matched only by its hostility.
Lambert: You admire it.
Ash: I admire its purity. A survivor … unclouded by conscience, remorse, or delusions of morality.
Parker: Look, I am … I’ve heard enough of this, and I’m asking you to pull the plug.
[Ripley goes to disconnect Ash, who interrupts]
Ash: Last word.
Ripley: What?
Ash: I can’t lie to you about your chances, but… you have my sympathies.
― “Alien” (1979)


Det. ‘George’ Francisco: You humans are very curious to us. You invite us to live among you in an atmosphere of equality that we’ve never known before. You give us ownership of our own lives for the first time and you ask no more of us than you do of yourselves. I hope you understand how special your world is, how unique a people you humans are. Which is why it is all the more painful and confusing to us that so few of you seem capable of living up to the ideals you set for yourselves.
“Alien Nation” (1988)


The less you eat, drink, buy books, go to the theatre or to balls, or to the pub, and the less you think, love, theorize, sing, paint, fence, etc., the more you will be able to save and the greater will become your treasure which neither moth nor rust will corrupt—your capital. The less you are, the less you express your life, the more you have, the greater is your alienated life and the greater is the saving of your alienated being.

Karl Marx on Alienation, “Economic Manuscripts” (1844)

The paradox and the tragedy of modern man. When we spend rather than save, we live more fully. We avoid the alienated life. But we create our alienated being, which is far worse. Without savings and capital, our labor is reduced to a commodity, something we must sell to our dying day simply to live. We must work to live, rather than work to BE. Our labor, our government, even our very thoughts become an alien thing to us, and us to them. Sound familiar?



Most of the blame for the struggle of male, less-educated workers has been attributed to lingering weakness in the economy, particularly in male-dominated industries such as manufacturing. Yet in new research, economists from Princeton, the University of Rochester and the University of Chicago say that an additional reason many of these young men — who don’t have college degrees — are rejecting work is that they have a better alternative: living at home and enjoying video games. The decision may not even be completely conscious, but surveys suggest that young men are happier for it.

Young men without college degrees have replaced 75 percent of the time they used to spend working with time on the computer, mostly playing video games, according to the study, which is based on the Census Bureau’s time-use surveys. Before the recession, from 2004 to 2007, young, unemployed men without college degrees were spending 3.4 hours per week playing video games. By 2011 to 2014, that time had shot up to 8.6 hours per week on average.

A few decades ago, an unemployed person might be stuck on the couch watching TV, isolated and depressed. Today, cheap or free services such as Facebook, Snapchat, YouTube and Netflix provide seemingly endless entertainment options and an easy connection to the outside world. Video games, in particular, provide a strong community and a sense of achievement that, for some, real-world jobs lack.

― Ana Swanson, Washington Post, “Why amazing video games could be causing a big problem for America”, Sept. 23, 2016

Robert Putnam (one of the good guys in academia, btw) wrote a famous book called Bowling Alone, where he chronicled the dissipation of civic groups (like bowling leagues) that had — truly — made America great. But today, community is back! It’s just not IRL, as the kids would say. The Marxist revolution isn’t coming out of Venezuela or some such failed state. It’s coming out of Call of Duty.


At first, man was enslaved by the gods. But he broke their chains. Then he was enslaved by the kings. But he broke their chains. He was enslaved by his birth, by his kin, by his race. But he broke their chains. He declared to all his brothers that a man has rights which neither god nor king nor other men can take away from him, no matter what their number, for his is the right of man, and there is no right on earth above this right.

― Ayn Rand, “Anthem” (1938)

Believe it or not, I’m actually not a big Ayn Rand fan. I appreciate her thesis. Really, I do. But man is a social animal. We are hard-wired to care about the We as much as the I. Unless you’re damaged.


Any writer, I suppose, feels that the world into which he was born is nothing less than a conspiracy against the cultivation of his talent — which attitude certainly has a great deal to support it. On the other hand, it is only because the world looks on his talent with such frightening indifference that the artist is compelled to make his talent important.

― James Baldwin, “Notes of a Native Son” (1955)

On the other hand, I’m a big James Baldwin fan. Here’s a man who experienced profound alienation, from his family and his church and his country (Baldwin’s FBI file was almost 2,000 pages long … talk about a badge of honor). Yes, the world is both a conspiracy and frighteningly indifferent to everything, including talent. Baldwin’s answer: get over yourself already. Make your talent important.


Gerald O’Hara: And what does the captain of our troops say?
Ashley Wilkes: Well, gentlemen, if Georgia fights, I go with her. But like my father I hope that the Yankees let us leave the Union in peace.
Man: But Ashley, Ashley, they’ve insulted us!
Charles Hamilton: You can’t mean you don’t want war!
Ashley Wilkes: Most of the miseries of the world were caused by wars. And when the wars were over, no one ever knew what they were about.
Gerald O’Hara: [the other men protest] Now gentlemen, Mr. Butler has been up North I hear. Don’t you agree with us, Mr. Butler?
Rhett Butler: I think it’s hard winning a war with words, gentlemen.
Charles Hamilton: What do you mean, sir?
Rhett Butler: I mean, Mr. Hamilton, there’s not a cannon factory in the whole South.
Man: What difference does that make, sir, to a gentleman?
Rhett Butler: I’m afraid it’s going to make a great deal of difference to a great many gentlemen, sir.
Charles Hamilton: Are you hinting, Mr. Butler, that the Yankees can lick us?
Rhett Butler: No, I’m not hinting. I’m saying very plainly that the Yankees are better equipped than we. They’ve got factories, shipyards, coalmines… and a fleet to bottle up our harbors and starve us to death. All we’ve got is cotton, and slaves and… arrogance.
Man: That’s treacherous!
Charles Hamilton: I refuse to listen to any renegade talk!
Rhett Butler: Well, I’m sorry if the truth offends you.
Charles Hamilton: Apologies aren’t enough sir. I hear you were turned out of West Point, Mr. Rhett Butler. And that you aren’t received in a decent family in Charleston. Not even your own.
Rhett Butler: I apologize again for all my shortcomings. Mr. Wilkes, Perhaps you won’t mind if I walk about and look over your place. I seem to be spoiling everybody’s brandy and cigars and… dreams of victory.
― “Gone With The Wind” (1939)

Now that’s the way a real man ends a Twitter fight. Lots of words and arrogance and dreams of victory going around these days, from the Fed to the DNC to the Trumpkins. Not so much the RNC.

The modern world is not evil; in some ways the modern world is far too good. It is full of wild and wasted virtues. When a religious scheme is shattered…it is not merely the vices that are let loose. The vices are, indeed, let loose, and they wander and do damage. But the virtues are let loose also; and the virtues wander more wildly, and the virtues do more terrible damage. The modern world is full of the old Christian virtues gone mad. The virtues have gone mad because they have been isolated from each other and are wandering alone. Thus some scientists care for truth; and their truth is pitiless. Thus some humanitarians only care for pity; and their pity (I am sorry to say) is often untruthful.
― G.K. Chesterton, “Orthodoxy” (1908)

Chesterton is so right … the social problems of the West aren’t (mostly) from rampant vices, but from alienated virtues. It’s the pitiless truth of Silicon Valley technologists and Wall Street financial engineers. It’s the truthless pity of Davos political elites and Jackson Hole central bankers.


That clean but lonely feeling when there are no other cars. The traffic lights changing just for you.

― Don DeLillo, “Libra” (1988)

Lee Harvey Oswald, the modern alienated man in full. A pawn for whatever political anthem is trumpeted into his ear. Erdogan gets it. But the political anthems of the modern West are like the music of the modern West — bittersweet songs played in a minor key. We need a new anthem, something we can whistle to. Otherwise the Trumpets are going to get louder still.

The other week I was driving in downtown Los Angeles, late for an appointment. The road I needed to turn onto was just past the freeway overpass, but I got confused and turned onto the freeway on-ramp. My GPS app promptly started recalculating my route and informed me that for all practical purposes I could no longer reach my destination. I was basically trapped on the freeway, and just getting back to my starting position would take at least 20 minutes, probably more.

Now this is probably because I’ve played way too many videogames in my life, but here’s the thought that popped into my head: no problem, let’s just hit the reset button. I’m not sure when I last saved the game, but it’s gotta be better than what I’m faced with now. Shoot, with the way autosave works these days, I bet I restart really close to my idiotic mistake to take the onramp. These were the thoughts I couldn’t shake for the next 20 minutes. And these are the thoughts that I can’t shake today.

It’s time for a reset.

I’m not talking about this misbegotten election. Both parties took the wrong on-ramp, and like my LA misadventure, there’s no way to walk (or drive) this back. At least I only lost 20 minutes of my life and missed an appointment. We’re going to lose four years of our political lives with this election, and the alienation that each and every citizen feels with his or her government … the alienation that each and every investor feels with this market … is just going to get worse, regardless of who wins.

Okay. So apparently things aren’t just going to magically get better on their own. Apparently, life is not a videogame, no matter how much unemployed young men (and I) wish it were, and we’re fresh out of reality reset buttons. Sorry ‘bout that. What’s to be done?

I’ll tell you what’s to be done. It’s time for us to get over ourselves. It’s time to get up off the basement couch in our parents’ house. It’s time to stop shaking our heads at our Twitter feed and thinking of wry bon mots to express our indignation at a frightfully indifferent world. Yes, I’m raising my own hand here. It’s time for us, as James Baldwin wrote, to make our talent important, whatever that talent is. It’s time for us to channel our inner Scarlett O’Hara, if not our inner Rhett Butler: tomorrow is another day.

I’m talking about a reset of our investment thinking, so that we survive the policy-driven markets of today and the policy-controlled markets of the next four years. My crystal ball is broken, as is yours, so we have no idea whether we’re going to see a market of Ice (deflation), a market of Fire (inflation), or more of this Long Gray Slog of markets turned into political utilities. But what we will never see is the Yellen or Draghi press conference where they say, “Sorry. We tried our best but it just didn’t work out. Good luck out there!” Policy intervention is our investment reality, not our investment dream or nightmare or whatever. They are IRL (in real life, for everyone over the age of 40), and we must engage with that reality, not wish them away or pine for the good old days.

I’m also talking about a reset of our political thinking, although that’s an even bigger fish to fry than our investment thinking. After my last note, “Virtue Signaling”, I had a lot of people ask if I were supporting a third party candidate. Ummm … no. Gary Johnson is Chance the Gardener, and Jill Stein is Ralph Nader, minus the passion and the brains. I wanted to like them so bad. I gave them so many chances. But both are is-this-trolling-at-a-Jedi-Master-level? disasters. No, I’m sitting this presidential vote out, and I’m in no hurry to engage with an existing third party. The disintegration of the Republican party today and the disintegration of the Democratic party tomorrow will create a really interesting broken field of political identities. The thing in short supply won’t be political organization, which is usually the rare bird, but coherent political IDEAS with the power to motivate and inspire. I can’t wait.

The common denominator in these reset efforts, whether we’re talking about investing or voting, is the common enemy: alienation.

This was Marx’s most profound observation about the human condition, that our labor becomes a separate and hungry beast in a capitalist world, bursting from our chests and eating us alive. (Well … that’s my hyperbole because I love the movie Alien. Marx’s language is a lot more restrained, but only because he lived in a pre-Ridley Scott world. Trust me, he’d be all over this analogy!) So many of us objectify our work and come to despise it, as we work to live and live to work. So few of us work to BE. So few of us find intrinsic and sustaining satisfaction in our work, such that it connects us to the world and we would pursue it whether or not our economic masters tossed us a bone or not. When we are separated from our work and our time, we are separated from ourselves, from what makes us unique. This is alienation. It is a separation from what makes a human being … human … and we begin to regard not only other people as cogs and objects, but also — and this is the really tragic part — we begin to regard ourselves as cogs and objects.

Sorry for the crash course in Marxism, but it’s important. It’s important because our alienation doesn’t stop with our labor. For many of us, it pervades every aspect of our lives, both public and private. Our participation in politics has been begrudging and forced for a long time now. When was the last time you were excited to cast a vote or — imagine this — contributed your labor and time (money doesn’t count … it’s not you) in a joyful and self-fulfilling way to a political candidate? Have you EVER done this? I haven’t.

It’s the same thing with our participation in markets. Does anyone reading this note still get a rush from fundamental investing? Do you still get an intrinsic pleasure out of reading Q’s and K’s and trying to figure out the puzzle of a company and connecting all that with a stock price? I know you used to. Do you still? Or is it your JOB, something that you do because it supports the comfortable life that you’ve built?


I used to be a patriotic guy and I used to be a fundamental investor. And then 2008 happened. And then the pretty skin of our banking and market system was ripped away to reveal the naked sinews of power beneath. In many respects, the 2016 election has been like an acid flashback to 2008. It doesn’t impact me as personally as 2008 did because I’m in the investing business, not the media business or the politics business. But I see the skin being ripped away, again. I see what lies beneath, again. And I become alienated from my country and my work, again.

The common denominator is also the common solution: anthem.

I want to be a patriot again. I want to be a fundamental investor again. It won’t ever be exactly like it was before, but that’s okay. A renewed faith can be a stronger faith. It just won’t be a blind faith. It has to be a faith based on my own labor and my own time, a non-alienated patriotism and a non-alienated investment strategy. It has to be a political participation and a market participation based on who we are, not who we are paid to be.

Who’s the “we” and how do we arm ourselves? Like Rhett Butler, I have no interest in fighting a war without a cannon factory. Politics and markets are social institutions, and voting and investing are social behaviors. They only make sense as organized, group activities, and that’s why we have to employ anthems. It’s not enough to have an idea about politics or investing that resonates personally. It has to be a Big Idea, a marching song in 4/4 time in a major key. It has to be a Narrative that motivates the We.

Over the next two notes I’ll be describing two anthems, one for investing and one for politics. Regular readers will have heard me hum some of these tunes before, particularly on the investing side, in notes like “Hobson’s Choice”, but it’s time to get more focused with this. More action oriented.

Why? Because a reset — both in markets and in politics — is coming whether we like it or not. We can either prepare for the reset … we can shape the reset as best we can … or we can let the reset shape us.


Here’s the most impactful chart I know. It can’t be fudged. It’s a measure of US household net worth over time, compared to US nominal GDP. Is it possible for the growth of household wealth to outstrip the growth of our entire economy? In short bursts or to a limited extent, sure. But it can’t diverge by a lot and for a long time. We can’t be a lot richer than our economy can grow.

But that’s exactly what’s happened. Again. Like the Housing Bubble of 2004–2007, we’ve gotten a lot richer than our economy has grown. But unlike the Housing Bubble, the riches of this latest bubble haven’t been as widely distributed. This latest bubble blown by our central bankers has been in the form of a stock market triple and bond prices at record highs, it’s been almost entirely in the form of financial assets, not real assets like houses. In 2007, everyone who owned a house was rich. That’s a lot of people. In 2016, the rich are the people who owned stocks and bonds in 2009. That’s a lot fewer people. If you don’t see the pernicious impact on our politics from this distributional difference in the bubbles, you’re just not paying attention.

Beyond the simple mechanics of who got the goodies in this latest bubble, the Narratives associated with the Dot-com Bubble of 1998–2000 and the Housing Bubble of 2004–2007 were structurally different from the Narrative associated with the Central Banking Bubble of today. There were anthems associated with the Dot-com Bubble and the Housing Bubble, anthems of a fundamental change in the real economy that brought all of us along for the ride, anthems that fit the political culture of the United States. Over the last six years, on the other hand, all we’ve heard is a statist, top-down, European-ish, tinny song of Central Bank Omnipotence that doesn’t fit the political culture of the United States, and that’s why the Central Banking Bubble is the most hated and mistrusted bull market in history.

From the perspective of both the Economic Machine and the Narrative Machine, our current market and political standing is untenable. Unlike prior wealth bubbles, this one is reshaping our political system in ways we haven’t seen since the 1850s. Yes, that’s right, the pre-Civil War 1850s. One way or another, this is going to be a bumpy ride. But that’s life. It’s not a video game. It’s not a simulation. It’s IRL. We can’t control when and where and to whom we were born. Often we can’t control where we end up. But we can control our own attitude and our own minds. We can control whether or not we allow ourselves to become alienated from our labor, our time … from our being. We can control whether or not we participate actively in The World As It Is, or whether we withdraw to our parents’ basement couch and play some more Call of Duty. We can help write a new anthem for our investing and our voting, or we can watch while the alt-priests of fascism and totalitarianism play their anthems louder and louder.

It’s time for a reset.

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Cat’s Cradle


“No wonder kids grow up crazy. A cat’s cradle is nothing but a bunch of X’s between somebody’s hands, and little kids look and look and look at all those X’s . . .”
“No damn cat, and no damn cradle.”

The Fourteenth Book is entitled, “What Can a Thoughtful Man Hope for Mankind on Earth, Given the Experience of the Past Million Years?”
It doesn’t take long to read The Fourteenth Book. It consists of one word and a period.
This is it: “Nothing.”

– Kurt Vonnegut, “Cat’s Cradle” (1963)

Negative rates are ice-nine. If you don’t know what ice-nine is, read the book. Spoiler alert: the world ends.

TIAA will end the voluntary expense waiver on the CREF Money Market Account by April 14, 2017. This decision was reached after ongoing discussions with the TIAA and CREF boards, as well as our state insurance regulator. It is anticipated that unless interest rates rise sufficiently, one or more classes of the CREF Money Market Account may have negative yields after the waiver ends.

TIAA Plan Update Review Guide 2016 [italics mine]
Emily Dickinson (1830 – 1886)

A great Hope fell
You heard no noise
The Ruin was within.

Admit it. You assume her poetry is soft because she’s a woman and writes about flowers. Read it again. Emily Dickinson is a total badass. You don’t even feel the slice of her work, but then you see the blood.

I saw her today at the reception
In her glass was a bleeding man
She was practiced at the art of deception
Well I could tell by her blood-stained hands
You can’t always get what you want
You can’t always get what you want
You can’t always get what you want
But if you try sometimes you just might find
You just might find You get what you need
– Mick Jagger and Keith Richards, “You Can’t Always Get What You Want” (1969)

Fed Governor James “Bleeding Man” Bullard

The Federal Reserve Bank of St. Louis is changing its characterization of the U.S. macroeconomic and monetary policy outlook. An older narrative that the Bank has been using since the financial crisis ended has now likely outlived its usefulness, and so it is being replaced by a new narrative. The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes. The concept of a single, long-run steady state to which the economy is converging is abandoned, and is replaced by a set of possible regimes that the economy may visit. Regimes are generally viewed as persistent, and optimal monetary policy is viewed as regime dependent. Switches between regimes are viewed as not forecastable.

James Bullard, “The St. Louis Fed’s New Characterization of the Outlook for the U.S. Economy” (June 2016)

Jim Bullard’s resignation letter here in the Silver Age of the Central Banker, as he adopts the game theoretic concept of minimax regret theory and the postmodern social theoretic concept of narrative construction.

Though nothing can bring back the hour
Of splendour in the grass, of glory in the flower;
We will grieve not, rather find
Strength in what remains behind;

– William Wordsworth (1770 – 1850)

Splendor In the Grass (1961)

Warren Beatty and Natalie Wood’s best work. I experience this movie so differently today, as the father of four teenage daughters, than I did watching it as a young man. In investing as in life, we all love and lose. The question is how you deal with it.

If we will be quiet and ready enough, we shall find compensation in every disappointment.
– Henry David Thoreau (1817 – 1862

In his classic work on game theory, “The Strategy of Conflict”, Nobel Prize winner Tom Schelling begins by writing about cooperative games, where players are trying to arrive at a common outcome for a mutual benefit. This is a different class of games from the competitive games like Chicken and Prisoner’s Dilemma that we usually consider when we think about game theory, but in truth it’s the cooperative games that account for so much more of our daily lives and social interactions. For example, driving on the right-hand side of the road (or the left-hand side in the UK) is an example of a cooperative game equilibrium. The only thing that matters is that we agree on which side of the road we drive on, not that my preferred side or your preferred side ends up being the final choice.

The most interesting cooperative games are those where — unlike driving conventions — we don’t have a government or other authority telling us what our agreement should be. Even more interesting are those games where we can’t communicate directly with the other players to talk through the appropriate equilibrium behavior that works for all concerned. For example, let’s say that a friend and I agree to meet in New York City at 1 pm tomorrow. Unfortunately, we neglected to agree on a location to meet, and now I have absolutely no way to communicate with my friend, or vice versa. What do we do?

As Schelling writes, almost everyone will, in fact, meet their friend successfully tomorrow at 1 pm in New York City. Where? By the big clock in the middle of Grand Central Station. Why? Because there is Common Knowledge — something that everyone knows that everyone knows — to guide both me and my friend to this outcome. Now Schelling doesn’t call it Common Knowledge — he calls it a focal point — but it’s exactly the same thing. And once you start looking for focal points that drive our strategic behavior in the cooperative games that comprise our daily social lives, you see them everywhere.

Okay, Ben, all kinda interesting, but what’s the point? The point is that when governments undertake emergency actions and extraordinary policies, they obliterate the focal points that make our cooperative games of investing and market making possible.

Specifically, extraordinary monetary policy has obliterated the focal points of price discovery. When you no longer have Common Knowledge regarding the price of money, you don’t have Common Knowledge regarding the price of anything. For more than seven years now, investors have been sitting down at the poker table ready to play the cards they’re dealt, only to find that central bankers with infinitely high stacks of chips have sat down at the table, too. And as any experienced poker player knows, the cards are meaningless if you tangle with an opponent like this. Maybe you think that was a bad flop. Maybe you think Nestle investment grade debt is worth 99 cents. But what you think about valuation and intrinsic worth Does. Not. Matter. when the infinite stack player says with his inexhaustible string of bets of massive size that this was actually a wonderful flop and that Nestle investment grade debt is actually worth $1.10 and the Emperor is actually wearing a beautiful suit of clothes. The very act of stock-picking or bond-picking or security selection in general has become nothing more than a bad joke in vast swaths of global markets. It’s a crooked game — a moke’s game — but it’s the only game in town.

Specifically, extraordinary regulatory policy has obliterated the focal points of liquidity. When you no longer have Common Knowledge regarding the ability of banks to make markets and hold an inventory of securities, you don’t have Common Knowledge regarding the liquidity of anything. The market risk from a Brexit “Leave” vote, for example, has absolutely nothing to do with anything in the real economy, and next to nothing as a signal or precedent for the core currency union of the EU. Instead, the market risk from a Brexit “Leave” vote is a liquidity shock in currency, rates, credit, or derivative securities that sets off a chain reaction of liquidity shocks across global risk assets. This sort of liquidity shock is temporary, to be sure, but that’s no consolation at all if you find yourself stopped out of a position. When trillions of dollars in risk assets move by several percentage points because a few thousand quid switched from one line or another in a UK betting parlor, or because the latest online poll with suspect (to be kind) methodology is printed by a tabloid … you can’t tell me that market liquidity and structural normalcy is more than skin deep. We swing from pillar to post and endure mini-Flash Crashes on a regular basis because too often the act of making a market in, say, equity index volatility is a potential career-ender for anyone sitting on a bank trading desk, and that’s entirely the result of unintended consequences from financial regulations like Dodd-Frank.

