Funding Secured

SoftBank CEO Masayoshi Son and Crown Prince MBS in happier times

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Quid

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

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

Source: Quid

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

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

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

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

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

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

The Tells of Fiat News

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

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

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

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

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

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

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

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

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

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

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

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

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

The Grammar of Risk

Butch: Alright. I’ll jump first.

 Sundance: No.

Butch: Then you jump first.

Sundance: No, I said.

Butch: What’s the matter with you?!

Sundance: I can’t swim!

Butch: Are you crazy?! The fall will probably kill you!

Butch Cassidy and the Sundance Kid (1969)

Now, I’m going to love you
Till the heavens stop the rain
I’m going to love you
Till the stars fall from the sky for you and I. 

Touch Me, by the Doors (1969)
Not even the Gods above
Can separate the two of us
No, nothing can come between You and I

You & I, by One Direction (2013)
Oh yeah, well, I’d rather die
Without you and I.

You and I, by Lady Gaga (2011)
Ain’t nobody in the world but you and I.

You and I (Nobody in the World), by John Legend (2013)
Between you and I darlin’,
Nothin’ could get better baby.

Between You & I, by Jessica Simpson (2006)
As long as I got you
As long as I got me
As long as we got you and I.

You and I, Kenny Rogers (1983)

I saw a funny little poll earlier this week from Bloomberg Opinion writer Noah Smith. “Which do you think,” it asked, “is correct grammar?” It then provided readers with two options:

  • “Come with Bob and I”
  • “Come with Bob and me”

Nearly one-fifth of what one would presume is a reasonably literate bunch picked the wrong answer. But this error is unlike the many other common language gaffes. You know the ones I mean. They’re/their/there. It’s/its. These are the kind of mistakes that are usually the result of someone simply not knowing what’s correct. Or forgetting. Or not caring.

But “come with Bob and I” isn’t the result of ignorance or indifference. It is the result a lesson badly taught and badly learned.

You see, there is no more present problem for elementary and middle school English teachers than the rampant misuse of the objective first-person pronoun in a series. In other words, just about every kid in America grows up saying, “Me and my friends are going to the park!” I am not sure why it is that every school and in America is so laser-focused on this quirky usage, which is far too ubiquitous and colloquial at this point to stamp out.  Say it in a school in America, and it will be corrected. Every time. Which is probably fine, I guess.

And it would be fine, except that the lesson inevitably becomes part of a recurring lesson plan on using nouns and pronouns in a series. Students are hammered year after year with “Jack, Jill, and I” exercises that unintentionally reinforce the idea that what matters is using the first-person subjective/nominative when referring to yourself in a series, and to always put yourself last. The latter lesson is utter hogwash, and the former lesson is fine as far as it goes – that is, until it becomes clear that most young English speakers have internalized a non-existent relationship between series of nouns and the subjective/nominative ‘I’. That’s how we end up with the lyrics to all those songs that will now set your teeth on edge every time you hear them.

You’re welcome. Since I’m already wielding this power, you now also have the Kars-4-Kids jingle in your head.

The confusion about ‘I’ is also one of the clearest examples I know of to describe what happens when you learn or teach people the answers to questions, instead of the process by which they will find answers in the future.

By the way, Happy Black Monday anniversary. You know, the day that we read opinion and feature articles about what went wrong and what lessons we learned?

One or more of the pieces usually turns into a brief survey-of-crashes piece. Here’s an intro to those portfolio insurance products back in ’87. Here’s what LTCM did just a decade later. Here’s a summary of the 2007 quant meltdown. Here are the proximate causes of the Global Financial Crisis. After this, you will learn about the actions that investors took to ensure that those things couldn’t happen to their portfolios and strategies again. We introduced this new risk measure. We stopped buying this kind of product. We sold this fund that didn’t work right during the crash. We stopped trusting computer models to run our money. We fixed this faulty assumption in our model. Finally, you will learn about the scary parallels today. Program trading! Trade disputes with Asia! Risk-targeting asset allocation strategies built around correlation estimates!