It’s the combination of focal point obliteration, from both monetary policy and regulatory policy sources, that creates the most powerful and destructive earthquakes in our investment landscape. For example, I’m often asked if I think that negative rates will ever come to the U.S. My answer: they’re already here by proxy (U.S. Treasury rates are so low today because German Bunds are negative out to 10 years duration), and negative rates will hit the U.S. in earnest and in practice early next year. How? Major U.S. money market fund providers like TIAA-CREF have already announced plans to stop providing fee waivers as new regulations force fund type consolidation, which will create negative rates in the safe, liquid funds that remain. It’s baked in. It’s going to happen. As George Soros is fond of saying, I’m not predicting. I’m observing. And nothing will ever be the same. If you think that the current anguished cries from savers and retirees and public pension plans are loud now … if you think that the rewardless risk of modern markets can’t get any worse … well, just wait until your money market fund starts charging you interest for the privilege of investing your cash in short-term government obligations. Just wait until Nestle floats a negative interest rate bond. Just wait until borrowing money, not lending money, becomes a profit center. Just wait until the entire notion of compounding — without exaggeration the most important force in human economic history — is turned on its head and becomes a wealth destroyer.


You know, I’ve written a lot of Epsilon Theory notes over the past three years. As I figure it, about three novels’ worth and just over the halfway mark of War and Peace. But in all that time and across all those notes I’ve never felt so … resigned … to the fact we are ALL well and truly stuck. The Fed is stuck. The ECB and the BOJ are stuck. The banks are stuck. Corporations are stuck. Asset managers are stuck. Financial advisors are stuck. Investors are stuck. Republicans are stuck. Democrats are stuck. We are all stuck in a very powerful political equilibrium where the costs of changing our current bleak course of ineffective monetary policy and counter-productive regulatory policy are so astronomical that The Powers That Be have no alternative but to continue with what they know full well isn’t working.

It’s through this lens of resignation that I think we should view one of the most fascinating Missionary statements of the past 20 years, St. Louis Fed Governor Jim Bullard’s latest paper, where he says that the entire exercise of Fed guidance and dot plots and planning for interest rate increases and interest rate normalization is a complete and utter waste of time. In fact, he goes farther than that. Bullard writes that forward guidance is actually highly counter-productive and credibility destroying, because it teases us with the notion that normalization is possible, when, in fact, absent some deus ex machina miracle, it’s not. My god, you think I’m a downer? This is the President of the St. Louis Fed, saying that everything the FOMC has been doing for the past four years is just a bad joke! Or as Vonnegut would say, there’s “no damn cat and there’s no damn cradle” in the oh-so-complex hand weaving that Bernanke and Yellen have crafted with forward guidance, no matter how hard we look. The Emperor has no clothes.

What Bullard wrote is a letter of resignation. Not just a letter of resignation in the sense of quitting one’s job (although that, too … if you’re not going to play the game you were appointed to play, if you’re just going to pick up your dot plot and go home, then you should actually go home), but more importantly in the emotional sense of resignation to one’s fate. It’s a capitulation, a recognition that the U.S. is well and truly stuck in the current macroeconomic regime of low growth + massive debt + insanely low interest rates, and there’s nothing the Fed can do in terms of jawboning or “communication policy” or forward guidance to get us out. So, Bullard says, let’s stop this charade of dot plots and just admit the truth: rates are not going up, maybe not EVER, until something beyond the Fed’s control shocks the world into some other macroeconomic regime.

By the way, here’s the problem with what Bullard is saying: the current regime/stable equilibrium of low growth + massive debt + negative interest rates isn’t something that just “happened”. It’s not like the Fed woke up one morning to find that some terrible houseguest soiled the sheets and overfed the dog and left a lit cigarette smoldering in the trash can. Please. Here’s a 4-year chart of the VIX, looking for all the world like a Whack-a-Mole game, as every surge in volatility is met with a mallet strike of Large Scale Asset Purchases (LSAPs), forward guidance, or (outside the U.S.) interest rate cuts well past the zero-bound.

Source: Bloomberg, as of 05/31/2016

Over the past four years, we haven’t seen the VIX stick over 20 for more than 2 months. Compare this to the seven year period of Sept. 1996 – Sept. 2003, where the VIX was almost never below 20.

Source: Bloomberg, as of 05/31/2016

Granted, there were some scary market moments from late 1996 through late 2003, but it’s not like the past four years have been a walk in the park. I don’t think anyone can deny that we are living today in a different regime or state of the world, where volatility is simply not allowed to raise its ugly head as it always has in the past. That’s the Entropic Regime in a nutshell — volatility is not allowed to reach historically normal levels. Not allowed by whom? By central banks, of course. S&P 500 down 8%? Gasp! We must provide more accommodation! The macroeconomic regime that Bullard finds so objectionable and resistant to any policy choices was created lock, stock, and barrel by the Fed and their regulatory cousins. They weren’t trying to lock the world into the Entropic Regime, a long gray slog where neither recession nor real growth appears, and maybe the world would have been even more wrecked if they had taken a different path, but they did what they did all the same.

My issue with Bullard is neither his assessment of the current macroeconomic regime nor the silliness of forward guidance and Fed communication policy. I am in violent agreement with Bullard in his recognition of the power of Narrative and the simple fact that all of our crystal balls are broken. But don’t tell me that the Fed “has no choice” but to accept the current macroeconomic regime, because they DO have a choice. The Fed giveth. The Fed can taketh away. It’s just a very, very, very painful choice that the Fed would have to make in order to taketh away, full of loss assignment and bankruptcy and status quo shattering. It’s a very brave choice they would have to make, a Volcker-esque choice they would have to make. And that’s why I don’t think they will ever do it.

So we’re left with Hope, hope that a miracle occurs after the November election to change our current political regime of decay and macroeconomic regime of low growth + massive debt + negative interest rates. Politically on the left, it’s hope that Hillary Clinton isn’t really as venal and principle-less and in-the-bag for Big Money and Big War as she seems. Politically on the right, it’s hope that Donald Trump doesn’t really mean what he says about Muslims and Hispanics and judges and torture and libel and debt and women and and and. On both the left and the right, it’s hope that the election will yield some massive Keynesian public infrastructure spending spree, where our “crumbling roads and bridges” are made whole, where every city gets a football stadium for the local billionaire’s use, and where high-speed rail and gleaming airports usher in a new age of productivity and easy trips to Grandma’s house. Truly, as Voltaire’s Pangloss would say, this is the best of all possible worlds.

But hope, of course, is not a strategy. What do investors and advisors and voters — The Non-Powers That Be — DO when the entire world is stuck in a powerful negative equilibrium, when we are presented with nothing but miserable choices, at the ballot box and public markets alike? How can we find “compensation in our disappointment”, to quote Thoreau? Or to be slightly more modern in our references, let’s accept that we can’t get what we want. Can we at least get what we need?

To answer that question, at least from an investment perspective, I need to go back to the big Epsilon Theory note I wrote earlier this year, “Hobson’s Choice.” I’m not going to repeat much of that here (at 26 pages long, it’s a bit of a tome), except to say that it’s as close to an Epsilon Theory investment strategy as I can convey in this public venue. But here’s the skinny, with what I call Five Easy Pieces for the Investment World As It Is.

We’re in a storm. Mind your sails.
We’re in a game. Play the player.
We’re in a negative carry world. Think like a short seller.
We’re in a policy-driven market. Don’t trust the models.
A policy-controlled market is next. Look to real assets.

In and of themselves, admonitions like “Mind your sails” may not sound like much, but I promise they make sense in context. Here’s what they mean translated into market behaviors.

Mind your sails. Keep risk constant, not dollars.
Play the player. Trend-following is a thing.
Think like a short seller. Focus on catalysts.
Don’t trust the models. Minimize regret.
Look to real assets. Survive the politics.

Now the point of “Hobson’s Choice” is that these behaviors I’m describing, like “Keep risk constant, not dollars”, are new ways of describing good old-fashioned investment ideas that just so happen to conflict with other investment ideas that have become rote articles of faith in our modern, overly equity-centric vision of what it means to be a “good” investor. For example, I think that it’s nuts to stay fully invested in the stock market through thick and thin, and I would love to embrace that most-hated epithet in investing today: market timer. (Shudder!) But I can’t SAY that I’m a market timer, any more than I could say that I’m a libertarian or that I love Emily Dickinson’s poetry or that my wife and I homeschool our children … no, no, you wouldn’t take me seriously if the conversation about politics or books or education were framed in this way. It’s the same with investing. In the immortal words of John Maynard Keynes, “it is better for reputation to fail conventionally than to succeed unconventionally” (and for an Epsilon Theory twist, I’d add, “and if you fail unconventionally, then your reputation is really dead”), which means that even if you agreed with me on the virtues of market timing, you’d never adopt a strategy based on market timing, because it would be way too risky from a social perspective. I mean, just imagine the shame if your client or wife or partner thought you were a … again, I can hardly bring myself to write the words … market timer. Oh, the humanity!

So let’s change the conversation. I’m NOT a market timer. Nope, not me. Instead, I’m a risk balancer. I have fewer dollars in the market when risk goes up, and I have more dollars in the market when risk goes down. Will I be over-invested in the market when it hits a top and rolls over? Yep. Will I be under-invested in the market when it hits bottom and turns up? Yep. But I’m going to be adding to my dollar exposure all the way up and I’m going to be subtracting from my dollar exposure all the way down. I’ll take those odds. And just imagine if I did this risk balancing thing across asset classes, or maybe across yield-oriented strategies. Hey, now.

Here are the broad categories of strategies that the Five Easy Pieces market behaviors imply.

Keep risk constant, not dollars. Risk Balanced Strategies
Trend-following is a thing. Managed Futures Strategies
Focus on catalysts. Long/Short Strategies
Minimize regret. Convex Strategies (Optionality)
Survive the politics. Active Mgmt for Real Assets

Is this a comprehensive list? Of course not. But it’s a start. Over the next few months I’ll try to take each topic in turn and dig into the specifics, or at least as much of the specifics as I’m allowed in this very public setting. Some of the topics have already been discussed at some length in prior notes (for Convex Strategies, for example, be sure to read one of my personal Epsilon Theory faves, “I Know It Was You, Fredo”), others will be largely starting from scratch or going in a new direction from the past. If you’re a professional investor or allocator and want to dig in more deeply than what you read in these pages, don’t hesitate to reach out.

You know, Emily Dickinson published fewer than a dozen of her almost 1,800 (!) poems while she was alive, and if not for a determined sister with a narrow interpretation of Dickinson’s final wishes (she asked for her correspondence to be burned, and it was, but she didn’t specifically say anything about the box of poems next to her letters), all of this genius work would have been lost. In Dickinson’s day, there was way too much intermediation and way too many barriers between author and audience. We got lucky. Today, there’s way too little intermediation and way too few barriers between author and audience, such that all of us are inundated with “content” and “marketing collateral”, to use the lingo. Dickinson’s challenge was standing up. My challenge is standing out. Thanks to all of you who have actively spread the word about the Epsilon Theory project and helped build the vibrant community that we have today. Keep those cards and letters coming (I really try to respond to everything I get), and please check out the Epsilon Theory podcasts when you get a chance. It feels like we’re just getting started, and that’s something that warrants Hope, indeed.

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Optical Illusion / Optical Truth




Portion of original dot map by Dr. John Snow, the founding father of epidemiology, showing the clusters of cholera cases in the London epidemic of 1854. The visual representation of Snow’s data analysis convinced local authorities to shut down the contaminated public well at ground zero of the cholera outbreak, although it would be another 20 years before Snow’s arguments in favor of germ theory and a direct connection between cholera and fecal contamination of water supply would be widely accepted.

John Snow, “On the Mode of Communication of Cholera” (1855)

Anscombe’s Quartet: four datasets that appear identical using summary statistical methods (mean, variance, correlation, linear regression), but are completely different in meaning and composition – a difference that is clearly revealed through visual inspection.


Frank Anscombe, “Graphs in Statistical Analysis” American Statistician v.27 no.1 (1973), drawing by Schutz 


Charles Joseph Minard, “Carte Figurative” of Napoleon’s 1812 Russian Campaign (1869)

The Minard Map: a map of Napoleon’s disastrous invasion of Russia in 1812, showing six distinct data dimensions (troop strength, temperature, distance marched, geographic latitude and longitude, direction of travel, location at event dates) in 2-dimensional form.

Mephistopheles:Here too it’s masquerade, I find:
As everywhere, the dance of mind.
I grasped a lovely masked procession,
And caught things from a horror show…
I’d gladly settle for a false impression,
If it would last a little longer, though.

Edouard de Reszke as Mephistopheles
in Gounod’s opera “Faust” (c. 1880)

So, so you think you can tell
Heaven from Hell,
Blue skies from pain.
Can you tell a green field
From a cold steel rail?
A smile from a veil?
Do you think you can tell?

– Roger Waters, “Wish You Were Here” (1975)

A great deal of intelligence can be invested in ignorance when the need for illusion is deep.

– Saul Bellow, “To Jerusalem and Back” (1976)

It is difficult to get a man to understand something, when his salary depends on his not understanding it.

– Upton Sinclair, “I, Candidate for Governor: And How I Got Licked” (1935)

Knowledge kills action; action requires the veils of illusion.

– Friedrich Nietzsche, “The Birth of Tragedy” (1872)

To find out if she really loved me, I hooked her up to a lie detector. And just as I suspected, my machine was broken.

– Jarod Kintz, “Love Quotes for the Ages. Specifically Ages 19-91” (2013)

Edward Tufte is a personal and professional hero of mine. Professionally, he’s best known for his magisterial work in data visualization and data communication through such classics as The Visual Display of Quantitative Information (1983) and its follow-on volumes, but less well-known is his outstanding academic work in econometrics and statistical analysis. His 1974 book Data Analysis for Politics and Policy remains the single best book I’ve ever read in terms of teaching the power and pitfalls of statistical analysis. If you’re fluent in the language of econometrics (this is not a book for the uninitiated) and now you want to say something meaningful and true using that language, you should read this book (available for $2 in Kindle form on Tufte’s website). Personally, Tufte is a hero to me for escaping the ivory tower, pioneering what we know today as self-publishing, making a lot of money in the process, and becoming an interesting sculptor and artist. That’s my dream. That one day when the Great Central Bank Wars of the 21st century are over, I will be allowed to return, Cincinnatus-like, to my Connecticut farm where I will write short stories and weld monumental sculptures in peace. That and beekeeping.

But until that happy day, I am inspired in my war-fighting efforts by Tufte’s skepticism and truth-seeking. The former is summed up well in an anecdote Tufte found in a medical journal and cites in Data Analysis:

One day when I was a junior medical student, a very important Boston surgeon visited the school and delivered a great treatise on a large number of patients who had undergone successful operations for vascular reconstruction. At the end of the lecture, a young student at the back of the room timidly asked, “Do you have any controls?” Well, the great surgeon drew himself up to his full height, hit the desk, and said, “Do you mean did I not operate on half of the patients?” The hall grew very quiet then. The voice at the back of the room very hesitantly replied, “Yes, that’s what I had in mind.” Then the visitor’s fist really came down as he thundered, “Of course not. That would have doomed half of them to their death.” God, it was quiet then, and one could scarcely hear the small voice ask, “Which half?”

‘Nuff said.

The latter quality — truth-seeking — takes on many forms in Tufte’s work, but most noticeably in his constant admonitions to LOOK at the data for hints and clues on asking the right questions of the data. This is the flip-side of the coin for which Tufte is best known, that good/bad visual representations of data communicate useful/useless answers to questions that we have about the world. Or to put it another way, an information-rich data visualization is not only the most powerful way to communicate our answers as to how the world really works, but it is also the most powerful way to design our questions as to how the world really works. Here’s a quick example of what I mean, using a famous data set known as “Anscombe’s Quartet”.

Anscombe’s Quartet
x y x y x y x y
10.0 8.04 10.0 9.14 10.0 7.46 8.0 6.58
8.0 6.95 8.0 8.14 8.0 6.77 8.0 5.76
13.0 7.58 13.0 8.74 13.0 12.74 8.0 7.71
9.0 8.81 9.0 8.77 9.0 7.11 8.0 8.84
11.0 8.33 11.0 9.26 11.0 7.81 8.0 8.47
14.0 9.96 14.0 8.10 14.0 8.84 8.0 7.04
6.0 7.24 6.0 6.13 6.0 6.08 8.0 5.25
4.0 4.26 4.0 3.10 4.0 5.39 19.0 12.50
12.0 10.84 12.0 9.13 12.0 8.15 8.0 5.56
7.0 4.82 7.0 7.26 7.0 6.42 8.0 7.91
5.0 5.68 5.0 4.74 5.0 5.73 8.0 6.89

In this original example (developed by hand by Frank Anscombe in 1973; today there’s an app for generating all the Anscombe sets you could want) Roman numerals I – IV refer to four data sets of 11 (x,y) coordinates, in other words 11 points on a simple 2-dimensional area. If you were comparing these four sets of numbers using traditional statistical methods, you might well think that they were four separate data measurements of exactly the same phenomenon. After all, the mean of x is exactly the same in each set of measurements (9), the mean of y is the same in each set of measurements to two decimal places (7.50), the variance of x is exactly the same in each set (11), the variance of y is the same in each set to two decimal places (4.12), the correlation between x and y is the same in each set to three decimal places (0.816), and if you run a linear regression on each data set you get the same line plotted through the observations (y = 3.00 + 0.500x).

But when you LOOK at these four data sets, they are totally alien to each other, with essentially no similarity in meaning or probable causal mechanism. Of the four, linear regression and our typical summary statistical efforts make sense for only the upper left data set. For the other three, applying our standard toolkit makes absolutely no sense. But we’d never know that — we’d never know how to ask the right questions about our data — if we didn’t eyeball it first.


Okay, you might say, duly noted. From now on we will certainly look at a visual plot of our data before doing things like forcing a line through it and reporting summary statistics like r-squared and standard deviation as if they were trumpets of angels from on high. But how do you “see” multi-variate datasets? It’s one thing to imagine a line through a set of points on a plane, quite another to visualize a plane through a set of points in space, and impossible to imagine a cubic solid through a set of points in hyperspace. And how do you “see” embedded or invisible data dimensions, whether it’s an invisible market dimension like volatility or an invisible measurement dimension like time aggregation or an invisible statistical dimension like the underlying distribution of errors?

The fact is that looking at data is an art, not a science. There’s no single process, no single toolkit for success. It requires years of practice on top of an innate artist’s eye before you have a chance of being good at this, and it’s something that I’ve never seen a non-human intelligence accomplish successfully (I can’t tell you how happy I am to write that sentence). But just because it’s hard, just because it doesn’t come easily or naturally to people and machines alike … well, that doesn’t mean it’s not the most important thing in data-based truth-seeking.

Why is it so important to SEE data relationships? Because we’re human beings. Because we are biologically evolved and culturally trained to process information in this manner. Because — and this is the Tufte-inspired market axiom that I can’t emphasize strongly enough — the only investable ideas are visible ideas. If you can’t physically see it in the data, then it will never move you strongly enough to overcome the pleasant fictions that dominate our workaday lives, what Faust’s Tempter, the demon Mephistopheles, calls the “masquerade” and “the dance of mind.” Our similarity to Faust (who was a really smart guy, a man of Science with a capital S) is not that the Devil may soon pay us a visit and tempt us with all manner of magical wonders, but that we have already succumbed to the blandishments of easy answers and magical thinking. I mean, don’t get me started on Part Two, Act 1 of Goethe’s magnum opus, where the Devil introduces massive quantities of paper money to encourage inflationary pressures under a false promise of recovery in the real economy. No, I’m not making this up. That is the actual, non-allegorical plot of one of the best, smartest books in human history, now almost 200 years old.

So what I’m going to ask of you, dear reader, is to look at some pictures of market data, with the hope that seeing will indeed spark believing. Not as a temptation, but as a talisman against the same. Because when I tell you that the statistical correlation between the US dollar and the price of oil since Janet Yellen and Mario Draghi launched competitive monetary policies in mid-June of 2014 is -0.96 I can hear the yawns. I can also hear my own brain start to pose negative questions, because I’ve experienced way too many instances of statistical “evidence” that, like the Anscombe data sets, proved to be misleading at best. But when I show you what that correlation looks like …


© Bloomberg Finance L.P., for illustrative purposes only

I can hear you lean forward in your seat. I can hear my own brain start to whir with positive questions and ideas about how to explore this data further. This is what a -96% correlation looks like.

What you’re looking at in the green line is the Fed’s favored measure of what the US dollar buys around the world. It’s an index where the components are the exchange rates of all the US trading partners (hence a “broad dollar” index) and where the individual components are proportionally magnified/minimized by the size of that trading relationship (hence a “trade-weighted” index). That index is measured by the left hand vertical axis, starting with a value of about 102 on June 18, 2014 when Janet Yellen announced a tightening bias for US monetary policy and a renewed focus on the full employment half of the Fed’s dual mandate, peaking in late January and declining to a current value of about 119 as first Japan and Europe called off the negative rate dogs (making their currencies go up against the dollar) and then Yellen completely back-tracked on raising rates this year (making the dollar go down against all currencies). Monetary policy divergence with a hawkish Fed and a dovish rest-of-world makes the dollar go up. Monetary policy convergence with everyone a dove makes the dollar go down.

What you’re looking at in the magenta line is the upside-down price of West Texas Intermediate crude oil over the same time span, as measured by the right hand vertical axis. So on June 18, 2014 the spot price of WTI crude oil was over $100/barrel. That bottomed in the high $20s just as the trade-weighted broad dollar index peaked this year, and it’s been roaring back higher (lower in the inverse depiction) ever since. Now correlation may not imply causation, but as Ed Tufte is fond of saying, it’s a mighty big hint. I can SEE the consistent relationship between change in the dollar and change in oil prices, and that makes for a coherent, believable story about a causal relationship between monetary policy and oil prices.

What is that causal narrative? It’s not just the mechanistic aspects of pricing, such that the inherent exchange value of things priced in dollars — whether it’s a barrel of oil or a Caterpillar earthmover — must by definition go down as the exchange value of the dollar itself goes up. More impactful, I think, is that for the past seven years investors have been well and truly trained to see every market outcome as the result of central bank policy, a training program administered by central bankers who now routinely and intentionally use forward guidance and placebo words to act on “the dance of mind” in classic Mephistophelean fashion. In effect, the causal relationship between monetary policy and oil prices is a self-fulfilling prophecy (or in the jargon du jour, a self-reinforcing behavioral equilibrium), a meta-example of what George Soros calls reflexivity and what a game theorist calls the Common Knowledge Game.

The causal relationship of the dollar, i.e. monetary policy, to the price of oil is a reflection of the Narrative of Central Bank Omnipotence, nothing more and nothing less. And today that narrative is everything.

Here’s something smart that I read about this relationship between oil prices and monetary policy back in November 2014 when oil was north of $70/barrel:

I think that this monetary policy divergence is a very significant risk to markets, as there’s no direct martingale on how far monetary policy can diverge and how strong the dollar can get. As a result I think there’s a non-trivial chance that the price of oil could have a $30 or $40 handle at some point over the next 6 months, even though the global growth and supply/demand models would say that’s impossible. But I also think the likely duration of that heavily depressed price is pretty short. Why? Because the Fed and China will not take this lying down. They will respond to the stronger dollar and stronger yuan (China’s currency is effectively tied to the dollar) and they will prevail, which will push oil prices back close to what global growth says the price should be. The danger, of course, is that if they wait too long to respond (and they usually do), then the response will itself be highly damaging to global growth and market confidence and we’ll bounce back, but only after a near-recession in the US or a near-hard landing in China.

Oh wait, I wrote that. Good stuff.


But that was a voice in the wilderness in 2014, as the dominant narrative for the causal factors driving oil pricing was all OPEC all the time. So what about that, Ben? What about the steel cage death match within OPEC between Saudi Arabia and Iran and outside of OPEC between Saudi Arabia and US frackers? What about supply and demand? Where is that in your price chart of oil? Sorry, but I don’t see it in the data. Doesn’t mean it’s not really there. Doesn’t mean it’s not a statistically significant data relationship. What it means is that the relationship between oil supply and oil prices in a policy-controlled market is not an investable relationship. I’m sure it used to be, which is why so many people believe that it’s so important to follow and fret over. But today it’s an essentially useless exercise in data analytics. Not wrong, but useless … there’s a difference!

Of course, crude oil isn’t the only place where fundamental supply and demand factors are invisible in the data and hence essentially useless as an investable attribute. Here’s the dollar and something near and dear to the hearts of anyone in Houston, the Alerian MLP index, with an astounding -94% correlation:


© Bloomberg Finance L.P., for illustrative purposes only

Interestingly, the correlation between the Alerian MLP index and oil is noticeably less at -88%. Hard to believe that MLP investors should be paying more attention to Bank of Japan press conferences than to gas field depletion schedules, but I gotta call ‘em like I see ‘em.

And here’s the dollar and EEM, the dominant emerging market ETF, with a -89% correlation:


© Bloomberg Finance L.P., for illustrative purposes only

There’s only one question that matters about Emerging Markets as an asset class, and it’s the subject of one of my first (and most popular) Epsilon Theory notes, “It Was Barzini All Along”: are Emerging Market growth rates a function of something (anything!) particular to Emerging Markets, or are they simply a derivative function of Developed Market central bank liquidity measures and monetary policy? Certainly this chart suggests a rather definitive answer to that question!

And finally, here’s the dollar and the US Manufacturing PMI survey of real-world corporate purchasing managers, probably the most respected measure of US manufacturing sector health. This data relationship clocks in at a -92% correlation. I mean … this is nuts.


© Bloomberg Finance L.P., for illustrative purposes only

Here’s what I wrote last summer about the inexorable spread of monetary policy contagion.

Monetary policy divergence manifests itself first in currencies, because currencies aren’t an asset class at all, but a political construction that represents and symbolizes monetary policy. Then the divergence manifests itself in those asset classes, like commodities, that have no internal dynamics or cash flows and are thus only slightly removed in their construction and meaning from however they’re priced in this currency or that. From there the divergence spreads like a cancer (or like a cure for cancer, depending on your perspective) into commodity-sensitive real-world companies and national economies. Eventually – and this is the Big Point – the divergence spreads into everything, everywhere.

I think this is still the only story that matters for markets.

The good Lord giveth and the good Lord taketh away. Right now the good Lord’s name is Janet Yellen, and she’s in a giving mood. It won’t last. It never does. But it does give us time to prepare our portfolios for a return to competitive monetary policy actions, and it gives us insight into what to look for as catalysts for that taketh away part of the equation.


Most importantly, though, I hope that this exercise in truth-seeking inoculates you from the Big Narrative Lie coming soon to a status quo media megaphone near you, that this resurgence in risk assets is caused by a resurgence in fundamental real-world economic factors. I know you want to believe this is true. I do, too! It’s unpleasant personally and bad for business in 2016 to accept the reality that we are mired in a policy-controlled market, just as it was unpleasant personally and bad for business in 1854 to accept the reality that cholera is transmitted through fecal contamination of drinking water. But when you SEE John Snow’s dot map of death you can’t ignore the Broad Street water pump smack-dab in the middle of disease outcomes. When you SEE a Bloomberg correlation map of prices you can’t ignore the trade-weighted broad dollar index smack-dab in the middle of market outcomes. Or at least you can’t ignore it completely. It took another 20 years and a lot more cholera deaths before Snow’s ideas were widely accepted. It took the development of a new intellectual foundation: germ theory. I figure it will take another 20 years and the further development of game theory before we get widespread acceptance of the ideas I’m talking about in Epsilon Theory. That’s okay. The bees can wait.

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The Placebo Effect



BOTOX® is the only FDA-approved, preventive treatment that is injected by a doctor every 12 weeks for adults with Chronic Migraine (15 or more headache days a month, each lasting 4 hours or more). BOTOX® prevents up to 9 headache days a month (vs up to 7 for placebo). BOTOX® therapy is not approved for adults with migraine who have 14 or fewer headache days a month.

Allergan website, April 18, 2016

I’ve had four or five true migraines in my life, mostly from getting whacked on the head with something like a baseball or a sharp elbow in basketball, and I honestly can’t imagine how horrible it must be to suffer from chronic migraines, defined by the FDA as 15 or more migraines per month with headaches lasting at least four hours. So I was happy to see a TV ad saying that the FDA had approved Botox as an effective treatment for chronic migraines, preventing up to 9 headache-days per month. That’s huge!

But in the fast-talking coda for the ad, I heard something that made me do a double-take. Yes, Botox can knock out up to 9 headache-days per month. But a placebo injection is almost as good, preventing up to 7 headache-days per month.

Now 9 is better than 7 … I get that … and that’s why the FDA approved the drug as efficacious. Still. Really? Most of the reports I’ve read say that the cost of a Botox migraine treatment is about $600. That’s just the cost of the drug itself. So what the FDA is telling us is that a saline solution injection (costing what? $2) is almost 80% as effective as the $600 drug, so long as it was presented to the patient as a “true” potential therapy. If I’m an Allergan shareholder I’m thanking god every day for the placebo effect.

And not for nothing, but I’d really like to learn more about why Botox was NOT approved for migraine sufferers with fewer than 15 headache-days per month. If I were a gambling man (and I am), I’d be prepared to wager a significant amount of money that Botox significantly reduces headache-days at pretty much any level of chronic-ness, from 1 day to 30 days per month, but that at lower migraine frequencies a placebo is just as efficacious as Botox. In other words, I’d bet that ALL migraine sufferers would benefit from a $600 Botox shot, but I’d also bet that ALL migraine sufferers would benefit from a cheap saline shot so long as the doctor told them it was a brilliant new drug, and they’d get as much or MORE benefit from the cheap saline shot than from Botox if they’re “just” enduring eight or nine migraine headaches. Per month. Geez. Of course, there’s no economic incentive to provide the cheap placebo injection nor the unapproved (and hence unreimbursed) Botox shot if you have fewer than 15 headache-days per month. Bottomline: I’d bet that millions of people who don’t meet the 15 day threshold are suffering from terrible pain that could absolutely be alleviated at a very reasonable cost if it weren’t criminally unethical and (worse) terribly unprofitable to lie about the “truth” of a placebo treatment.

Of course, we have no such restrictions, ethical or otherwise, when it comes to monetary policy, and that’s the connection between investing and this little foray into the special hell that we call healthcare economics. The primary instruments of monetary policy in 2016 – words used to construct Common Knowledge and mold our behavior, words chosen for effect rather than truthfulness, words of “forward guidance” and “communication policy” – are placebos. Like a fake migraine therapy, the placebos of monetary policy are enormously effective because they act on the brain-regulated physiological phenomena of pain (placebos are essentially useless on non-brain-regulated phenomena like joint instability from a torn ligament or cellular chaos from cancer). Even in fundamentally-driven markets there’s a healthy balance between pain minimization and reward maximization. In a policy-driven market? The top three investing principles are pain avoidance, pain avoidance, and pain avoidance. We’re just looking to survive, not literally but in a brain-regulated emotional sense, and that leaves us wide open for the soothing power of placebos.

I get lots of comments from readers who don’t understand how markets can continue to levitate higher with anemic-at-best global growth, stretched valuation multiples, and an earnings recession in vast swaths of corporate America. This week I’m reading lots of comments post the failed Doha OPEC meeting that oil prices are doomed to see a $20 handle now that there’s no supply limitation agreement forthcoming. Yep, that’s the real world. And there’s zero monetary or fiscal policy in the works that has any direct beneficial impact on any of this.

But that’s not what matters. That’s not how the game is played. So long as the Fed and the ECB and the BOJ are playing nice with China by talking down the dollar regardless of what’s happening in the real world economy, then it’s an investable rally in all risk assets, and oil goes up more easily than it goes down, regardless of what happens with OPEC. The placebo effect of insanely accommodative forward guidance that has zero impact on the real economy is in full swing. Oil prices are driven by forward guidance and the dollar, not real world supply and demand. Every day that Yellen talks up global risks and talks down the dollar is another day of a pain-relieving injection, regardless of whether or not that talk is “real” therapy.

Does this mean that we’re off to the races in the market? Nope. The notion that we have a self-sustaining recovery in the global economy is laughable, and that’s what it will take to stimulate a new greed phase of a rip-roaring bull market. But by the same token I have no idea what makes this market go down, so long as we have monetary policy convergence rather than divergence, and so long as we have a Fed that loses its nerve and freaks out if the stock market goes down by more than 5%. So long as the words of a monetary policy truce hold strong, this isn’t a world that ends in fire and it isn’t a world that ends in ice. It’s the long gray slog of an Entropic Ending. Anyone else intrigued by the potential of a covered call strategy in this environment? I sure am.

But wait, Ben, isn’t a covered call strategy (where you’re selling call options on your long positions) the opposite of convexity? Haven’t you been saying that a portfolio should have more convexity – i.e. optionality, i.e. buying options rather than selling options – rather than less? Yes. Yes, I have. But optionality isn’t the same thing as owning options. In the same way that I want portfolio optionality that pays off in a fire scenario (a miracle happens and global growth + inflation surges forward) and portfolio optionality that pays off in an ice scenario (China drops a deflationary atom bomb by floating the yuan), so do I want portfolio optionality that pays off in a gray slog scenario. That’s where covered calls (and covered puts for short positions) come into play. It’s all part of applying the principles of minimax regret to portfolio construction, where we don’t try to assign probabilities and expected return projections to our holdings, but where we think in terms of risk tolerance and minimizing investment pain for any of the market scenarios that could develop in a politically fragmented world. It’s all part of having an intentional portfolio, where every exposure plays a defined role with maximum capital efficiency, as opposed to an accidental portfolio where we just slather on layer after layer of “quality” large cap stocks.

The Silver Age of the Central Banker gives me a headache. I bet it does you, too. Let’s take our relief where we can find it, placebo or no, but let’s not mistake forward guidance for a cure and let’s not forget that sometimes pretty words just aren’t enough. The truth is that the global trade pie is still shrinking and domestic politics are still anti-growth in both the US and Europe. Neither math nor human nature gives me much confidence that the currency truce can hold indefinitely, and I still think that every policy China has undertaken is exactly what I would do to prepare for floating (i.e. massively devaluing) the yuan. It’s at moments like this, though, that I remember the short seller’s creed: if you’re wrong on timing, you’re just wrong. I don’t know the timing of the bigger headaches to come, the ones that words and placebos won’t fix. What I do know, though, is that an investable rally in risk assets today gives us some breathing space to prepare our portfolios for the even more policy-controlled markets of the future. Let’s not waste this opportunity.

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My Passion is Puppetry

Launch Date
epsilon-theory-my-passion-is-puppetry-april-6-2016-progressive-insurance “Flo” Progressive Insurance 2008
epsilon-theory-my-passion-is-puppetry-april-6-2016-geico “Rhetorical Question”
“Happier Than A … ”
“Did You Know?”
“It’s What You Do”
GEICO 2009
epsilon-theory-my-passion-is-puppetry-april-6-2016-allstate “Mayhem” Allstate 2010
epsilon-theory-my-passion-is-puppetry-april-6-2016-farmers “University of Farmers” Farmers Insurance 2010
epsilon-theory-my-passion-is-puppetry-april-6-2016-state-farm-jingle “Magic Jingle” State Farm 2011
epsilon-theory-my-passion-is-puppetry-april-6-2016-esurance “That’s Not How It Works” Esurance 2014
epsilon-theory-my-passion-is-puppetry-april-6-2016-nationwide “Chicken Parm You Taste So Good” Nationwide 2014

We are supposedly living in the Golden Age of television. Maybe yes, maybe no (my view: every decade is a Golden Age of television!), but there’s no doubt that today we’re living in the Golden Age of insurance commercials. Sure, you had the GEICO gecko back in 1999 and the caveman in 2004, and the Aflac duck has been around almost as long, but it’s really the Flo campaign for Progressive Insurance in 2008 that marks a sea change in how financial risk products are marketed by property and casualty insurers. Today every major P&C carrier spends big bucks (about $7 billion per year in the aggregate) on these little theatrical gems.

This will strike some as a silly argument, but I don’t think it’s a coincidence that the modern focus on entertainment marketing for financial risk products began in the Great Recession and its aftermath. When the financial ground isn’t steady underneath your feet, fundamentals don’t matter nearly as much as a fresh narrative. Why? Because the fundamentals are scary. Because you don’t buy when you’re scared. So you need a new perspective from the puppet masters to get you to buy, a new “conversation”, to use Don Draper’s words of advertising wisdom from Mad Men. Maybe that’s describing the price quote process as a “name your price tool” if you’re Flo, and maybe that’s describing Lucky Strikes tobacco as “toasted!” if you’re Don Draper. Maybe that’s a chuckle at the Mayhem guy or the Hump Day Camel if you’re Allstate or GEICO. Maybe, since equity markets are no less a financial risk product than auto insurance, it’s the installation of a cargo cult around Ben Bernanke, Janet Yellen, and Mario Draghi, such that their occasional manifestations on a TV screen, no less common than the GEICO gecko, become objects of adoration and propitiation.

epsilon-theory-my-passion-is-puppetry-april-6-2016-bernanke epsilon-theory-my-passion-is-puppetry-april-6-2016-yellen epsilon-theory-my-passion-is-puppetry-april-6-2016-draghi

For P&C insurers, the payoff from their marketing effort is clear: dollars spent on advertising drive faster and more profitable premium growth than dollars spent on agents. For central bankers, the payoff from their marketing effort is equally clear. As the Great One himself, Ben Bernanke, said in his August 31, 2012 Jackson Hole speech: “It is probably not a coincidence that the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases.” Probably not a coincidence, indeed.

Here’s what this marketing success looks like, and here’s why you should care.

This is a chart of the S&P 500 index (green line) and the Deutsche Bank Quality index (white line) from February 2000 to the market lows of March 2009.


Source: Bloomberg Finance L.P., as of 3/6/2009. For illustrative purposes only.

Now I chose this particular factor index (which I understand to be principally a measure of return on invested capital, such that it’s long stocks with a high ROIC, i.e. high quality, and short stocks with a low ROIC, all in a sector neutral/equal-weighted construction across a wide range of global stocks in order to isolate this factor) because Quality is the embedded bias of almost every stock-picker in the world. As stock-pickers, we are trained to look for quality management teams, quality earnings, quality cash flows, quality balance sheets, etc. The precise definition of quality will differ from person to person and process to process (Deutsche Bank is using return on invested capital as a rough proxy for all of these disparate conceptions of quality, which makes good sense to me), but virtually all stock-pickers believe, largely as an article of faith, that the stock price of a high quality company will outperform the stock price of a low quality company over time. And for the nine years shown on this chart, that faith was well-rewarded, with the Quality index up 78% and the S&P 500 down 51%, a stark difference, to be sure.

But now let’s look at what’s happened with these two indices over the last seven years.


Source: Bloomberg Finance L.P., as of 3/28/2016. For illustrative purposes only.

The S&P 500 index has tripled (!) from the March 2009 bottom. The Deutsche Bank Quality index? It’s up a grand total of 10%. Over seven years. Why? Because the Fed couldn’t care less about promoting high quality companies and dissing low quality companies with its concerted marketing campaign — what Bernanke and Yellen call “communication policy”, the functional equivalent of advertising. The Fed couldn’t care less about promoting value or promoting growth or promoting any traditional factor that requires an investor judgment between this company and that company. No, the Fed wants to promote ALL financial assets, and their communication policies are intentionally designed to push and cajole us to pay up for financial risk in our investments, in EXACTLY the same way that a P&C insurance company’s communication policies are intentionally designed to push and cajole us to pay up for financial risk in our cars and homes. The Fed uses Janet Yellen and forward guidance; Nationwide uses Peyton Manning and a catchy jingle. From a game theory perspective it’s the same thing.

Where do the Fed’s policies most prominently insure against financial risk? In low quality stocks, of course. It’s precisely the companies with weak balance sheets and bumbling management teams and sketchy non-GAAP earnings that are more likely to be bailed out by the tsunami of liquidity and the most accommodating monetary policy of this or any other lifetime, because companies with fortress balance sheets and competent management teams and sterling earnings don’t need bailing out under any circumstances. It’s not just that a quality bias fails to be rewarded in a policy-driven market, it’s that a bias against quality does particularly well! The result is that any long-term expected return from quality stocks is muted at best and close to zero in the current policy regime. There is no “margin of safety” in quality-driven stock-picking today, so that it only takes one idiosyncratic stock-picking mistake to wipe out a year’s worth of otherwise solid research and returns.

So how has that stock-picking mutual fund worked out for you? Probably not so well. Here’s the 2015 S&P scorecard for actively managed US equity funds, showing the percentage of funds that failed to beat their benchmarks over the last 1, 5, and 10 year periods. I mean … these are just jaw-droppingly bad numbers. And they’d be even worse if you included survivorship bias.

% of US Equity Funds that FAILED to Beat Benchmark

1 Year 5 Years 10 Years
Large-Cap 66.1% 84.2% 82.1%
Mid-Cap 56.8% 76.7% 87.6%
Small-Cap 72.2% 90.1% 88.4%

Source: S&P Dow Jones Indices, “SPIVA US Scorecard Year-End 2015” as of 12/31/15. For illustrative purposes only.

Small wonder, then, that assets have fled actively managed stock funds over the past 10 years in favor of passively managed ETFs and indices. It’s a Hobson’s Choice for investors and advisors, where a choice between interesting but under-performing active funds and boring but safe passive funds is no choice at all from a business perspective. The mantra in IT for decades was that no one ever got fired for buying IBM; today, no financial advisor ever gets fired for buying an S&P 500 index fund.

But surely, Ben, this, too, shall pass. Surely at some point central banks will back away from their massive marketing campaign based on forward guidance and celebrity spokespeople. Surely as interest rates “normalize”, we will return to those halcyon days of yore, when stock-picking on quality actually mattered.

Sorry, but I don’t see it. The mistake that most market observers make is to think that if the Fed is talking about normalizing rates, then we must be moving towards normalized markets, i.e. non-policy-driven markets. That’s not it. To steal a line from the Esurance commercials, that’s not how any of this works. So long as we’re paying attention to the Missionary’s act of communication, whether that’s a Mario Draghi press conference or a Mayhem Guy TV commercial, then behaviorally-focused advertising — aka the Common Knowledge Game — works. Common Knowledge is created simply by paying attention to a Missionary. It really doesn’t matter what specific message the Missionary is actually communicating, so long as it holds our attention. It really doesn’t matter whether the Fed hikes rates four times this year or twice this year or not at all this year. I mean, of course it matters in terms of mortgage rates and bank profits and a whole host of factors in the real economy. But for the only question that matters for investors — what do I do with my money?nothing changes. Stock-picking still won’t work. Quality still won’t work. So long as we hang on every word, uttered or unuttered, by our monetary policy Missionaries, so long as we compel ourselves to pay attention to Monetary Policy Theatre, then we will still be at sea in a policy-driven market where our traditional landmarks are barely visible and highly suspect.

Here’s my metaphor for investors and central bankers today — the brilliant commercial where a woman is stuck on a date with an incredibly creepy guy who declares that “my passion is puppetry” and proceeds to make out with a replica of the woman.


What we have to do as investors is exactly what this woman has to do: get out of this date and distance ourselves from this guy as quickly as humanly possible. For some of us that means leaving the restaurant entirely, reducing or eliminating our exposure to public markets by going to cash or moving to private markets. For others of us that means changing tables and eating our meal as far away as we possibly can from Creepy Puppet Guy. So long as we stay in the restaurant of public markets there’s no way to eliminate our interaction with Creepy Puppet Guy entirely. No doubt he will try to follow us around from table to table. But we don’t have to engage with him directly. We don’t have participate in his insane conversation. No one is forcing you keep a TV in your office so that you can watch CNBC all day long!

Look … I understand the appeal of a good marketing campaign. I live for this stuff. And I understand that we all operate under business and personal imperatives to beat our public market benchmarks, whatever that means in whatever corner of the investing world we live in. But I also believe that much of our business and personal discomfort with public markets today is a self-inflicted wound, driven by our biological craving for Narrative and our social craving for comfortable conversations with others and ourselves, no matter how wrong-headed those conversations might be.

Case in point: if your conversation around actively managed stock-picking strategies — and this might be a conversation with managers, it might be a conversation with clients, it might be a conversation with an Investment Board, it might be a conversation with yourself — focuses on the strategy’s ability to deliver “alpha” in this puppeted market, then you’re having a losing conversation. You are, in effect, having a conversation with Creepy Puppet Guy.

There is a role for actively managed stock-picking strategies in a puppeted market, but it’s not to “beat” the market. It’s to survive this puppeted market by getting as close to a real fractional ownership of real assets and real cash flows as possible. It’s recognizing that owning indices and ETFs is owning a casino chip, a totally different thing from a fractional ownership share of a real world thing. Sure, I want my portfolio to have some casino chips, but I ALSO want to own quality real assets and quality real cash flows, regardless of the game that’s going on all around me in the casino.

Do ALL actively managed strategies or stock-picking strategies see markets through this lens, as an effort to forego the casino chip and purchase a fractional ownership in something real? Of course not. Nor am I using the term “stock-picking” literally, as in only equity strategies are part of this conversation. What I’m saying is that a conversation focused on quality real asset and quality real cash flow ownership is the right criterion for choosing between intentional security selection strategies, and that this is the right role for these strategies in a portfolio.

Render unto Caesar the things that are Caesar’s. If you want market returns, buy the market through passive indices and ETFs. If you want better than market returns … well, good luck with that. My advice is to look to private markets, where fundamental research and private information still matter. But there’s more to public markets than playing the returns game. There’s also the opportunity to exchange capital for an ownership share in a real world asset or cash flow. It’s the meaning that public markets originally had. It’s a beautiful thing. But you’ll never see it if you’re devoting all your attention to CNBC or Creepy Puppet Guy.

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Hobson’s Choice


If you don’t like what’s being said, change the conversation.

– Don Draper, Mad Men: “Love Among the Ruins” (2009)

It is better for reputation to fail conventionally than to succeed unconventionally.

– John Maynard Keynes, “The General Theory of Employment, Interest, and Money” (1936)

– “Five Easy Pieces” (1970)
Bobby: What do you mean you don’t make side orders of toast? You make sandwiches, don’t you?
Waitress: Would you like to talk to the manager?
Bobby: You’ve got bread and a toaster of some kind?
Waitress: I don’t make the rules.
Bobby: Okay, I’ll make it as easy for you as I can. I’d like an omelet, plain, and a chicken salad sandwich on wheat toast, no mayonnaise, no butter, no lettuce, and a cup of coffee.
Waitress: A number two, chicken salad san, hold the butter, the lettuce, and the mayonnaise, and a cup of coffee. Anything else?
Bobby: Yeah. Now all you have to do is hold the chicken, bring me the toast, give me a check for the chicken salad sandwich, and you haven’t broken any rules.
Waitress: You want me to hold the chicken, huh?
Bobby: I want you to hold it between your knees.
Waitress: You see that sign, sir? Yes, you’ll all have to leave. I’m not taking any more of your smartness and sarcasm.
Bobby: You see this sign? [sweeps all the water glasses and menus off the table]

Honestly, if you’re given the choice between Armageddon or tea, you don’t say “what kind of tea?”