If you don’t know what I’m talking about, stop and find a hedge fund that publishes stress tests with their quarterly fact card or investor deck. Talk to them about how those stress tests are conducted. Then come back to this note when your brain asks itself, ‘Wait, you mean they’re just telling me what their current positions would do if every asset performed exactly like it did in that event 30 years ago?’

These are answers. They aren’t just not useful. They have negative value. They make you see ghosts. They waste your time. They prevent you from taking what are perfectly prudent steps to diversify, hedge and get the right level of risk in your portfolios. So in celebration of this anniversary and the opportunities it affords to learn lessons badly, let me instead offer a heuristic and a process I learned from Brad Gilbert, Matt Strube and Todd Centurino, my friends and former colleagues on the hedge fund team at Texas Teachers. It has served me well.




You can almost always get away with one. You can almost never get away with three. In a normal market you can handle two. In a bad market you can’t. I’ve been toying with adding Abstraction to my little list, but it’s tough to measure. This is the grammar of risk. These – not algorithms, not derivatives, not some specific mix of news events that matches a prior crisis, not some other lesson badly learned – are what will blow you up. 

Investment Diligence and the Cornelius Effect

Earlier this week Ben wrote a note about the Curse of Some Talent. There is a related idea that comes with a story. This is one of my favorite stories. It recounts a seminal event from the earliest days of Saturday Night Live.

The inaugural cast was a gifted one. If, like me, you weren’t there, it included John Belushi, Gilda Radner and Dan Aykroyd, among other generational talents. It also included Chevy Chase. His stint would be brief. After one full season in 1975 and a few episodes in the 1976 season, Chevy left the show. He claimed that he did so because his fiancée wasn’t willing to live in New York, which may have been true. The cast and many others, however, believed he left to quickly cash in on the platform and fame their young repertory company had provided him. He was a star, and they weren’t (yet). He was Chevy Chase, and they weren’t. And by all accounts, his behavior quickly started to reflect that belief.

And then, just as quickly, he was gone.

Chevy was replaced by a 26-year old actor named Bill Murray, only six years removed from having been arrested at O’Hare for possession of 10 pounds of marijuana. True to form, he was only caught because he made a joke about smuggling weed to the passenger sitting next to him.

Bill and Chevy overlapped a bit during Chevy’s transition, and did not get along. But John Belushi and Chevy really did not get along. And when Chevy came back to host the show in 1978, Bill, being the force of nature that he was, was enlisted by John and the rest of the cast to confront Chevy. The entire week of rehearsals was a mess of accusations and rancor. It escalated into insults, first about Murray’s complexion, and then about…well…Chevy’s prowess, to put it delicately. The confrontation culminated in a physical altercation at one of the final rehearsals. Upon being separated, a furious Murray pointed at Chevy and delivered the real pièce de résistance:

Medium Talent.

God, what an amazing line. It was the most cutting possible blow. Unanswerable. It wasn’t so absurdly critical that it could be brushed off as a mere insult. Instead, Murray found the thing that a star quickly elevated would most fear, and laid it bare for everyone to hear. To be fair, Cornelius Crane Chase is talented and funny. Far more, probably, than you or I. Do his natural gifts exceed those of 99% of Americans? 99.9%? 99.99%? Almost certainly. But at least in the opinion of his castmates, that wasn’t enough. And while I don’t know enough about the craft of comedy to issue my own opinion, I know enough to agree with Bill Murray, Jane Curtin and John Belushi on the subject.

Alas, the investment world, too, is cursed with the problem of Medium Talent.

I am an investor of Medium Talent. Ben is a Medium Talent. Most of the investors I’ve ever worked with were Medium Talents. Almost every fund manager I’ve ever invested with, and almost every analyst I’ve hired. Unlike Bill Murray, I don’t mean this as an insult. The term simply describes the reality in which, beyond some baseline threshold, further increases in talent, intelligence and skill are not the factors which influence outcomes. What’s more, it describes the basis on which our expectations for ourselves and others continue to rise despite the declining relevance of increases in those traits. Maybe this phenomenon already has a name. In honor of Chevy, however, let’s call it the Cornelius Effect. Here’s a No Talent sketch of what I mean:

The Cornelius Effect pervades the identification of talent across many – although certainly not all – fields. It is ubiquitous in financial markets. It governs how we hire analysts. It governs how we hire fund managers. It governs how we hire financial advisers. It governs how we invest in management teams.