– Neil Gaiman (b. 1960)

In the end the Party would announce that two and two made five, and you would have to believe it. … The heresy of heresies was common sense. And what was terrifying was not that they would kill you for thinking otherwise, but that they might be right.

– George Orwell, “1984” (1949)

You had a choice: you could either strain and look at things that appeared in front of you in the fog, painful as it might be, or you could relax and lose yourself.

– Ken Kesey, “One Flew Over the Cuckoo’s Nest” (1962)

And, first, we will ask you to consider with us, how and in what respect the kings of Argos and Messene violated these our maxims, and ruined themselves and the great and famous Hellenic power of the olden time. Was this because they did not know the truly excellent saying of Hesiod, that the half is often greater than the whole?

– Plato, “The Dialogues of Plato: Laws, Book III” (c. 370 BC)

Some people see the glass half full. Others see it half empty. I see a glass that’s twice as big as it needs to be.

– George Carlin (1937 – 2008)

Five Easy Pieces for the World-As-It-Is


Our story so far…

In the second half of 2014, export volumes in every major economy on Earth began to decline, the result of divergent monetary policies that crystallized with the Fed’s announced tightening bias in the summer of 2014. This decline in trade activity – which is far more impactful than a decline in trade value, because it means that the global growth pie is structurally shrinking – accelerated in 2015 and 2016 as Europe and Japan intentionally devalued their currencies to protect their slices of the global trade pie. In game theoretic terms, Europe and Japan have been “free riders” on the global system, using currency devaluation to undercut the prices of competing US and Chinese products in a way that avoids domestic political pain.

But if there’s an iron law of international politics, it’s this: once the strategic interaction between nations begins to shift from cooperation to competition, once a principal player decides to defect and go for free rider benefits, then the one and only equilibrium of the new game has ALL principal players abandoning cooperation and competing with each other. Moreover, once one principal player begins to compete with a new and terrible weapon (i.e., mustard gas in World War I or negative interest rates in monetary policy or Trump-esque debate tactics in a Republican primary), then all principal players must adopt those tactics or lose the game. Universal competition is a highly stable equilibrium, both on the international stage and the domestic stage, particularly in the way it plays out in domestic politics, where there is never a shortage of populist politicians ready and willing to blame global trade for a host of ills. And because universal competition is such a stable equilibrium, typically only a giant crisis – one that shakes the principal players to their domestic political cores – gets you back, maybe, to a Cooperative game.

 Yikes, that sounds pretty dire, Ben. Are you sure? What about some prominent sell-side economists who recently published notes saying that you’re wrong about global trade? While it’s true, say these voices of consensus, that global trade values as measured in dollars are declining as commodities slide and the dollar gets stronger, aggregate global trade volumes are not contracting, so we really don’t have anything to worry about.

Hmm … here’s what the World Trade Organization (the gold standard in the field) says about seasonally-adjusted quarterly export volumes in the four economies that matter for international relations. The chart below starts with the low-water mark of all four geographies in Q1 2009, draws a line to the respective high-water marks hit in the second half of 2014, and then connects to the current index value. I find this sort of minimum-to-maximum-to-current data representation to be a very effective way of isolating inflection points in data series that should (if all is well with the world) grow at a pretty steady linear clip. And no, that’s not an error in the Japan and China graphs. Both countries’ export volumes peaked more than 5 years ago, essentially flatlined (a dip and recovery around the European crisis of 2012 not shown), and rolled over in late 2014. It’s pretty stunning, right? This is the primary reason why I think Japan gets no respect with their monetary policy experiments, and why I think we are already past the event horizon for China to float or otherwise devalue their currency. China has been trying to jumpstart industrial production growth for years now, nothing has worked, and the downturn since Q3 2014 not only puts them embarrassingly behind both the US and Europe in export activity, but also gives the lie to the idea that they can stimulate their way out of this.

Source: World Trade Organization, as of 12/09/15. For illustrative purposes.

To paraphrase George Soros, I’m not expecting a shrinking of the global trade pie and an expansion of competitive, protectionist domestic policies; I’m observing it. Something derailed the global trade locomotive in the second half of 2014, and it doesn’t take a genius to figure out that this something was divergent monetary policy, with the Fed embarking on a public quest to tighten, and the rest of the world doubling down on monetary policy easing. This is Exhibit 1 to support the case that we’ve entered a new, more competitive international political environment, as all four major global economies suffer a simultaneous contraction in trade volumes. I’m often asked what would need to happen for me to change my structurally bearish views about the world. So here you go. If this chart changes, then my views will change.

As you can see, the published WTO data currently goes through Q3 2015. Now maybe the Q4 2015 WTO data will come out and show a new high-water mark for these principal players in the global economy. But I don’t see how. First, I’ve looked at Q4 year-over-year trade values in local currency. Not a perfect measure of volumes, but indicative. The US, Japan, and China are all clearly down year-over-year in Q4; it’s hard to tell for the EU without including intra-EU trade. Second, I’ve looked at the raw data of container volume in the major ports in the world. 2015 data isn’t available for China and Japan, but partial data is available for the largest EU port (Rotterdam) and full data for the largest two US ports (Los Angeles and Long Beach). Rotterdam is down a little in 2015 total volumes; Los Angeles and Long Beach are down a lot in export volumes, with the declines accelerating in Q4 (partially labor issues, but still). Want more? Read this FT article on structural shifts in global trade. Read this WSJ article on the expanding January US trade deficit driven by disappointing exports, or this WSJ article on enormous new US tariffs on Chinese cold-rolled steel (while you’re at it, look who the biggest direct beneficiary of these tariffs is: Indian mega-billionaire Lakshmi Mittal … I swear to god, you can’t make this stuff up … and you wonder why Bernie Sanders strikes a chord with his message?). Take a look at Chinese electricity consumption data for 2015 (highly correlated with industrial production) and tell me that we’re not seeing continued declines.

How, then, do consensus sell-side analysts claim that global trade volumes are increasing? Two ways. First, they include countries that don’t matter, like Canada and Brazil. Sorry, my friends to the north and south, but you can increase your export volumes all you like and it matters not to the Great Game. Second – and this is the really egregious data interpretation mistake – they report global trade growth byincluding intra-EU trade! It’s a statistic that the WTO reports (as they should), and they include it in their aggregated global trade number (as they should). But if you can’t see that you need to back this number out if you’re trying to understand the strategic interaction between central banks … if you can’t see that intra-EU trade is as extraneous to this analysis as trade between Texas and California … well, I really don’t know what to say.

Now even though I think it’s totally disingenuous to claim that all is well with global trade volumes, I will be the first to admit that all is not lost. Yet.

First, export volumes have rolled over since the second half of 2014, but they haven’t collapsed, certainly not in the US, anyway. Export values, on the other hand, have taken a nose dive, particularly in the US (the total value of merchandise goods exported by the US is currently off more than 15% from its high-water mark). Keep in mind, though, that I don’t think that a decline in export values is as much of an emergency alarm as a decline in volumes. Why? Because a decline in export values impacts industrial sector earnings, while a decline in export volumes impacts actual industrial sector production. I think this is exactly why we’ve seen an earnings recession in the US, particularly in any sector with a connection to trade, but not a jobs recession. When export values decline, companies are missing their revenue targets. When export volumes decline, companies are shutting down factories. This is the big question I have for the US economy: will export volume declines start catching up to export value declines? If yes, then I think we’re going to have a “real” recession. If no, then I think we’re likely to muddle through in the real economy.

Second, it’s not like you can hide the fact that this enormous barge called global trade has reversed course over the past year and a half, and it’s not like central bankers or the IMF are oblivious to what’s going on. They’re going to respond, and who knows, maybe they’ll be successful in turning this barge back around. I don’t think they have the proverbial snowball’s chance, for reasons I’ll talk about in a second, but they’re certainly going to try.

Here’s a chart of the CDS spread (the premium you have to pay to insure your bond against default) for a senior credit index of the 33 largest European financial institutions as of February 8. I used this chart in the Epsilon Theory note “Snikt” to show what it looks like when the claws of systemic risk pop out.

© Bloomberg Finance L.P., as of 02/08/16. For illustrative purposes.

But now here’s a chart of the same CDS spread as of March 11. We’ve retraced the entire move.

© Bloomberg Finance L.P., as of 03/11/16. For illustrative purposes.

What happened? Exactly what happened in August 2012, the last time Draghi built up huge expectations for a miracle cure, blew the press conference, and had to be bailed out by the Powers That Be. In short, I suspect that the allocation heads at one or two European mega-insurance firms were informed that they would be supporting risk assets, I can observe how the Narrative machine got into gear, and I am certain that real world investors do what they always do, they play the Common Knowledge Game. Hopefully, if you’ve seen this movie before, you traded around the spike in February, got out of the position entirely, and are looking for a reprise.

Is there some reality to what the Narrative machine is pumping out? Sure, there always is. I think we have to take seriously the idea that the G-20 Shanghai meeting of the world’s central bankers and finance ministers in late February was more productive than anyone thought, and that maybe the joint communiqué calling for fewer beggar-thy-neighbor currency devaluations is a temporary truce of sorts. What would this truce look like? China agrees to give it the old college try one more time with domestic credit expansion and money printing, in an effort to replace feeble foreign demand for their products with goosed-up domestic demand and fiscal deficit spending. Europe agrees to lower its negative rates as little as humanly possible, and instead concentrate on good old-fashioned asset purchases. The US agrees to sit on its hands for a while with any more rate hikes, and Japan agrees to sit on its hands for a while with any more rate cuts. Sounds like a plan to me.

So we’re in the early days of a perfectly investable rally, driven by a plausible Narrative of central bank cooperation on currencies. Reminds me for all the world of September 2007, right after every quant-oriented multi-strat fund in the world was gob-smacked in July and August (and if you’ve seen the returns for quant-oriented multi-strat funds this January and February you’ll get my point). We had a perfectly investable rally then, too, driven by the Bernanke Narrative that the sub-prime crisis was “contained” and that the real economy was just in a “mid-cycle slow-down”. All good, until Bear Stearns was taken out into the street and shot the following March. Which was itself followed by a perfectly investable rally from April to mid-summer 2008, under the pervasive Narrative that “systemic risk was off the table.” Until it wasn’t.

So forgive me if I call this a temporary truce, an investable rally before the next “shock” that no one sees coming. Forgive me if I note that yet another FT puff piece on the unappreciated genius of Mario Draghi is ultimately small comfort given that we are smack-dab in the middle of an endemic of political polarization and anti-liberal sentiment (that’s small-l liberalism, of course, the Adam Smith and John Locke sort), the sort of political plague that the world hasn’t seen since the 1930s.


We are now in a world where principled politicians are called fascists, and fascist politicians are called principled. In most Western countries, we are one Reichstag Fire away from a complete up-ending of the core liberal principles of limited government and individual rights. At least the ascendant candidates on the right have the guts, for the most part, to wear their authoritarianism on their sleeves. The other side of the political spectrum, equally ascendant, is no less anti-liberal, they’ve just adopted the façade of smiley-face authoritarianism.

Politics always trumps economics, and until someone can show me that the structural advance in anti-liberal politics is any less pronounced than the structural decline in global trade volumes, I can’t get away from my structurally bearish views about this market. Or about this world, for that matter.

So what do we do about it?


After all, as fictional gangster Hyman Roth, patterned after real-life gangster Meyer Lansky, would say, “This is the business we have chosen.” It’s all well and good to bemoan the thin gruel we are served in modern politics and markets, but it’s the only food we’ve got, and we have a responsibility to make the most of it. I’ve got some ideas, but to be useful, these ideas need to fit the reality of the investment world and the business we have chosen. Let’s talk about that for a minute.

I think that many investors, allocators, and financial advisors today find themselves in the position of Bobby Dupea, the character played brilliantly by a young Jack Nicholson in “Five Easy Pieces.” In that movie’s iconic scene, Bobby just wants to get a side order of wheat toast with his breakfast at the local diner. But he is faced with what game theorists call a Hobson’s Choice, which is part of a more general class of games that includes ultimatums and dilemmas. A Hobson’s Choice is best understood as a strategic interaction where you are presented with what at first glance seem to be multiple opportunities for free will and free choice, but where in truth you only have a single option. Bobby has an entire menu to choose from, and the diner makes toast for sandwiches all day long, but it is impossible – despite a smart proposal of pair trades and long/short exposures that would isolate the wheat toast factor – for Bobby to get what he wants. He can have an omelet with a roll, or he can have nothing. Those are his true choices.

A Hobson’s Choice is Henry Ford telling you that you can have your Model-T in whatever color you like, so long as it’s black. A Hobson’s Choice is a Klingon telling you to surrender or die. A Hobson’s Choice is Vito Corleone making you an offer that you can’t refuse.

Today we have what appears to be a wide-ranging menu of investment strategies and ideas to choose from. But like Bobby Dupea, our true range of choices turns out to be terribly limited if we show the least preference for something that goes against the grain of conventional wisdom. Specifically, the dominant conventions of modern investment are “stocks for the long haul”, “you can’t time markets”, “focus on the fundamentals”, and “buy quality”. Everything you order from the investment menu has these conventional items embedded within them, and the more you question the conventional wisdom (not that it’s all wrong or a big lie, but simply to inquire whether the conventional wisdom is perhaps less useful in unconventional times, and maybe – just maybe – you might want to have some wheat toast with your omelet) the more you risk getting kicked out of the diner.

The Hobson’s Choice that nearly every investor, allocator, or financial advisor faces today is always some variation of the famous quote from John Maynard Keynes: it’s better for your reputation (i.e., your business) to fail conventionally than to succeed unconventionally. Every investment professional I’ve ever met – every. single. one. – wrestles with this dilemma. So do I. We’ve all seen examples in our portfolio results that the conventional tools aren’t working. We know that the words we hear from our Dear Leaders and the articles we read from our Papers of Record are designed to manipulate and entertain us, not inform us. We want to succeed, and we feel in our gut that we should be trying something new and (maybe) better. But not if it means losing our clients or losing the support of our Board or losing the support of that little voice of convention inside each of our heads. It’s that last bit that’s probably the most powerful. As George Orwell so correctly observed about human psychology, the most terrifying part of hearing Big Brother say that two plus two equals five isn’t that they might kill you for believing otherwise, but that you think they might be right!

And make no mistake about it, our Hobson’s Choice is getting worse. Investing according to conventional wisdom has always been the reputationally safe decision, but in the policy-controlled markets to come, investing according to conventional wisdom may well be the only legally safe decision.

So here’s what I’m not going to do. I’m not going to discuss “alternative strategies” that are always set off to the side in a little section of their own on an investment menu, intentionally organized and presented as if to say “Careful now! Here are some exotic side dishes that you might use to spice up your core portfolio a bit, but you’d be crazy to make a meal out of this … not that we’d let you do that anyway.” I’m not going to perpetuate the Hobson’s Choice game and its charade of false choices and hidden ultimatums. Instead, I’m going to recommend alternative thinking about your portfolio here in the Silver Age of the Central Banker. I’m going to recommend five specific ideas – Five Easy Pieces – that challenge conventional wisdom and (I hope) will spark readers to think differently about their entire portfolio and investment process, not just whatever small slice of the pie is reserved for “alternative strategies”.

Five Easy Pieces for the World-As-It-Is


Because this is how we escape a Hobson’s Choice. We must look beyond the false choice. We must reject the ultimatum (act conventionally or risk your business) and find a new dimension that avoids the false choice entirely. This was the genius of Mad Men‘s Don Draper: “If you don’t like what’s being said, change the conversation.” Or to use a far more trite and shop-worn phrase, this is what “thinking outside the box” means – expanding our field of vision to incorporate not only the specific choice we’re presented with, but also the act of choosing. To escape a Hobson’s Choice we can’t look at the world as (x) OR (y), as a series of choices we make from a menu that’s handed to us. We have to step back and see the menu itself as a choice, that what we thought was (x) OR (y) is really (x OR y), and there’s a big world outside of (x OR y). Expanding our perspective and changing our conversation changes everything. It allows us to re-engage in an entirely new way with whatever investment menu we might have in whatever our World-As-It-Is might be, such that whatever investment decisions we make are truly OUR choices, not THEIR choices. Maybe for the first time.


This is a good example of what I’m talking about. Investment convention holds that you should be fully invested throughout a market cycle. Otherwise you must be—gasp!—a market timer. Boo! Hiss! If there’s a worse insult in the investment world or a quicker way to get fired by your client than to be called a market timer, I’m not aware of it. And god forbid that you actually propose an “alternative strategy” that embraces market timing. But of course, we’re ALL market timers, we just do it in a conventionally acceptable way by “shifting to defensive sectors” or “keeping our powder dry” or “managing risk” (whatever that means). We’re all hypocrites when it comes to our professed faith in full investment, because we don’t really believe in it. We all want to get out of markets when they’re going down, we all want to get into markets when they’re going up, and we all think that we have some insight into what’s next.

And that, of course, is the source of the actual wisdom in this conventional wisdom. We really don’t have a crystal ball to predict whether the market will be up or down tomorrow or over the next week or over the next month or over the next year. We really do have biologically evolved social behaviors that push us to sell low and buy high. Whatever you think you should do as a short-term trade, you’re probably wrong. Left to our own devices, almost all of us are almost always better off to put our investments in a drawer, close our eyes, and walk away.

So here’s the question. How do we change the conversation so that a rigorously conceived adjustment in portfolio exposure to risk assets isn’t characterized as market timing? Because as soon as a strategy is characterized as market timing, then it’s a Hobson’s Choice situation, where you don’t really have a choice but to reject it. Now I’m not talking about reading ZeroHedge and selling because you got all freaked out by an article, and I’m not talking about watching CNBC and buying because you got all bulled up by a talking head. That IS market timing, of an indefensible sort. But is there a defensible sort of portfolio exposure adjustment, one that has a foundation strong enough to allow a non-Hobson’s Choice implementation? My answer: yes. In fact, I think there are two such approaches.

First, markets are more volatile when countries are playing a Competitive game than when they’re playing a Cooperative game. Now granted, this is a prediction of a sort, but it’s a prediction of political dynamics – which is exactly what the game theory toolkit is designed to do – as opposed to a market prediction like whether the S&P 500 will be up or down next week. I think this is where Epsilon Theory can make a unique analytical contribution. The international political regime matters to markets. It matters a lot. I am convinced that we have entered a new, analyzable, competitive regime of domestically stressed nations, and that means that we have a deflationary hurricane brewing. What I don’t know (yet) is whether this is going to be a Category 1 hurricane, a Category 3 hurricane, or a Category 5 hurricane. If China floats the yuan – and that’s the big catalyst I think has a decidedly non-trivial chance of occurring – then it’s Category 5. If they don’t, it’s something less. But regardless, a Competitive global trade game is going to be a big storm. Trim your sails. Whatever that means to you and your investment process, whether it’s increasing cash, reducing net or gross exposure, shifting to long-dated Treasuries … whatever … that’s what I think you should do when the world plays a Competitive game. Does that make me a market timer? Well, if that’s the conversation you’re stuck in … yes. But it’s not the conversation I’m having, either with others or myself.

Second, although I can’t predict future market returns, I can observe how volatile the market has been in the short, medium, and long-term past. It’s that George Soros quote again: I’m not predicting; I’m observing. I can also tell you about my personal appetite for risk and volatility. Put these two items together and you have the foundation for a new conversation about investing, a conversation based on observable risk rather than predicted reward. Is observed volatility going up above a level where I am personally comfortable? Well, let’s take my market exposure down. Is observed volatility going down below that level? Well, let’s take my market exposure up. There are a dozen variations on this theme: call it risk balancing or risk parity or volatility targeting or whatever. But whatever you call it, I think it is a better way of staying invested in markets through thick and thin. Just less invested when thick and more invested when thin.

A systematic risk balancing strategy is at the core of what I have been describing as Adaptive Investing over the past two years. That and an appreciation for the political dynamics that underpin markets, creating different investment regimes as the game-playing moves from one equilibrium state to another. There is zero crystal ball gazing in a risk balancing strategy – zero. In that sense it is entirely compatible with the investment convention of not trying to time markets. But the alternative thinking I’m suggesting here is that “full investment over a market cycle” works better if it’s risk being fully invested over a market cycle, not dollars. It’s a new twist on an old idea, and once you start thinking of risk budgets first and dollar budgets second, everything changes.


The usefulness of the game theory toolkit isn’t limited to understanding the dynamics of strategic interactions between international political players like central banks. It’s also useful in understanding the dynamics of strategic interactions between market players. It’s also the rigorous foundation for changing the conversation about another market convention: focus on the fundamentals. Are fundamentals important? Of course they are. Knowing the fundamentals of an investment is like knowing how to play the cards you’re dealt in a poker game. But as any successful poker player will tell you, it’s not enough to play the cards well. More importantly, you also have to play the player.


Wall Street players today aren’t like a historical Jay Gould or a fictional Gordon Gecko, ruthless seat-of-their-pants robber barons with a great eye for arbitrage and leverage. To be sure, it’s not the ruthless part that’s missing today, or the eye for arbitrage and leverage. No, what’s changed from the past and what Hollywood still doesn’t get is that the whole instinctive, seat-of-the-pants thing is totally dead.


Wall Street players today are creatures of process. They are Bill Belichick and Nick Saban, seemingly joyless automatons who do nothing but win (Roll Tide!) because they are monomaniacally focused on efficient process in every aspect of their organization and constant incremental adaptation to new information. It’s not just the quants that have uniformly adopted a process-focused business strategy, but every successful investment firm, regardless of discipline or market focus. Ray Dalio at Bridgewater, certainly the most out-there proponent of Belichick-ian process discipline in the investment world, is best known for creating the largest hedge fund in the world. More interesting to me, though, is how the meme of process and incremental adaptation – principally authored by Dalio – is now part of the internal Narrative of every investment firm on Earth. Note that I’m saying this meme is part of the Narrative of these firms, not their investment DNA. Like all good memes, the belief in process and incremental adaptation is principally an instrument of internal social control, part of the modern day Panopticon (“what, you don’t believe in process? hmm, not sure that you’re going to fit here.”), as well as an instrument of external social expression (“you can trust us … we’re process-oriented!”).

Why is this primacy of process so important for understanding market dynamics? Because it means that while there is no single mode of market participant behavior, no single way of playing the market game, there is an underlying dimension – a common behavioral denominator, if you will – of prioritizing process and incremental adaptation. To torture the poker analogy a bit more, you have tens of thousands of poker tables in operation every day, with hundreds of different poker variations being played … No Limit Texas Hold ‘Em here, 5 Card Draw there, etc. Some players have big stacks, some have small stacks, some play tight, some play loose. But they are ALL process-oriented players. They are ALL watching each other and the cards closely, they are ALL reacting to each other and the cards in an incremental process-oriented way, and they are ALL “learning” in an incremental process-oriented way.

I don’t think you have to be a poker expert to recognize that there’s game-playing power to be found in the recognition of a common behavioral denominator, no matter how deeply it runs. In truth, the deeper it is, the more powerful it is. This is the structural reason why the Common Knowledge Game is such a useful way to analyze market dynamics in the modern age. The market-playing crowd is always looking at the market-playing crowd, and the crowd is hardwired – not by biology but by business process – to “learn” a similar reaction to similar Missionary statements.

This is also the structural reason why I believe trend-following strategies are so interesting and effective in modern markets. In a very real sense, all of these process-focused and iteratively-learning investors are themselves augmenting whatever initial stimulus they’re all looking at, creating trends where none was present before. If you’ve never read George Soros’s “Alchemy of Finance”, now might be a good time to start. What’s perhaps even more interesting – and this will have to be a tease because it deserves several Epsilon Theory notes on its own – is whether it’s possible to design alearning-following investment strategy. Now that would be something.


Okay, this is a big one. What is negative carry? It’s time working against you. It’s the price you pay to carry or hold a position. Investors HATE negative carry, because almost all investment conventions are based on the assumption that time works for you, not against you. What’s the basis of “stocks for the long haul”? Time working for you. What’s the basis of compounding, which is nothing less than the most powerful investment idea in all of human history? Time working for you. What’s the basis of retirement planning, saving, and – in a very real sense – the entire concept of investment? Time working for you.

The damaging impact of negative interest rates on bank earnings and all that is very true and very real. But far more damaging is the impact of negative interest rates on these basic IDEAS about what it means to be an investor in public markets. If you see the world as principally a market of ideas and memes, rather than as a market of capital and labor – and this is exactly the perceptual lens I’m trying to explore with Epsilon Theory – then I don’t see how you can’t be freaked out by what’s happening today. Certainly it’s why I’ve gotten much more alarmist over the past few months in what I write. We are seeing huge chunks of stone being taken out almost daily from these central idea pillars of public markets. As market participants lose faith in the idea that time is on your side, as they start to question the idea that there’s an inherent up-and-to-the-right arrow to any price-over-time chart … the entire financial advisory world is going to burn.

So what do you do?

I suggest we start thinking like a short seller. We don’t have to BE short sellers, but we all need to THINK like short sellers. Why? Because short sellers naturally live in a negative carry world, both in their investments and their ideas. Dividends and yield-bearing securities constantly chip away at the value of a short seller’s portfolio. Similarly, the long-biased information flow promoted by corporate management and the sell-side constantly chips away at the investment theses embedded in a short seller’s portfolio. Time always works against a short seller (particularly in a zero or negative interest rate world … boy, do I miss the 5% interest paid on the cash generated from borrowing shares), and successful short sellers have learned to think differently as a result.

1) If you’re wrong on timing, you’re just wrong. A successful short seller focuses on near-term catalysts, and that’s exactly the focus that I think most investors could adopt, or at least incorporate, in this environment. If there’s no catalyst to force investors to recognize the value that you think exists in a stock, then it doesn’t exist. When a short seller reads a sell-side buy recommendation that begins with something like “For the patient, long-term investor…” they almost always look to short the stock, because it almost always means that the near-term catalysts are very negative for the company. But by the same token, a long-biased investor who thinks like a short seller is happy to buy a company with positive near-term catalysts even if the long-term prospects don’t look so great. In fact, that’s exactly how I would characterize risk assets in general today – structurally awful in the long-term as global trade and global cooperation and the idea of a positive risk-free rate and the liberal tenets of free markets die a little more every day, but with positive short-term catalysts as central bankers and their sell-side apologists rally the troops one more time. Every position is a rental if you’re thinking like a short seller.Nothing is owned.

A catalyst-oriented, everything-is-a-rental way of thinking sounds easy, but it’s the hardest thing you’ll ever do. It’s hard because it’s utterly unforgiving. Meaning, you can never forgive yourself. Here are the two thought processes that have ruined more catalyst-oriented investors than anything else:

“Huh? No price reaction yet to this realized catalyst that I so brilliantly anticipated? Well, I suppose the market just needs a little more time to absorb its importance.”

“Golly, the earnings call just ended and the company didn’t make the announcement I thought they would. Oh, well, I’m sure they’ll announce it next quarter.”

Bzzzzt! Sorry, that’s our tacky buzzer and you’ve just been eliminated from the game. When the catalyst happens – whether or not it impacts the price of the stock or bond like you think it should – you get out. If the time frame or event frame for the catalyst expires – whether or not the catalyst actually occurs – you get out. Thinking like a short seller means no excuses, particularly in the easiest place to make excuses – inside our own heads.

2) The question that really matters: is the story broken? I’ve written about this at length, so I won’t repeat all that here. But I’ll give you an example of a story that ALWAYS breaks in a squirrely market: financial engineering. If you’re long a company because “management is buying back lots of stock” or “there’s a tax-advantaged spin-out possible here” or something similar … well, good luck with that in a risk-off environment. I’m not saying that financial engineering is bad. On the contrary, I love financial engineering. Seriously. It’s an incredibly powerful tool for potentially making money. What I’m saying is that a financial engineering STORY is inherently pro-cyclical – it always works better than you expect in a rising market and worse than you expect in a declining market. A stock with a broken story will go down a lot more than what’s “fair”, and that’s a very unpleasant ride. Fortunately, all stories heal and all stories evolve, which makes for some potential buying opportunities. But you won’t recognize those opportunities (or you’ll probably butcher the timing) unless you’re focusing on what really matters – the story.

So what strategies inherently “think” like a short seller? Managed futures and trend-following, for sure. Everything is a rental for a trend follower, by definition, and trends – because they are created by market behaviors, not the underlying qualities of a company – are inherently linked to the stories and narratives that shape behavior. More basically, any trader and any trading strategy tends to think like a short seller, and I believe there’s room for these strategies to work in markets dominated by a Competitive international game. Ditto for some global macro strategies. Doesn’t mean any of these strategies will work, of course, only that they possess what I think are some of the necessary qualities (as opposed to the sufficient qualities) to succeed.

But when I say it’s important to think like a short seller in a negative carry world, I don’t mean that we have to go out and hire short selling managers. Because I will tell you that there are plenty of short sellers who think like long-only guys, and are thus the worst possible discretionary managers to turn to in this environment. The really crucial action, though, and it’s an action we can all take inside our own heads even if we’re not able or not allowed to actually do short selling, is to step back and reconsider all of our investment menu choices if time no longer works so clearly in our favor. That’s the existential issue every investor, allocator, or advisor needs to wrestle with, no matter how painful that is. Otherwise, to use Ken Kesey’s phrase from “One Flew Over the Cuckoo’s Nest,” you’re choosing to let yourself be lost in the fog. And that’s a Hobson’s Choice of an entirely different sort.


I’m pretty sure that I was the first to come up with the phrase “Central Bank Omnipotence.” It was in one of my very first notes – “How Gold Lost Its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories” – back in the summer of 2013, a note that even today remains one of the most popular in the Epsilon Theory canon. For the next six months or so, however, I would go around and talk with institutional investors about the Narrative of Central Bank Omnipotence – that markets acted as if central bank policy determined market outcomes – and I got enormous pushback. No, no, I heard, we’re on the cusp of a self-sustaining real economic recovery here in the US, and whatever the Fed and other central banks are doing, whatever the market reaction might be, it’s just a bridge to the happy days of “normal” markets ahead. And this is after the Taper Tantrum, mind you. It really wasn’t until the spring of 2014 that the steady drip, drip, drip of the Central Bank Omnipotence meme became a tsunami, and by the fall of 2014 it was impossible to find anyone who didn’t believe in their heart of hearts that Central Banks, for good or for ill, determined market outcomes.

I bring this up because I’ve read lots of suggestions, particularly after the one day half-life of effectiveness for Kuroda’s negative rates announcement on January 28 and the one hour half-life of effectiveness for Draghi’s negative rates announcement on March 11, that the Narrative of Central Bank Omnipotence is dying. But then you get a day like March 12, where the Narrative engine springs to life in support of Draghi’s “bold move”, and now I read that the Narrative of Central Bank Omnipotence is alive and well.

Here’s what I think. As the strategic interaction between the four largest economies in the world shifts from self-enforced cooperation to self-enforced competition, from a Golden Age to a Silver Age, so does the market’s Common Knowledge or Narrative regarding that strategic interaction. But it doesn’t die, any more than the strategic interaction dies. Think of it as the same song, but now in a minor key. So long as every CNBC talking head genuflects in the direction of central banks in every single conversation, so long as front page articles about central banks dominate every day’s issue of the WSJ and FT … then the Narrative of Central Bank Omnipotence is alive and well. The power of the Narrative is that we believe that all market outcomes are somehow the result of central bank policy, not that central bank policy necessarily generates a good or even intended market outcome. It’s a narrative of Omnipotence, not Competence or Omniscience. The day that central bankers give up, the day that Yellen or Draghi appears on stage and says, “Well, there’s really nothing more we can do. It’s just out of our hands now. Sorry ’bout that.” … that’s the day that we lose our religion and the Narrative dies.

Ultimately, we’re no closer to “normal” markets driven by fundamentals here in the Silver Age of the Central Banker – the age of strife and competition – than we were in the Golden Age of the Central Banker – the age of cooperation and great deeds. In fact, we’re farther away than ever. It’s a policy-driven market just as far as the eye can see.

Policy-driven markets change the rules, both the formal rules of regulation and – more importantly – the informal rules of correlation, and they change these rules in predictably surprising ways. That is, the regulatory rule changes will always be surprisingly to the left or surprisingly to the right, never what you might expect by a central tendency theorem. That goes for correlation surprises, too. Both tails are equally fair game for a shock. I mean, the euro had a four percent trough to peak move on March 11! Two percent down and then two percent up. You think that didn’t blow up some correlation and volatility trades?

When I say don’t trust the models – and by models I mean pretty much of all mainstream portfolio and investment analysis, basically anything that says “Here’s a pattern we observe from some period of time over the last 40 years, and now we’re going to extrapolate what the future holds because of that observed pattern.” – I mean two things. First, we haven’t had a policy-driven market like this since the 1930s, so whatever historical data was used to power whatever model you’re using needs to be taken with a grain of salt (read “I Know It Was You, Fredo“, “Inherent Vice“, “Funny How?“, and “Ghost in the Machine” for more, and of course you can read anything by Nassim Nicholas Taleb or Benoit Mandelbrot for the same message presented in book form). Second, investors are not only risk/reward maximizers, but they are also regret minimizers. Almost all of modern econometrics, particularly portfolio analysis, is an exercise in risk/reward maximization and thus fails to connect with investors who are focused on concerns of regret minimization (read “It’s Not About the Nail” for more).

What this means in practice is that most portfolios are too flabby in what I’ll call the Big Middle – the large portfolio allocation that most investors, large and small, maintain in large cap stocks. The easy way out when it comes to investment conventions and the Hobson’s Choice we all face when it comes to portfolio construction is always to add more S&P 500 exposure. The old IT saying used to be that no one ever got fired for buying IBM, and the current financial advisory saying should be that no one ever got fired for buying more Apple. Although maybe they should.

I’m not saying that capital invested in the Big Middle must always be reallocated to make for a more convex, more diversified portfolio. But I am saying that every bit of your portfolio should be purposeful. I am also saying that there’s a lot of wisdom for investing in what Plato said about politics almost 2,500 years ago (and he was quoting a guy who lived 400 years earlier), that the half is often greater than the whole. Meaning? Meaning that you get better outcomes when half of your citizens or half of your investments are organized efficiently and with right purpose than if all your citizens or all of your investments are organized haphazardly or without common purpose. Or for a more modern slant, I like George Carlin’s take, that while some see a glass half-full and some see a glass half-empty, he sees a glass that’s twice as big as it needs to be. Many portfolios are twice as big as they need to be. Not in dollars, of course (may your portfolio get much larger in that regard), but in terms ofinefficient, mushy allocation to low risk, low reward, highly correlated investments.

What goes into a purposeful portfolio in the Silver Age of the Central Banker? A lot of optionality, for one thing, which does not necessarily require expression through options and derivatives (although that certainly makes it easier) and is another way of saying convexity. A keen sense of correlation and correlation change, for another, which does not necessarily require expression through covariance matrices (although that certainly makes it easier) and is another way of saying diversification. While the terms can be daunting, the logic and practice aren’t so much. Like thinking in terms of a risk budget instead of a dollar budget, it’s more of a matter of perspective than anything else.

One exercise I find useful is to think of different future scenarios for the world (not because I’m trying to predict which one will happen, but precisely because I can’t!) and then to consider how my current exposures and strategies are likely to fare in those futures. My goal isn’t to figure out the scenario where I think I’ll do the best, because then I’ll start hoping for it and consciously or unconsciously will start to assign a higher probability of it occurring, but to figure out the scenario where I’ll do the worst (both in absolute terms and relatively to whatever I compare myself to). I’m trying to minimize my maximum regret – minimax regret, a powerful game theoretic tool for dealing with technical uncertainty, where you’re not sure that you’ve identified all the potential outcomes and you’re certainly not sure of the probability distribution to assign to those outcomes – and I do so by planting seeds (buying exposure with either embedded or overt optionality) in that least happy scenario. I find that this iterative, new information-friendly exercise changes the conversation you can have with others or yourself, away from a needlessly daunting conversation on risk/reward maximization and towards a more fruitful conversation on being an investment survivor in a decidedly dangerous time.


And now for the big finish.

Last summer I wrote a note called “The New TVA”, which made a direct comparison between the political dynamics of the 1930s and the political dynamics of today. What amazes me (still), is how the political conversations then are almost identical to the political conversations now.


Just switch out FDR for Obama and you could easily imagine this cartoon being about healthcare or some such rather than New Deal legislation.

Here’s the skinny for that note: in the same way that FDR had an existential political interest in generating inflation and preventing volatility in the US labor market, so does the US Executive branch today (regardless of what party holds the office) have an existential political interest in generating inflation and preventing volatility in the US capital markets. Transforming Wall Street into a political utility was an afterthought for FDR, a nice-to-have but not a must-have, as Wall Street was not yet a Main Street phenomenon. Today the relative importance of the labor markets and capital markets have completely switched positions. Wall Street is now decidedly a Main Street phenomenon, and every status quo politician – again, regardless of party, and let’s remember that the Fed is part of the Executive Branch – keenly desires to keep the genie of unfettered fear and greed firmly stopped up in its bottle. Georges Clemenceau, French Prime Minister before and after World War I, famously said that “war is too important to be left to the generals.” Today, the quote would be “markets are too important to be left to investors.”

But it was only after Draghi’s ECB announcement last Thursday that I think I see how a policy-driven market becomes a policy-controlled market. The ECB took a page from the Bank of Japan’s playbook and announced that they would now buy non-bank investment grade corporate credit as part of their QE asset purchases, and that’s at least as big of a deal as the BOJ taking a page from the ECB playbook in January and adopting negative interest rates. When two of the Big 4 adopt any policy, a point becomes a line and an idiosyncrasy becomes a pattern. The direct purchase of corporate securities by central banks is now in the official tool kit of every central bank. You cannot un-ring this bell. It is a “Goodfellas moment” of enormous consequence.

In one fell swoop, Draghi has essentially made useless the most effective portfolio hedge I know against systemic risk – shorting investment grade credit through the CDS market. And he conceived this plan when senior bank debt CDS spreads (the best indicator of systemic risk levels I know) were only 120 bps wide! Imagine what’s going to happen the next time spreads blow out to 200 bps wide, much less if we ever got close to the 350 bps spread of 2011. My point, of course, is that Draghi isn’t going to allow CDS spreads to blow out again. Ever. Not even a little bit. The ECB will intervene directly in credit spreads from here to eternity, first in sovereign debt, now in non-bank corporate debt, tomorrow in bank corporate debt. That’s how a policy-driven market becomes a policy-controlled market, not by outlawing short sales or credit default swaps, but by sitting down at the poker table with an infinitely large stack of chips relative to any other player. The ECB can now run over anyone who sits down at the European corporate credit poker table. Thanks, but I’d rather not play, no matter what cards I’m dealt.

So if I can’t protect my portfolio through effective shorts, and the Powers That Be are determined to turn public markets into political utilities, but I’m structurally bearish on the ability of the Powers That Be to prevent domestic political shocks and international political conflict of 1930-ish proportions, what’s to be done with public market investing other than the occasional short-term trade? Two things, I think.

First, I think it makes sense to use public markets for their liquidity and for tapping whatever this utility-like rate of return the Powers That Be have in mind. But I also think it makes sense to tap global beta through risk balancing strategies, because I really do think we’re in for a bad storm, and I don’t trust Captain Yellen or Captain Draghi to guide the ship for my benefit rather than their own political benefit. As for any effort to find alpha in public markets? Forget it.

But, Ben, what about stock picking? Yeah, what about stock picking? You can read the S&P scorecard here. How did that actively managed US equity fund work out for you last year? Or the last 5 years? Or the last 10 years? Here’s my issue with stock picking. Most stock pickers look at companies pretty much exclusively through the lens of “quality” – a quality management team, a quality earnings profile, a fortress balance sheet, etc. Unfortunately, this is the worst possible investment perspective to use in a policy-driven market, much less a policy-controlled market. It does not outperform a broad passive index. It does not generate alpha. Again with the George Soros quote: I’m not expecting it; I’m observing it. I know, I know. Heresy. But ask yourself this. Do you really think that the mandarins of the Fed or the ECB or the BOJ care one whit about whether this company or that company has a higher stock price? Of course not. They want ALL companies to have a higher stock price, and as a result the policies they are going to implement will inevitably help the weakest, lowest quality companies the most. Now if investing in quality-uber-alles is the conventional conversation you need to have to justify participating in public markets, I get it. But to me it’s just another form of fighting the Fed, and for me it’s always a losing conversation.

Second, I think it makes sense to use public markets if that’s the best way to own real assets. Why real assets? Because while nothing is immune to the predation of illiberal governments and the capricious rule-making and rule-breaking of central banks, real assets are at least insulated from both. What real assets? I have a very broad definition, including not only the obvious suspects like real estate and infrastructure and commodities, but also gold and intellectual/digital property. Actually, I think of gold as very similar to many forms of intellectual property, as its worth is found in behavioral preferences and affect, not in some intrinsic or commercial use case.

All real assets are not created equal, of course. I’d much rather own an asset that generates some sort of cash flow than one that just sits there, but price will usually (although not always) take care of that differentiation. The most important consideration, I think, particularly when using public markets, is to get as close as you can to the fractional ownership share in the asset itself and as far away as you can from the casino chip. What that means in practice is getting as high up in the capital stack as you can while still having an equity claim on assets. For a highly levered or distressed company that probably means being in the senior secured debt. For a more typical company that might mean being in the preferred equity shares, if they exist, or choosing between this company’s equity and that company’s equity. It’s making this sort of evaluation where I think that active managers, whether it’s in equity or in fixed income, can prove themselves, and where I think there’s a role for fundamentally-oriented, stock-picking active managers. It’s not because I think they can stock pick their way to outperformance versus a passive index while we’re in a policy-driven or policy-controlled market, but because I think they can identify a margin of safety in my public market ownership of real assets and real cash flows better than a passive index. Now that’s a conversation worth having with active managers here in the Silver Age of the Central Banker.

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As longtime Epsilon Theory readers know, I’m a big comic book fan. One of the joys of a comic done well is the effective representation of a dynamic multi-dimensional narrative within a static two-dimensional art form. As the saying goes, a picture is worth a thousand words, but occasionally so is a sound. Or rather, a picture of a sound. Whether it’s the “Thwip” of Spiderman shooting his web or the “Snikt” of Wolverine popping his claws, certain classic onomatopoeias (to use the $10 word) communicate immediately everything you need to know about what’s going on and what’s about to happen.


© Marvel Characters, Inc.

So here’s another picture of a sound, another effective representation of a dynamic multi-dimensional narrative within a static two-dimensional form.


This is the market price of credit default swap (CDS) protection on the senior debt of the largest European banks and insurers over the past 6 months, and the sound you are hearing is the “Snikt” of systemic risk popping out its claws once again.

A month ago I wrote the following:

There were trades available [in 2008] that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades.

The susceptibility of credit spreads to systemic risk(s) that I was describing last month was borne out last week. Protection on the ITRAXX senior European financial debt index widened by over 45 bps from 92 bps at the close of January to 137 bps at the close on February 8, as systemic risks emanating from the deflationary hurricane coming out of Asia wreaked havoc on a financial system already reeling from the collapse of the global commodity and industrial complex. I think there’s another 50+ bps of further spread widening to go, but it’s a tougher slog from here. The money in any major market shift is generally made during the discovery phase, and once you get the third WSJ article talking about the issue (much less the thirtieth), many market participants will start trading around the position.

Now the truth is that this outcome worked faster than I thought it would, and I attribute that to two factors. First, everyone and his brother is looking for a massive correlation like this, and once George Soros and Kyle Bass and the rest of the short-the-yuan crew started talking their book on CNBC, it doesn’t take a genius to figure out what the knock-on effects of their premise might be for global recession risks and investment grade (IG) credit. But second … the speed of this outcome means that things are even worse than I thought. We don’t need a yuan float or announced devaluation to start a 1930s-esque deflationary spiral and the insanely aggressive political response to come. It’s already here.

So Epsilon Theory is ringing the bell, with three big notes over the next month or so.

First, I’ll write about the 1930s-esque deflationary spiral and why I think it’s all happening again. This is “The Thesis”, and here’s the skinny: In 1930, the United States passed the Smoot-Hawley Tariff Act, establishing a massive system of protectionist tariffs and quotas that sparked competitive protectionist measures around the world. Within a year, the largest bank in Austria, Credit Anstalt, failed, and the Great Depression was unleashed as global trade finance collapsed. Today I believe that competitive currency devaluations will lead to the failure of another massive bank, perhaps one whose native language is also German and is in fact a direct descendant of Credit Anstalt, as global trade finance collapses once again.

Second, I’ll write about what’s next. This is “Five Easy Pieces (to Wreck the World)”, and here’s the skinny in a visual format that should be familiar to anyone who’s ever taken the SAT:

Gaussian Copula : 2008     ::     Negative Rates : 2016

If you don’t know what a Gaussian copula is, do yourself a favor and read Felix Salmon’s magisterial Wired article from 2009. The Gaussian copula was the financial innovation that broke the world in 2008, and negative rates will be the financial innovation to break the world today.

Third, I’ll write about what you can do about all this. You already know part of what I’m going to say, because I’ve said it before. Now more than ever you need convexity in your portfolio. Now more than ever you need to focus on the strategies and the assets that will do well in a deflationary hurricane AND the political response to that hurricane. Once the claws of systemic risk pop out with a Snikt, you’re in for a long and bloody fight. It’s time to prepare ourselves for that fight if we’re going to be investment survivors here in the Golden Age of the Central Banker.

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You Can Either Surf, or You Can Fight

Kilgore: Smell that? You smell that?
Lance: What?
Kilgore: Napalm, son.  Nothing else in the world smells like that.

– Apocalypse Now (1979)

Hello, hello, hello, how low? [x3]
– Nirvana, Smells Like Teen Spirit (1991)

Outside the bus the smell of sulfur hit Bond with sickening force.  It was a horrible smell, from somewhere down in the stomach of the world.
– Ian Fleming, Diamonds Are Forever (1956)

There’s more than a whiff of 2008 in the air. The sources of systemic financial sector risk are different this time (they always are), but China and the global industrial/commodity complex are even larger tectonic plates than the US housing market, and their shifts are no less destructive. There’s also more than a whiff of 1938 in the air (hat tip to Ray Dalio), as we have a Fed that is apparently hell-bent on raising rates even as a Category 5 deflationary hurricane heads our way, even as the yield curve continues to flatten.