If your organization is like any investment organization I have been a part of or have performed due diligence on, each of those talent identification processes can be distilled into a simple philosophy: hire or invest with the smartest-seeming person everyone seems to like. Oh, we almost always make some attempt to find useful proxies for these traits that permit us to feel like we’re evaluating some other characteristics as part of a targeted process. This is a cartoon. As an industry, we hire based on our perception of intelligence. Maybe you think you or your organization don’t do this. And maybe you really don’t. But I’d ask you to really think about your last few decisions before you draw that conclusion.

Up to a point, emphasizing intellectual talent is kind of what we should be doing. The work isn’t trivial, and simple measures of intelligence are still a far better indicator of outcome than the skill inventories so many HR departments emphasize. You know, the kinds that search for resume keywords of skills that the average human could pick up in a week or so? It is also certainly the case that there ARE some legitimate investment activities which require a bit more horsepower. But in context of the very high average intelligence of people in this industry, the threshold of intellect at which the traits we are seeking out should shift to traits related specifically to our process – or theirs – is low. Much lower than most people think. By and large, if you are hiring managers, advisers and staff by trying to find the smartest PM/FA/consultant/analyst you can find, this practice will lead you to constant surprise and disappointment.

I’ve got a lot more to say about how the Cornelius Effect ought to influence our diligence processes for these advisers and professionals, but all of these concepts orbit around the belief in emphasizing process over the idea that we’re going to find someone with the answers. When we are hiring, doing this requires us to have a clear-eyed view of the part of our process which we believe is truly value additive, and for which aspect of that process this individual would be responsible. When we are selecting a fund manager or adviser to work with, we must first develop a clear (or as clear as it is really possible to be in this muddy mess of markets) mental model of what it is about their process that should theoretically be capable of producing better outcomes. Our diligence questions then become less about ascertaining just how blindingly brilliant and knowledgeable they are, and more about judging whether they have the intellectual and temperamental traits necessary to execute that process.

The alternative is to be stuck with the constant disappointment of Medium Talent.

Putting the Real Back Into Realpolitik

All I know is that we have to find some way to censure M.B.S. for this — without seeming to attack the whole Saudi people and destabilize the country. And we have to make sure that the social/religious reform process in Saudi Arabia proceeds — whoever is in charge there. Because that is a vital U.S. interest.

— Tom Friedman, “America’s Dilemma: Censuring M.B.S. and Not Halting Saudi ReformsNew York Times, October 17, 2018

The West won the world not by the superiority of its ideas or values or religion … but rather by its superiority in applying organized violence. Westerners often forget this fact; non-Westerners never do. – Samuel P. Huntington (1927 – 2008)

Upon learning of Cardinal Richelieu’s death, Pope Urban VIII is alleged to have said, “If there is a God, then Cardinal de Richelieu will have much to answer for. If not … well, he had a successful life.”– Henry Kissinger, “Diplomacy” (1994)

Order should not have priority over freedom. But the affirmation of freedom should be elevated from a mood to a strategy.  – Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

I’m a realist. Not a neo-realist, but a realist. There’s a difference. I learned my craft from the two guys quoted immediately above – Sam Huntington and Henry Kissinger. Neither man was a peach. Huntington was a curmudgeon and Kissinger sold his soul for wealth and power, not just once but at least four times over. I wouldn’t want either man in my pack, but I’m grateful that I had both men as teachers.  I think they’re largely correct about … everything. 

It’s that last quote of Kissinger’s that I think is so important in the aftermath of the Khashoggi murder and the crystallization of common knowledge regarding the Saudi regime in general and MBS in particular.  “Order should not have priority over freedom. But the affirmation of freedom should be elevated from a mood to a strategy.

Yes, please.