What really stinks of 2008 to me is the dismissive, condescending manner of our market Missionaries (to use the game theory lingo), who insist that the US energy and manufacturing sectors are somehow a separate animal from the US economy, who proclaim that China and its monetary policy are “well contained” and pose little risk to US markets. Unfortunately, the role and influence of Missionaries is even greater today in this policy-driven market, and profoundly misleading media Narratives reverberate everywhere.

For example, we all know that it’s the overwhelming oil “glut” that’s driving oil prices down and wreaking havoc in capital markets, right? It’s all about OPEC versus US frackers, right?

Here’s a 5-year chart of the broad-weighted US dollar index (this is the index the Fed publishes, which – unlike the DXY index and its >50% Euro weighting – weights all US trading partners on a pro rata basis) versus the price of WTI crude oil. The red line marks Yellen’s announcement of the Fed’s current tightening bias in the summer of 2014.


Source: Bloomberg, January 2016.

Ummm … this nearly perfect inverse relationship is not an accident. I’m not saying that supply and demand don’t matter. Of course they do. What I’m saying is that divergent monetary policy and its reflection in currency exchange rates matter even more. Where is the greatest monetary policy divergence in the world today? Between the US and China. What currency is the largest contributor to the Fed’s broad-weighted dollar index? The yuan (21.5%). THIS is what you need to pay attention to in order to understand what’s going on with oil. THIS is why the game of Chicken between the Fed and the PBOC is so much more relevant to markets than the game of Chicken between Saudi Arabia and Texas.

But wait, there’s more.

>My belief is that a garden variety, inventory-led recession emanating from the energy and manufacturing sectors is already here. Maybe I’m wrong about that. Maybe I spend too much time in Houston. Maybe low wage, easily fired service sector jobs are the new engine for US GDP growth, replacing the prior two engines – housing/construction 2004-2008 and energy/manufacturing 2010-2014. But I don’t see how you can look at the high yield credit market today or projections of Q4 GDP or any number of credit cycle indicators and not conclude that we are rolling into some sort of “mild” recession.

My fear is that in addition to this inventory-led recession or near-recession, we are about to be walloped by a new financial sector crisis coming out of Asia.

What do I mean? I mean that Chinese banks are not healthy. At all. I mean that China’s attempt to recapitalize heavily indebted state-owned enterprises through the equity market was an utter failure. I mean that China is going to need every penny of its $3 trillion reserves to recapitalize its banks when the day of reckoning comes. I mean that China’s dollar reserves were $4 trillion a year ago, and they’ve spent a trillion dollars already trying to manage a slow devaluation of the yuan. I mean that the flight of capital out of China (and emerging markets in general) is an overwhelming force. I mean that we could wake up any morning to read that China has devalued the yuan by 10-15%.

Look … the people running Asian banks aren’t idiots. They can see where things are clearly headed, and they are going to do what smart bankers always do in these circumstances: TRUST NO ONE. I believe that there is going to be a polar vortex of a credit freeze coming out of Asia that will look a lot like 1997. Put this on top of the deflationary impact of China’s devaluation. Put this on top of an inventory-led recession or near recession in the US, together with high yield credit stress. Put this on top of massive market complacency driven by an ill-placed faith in central banks to save the day. Put this on top of a potentially realigning election in the US this November. Put this on top of a Fed that is tighteningStorm warning, indeed.

So what’s to be done? As Col. Kilgore said in “Apocalypse Now”, you can either surf or you can fight. You can adopt strategies that can make money in this sort of environment (historically speaking, longer-term US Treasuries and trend-following strategies that can go short), or you can slog it out with a traditional equity-heavy portfolio.

Also, as some Epsilon Theory readers may know, I co-managed a long/short hedge fund that weathered the 2008 systemic storm successfully. There were trades available then that, in slightly different form, are just as available today. For example, it may surprise anyone who’s read or seen (or lived) “The Big Short” that the credit default swap (CDS) market is even larger today than it was in 2008. I’d welcome a conversation with anyone who’d like to discuss these systemic risk trades and how they might be implemented today.

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Storm Warning


Unfortunately for mariners, the total amount of wave energy in a storm does not rise linearly with wind speed, but to its fourth power. The seas generated by a forty-knot wind aren’t twice as violent as those from a twenty-knot wind, they are seventeen times as violent. A ship’s crew watching the anemometer climb even ten-knots could well be watching their death sentence.

Sebastian Junger, “The Perfect Storm: A True Story of Men Against the Sea” (2009)

[the crew watch emergency surgery performed on the ship’s deck]

Able Seaman: Is them ‘is brains, doctor?
Dr. Stephen Maturin: No, that’s just dried blood. THOSE are his brains.

“Master and Commander: The Far Side of the World” (2003)

[the Konovalov’s own torpedo is about to strike the Konovalov]

Andrei Bonovia: You arrogant ass. You’ve killed *us*!
“The Hunt for Red October” (1990)

Can everyone saying “a 25 bps rate hike doesn’t change anything” or “manufacturing is a small part of the US economy today, so the ISM number doesn’t mean much” or “trade with China is only a few percent of US GDP, so their currency devaluation isn’t important” just stop? Seriously. Can you just stop? Maybe if you were making these statements back in the ‘80s – and by that I mean the 1880s, back when the US was effectively a huge island in the global economy – it would make some sense, but today it’s just embarrassing.

There is a Category 5 deflationary hurricane forming off the Chinese coast as Beijing accelerates the devaluation of the yuan against the dollar under the guise of “reform”. I say forming … the truth is that this deflationary storm has already laid waste to the global commodity complex, doing trillions of dollars in damage. I say forming … the truth is that this deflationary storm has driven inflation expectations down to levels last seen when the world was coming to an end in the Lehman aftermath. And now the Fed is going to tighten? Are you kidding me?

Look, I’m personally no fan of ZIRP and QE and “communication policy”, certainly not the insatiable market devourers they’ve become over the past few years. But you can’t just wish away the Brave New World of globally interlocked, policy-driven, machine-dominated capital markets in some wave of nostalgia and regret for “normalized” days. In an existential financial crisis, emergency government action always becomes permanent government policy, reshaping markets in similarly permanent ways. This was true in the 1930s and it’s true today. It’s neither good nor bad. It just IS. Did QE1 save the market? Yes. Did QE2 and QE3 and all the misbegotten QE children in Europe and Asia break the market? Yes. And in the immortal words of shopkeepers everywhere: you break it, you bought it. The Fed owns capital markets today, like it or not, and raising rates now, as opposed to a year ago when there was a glimmer of a chance to walk back the Narrative of central bank omnipotence, isn’t “brave” or “prudent” or “necessary” or any of the other laudatory adjectives you’ll hear from Fed media apologists after they raise. It’s simply buyer’s remorse. The Fed is sick and tired of owning the market, sick and tired of giving interviews to CNBC every time some jobs report hits the wires, sick and tired of this Frankenstein’s monster called communication policy. So they’re going to raise rates, declare victory, and hope that things go their way.

Am I annoyed by China’s currency actions and their adept use of communication policy to shape the Narrative around devaluation? Not at all. This is exactly what China must do to bolster economic growth while maintaining the pleasant diplomatic fiction that they’re not a command economy. What annoys me is the Fed’s apparent hell-bent intention to force a low-level currency war with China AND whack our own manufacturing and industrial base on the kneecaps with a crowbar, just so they can get out of the communication policy corner they’ve painted themselves into.

Three or four years ago, one of THE dominant market narratives, particularly in the value investment crowd, was the “renaissance of American manufacturing”. Not only was the manufacturing sector going to be the engine of job growth in this country (remember “good jobs with good wages”? me, neither), but this was going to be the engine of economic growth, period (remember the National Export Initiative and “doubling exports in five years”? me, neither). Now we are told that we’re just old fogies to worry about a contracting US manufacturing sector. Now we are told that a global recession in the industrial and commodity complex is well contained here in our vibrant services-led economy. Right. You want some fries with that?

So what’s to be done? You do what you always do in a deflationary, risk-off world – you buy long-dated US Treasuries. Stocks down, USTs up. Of course, if you think that the yield curve is going to steepen after the Fed does whatever it’s going to do this week … you know, because the Fed rate hike is obviously an all-clear sign that we have a robust self-sustaining economic recovery and we’re off to the races … then you want to do the exact opposite, which is to buy stocks and sell the 10-year UST. Yep, time to load up on some bank stocks if that’s your view.

What else can you do? You can read the Epsilon Theory note “I Know It Was You, Fredo” and consider ways to make your portfolio more convex, i.e., more resilient and responsive to both upside and downside surprises in these policy-driven markets. The big institutional allocators use derivative portfolio overlays to inject convexity into their portfolio, and that’s all well and good. But there are steps the rest of us can take, whether that’s adopting strategies that can short markets and asset classes (like some tactical strategies and most trend-following strategies) or whether that’s investing in niche companies and niche strategies that are designed to outperform in either a surprisingly deflationary or a surprisingly inflationary world. The trick really isn’t to choose this fund or that fund. The trick is to broaden your perception of portfolio outcomes so that you don’t have a misplaced faith in either the Fed or econometric models.

I suppose there’s one more thing we should all do. We should all prepare ourselves to perform some emergency surgery on the deck of whatever portfolio ship we’re sailing in 2016. Because with a Fed hike the currency wars will begin in earnest, magnifying the deflationary storm already wreaking havoc in industrials, energy, and materials. No sector or strategy is going to be immune, and we’re all going to suffer some casualties.

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I Know It Was You, Fredo

Sen. Geary: Hey, Freddie, where did you find this place?
Fredo Corleone: Johnny Ola told me about this place. He brought me here. I didn’t believe it, but seeing’s believing, huh? Old man Roth would never come here, but Johnny knows these places like the back of his hand.

“The Godfather, Part II” (1974)


Michael Corleone: C’mon, Frankie… my father did business with Hyman Roth, he respected Hyman Roth.
Frank Pentangeli: Your father did business with Hyman Roth, he respected Hyman Roth… but he never *trusted* Hyman Roth!

“The Godfather, Part II” (1974)

There’s no more dramatic moment in all of movies than the Havana club scene in Godfather, Part II, where Michael overhears Fredo blurting out that he’s partied with Johnny Ola, Hyman Roth’s lieutenant, and lied to Michael about knowing him. The look on Michael’s face as he realizes that Fredo has betrayed the family is, for my money, Al Pacino’s finest scene as an actor, and it helped him gain a 1975 Oscar nomination for Best Leading Actor. Unfortunately for Pacino, it was a good year for strong leading man performances, as Jack Nicholson was also nominated that year for his role in “Chinatown”. The winner, of course, was Art Carney from the immortal film “Harry and Tonto”. Thank you, Academy.

But this isn’t going to be a note focused on Michael or Fredo, or even my favorite Godfather character of all time, Hyman Roth. No, this is a note focused on the polite and respected henchman, Johnny Ola.  Johnny Ola is the transmission mechanism, the disease vector, the crucial connection between the schemes of Hyman Roth and the survival of the Corleone family. Without Johnny Ola there is no Fredo betrayal, no path for a misplaced trust in Hyman Roth to infect the Corleone family. Without Johnny Ola there is no movie.


Now bear with me for a moment. There is a Fredo inside all of us. We are, each and every one of us, often betrayed in our actions and decision making by aspects of our own psyches, and our investment actions and decision making are no exception. The Epsilon Theory Fredo is the little voice inside our heads that convinces us to act in what we think is our own self-interest when actually we are acting in the interests of others. The internal Fredo that we all must seek to identify and root out is, like the movie Fredo, not an inherently bad or evil sort, but weak-willed and easily misled by the Johnny Olas of the world.

The Johnny Olas of the world are not so much flesh and blood people as they are idea or concepts. They are the transmission mechanism by which powerful institutions and even more powerful ideas and concepts – the Hyman Roths of the world – wield their most potent influence: the internalized influence of trust. It’s necessary and smart to do business with the Hyman Roths of the world. It’s necessary and smart to respect the Hyman Roths of the world. But as Frankie Pentangeli reminds Michael, you can never trust the Hyman Roths of the world, and that’s what Johnny Ola does … he convinces our internal Fredo to trust Roth and betray our self-interest.

I could write a long note about how the Fed is Hyman Roth and “communication policy” is Johnny Ola. Too easy. Too true, but too easy.

No, this note is about the Hyman Roth that works above even the Fed. It’s a note about the Johnny Ola that sweet talks all of our internal Fredos, even the Fredo inside Janet Yellen.

The Epsilon Theory Hyman Roth is Econometric Modeling.
The Epsilon Theory Johnny Ola is The Central Tendency.

It’s important to respect the power of econometric models. It’s important to work with econometric models. But I don’t care who you are … whether you’re the leader of the world’s largest central bank or you’re the CIO of an enormous pension fund or you’re the world’s most successful financial advisor … it’s a terrible mistake to trust econometric models. But we all do, because we’ve been convinced by modeling’s henchman, The Central Tendency.

What is the The Central Tendency? It’s the overwhelmingly widespread and enticing idea that there’s a single-peaked probability distribution associated with everything in life, and that more often than not it looks just like this:


It’s our acceptance of The Central Tendency as The Way The World Works that transforms our healthy respect for econometric modeling into an unhealthy trust in econometric modeling. It’s what creates our unhealthy trust in projections of asset price returns. It’s what creates our unhealthy trust in projections of monetary policy impact.

It also creates an unhealthy trust in the mainstream tools we use to project risk and reward in our investment portfolios.

I’m not saying that The Central Tendency is wrong. I’m saying that it is (much) less useful in a world that is polarized by massive debt and the political efforts required to maintain that debt. I’m saying that it is (much) less useful in a market system where exchanges have been transformed into for-profit data centers and liquidity is provided by machines programmed to turn off when profit margins are uncertain.

These are the two big Epsilon Theory topics of the past year – polarized politics and structurally hollow markets – and I’ll give a few paragraphs on each. Then I’ll tell you what I think you should do about it.

Polarized Politics
The world is awash in debt, with debt/GDP levels back to 1930 levels and far higher than 2007 levels prior to the Great Recession. What’s different today in 2015 as compared to the beginning of the Great Recession, however, is that governments rather than banks are now the largest owners (and creators!) of that debt. Governments have more tools and time than corporations, households, or financial institutions when it comes to managing debt loads, but the tools they use to kick the can down the road always result in a more polarized electorate. Why? Because the tools of status quo debt maintenance, particularly as they inflate financial asset prices and perpetuate financial leverage, always exacerbate income and wealth inequality. I’m not saying that’s a good thing or a bad thing. I’m not saying that some alternative debt resolution path like austerity or loss assignment would be more or less injurious to income and wealth equality. I’m just observing that whether you’re talking about the 1930s or the 2010s, whether you’re talking about the US, Europe, or China, greater income and wealth inequality driven by government debt maintenance policy simply IS.

Greater income and wealth inequality reverberates throughout a society in every possible way, but most obviously in polarization of electorate preferences and party structure. Below is a visual representation of increased polarization in the US electorate, courtesy of the Pew Research Center. Other Western nations are worse, many much worse, and no nation is immune.


There’s one inevitable consequence of significant political polarization: the center does not hold. Our expectation that The Central Tendency carries the day will fail, and this failure will occur at all levels of political organization, from your local school board to a congressional caucus to a national political party to the overall electorate. Political outcomes will always surprise in a polarized world, either surprisingly to the left or surprisingly to the right. And all too often, I might add, it’s a surprising outcome pushed by the illiberal left or the illiberal right.

The failure of The Central Tendency occurs in markets, as well. Below is a chart of 3-month forward VIX expectations in December 2012, as the Fiscal Cliff crisis reared its ugly head, as calculated by Credit Suisse based on open option positions. If you calculated the average expectations of the market (the go-to move of all econometric models based on The Central Tendency), you’d predict a future VIX price of 19 or so. But that’s actually the least likely price outcome! The Fiscal Cliff outcome might be a policy surprise of government shutdown, resulting in a market bearish equilibrium (high VIX). Or it might be a policy surprise of government cooperation, resulting in a market bullish equilibrium (low VIX). But I can promise you that there was no possible outcome of the political game of Chicken between the White House and the Republican congressional caucus that would have resulted in a market “meh” equilibrium and a VIX of 19.


If you want to read more about the Epsilon Theory perspective on polarized politics and the use of game theory to understand this dynamic, read “Inherent Vice”, “1914 Is the New Black”, and “The New TVA”.

Hollow Markets
Whatever shocks emanate from polarized politics, their market impact today is significantly greater than even 10 years ago. That’s because we have evolved a profoundly non-robust liquidity provision system, where trading volumes look fine on the surface and appear to function perfectly well in ordinary times, but collapse utterly under duress. Even in the ordinary times, healthy trading volumes are more appearance than reality, as once you strip out all of the faux trades (HFT machines trading with other HFT machines for rebates, ETF arbitrage, etc.) and positioning trades (algo-driven rebalancing of systematic strategies and portfolio overlays), there’s precious little investment happening today.

Here’s how I think we got into this difficult state of affairs.

First, Dodd-Frank regulation makes it prohibitively expensive for bulge bracket bank trading desks to maintain a trading “inventory” of stocks and bonds and directional exposures of any sort for any length of time. Just as Amazon measures itself on the basis of how little inventory it has to maintain for how little a span of time, so do modern trading desks. There is soooo little risk-taking or prop desk trading at the big banks these days, which of course was an explicit goal of Dodd-Frank, but the unintended consequence is that a major trading counterparty and liquidity provider when markets get squirrelly has been taken out into the street and shot.

Second, the deregulation and privatization of market exchanges, combined with modern networking technologies, has created an opportunity for technology companies to provide trading liquidity on a purely voluntary basis. To be clear, I’m not suggesting that liquidity was provided on an involuntary basis in the past or that the old-fashioned humans manning the old-fashioned order book at the old-fashioned exchanges were motivated by anything other than greed. As Don Barzini would say, “after all, we are not Communists”. But there is a massive and systemically vital difference between the business model and liquidity provision regime (to use a good political science word) of humans operating within a narrowly defined, publicly repeatable game with forced participation and of machines operating within a broadly defined, privately unrepeatable game with unforced participation.

Whatever the root causes, modern market liquidity (like beauty) is only skin deep. And because liquidity is only skin deep, whenever a policy shock hits (say, the Swiss National Bank unpegs the Swiss franc from the euro) or whenever there’s a technology “glitch” (say, when a new Sungard program misfires and the VIX can’t be priced for 10 minutes) everything falls apart, particularly the models that we commonly use to calculate portfolio risk.

For example, here’s a compilation of recent impossible market events across different asset classes and geographies (hat tip to the Barclays derivatives team) … impossible in the sense that, per the Central Tendency on which standard deviation risk modeling is based, these events shouldn’t occur together over a million years of market activity, much less the past 4 years.


Source: Barclays, November 2015. 

So just to recap … these market dislocations DID occur, and yet we continue to use the risk models that say these dislocations cannot possibly occur. Huh? And before you say, “well, I’m a long term investor, not a trader, so these temporary market liquidity failures don’t really affect me”, ask yourself this: do you use a trader’s tools, like stop-loss orders? do you use a trader’s securities, like ETFs? If you answered yes to either question, then you can call yourself a long term investor all you like, but you’ve got more than a little trader in you. And a trader who doesn’t pay attention to the modern realities of market structure and liquidity provision is not long for this world.

If you want to read more about the Epsilon Theory perspective on hollow markets and the use of game theory to understand this dynamic, read “Season of the Glitch”, “Ghost in the Machine”, and “Hollow Men, Hollow Markets, Hollow World”.

Adaptive Investing and Aware Investing 
Okay, now for the big finish. What does one DO about this? How does one invest in a world of bimodal uncertainty and a market of skin-deep liquidity?

Both of these investment goblins – Political Polarization and the Hollow Market – are so thoroughly problematic because our perceptions of both long-term investment outcomes and short-term trading outcomes are so thoroughly infected by The Central Tendency and a quasi-religious faith in econometric modeling. But while their problematic root cause may be the same, their Epsilon Theory solutions are different.  I call the former Adaptive Investing, and I call the latter Aware Investing.

Adaptive Investing focuses on portfolio construction and the failure of The Central Tendency to predict long(ish)-term investment returns. Aware Investing focuses on portfolio trading and the failure of The Central Tendency to predict short(ish)-term investment returns. Each is a crucial concept. Each deserves its own book, much less its own Epsilon Theory note. But this note is going to focus on Adaptive Investing.

Adaptive Investing tries to construct a portfolio that does as well when The Central Tendency fails as when it succeeds. Adaptive Investing expects historical correlations to shift dramatically as a matter of course, usually in a market-jarring way. But this is NOT a tail-risk portfolio or a sky-is-falling perspective. I really, really, really don’t believe in either. What it IS – and the stronger your internal Fredo the harder this concept will be to wrap your head around – is a profoundly agnostic investing approach that treats probabilities and models and predictions as secondary considerations.

I’ll use two words to describe the Adaptive Investing perspective, one that’s a technical term and one that’s an analogy. The technical term is “convexity”. The analogy is “barbell”. In truth, both are metaphors. Both are Narratives. As such, they are applicable across almost every dimension of investing or portfolio allocation, and at almost every scale.

Everyone knows what a barbell is. Convexity, on the other hand, is a daunting term. Let’s un-daunt it.

The basic idea of convexity is that rather than have Portfolio A, where your returns go up and down with a market or a benchmark’s returns in a linear manner, you’d rather have Portfolio B, where there’s a pleasant upward curve to your returns if the market or benchmark does really well or really poorly. The convex Portfolio B performs pretty much the same as the linear Portfolio A during “meh” markets (maybe a tiny bit worse depending on how you’re funding the convexity benefits), but outperforms when markets are surprisingly good or surprisingly bad. A convex portfolio is essentially long some sort of optionality, such that a market surprising event pays off unusually well, which is why convexity is typically injected into a portfolio through the use of out-of-the-money options and other derivative securities. Another way of saying that you’re long optionality is to say that you’re long gamma. If that term is unfamiliar, check out the Epsilon Theory note “Invisible Threads”.


All other things being equal, few people wouldn’t prefer Portfolio B to Portfolio A, particularly if you thought that markets are likely to be surprisingly good or surprisingly bad in the near future. But of course, all other things are never equal, and there are (at least) three big caveats you need to be aware of before you belly up to the portfolio management bar and order a big cool glass of convexity.

Caveat 1:  A convex portfolio based on optionality must be an actively managed portfolio, not a buy-and-hold portfolio. There’s no such thing as a permanent option … they all have a time limit, and the longer the time limit the more expensive the option. The clock works in your favor with a buy-and-hold portfolio (or it should), but the clock always works against you with a convex portfolio constructed by purchasing options. That means it needs to be actively traded, both in rolling forward the option if you get the timing wrong, as well as in exercising the option if you get the timing right. Doing this effectively over a long period of time is exactly as impossible difficult and expensive as it sounds.

Caveat 2:  A convex portfolio fights the Fed, at least on the left-hand part of the curve where you’re making money (or losing less money) as the market gets scorched. Yes, there are going to be more and more political shocks hitting markets over the next few years, and yes, those shocks are going to be exacerbated by the hollow market and its structurally non-robust liquidity provision. But in reaction to each of these market-wrenching policy and liquidity shocks, you can bet your bottom dollar that every central bank in the world will stop at nothing to support asset price levels and reduce market volatility. Make no mistake – if you’re long down-side protection optionality in your portfolio, you’re also long volatility. That puts you on the other side of the trade from the Fed and the ECB and the PBOC and every other central bank, and that’s not a particularly comfortable place to be. Certainly it’s not a comfortable (or profitable) place to be without a keen sense of timing, which is why, again, a convex portfolio expressed through options and derivatives needs to be actively managed and can’t be a passive buy-and-hold strategy.

Caveat 3:  Top-down portfolio risk adjustments like convexity injection through index options or risk premia derivatives are *always* going to disappoint bottom-up stock-picking investors. I’ve written a lot about this phenomenon, from one of the first Epsilon Theory notes, “The Tao of Portfolio Management”, to the more recent “Season of the Glitch”, so I won’t repeat all that here. The basic idea is that it’s a classic logical fallacy to infer characteristics of the whole (in this case the portfolio) from characteristics of the component pieces (in this case the individual securities selected via a bottom-up process), and vice versa. What that means in more or less plain English is that risk-managing individual positions in an effort to achieve a risk-managed overall portfolio is inherently an exercise in frustration and almost always ends in unanticipated underperformance for stock pickers.

Okay, Ben, those are three big problems with implementing convexity in a portfolio. I thought you said this was a good thing.

You’ll notice that each of these three caveats pertain most directly to the largest population of investors in the world – non-institutional investors who create an equity-heavy buy-and-hold portfolio by applying a bottom-up, fundamental, stock-picking perspective. The caveats don’t apply nearly so much to institutional allocators who apply a systematic, top-down perspective to a portfolio that’s typically too large to engage in anything so time-consuming as direct stock-picking. They have no problem employing a staff to manage these portfolio overlays (or hiring external managers who do), and they’re not terrified by the mere notion of negative carry, derivatives, and leverage. These institutional allocators may not be large in numbers, but they are enormous in terms of AUM. I spend a lot of time meeting with these allocators, and I can tell you this – implementing convexity into a portfolio in one way or another is the single most common topic of conversation I’ve had over the past year. Every single one of these allocators is thinking in terms of portfolio convexity, even if most are still in the exploration phase, and you’re going to be hearing more and more about this concept in the coming months.

So that’s all well and good for the CIO of a forward thinking multi-billion dollar pension fund, but what if it’s a non-starter to have a conversation about the pros and cons of a long gamma portfolio overlay with your client or your investment committee?  What if you’re a stock picker at heart and you’d have to change your investment stripes (something no one should ever do!) and reconceive your entire portfolio to adopt a top-down convexity approach using derivatives and risk premia and the like?

This is where the barbell comes in.


The basic concepts of Adaptive Investing can be described as placing modest portfolio “weights” or exposures on either side of an investment dimension. This is in sharp contrast to what Johnny Ola has convinced most of us to do, which is to place lots and lots of portfolio weight right in the middle of the bar, with normally distributed tails on either end of the massive weight in the center (i.e., a whopping 5% allocation to “alternatives”). What are these investment dimensions? They are the Big Questions of investing in a world of massive debt maintenace (and are actually very similar to the Big Questions of the 1930s), questions like … will central banks succeed in preventing a global deflationary equilibrium? … is there still a viable growth story in China and in Emerging Markets more broadly, or was it all just a mirage built on post-war US monetary policy? … is there a self-sustaining economic recovery in the US?

Here’s an example of what I’m talking about, a barbell portfolio around the Biggest of the Big Questions in the Golden Age of the Central Banker: will extraordinarily accommodative monetary policy everywhere in the world spur inflationary expectations and growth-supporting economic behaviors? Like all barbell dimensions, there’s really no middle ground on this. In 2016, either the market will be surprised by resurgent global growth / inflation, or the market will be surprised by anemic growth / deflation despite extraordinary monetary policy accommodation. I want to “be there” in my portfolio with modest exposures positioned to succeed in each potential outcome, as opposed to having a big exposure somewhere in the middle that I have to drag in one direction or another when I end up being “surprised” just like the rest of the market.

Specifically, what might those positions look like? Everyone will have a different answer, but here’s mine:

  • If deflation and low global growth carry the day, then I want to be in yield-oriented securities where the cash flows are tied to real economic activity in geographies with real growth prospects, and where company management is really distributing those cash flows to shareholders directly. 
  • If inflation and resurgent growth carry the day, then I want to be in growth-oriented securities linked to commodities.
  • And yes, there are companies that can thrive in both environments.

Now of course you’ll get push-back to the notion of a barbell portfolio from your client or investment committee (maybe the investment committee inside your own head), most likely in the form of some variation on these three natural questions:

Q:     Wouldn’t you be be better off predicting the winning side of any of these Big Questions and putting all your weight there? 

A:     Yes, if I had a valid econometric model that could predict whether central banks will fail or succeed at spurring inflationary expectations in the hearts and minds of global investors, then I would definitely put all my portfolio weight on that answer. But I don’t have that model, and neither do you, and neither does the Fed or anyone else. So let’s not pretend that we do.

Q:     But if one side of your portfolio barbell ends up being right, that must mean that the other side is wrong. Wouldn’t we be just as well off putting all the weight somewhere in the middle like we usually do?  

A:     No, that’s not how these politically-polarized investment dimensions play out, with one side clearly winning and one side clearly losing. The underlying dynamics of the Big Questions in investing today are governed by the multi-year spiraling back-and-forth of multiple equilibria games like Chicken, not The Central Tendency (read “Inherent Vice” for some examples). Not only is it far more capital efficient to use a barbell approach, but both sides will do relatively better than the middle. That is, in fact, the entire point of using an allocation approach that creates optionality and effective convexity in a portfolio without forcing the top-down imposition of option and derivative overlays.

Q:     But how do we know that you’ve identified the right positions to take on either side of these Big Questions?  

A:     Well, that’s what you hire me for: to identify the right investments to execute our portfolio strategy effectively. But if we’re not comfortable with selecting specific assets and companies, then we might consider a trend-following strategy. Trend-following is profoundly agnostic. Unlike almost any other strategy you can imagine, trend-following doesn’t embody an opinion on whether something is cheap or expensive, overlooked or underappreciated, poised to grow or doomed to failure. All it knows is whether something is working or not, and it is as happy to be short something as it is to be long something, maybe that same thing under different circumstances. As such, a pure trend-following strategy will automatically move on its own accord from weighting one end of a barbell to the other, spending as little time as possible in the middle, depending on which side is working better. That is an incredibly powerful tool for this investment perspective.

A barbell portfolio captures the essence or underlying meaning of portfolio convexity without requiring top-down portfolio overlays that are either impractical or impossible for many investors. The investments described here have a positive carry, meaning that the clock works in your favor, meaning that – unlike convex strategies that are actively trading options and volatility – these strategies fit well in a buy-and-hold, non-Fed fighting, stock-picking portfolio. I think it’s a novel way of rethinking the powerful notions of convexity and uncertainty so that they fit the real world of most investors, and whether these ideas are implemented or not I’m certain that it’s a healthy exercise for all of us to question the conceptual dominance of The Central Tendency.


You know, Michael Corleone has a great line after he wised up to Fredo’s betrayal and the true designs of Johnny Ola and Hyman Roth: “I don’t feel I have to wipe everybody out … just my enemies.” It’s the same with our portfolios. We don’t have to completely reinvent our investment process to incorporate the valuable notion of convexity into our portfolios. We don’t have to sell out of everything and start fresh in order to adopt an Adaptive Investing perspective. Our investment enemies live inside our own heads. They are the ideas and concepts that we have allowed to hold too great a sway over our internal Fredo, and they can be put in their proper place with a fresh perspective and a questioning mind. Econometric modeling and The Central Tendency don’t need to be eliminated; they need to be demoted from a position of unwarranted trust to a position of respectful but arms-length business relationship. After all, let’s remember the secret of Hyman Roth’s success: he always made money for his partners. I’m happy to be partners with modeling because I think it’s a concept that can make me a lot of money. But I’m never going to trust my portfolio to it.

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Mike McDermott: In “Confessions of a Winning Poker Player,” Jack King said, “Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career.” It seems true to me, cause walking in here, I can hardly remember how I built my bankroll, but I can’t stop thinking of how I lost it.
– “Rounders” (1998)

I know it’s crooked, but it’s the only game in town.
– Canada Bill Jones (c. 1840 – 1880), described as “the greatest three-card monte sharp to ever work the boats”, on being told by his partner George Devol that a Faro game in Cairo, Illinois was rigged.


David Howard: We’re up!
Linda Howard: We’re still down.
David Howard: How down?
Linda Howard: Down.
David Howard: How down is she?
Desert Inn Casino Manager: Down.
Desert Inn Casino Manager: You’re a nice guy. You make me laugh. But our policy is: we can’t give your money back.

– “Lost in America” (1985) 


Boredom is the conviction that you can’t change … the shriek of unused capacities.
– Saul Bellow, “The Adventures of Augie March” (1953)

Anything becomes interesting if you look at it long enough.

– Gustave Flaubert (1821 – 1880)

She wanted to die, but she also wanted to live in Paris. 

– Gustave Flaubert (1821 – 1880)


To me, at least in retrospect, the really interesting question is why dullness proves to be such a powerful impediment to attention. Why we recoil from the dull…surely something must lie behind not just Muzak in dull or tedious places but now also actual TV in waiting rooms, supermarkets’ checkouts, airport gates, SUVs’ backseats. Walkman, iPods, BlackBerries, cell phones that attach to your head. This terror of silence with nothing diverting to do. I can’t think anyone really believes that today’s so-called ‘information society’ is just about information. Everyone knows it’s about something else, way down.

– David Foster Wallace, “The Pale King” (2011)


Carl:  This is crazy. I finally meet my childhood hero and he’s trying to kill us. What a joke.
Dug: Hey, I know a joke! A squirrel walks up to a tree and says, “I forgot to store acorns for the winter and now I am dead.” Ha! It is funny because the squirrel gets dead.

– “Up” (2009)

I’m a good poker player. I know that everyone says that about themselves, so you’ll just have to take my word for it. I’m also a good stock picker, which again is something that everyone says about themselves. At least on this point I’ve got a track record from a prior life to make the case. But I don’t consider myself to be a great poker player or a great stock picker. Why not? Because I get bored with the interminable and rigorous discipline that being a great poker player or a great stock picker requires. And I bet you do, too.

To be clear, it’s not the actual work of poker playing or stock picking that I find boring. I could happily spend every waking moment turning over a new set of cards or researching a new company. And it’s certainly not boring to make a bet, either on a hand or a stock. What’s boring is NOT making a bet on a hand or a stock. What’s boring is folding hand after hand or passing on stock after stock because you know it’s the right thing to do. The investment process that makes a great poker player or a great stock picker isn’t the research or the analysis, even though that’s what gets a lot of the attention. Nor is it the willingness to make a big bet when you believe the table or the market or the world has given you a rare combination of edge and odds, even though that’s what gets even more of the attention. No, what makes for greatness as a stock picker is the discipline to act appropriately on whatever the market is giving you, particularly when you’re being dealt one low conviction hand after another. The hardest thing in the world for talented people is to ignore our mental “shriek of unused capacities”, to use Saul Bellow’s phrase, and to avoid turning a low edge and odds opportunity into an unreasonably high conviction bet simply because we want it so badly and have analyzed the situation so smartly. In both poker and investing, we brutally overestimate the edge and odds associated with merely ordinary opportunities once we’ve been forced by circumstances to sit on our hands for a while.

As David Foster Wallace puts it so well, “the really interesting question is why dullness proves to be such a powerful impediment to attention.” Why do we increasingly suffer from a “terror of silence” where we use electronic information devices to fill the void? Why are most of you reading this note with at least one TV screen showing CNBC or Bloomberg within easy viewing distance? How many of us are bored to tears with the Fed’s Hamlet act on raising rates, and yet have been staring at this debate for so long that we have convinced ourselves that we have a meaningful view on what will transpire, even though it’s a decision where we have zero investing edge and unknowable risk/reward odds. I’m raising my hand as I re-read this sentence.

The biggest challenge of our investing lives is not finding ways to process more information, or even finding ways to process information more effectively. Our biggest challenge is finding the courage to focus on what matters, to admit that more or quicker information will not help our investment decisions, to recognize that our investment discipline suffers mightily at the hands of the impediment of dullness. Because let’s be honest… the Golden Age of the Central Banker is a really, really dull time for a stock-picking investor. I’m not saying that the markets themselves are dull or that market price action is boring. On the contrary, this joint is jumping. I’m saying that stock pickers are being dealt one dull, low conviction hand after another by global Central Banks, even though they’re forced to sit inside a glitzy casino with lots of lights and sounds and exciting gambling action happening all around them. We have little edge in a Reg-FD public market. We have at best unknowable odds and at worst a negatively skewed risk/reward asymmetry in a market where policy shocks abound. And yet we find ways to convince ourselves that we have both edge and odds, making the same concentrated equity bets we made back in happier times when idiosyncratic company fundamentals and catalysts were actually attached to a company’s stock price. Builders build. Drillers drill. Stock pickers pick stocks. We can’t help ourselves, even if the deck is stacked against us here in the only game in town.

Investment discipline suffers under the weight of dullness and low conviction in at least four distinct ways here in the Golden Age of the Central Banker.

First, just as there’s a winner on every poker hand that you sit out, there’s a winner every day in the markets regardless of whether or not you are participating. The business risk of sitting out too many hands weighs heavily on most of us in the asset management or financial advisory worlds. We can talk about maintaining our investment discipline all we like, but the truth is that all of us, in the immortal words of Bob Dylan, gotta serve somebody. If we’re not telling our investors or our board or our CIO that we have high conviction investment ideas … well, they’re going to find someone else who WILL tell them what they want to hear. And for those lucky few of you reading this note blessed with access to more or less permanent capital, I’ll just say that the conversations we have with ourselves tend to be even more pressuring than the conversations we have with others. No one forces me to “make a play” when I have a middle pair and a so-so kicker, but I’ve somehow convinced myself that I can take down a pot just because I’ve been playing tight for the past hour. No one forced Stanley Druckenmiller – one of the truly great investors of our era – to top-tick the NASDAQ bubble when he bought $6 billion worth of Internet stocks in March 2000. Why did he do it?

So, I’ll never forget it. January of 2000 I go into Soros’s office and I say I’m selling all the tech stocks, selling everything. This is crazy at 104 times earnings. This is nuts. Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day and I’m out. It is driving me nuts. I mean their little account is like up 50 percent on the year. I think Quantum was up seven. It’s just sitting there.

So like around March I could feel it coming. I just … I had to play. I couldn’t help myself. And three times during the same week I pick up a phone but don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So maybe I learned not to do it again, but I already knew that.

If living in the NASDAQ bubble can make Stan Druckenmiller convince himself that stocks trading at >100x earnings were a high conviction play only a few months after selling out of them entirely, what chance do we mere mortals have in not succumbing to 6-plus years of the most accommodative monetary policy in the history of man?

Second, every facet of the financial services industry is trying to convince you to play more hands, and we are biologically hard-wired to respond. I don’t have a good answer to Wallace’s question about why we all fear the silence and all feel compelled to fill the void with electronically delivered “information”, but I am certain that the business models of the Big Boy information providers all depend on Flow.So you can count on the “information” that we constantly and willingly beam into our brains being geared to convince us to join the casino fun. My favorite character in the wonderful movie “Up” is Dug the dog, who despite his advanced technological tools is a prisoner of his own biology whenever he hears the signal “Squirrel!”. We are all Dug the dog.


Third, Central Bankers have intentionally sown confusion in our ranks. Like the barkers on CNBC and the sell-side, the Fed and the ECB and the BOJ and the PBOC are determined to force us into riskier investment decisions than we would otherwise choose to make. This is the entire point of extraordinary monetary policy over the past 6 years! All of it. All of the LSAPs, all of the TLTROs, all of the exercises in “Communication Policy” … all of it has been designed with one single purpose in mind: to punish investors who choose to sit on their hands and reward investors who make a bet, all for the laudable goal of preventing a deflationary equilibrium. And as a result we have the most mistrusted bull market in history, a bull market where traditional investment discipline was punished rather than rewarded, and where any investor who hasn’t been totally hornswoggled by Fed communication policy is now rightly worried about having the policy rug pulled out from underneath his feet.

Or to make this point from a slightly different perspective, while there is confusion between the concepts of investing and allocation in the best of times, there is an intentional conflation of the two notions here in the Golden Age of the Central Banker. The Fed wants to turn investors into allocators, and they’ve largely succeeded. That is, the Fed doesn’t care about your picking one stock over another stock or one sector over another sector or one company over another company. They just want to push you out on the risk curve, which for the vast majority of investors just means buying stocks. Any stock. All stocks. This is why the quality bias that most investors have – preferring solid management, strong balance sheets, and good cash flow generation to their opposites – has been largely immaterial as an investment factor (if not an outright drag on investment returns) over the past 6 years. If the King is flooding the town with easy credit, the deadbeat tailor will do relatively better than the thrifty mason every time. But try telling a true-believer that quality is just an investment factor, no more (and no less) privileged than any other investment factor. Honestly, I’ll get 50 unsubscribe emails just for writing this down.

Fourth, our small-number brains are good local data relativists, not effective cross-temporal or global data evaluators. Okay, that’s a mouthful. Translation: the human brain has evolved over millions of years and human society has been trained for tens of thousands of years to make sense of highly localized data patterns. Humans are excellent at prioritizing the risks and opportunities that they are paying attention to at any moment in time, and excellent at allocating their behavioral budget accordingly. It’s why we’re really good at driving cars or, in primate days of yore, surviving on the Serengeti plains. But if asked to compare the risks and rewards of a current decision opportunity with the risks and rewards of a decision opportunity last year (much less 10 years ago), or if asked to compare the opportunity we’ve been evaluating for months with something less familiar, we are utterly flummoxed. It’s not that we can’t remember or think on our feet, but there is an overwhelming attention and recency bias in human decision-making. That’s fine so long as we share the market with other humans, much less fine when we share the market with machine intelligences that excel at the information processing tasks we consistently flub. Whether it’s trading or investing, humans are no longer the apex predator in capital markets, but we act as if we are. 

So what’s an investor to do?

I can sum it up in one deceptively simple sentence: You take what the market gives you.

It’s deceptively simple because it implies a totally different perspective on markets than most investors (or allocators, frankly) bring to bear. It means approaching markets from a position of humility, i.e. risk tolerance, rather than from a position of hubris, i.e. return expectations. It’s all well and good to tell your financial advisor or your board or yourself that you’re “targeting an 8% return.” That’s great. I understand that’s your desire. But the market couldn’t care less what your desire might be. I think it’s so important to stop focusing on our “expectations” of the market, as if it were some unruly teenager that needs to get its act together and start doing what it’s told. It’s madness to anthropomorphize the market and believe that we can control it or predict its behavior. Instead, we need to focus on what we CAN control and what we CAN predict, which is our own reaction to what a stochastically-dominated social system like the market is going to throw at us over time. Tell me what your risk tolerance is. Tell me what path you’re comfortable walking. Then we can talk about the uncorrelated stepping stone strategies that will make up that path to get you where you want to go. Then we can talk about sticking to the path, which far more often means keeping risk in the portfolio than taking it out. Then we can talk about adaptively allocating between the stepping stone strategies as the risk they generate today differs from the risk they generated in the past. Maybe you’ll get lucky and one of the strategies will crush it, like US equities did in 2013. Excellent! But aren’t we wise enough to distinguish allocation luck from investment skill? I keep asking myself that rhetorical question, but I’m never quite happy with the answer.

You know, there’s this mythology around poker tournaments that the path to success is a succession of all-in bets where you “read” your opponent and make some seemingly brilliant bluff or call. I’m sure this mythology is driven by the way in which poker tournaments are televised, where viewers see a succession of exactly this sort of dramatic moment, complete with commentary attributing deep strategic thoughts to every action. What nonsense. The goal of great poker players is NEVER to go all-in. Going all-in is a failure of risk management, not a success. I’m exaggerating when it comes to poker, because the nice thing about poker tournaments is that there’s always another one. But I’m not exaggerating when it comes to investing. There’s only one Nest Egg (“Lost In America” is by far my favorite Albert Brooks movie), and thinking about investing and allocation through the lens of risk tolerance rather than return expectations is the best way I know to grow and keep that Nest Egg.

Taking What The Market Gives You has specific implications for each of the four ways in which the Golden Age of the Central Banker weakens investor discipline.

1) For the business risk associated with maintaining a stock-picking discipline and sitting out an equity market that you just don’t trust … it means taking complementary non-correlated strategies into your portfolio, as well as strategies that have positive expected returns but can make money when equities go down (like trend-following strategies or government bonds). It rarely means going to cash. (For more, see “It’s Not About the Nail”)

2) For the constant exhortations from the financial media and the sell-side to try a new game at the market casino … it means taking what you know. It means taking what you know the market is giving you because you have direct experience with it, not taking what other people are telling you that the market is giving you. Here’s my test: if I hear a pitch for a stock or a strategy and I find myself looking around the room (either literally or metaphorically) to see how other people are reacting to the pitch, then I know that I’m being sucked into the Common Knowledge Game. I know that I’m at risk of playing a hand I shouldn’t. (For more, see “Wherefore Art Thou, Marcus Welby?”)

3) For the communication policy of the Fed and the soul-crushing power of a risk-free rate that pays absolutely nothing … it means taking stocks that get as close as possible to real-world economic growth and real-world cash flows in order to minimize the confounding influence of Central Bankers and the game-playing that surrounds them. There’s nowhere to hide completely, as the volatility virus that started with the end of global monetary policy coordination in the summer of 2014 will eventually spread everywhere, but there’s no better place to ride out the storm than getting close to actual cash flows of companies that are determined to return those cash flows to investors. (For more, see “Suddenly Last Summer”)

4) For the transformation of the market jungle into a machine-dominated ecosystem … it means either adopting the same market perspective as a machine intelligence through systematic asset allocation strategies, or it means focusing on niche areas of the market where useful fundamental information is not yet aggregated for the machines. In either case, it means leaving behind the quaint notion that you can do fundamental analysis on large cap public companies and somehow gain an edge or identify attractive odds. (For more, see “One MILLION Dollars”)

One final point, and it’s one that seems particularly apropos after watching some bloodbaths in certain stocks and sectors over the past week or two. Investor discipline isn’t only the virtue of great investors when it comes to buying stocks. It’s also the virtue of great investors when it comes to selling stocks. I started Epsilon Theory a little more than two years ago in the midst of a grand bull market that I saw as driven by Narrative and policy rather than a self-sustaining recovery in the real economy. For about a year, I got widespread pushback on that notion. Today, it seems that everyone is a believer in the Narrative of Central Bank Omnipotence. What I find most interesting, though, is that not only is belief in this specific Narrative widespread, but so is belief in the Epsilon Theory meta-Narrative … the Narrative that it is, in fact, Narratives that drive market outcomes of all sorts. My hope, and at this point it’s only a hope, is that this understanding of the power of Narratives will inoculate a critical mass of investors and allocators from this scourge. Because the same stories and Narratives and low conviction hands that shook us out of our investment discipline on the way up will attack us even more ferociously on the way down.

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Season of the Glitch


When I look over my shoulder
What do you think I see?
Some other cat lookin’ over
His shoulder at me.

Donovan, “Season of the Witch” (1966)


Josh Leonard: I see why you like this video camera so much.
Heather Donahue: You do?
Josh Leonard: It’s not quite reality. It’s like a totally filtered reality. It’s like you can pretend everything’s not quite the way it is.

“The Blair Witch Project” (1999)

Over the past two months, more than 90 Wall Street Journal articles have used the word “glitch”. A few choice selections below:

Bank of New York Mellon Corp.’s chief executive warned clients that his firm wouldn’t be able to solve all pricing problems caused by a computer glitch before markets open Monday.

“BNY Mellon Races to Fix Pricing Glitches Before Markets Open Monday”, August 30, 2015

A computer glitch is preventing hundreds of mutual and exchange-traded funds from providing investors with the values of their holdings, complicating trading in some of the most widely held investments.

“A New Computer Glitch is Rocking the Mutual Fund Industry”, August 26, 2015

Bank says data loss was due to software glitch.

“Deutsche Bank Didn’t Archive Chats Used by Some Employees Tied to Libor Probe”, July 30, 2015

NYSE explanation confirms software glitch as cause, following initial fears of a cyberattack.

“NYSE Says Wednesday Outage Caused by Software Update”, July 10, 2015

Some TD Ameritrade Holding Corp. customers experienced delays in placing orders Friday morning due to a software glitch, the brokerage said..

“TD Ameritrade Experienced Order Routing, Messaging Problems”, July 10, 2015

Thousands of investors with stop-loss orders on their ETFs saw those positions crushed in the first 30 minutes of trading last Monday, August 24th. Seeing a price blow right through your stop is perhaps the worst experience in all of investing because it seems like such a betrayal. “Hey, isn’t this what a smart investor is supposed to do? What do you mean there was no liquidity at my stop? What do you mean I got filled $5 below my stop? Wait… now the price is back above my stop! Is this for real?”  Welcome to the Big Leagues of Investing Pain.

What happened last Monday morning, when Apple was down 11% and the VIX couldn’t be priced and the CNBC anchors looked like they were going to vomit, was not a glitch. Yes, a flawed SunGard pricing platform was part of the proximate cause, but the structural problem here – and the reason this sort of dislocation WILL happen again, soon and more severely – is that a vast crowd of market participants – let’s call them Investors – are making a classic mistake. It’s what a statistics professor would call a “category error”, and it’s a heartbreaker.

Moreover, there’s a slightly less vast crowd of market participants – let’s call them Market Makers and The Sell Side – who are only too happy to perpetuate and encourage this category error. Not for nothing, but Virtu and Volant and other HFT “liquidity providers” had their most profitable day last Monday since … well, since the Flash Crash of 2010. So if you’re a Market Maker or you’re on The Sell Side or you’re one of their media apologists, you call last week’s price dislocations a “glitch” and misdirect everyone’s attention to total red herrings like supposed forced liquidations of risk parity strategies. Wash, rinse, repeat.

The category error made by most Investors today, from your retired father-in-law to the largest sovereign wealth fund, is to confuse an allocation for an investment. If you treat an allocation like an investment… if you think about buying and selling an ETF in the same way that you think about buying and selling stock in a real-life company with real-life cash flows… you’re making the same mistake that currency traders made earlier this year with the Swiss Franc (read “Ghost in the Machine” for more). You’re making a category error, and one day – maybe last Monday or maybe next Monday – that mistake will come back to haunt you.

The simple fact is that there’s precious little investing in markets today – understood as buying a fractional ownership position in the real-life cash flows of a real-life company – a casualty of policy-driven markets where real-life fundamentals mean next to nothing for market returns. Instead, it’s all portfolio positioning, all allocation, all the time. But most Investors still maintain the pleasant illusion that what they’re doing is some form of stock-picking, some form of their traditional understanding of what it means to be an Investor. It’s the story they tell themselves and each other to get through the day, and the people who hold the media cameras and microphones are only too happy to perpetuate this particular form of filtered reality.

Now there’s absolutely nothing wrong with allocating rather than investing. In fact, as my partners Lee Partridge and Rusty Guinn never tire of saying, smart allocation is going to be responsible for the vast majority of public market portfolio returns over time for almost all investors. But that’s not the mythology that exists around markets. You don’t read Barron’s profiles about Great Allocators. No, you read about Great Investors, heroically making their stock-picking way in a sea of troubles. It’s 99% stochastics and probability distributions – really, it is – but since when did that make a myth less influential? So we gladly pay outrageous fees to the Great Investors who walk among us, even if most of us will never enjoy the outsized returns that won their reputations. So we search and search for the next Great Investor, even if the number of Great Investors in the world is exactly what enough random rolls of the dice would produce with Ordinary Investors. So we all aspire to be Great Investors, even if almost all of what we do – like buying an ETF – is allocating rather than investing.

The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug.

What we saw last Monday morning was a specific manifestation of the behavioral fallacy of a category error, one that cost a lot of Investors a lot of money. Investors routinely put stop-loss orders on their ETFs. Why? Because… you know, this is what Great Investors do. They let their winners run and they limit their losses. Everyone knows this. It’s part of our accepted mythology, the Common Knowledge of investing. But here’s the truth. If you’re an Investor with a capital I (as opposed to a Trader with a capital T), there’s no good reason to put a stop-loss on an ETF or any other allocation instrument. I know. Crazy. And I’m sure I’ll get 100 irate unsubscribe notices from true-believing Investors for this heresy. So be it.

Think of it this way… what is the meaning of an allocation? Answer: it’s a return stream with a certain set of qualities that for whatever reason – maybe diversification, maybe sheer greed, maybe something else – you believe that your portfolio should possess. Now ask yourself this: what does price have to do with this meaning of an allocation? Answer: very little, at least in and of itself. Are those return stream qualities that you prize in your portfolio significantly altered just because the per-share price of a representation of this return stream is now just below some arbitrary price line that you set? Of course not. More generally, those return stream qualities can only be understood… should only be understood… in the context of what else is in your portfolio. I’m not saying that the price of this desired return stream means nothing. I’m saying that it means nothing in and of itself. An allocation has contingent meaning, not absolute meaning, and it should be evaluated on its relative merits, including price. There’s nothing contingent about a stop-loss order. It’s entirely specific to that security… I want it at this price and I don’t want it at that price, and that’s not the right way to think about an allocation.

One of my very first Epsilon Theory notes, “The Tao of Portfolio Management,” was on this distinction between investing (what I called stock-picking in that note) and allocation (what I called top-down portfolio construction), and the ecological fallacy that drives category errors and a whole host of other market mistakes. It wasn’t a particularly popular note then, and this note probably won’t be, either. But I think it’s one of the most important things I’ve got to say.

Why do I think it’s important? Because this category error goes way beyond whether or not you put stop-loss orders on ETFs. It enshrines myopic price considerations as the end-all and be-all for portfolio allocation decisions, and it accelerates the casino-fication of modern capital markets, both of which I think are absolute tragedies. For Investors, anyway. It’s a wash for Traders… just gives them a bigger playground. And it’s the gift that keeps on giving for Market Makers and The Sell Side.

Why do I think it’s important? Because there are so many Investors making this category error and they are going to continue to be, at best, scared out of their minds and, at worst, totally run over by the Traders who are dominating these casino games. This isn’t the time or the place to dive into gamma trading or volatility skew hedges or liquidity replenishment points. But let me say this. If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily “news”. You’re going to be whipsawed mercilessly by these Hollow Markets, especially now that the Fed and the PBOC are playing a giant game of Chicken and are no longer working in unison to pump up global asset prices.

One of the best pieces of advice I ever got as an Investor was to take what the market gives you. Right now the market isn’t giving us much, at least not the sort of stock-picking opportunities that most Investors want. Or think they want. That’s okay. This, too, shall pass. Eventually. Maybe. But what’s not okay is to confuse what the market IS giving us, which is the opportunity to make long-term portfolio allocation decisions, for the sort of active trading opportunity that fits our market mythology. It’s easy to confuse the two, particularly when there are powerful interests that profit from the confusion and the mythology. Market Makers and The Sell Side want to speed us up, both in the pace of our decision making and in the securities we use to implement those decisions, and if anything goes awry … well, it must have been a glitch. In truth, it’s time to slow down, both in our process and in the nature of the securities we buy and sell. And you might want to turn off the TV while you’re at it.

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When the Story Breaks

The Three Types of Fear:

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

Stephen King

Brody: You’re gonna need a bigger boat.

“Jaws” (1975)

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

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

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

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

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

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


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

Three final Narrative-related points…

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

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

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

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The New TVA


War is too important to be left to the generals.
Georges Clemenceau (1841 -1929)

Competition has been shown to be useful up to a certain point and no further, but cooperation, which is the thing we must strive for today, begins where competition leaves off. … If we call the method regulation, people will hold up their hands in horror and say ‘un-American’ or ‘dangerous.’ But if we call the same process cooperation these same old fogeys will cry out ‘well done.’
Franklin Roosevelt (1882 – 1945)




The New Yorker magazine’s cartoons of the plump, terrified Wall Streeter were accurate; business was terrified of the president. But the cartoons did not depict the consequences of that intimidation: that businesses decided to wait Roosevelt out, hold on to their cash, and invest in future years.

– Amity Shlaes, “The Forgotten Man” (2007)

Quite possibly the TVA idea is the greatest single American invention of this century, the biggest contribution the United States has yet made to society in the modern world.
John Gunther, “Inside USA” (1947) 

Don Draper: This is the greatest advertising opportunity since the invention of cereal. We have six identical companies making six identical products. We can say anything we want. How do you make your cigarettes?
Lee Garner, Jr.: I don’t know.
Lee Garner, Sr.: Shame on you. We breed insect repellant tobacco seeds, plant them in the North Carolina sunshine, grow it, cut it, cure it, toast it…
Don Draper: There you go. There you go.

[Writes on chalkboard and underlines: “IT’S TOASTED.”]

Lee Garner, Jr.: But everybody else’s tobacco is toasted.
Don Draper: No. Everybody else’s tobacco is poisonous. Lucky Strikes…is toasted.

“Mad Men: Smoke Gets inYour Eyes” (2007)


“How the Children Played at Slaughtering,” for example, stays true to its title, seeing a group of children playing at being a butcher and a pig. It ends direly: a boy cuts the throat of his little brother, only to be stabbed in the heart by his enraged mother. Unfortunately, the stabbing meant she left her other child alone in the bath, where he drowned. Unable to be cheered up by the neighbours, she hangs herself; when her husband gets home, “he became so despondent that he died soon thereafter”.
The Guardian, “Grimm Brothers’ Fairytales have Blood and Horror Restored in New Translation” November 12, 2014



The California Public Employees’ Retirement System said it missed its return target by a wide margin, hurt by a sluggish global economy and an under-performing private equity portfolio. The nation’s largest public pension fund said its investments returned just 2.4% for its fiscal year, ended June 30, far below its 7.5% investment target.
Los Angeles Times, “CalPERS Misses Its Target Return by a Wide Margin” July 13, 2015

As the world moves slowly towards more economic stability, the outlook for gold is more uncertain than ever.
Wall Street Journal, “How the Street is Weighing Up Gold’s Lost Shine” July 20, 2015

When a market malfunctions, the government should not let market sentiment turn from bad to worse. It should use powerful measures to strengthen market confidence.
The People’s Daily (official China newspaper), July 20, 2015

My favorite scene from Mad Men is the picnic scene from Season 2. The Draper family enjoys a lovely picnic at some park, and at the conclusion of the meal Don tosses his beer cans into the bushes and Betty just flicks the blanket and leaves all the trash right there on the grass. Shocking, right? I know this is impossible for anyone under the age of 30 to believe, but this is EXACTLY what picnics were like in the 1960’s, even if a bit over the top in typical Draper fashion. There was no widespread concept of littering, much less recycling and all the other green concepts that are second nature to my kids. I mean … if I even thought about Draper-level littering at a Hunt picnic today my children would consider it to be an act of rank betrayal and sheer evil. I’d be disowned before they called the police and had me arrested.


Like many of us who were children in a Mad Men world, I can remember the moment when littering became a “thing”, with the 1971 public service commercial of an American Indian (actually an Italian actor) shedding a tear at the sight of all the trash blighting his native land.  Powerful stuff, and a wonderful example of the way in which Narrative construction can change the fundamental ways our society sees the world, setting in motion behaviors that are as second nature to our children as they were unthinkable to our parents. It’s barely noticeable as it’s happening, but one day you wake up and it’s hard to remember that there was a time when you didn’t believe that littering was a crime against humanity.


This dynamic of change in meaning is rare, but it takes place more often than you might think. Dueling and smoking are easy examples. Slavery is, too. Myths and legends turned into nursery rhymes and fairy tales is one of my favorite examples, as is compulsory public education … a concept that didn’t exist until the Prussian government invented it to generate politically indoctrinated soldiers who could read a training manual. Occasionally – and only when political systems undergo the existential stress of potential collapse – this dynamic of change impacts the meaning of the Market itself, and I think that’s exactly what’s taking place today. Through the magic of Narrative construction, capital markets are being transformed into political utilities. 

It’s not a unique occurrence. The last time investors lived through this sort of change in what the market means was the 1930s, and it’s useful to examine that decade’s events more closely, in a history-rhyming sort of way. What’s less useful, I think, is to spend our time arguing about whether this transformation in market meaning is a good thing or a bad thing. It is what it is, and the last thing I want to be is a modern day version of one of those grumpy old men who railed about how Roosevelt was really the Anti-Christ. What I will say, though (and I promise this will be my last indication of moral tsk-tsking, for this note anyway), is that I have a newfound appreciation for why they were grumpy old men, and I feel keenly a sense of loss for the experience of markets that I suspect my children will never enjoy as I have. I suspect they will never suffer in their experience of markets as I have, either, but there’s a loss in that, as well.

It’s totally understandable why status quo political interests would seek to transform hurly-burly capital markets into a stable inflation-generation utility, as summed up in the following two McKinsey charts.



Both of these charts can be found in the February 2015 McKinsey paper, “Debt and (not much) deleveraging”, well worth your time to peruse. Keep in mind that the data used here is from Q2 2014, back when Greece was still “fixed”, the Fed had not proclaimed its tightening bias, and China was still slowing gracefully. All of these numbers are worse today, not better.

So what do the numbers tell us? Two things. First, there’s more debt in the world today than before the Great Recession kicked off in 2008. All the deleveraging that was supposed to happen … didn’t. Sure, it’s distributed slightly differently, both by sector and by geography – and that’s critically important for the political utility thesis here – but whatever overwhelming debt levels you thought triggered a super-cyclical, structural recession then … well, you’ve got more of it now.  Second, it’s impossible to grow our way out of these debt levels. Japan, France and Italy would have to more than double their current GDP growth rates (and again, these are last year’s more optimistic projections) to even start to grow their way out of debt. Right. Good luck with that. Spain needs a triple. Even the US, the best house in a bad neighborhood, needs >3% growth from here to eternity to start making a dent in its debt. Moreover, every day you don’t achieve these growth levels is a day that the debt load gets even larger. These growth targets are a receding target, soon to be well out of reach for every country on Earth.

The intractable problem with these inconvenient facts is that there are only three ways to get out from under a massive debt. You can grow your way out, you can inflate your way out, or you can shrink your way out through austerity and/or assignment of losses. Door #1 is now effectively impossible for most developed economies. Door #3 is unacceptable to any status quo regime. So that leaves Door #2. The ONLY way forward is inflation, so that’s what it’s going to be. There is no Plan B. What sort of inflation is most amenable to modern political influence? Financial asset inflation, by a wide margin. Inflation in the real economy depends on real investment decisions by real businesses, and just as in the 1930s most business decision makers are sitting this one out, thank you very much. Or just as in the 1930s they’re “investing” in stock buy-backs and earnings margin improvement, which doesn’t help real world inflation at all. What political institutions are most capable of promoting inflation? Central banks, again by a wide margin. Just as in the 1930s, almost every developed economy in the world has a highly polarized electorate and an equally polarized legislature. The executive may be willing, but the government is weak. Far better to wage the inflation wars from within the non-elected walls of the Eccles Building rather than the White House.

Now … how to wage that inflation war with the proper Narrative armament? No one wants inflation in the sense of “runaway inflation”, to use the phrasing of doomsayers everywhere. In fact, unless you’re speaking apparatchik to apparatchik, you don’t want to use the word “inflation” at all. It’s just like Roosevelt essentially banning the word “regulation” from his Cabinet’s vocabulary. Don’t call it “regulation”. Call it “cooperation”, Roosevelt said, and even the grumpy old men will applaud. So today China calls it a “market malfunction” when their stock market deflates sharply (of course, inflating sharply is just fine). Better fix that malfunctioning machine! How can you argue with that language? But at least the political mandarins in the East are more authentic with their words than the political mandarins in the West. Here we now call market deflation by the sobriquet “volatility”, as in “major market indices suffered from volatility today, down almost one-half of one percent”, where a down day is treated as something akin to the common cold, a temporary illness with symptoms that we can shrug off with an aspirin or two. You can’t be in favor of volatility, surely. It’s a bad thing, almost on a par with littering. No, we want good things and good words, like “wealth effect” and “accommodation” and “stability” and “price appreciation”. As President Snow says in reference to The Hunger Games version of a political utility, “may the odds be always in your favor”. Who doesn’t want that?

There are two problems with the odds being always in your favor.

First, the casino-fication of markets ratchets up to an entirely new level of pervasiveness and permanence. By casino-fication I mean the transformation of the meaning of market securities from a partial ownership interest in the real-life cash flows of real-life companies to a disembodied symbol of participation in a disembodied game. Securities become chips, pure and simple. Now there’s nothing new in this gaming-centric vision of what markets mean; it’s been around since the dawn of time. My point is that with the “innovation” of ETF’s and the regulatory and technological shifts that allow HFTs and other liquidity game-players to dominate the day-to-day price action in markets, this vision is now dominant. There’s so little investing today. It’s all positioning And in a capital-markets-as-political-utility world, the State is now actively cementing that view. After World War I, French Prime Minister Georges Clemenceau famously said that war was too important to be left to the generals, meaning that politicians would now take charge. Today, the pervasive belief in every capital in the world is that markets are too important to be left to the investors. These things don’t change back. Sorry.

Second, if you’re raising the floor on what you might suffer in the way of asset price deflation, you are also lowering the ceiling on what you might enjoy in the way of asset price inflation. That’s what investing in a utility means – you’re probably not going to lose money, but you’re not going to make a lot of money, either. So to all of those public pension funds who are wringing their hands at this fiscal year’s meager returns, well below what they need to stay afloat without raising contributions, I say get used to it. All of your capital market assumptions are now at risk, subject to the tsunami force of status quo politicians with their backs up against the debt wall. Their market-as-utility solution isn’t likely to go bust in a paroxysm of global chaos, any more than it’s likely to spark a glorious age of reinvigorated global growth. Neither the doomsday scenario nor the happy ending is likely here, I think. Instead, it’s what I’ve called the Entropic Ending, a long gray slog where a recession is as unthinkable as a 4% growth rate. It’s a very stable political equilibrium. Sorry.

As the title of this note suggests, we’ve been down this road before in the 1930s. But the historical rhyming I see is not so much in the New Deal policies that directly impacted the stock market as it is in the policies that established a real-life utility, the Tennessee Valley Authority (TVA).  That’s because the nature of the existential threat posed by overwhelming debt to the US political system was different in the 1930s than it is today. When FDR took office, the flash point of that systemic threat was the labor market, not the capital market. Sure, the stock market took its hits in the Great Depression, but the relevance of the stock market to either the overall economic health of the country or – more importantly to FDR – his ability to remain in office was dwarfed by the relevance of the labor market. It’s another one of those changes in meaning that seems bizarre to the modern eye or ear. What, you mean there wasn’t 24/7 coverage of financial markets in 1932? You mean that most Americans didn’t really know what a stock certificate was, much less own one?  To succeed politically, Roosevelt had to change the meaning of the labor market, not the capital market, and that’s exactly what he did with the creation of the TVA.

The TVA was only one effort in an alphabet soup of New Deal policies that FDR rammed through in his first Administration to change the popular conception of what the labor market meant to Americans. Other famous initiatives included the National Recovery administration (NRA) and the Civilian Conservation Corps (CCC), and the common thread in all of these efforts was a VERY active Narrative management embedded in their process from the outset, with photographers and journalists hired by the White House to document the “success” of the programs. Everything I write in Epsilon Theory about today’s pervasive Narrative construction also took place in the 1930s, in amazingly similar venues and formats, down to the specific words used.

The Narrative effort worked. Not necessarily in the permanence of the institutions FDR established (the Supreme Court declared the NRA unconstitutional in 1935, and the CCC faded into obscurity with the outbreak of World War II), but in the complete reshaping of what the labor market meant to Americans and what government’s proper role within the labor market should be. Yes, there were important things lost in FDR’s political achievements (and plenty of grumpy old men to complain about that), but let’s not forget that he was re-elected THREE times on the back of these labor market policies. If that’s not winning, I don’t know what is. And if you don’t think that lesson from history hasn’t been absorbed by both Clinton™ and Bush™, you’re living in a different world than I am.

One last point on the TVA. It’s still around today as a very powerful and oddly beloved institution, and I think its lasting political success is due in large part to the fact that it – unlike the other alphabet soup institutions – was explicitly a utility. Who doesn’t like the stability of a utility in the midst of vast inequality? Who doesn’t like the odds being ever in their favor? The more that I see today’s policy impact on markets described in utility-like terms – words like “stability” and notions like “volatility is bad and a thing to be fixed” – the more confident I am that the TVA political experience of the 1930s is coming soon to the capital markets of today. Scratch that. It’s already here.

So, Ben, let’s assume you’re right and that current events are rhyming with the historical events of the last time the world wrestled with an overwhelming debt load. Let’s assume that a politically popular shift in the meaning of markets to cement its public utility function is taking shape and won’t reverse itself without a political shock of enormous proportions. What’s an investor or allocator to do, other than become a grumpy old man? Look, the hardest thing in the world is to recognize structural change when you’re embedded in the structure. If reading Epsilon Theory has given you a new set of lenses to see the relationship between State and Market, then you’ve already done the heavy lifting. From here, it’s a matter of applying that open-eyed perspective to your portfolio, not of buying this or selling that! Everyone will be different in their particular application, but I think everyone should have three basic goals:

  1. shake out the category errors in your investment assumptions, understanding that we humans are terrible judges of causality, particularly when something has worked recently;
  2. re-evaluate your capital market assumptions for a further transformation of those markets into state-run casinos and political utilities, understanding that whatever crystal ball you’ve used in the past is almost certainly broken today;
  3. adopt an investment process or find investment strategies that can adapt to the structural changes that are already underway in capital markets, understanding that the patterns of belief and meaning we think are “natural” today can change in the blink of a central banker’s eye.

Put simply, it’s time for some good new thinking on some good old ideas like diversification. It’s time to recognize the world as it is rather than lose ourselves in nostalgia for the world that was. Most of all, it’s time to call things by their proper names and stop demonizing words like “leverage” and “volatility”. These are tools, for god’s sake, neither good nor bad in and of themselves, and they’re tools we are all going to need to learn how to use if we want to be survivors in the Golden Age of the Central Banker. It’s time to get to work.

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