Huntington is dead and Kissinger can’t speak in public without an angry mob shouting him down, so I’m going to speak for both of them.

Any realist worth his or her salt should be appalled at the foreign policy of BOTH Trump and Team Elite toward Saudi Arabia.

The foreign policy failure, from a realist perspective, of both Trump and Team Elite (who I’ll personify with Tom Friedman) has exactly the same root – they believe that they can be friends with Saudi leaders. They believe that it matters whether or not they are friends with Saudi leaders. They believe that Saudi Arabia can be advanced (Trump’s language) or reformed (Friedman’s language) because of this direct personal support, and that advancement/reform is impossible without it.

For Trump, it’s working with the Saudi regime on some cockamamie “rogue killers” notion to get Jared’s good friend MBS off the hook from direct culpability, so that we can “get back to doing business with our great friends in Saudi Arabia”. For Friedman, it’s finding some way to “censure” MBS, his former interview buddy and confidante, so that we can “make sure that the social/religious reform process in Saudi Arabia proceeds”. For BOTH, there is this notion that it matters whether or not the Saudi political leadership has credibility and a winning narrative in the West. For BOTH, there is this notion that US-Saudi relations can move forward in a mutually beneficial fashion if and only if there’s a smiley-face button that everyone can wear.  

In truth, of course, King Salman and Crown Prince MBS and the Saudi royal family are not our “friends”. They will never be our “friends”. There is no smiley-face narrative to be created here. Not now. Not ever.

And that’s fine. 

Here’s the realist truth for Donald Trump: friendship is not necessary, and is in fact counterproductive, to your mercantile goals in Saudi Arabia. You will not get a better “deal” because you are “friendly” with the Saudi regime.

Here’s the realist truth for Tom Friedman: friendship is not necessary, and is in fact counterproductive, to your liberalization goals in Saudi Arabia. You will not get more “reform” because you are “friendly” with the Saudi regime.

The greatest self-delusion of powerful and extremely wealthy men like Trump and Friedman (yes, Friedman), is that they can personally make a difference in grand historic events. That international relations are some Great Game in which they are uniquely able to shape outcomes. That if only they can sit down and look that other extremely wealthy and powerful man straight in the eye, then they can, in the immortal words of George W. Bush vis-a-vis Putin, “get a sense of his soul” and negotiate a treaty, work out a trade deal, push for reforms, denuclearize a war zone … accomplish anything, really.

What a crock.

I’ll close this note with one last Kissinger quote.

Side by side with the limitless possibilities opened up by the new technologies, reflection about international order must include the internal dangers of societies driven by mass consensus, deprived of the context and foresight needed on terms compatible with their historical character. As diplomacy is transformed into gestures geared toward passions, the search for equilibrium risks giving way to a testing of limits. … 

Because information is so accessible and communication instantaneous, there is a diminution of focus on its significance, or even on the definition of what is significant. This dynamic may encourage policymakers to wait for an issue to arise rather than anticipate it, and to regard moments of decision as a series of isolated events rather than part of a historical continuum. When this happens, manipulation of information replaces reflection as the principal policy tool.

– Henry Kissinger, “World Order: Reflections on the Character of Nations and the Course of History” (2014)

If this quote doesn’t ring true to you … if it doesn’t scare the bejeesus out of you as Trump looks for those darn rogue killers … well, you’re just not paying attention.

Saudi Arabia and the Common Knowledge Game

An historic night it was.

A pleasure to have a private dinner with the Crown Prince of Saudi Arabia, Mohammed bin Salman, his royal family and distinguished cadre.

A fun night and great to hear his deep rooted, yet modern views on the world and certainly the positive growth of his country.

Thank you my friend Rupert Murdoch for being such a great host, as well Bob Iger – my mentor who still wakes up 15mins before I do every morning at 4:15am. I’m still slacking.

— Dwayne “The Rock” Johnson’s Instagram feed (pre-editing), April 5, 2018

At least Oprah had the good sense not to allow any photographs of her meeting with MBS to get out.

On Sunday evening, a spokesman for Mr. Dimon said the chief executive, who was scheduled to be one of the headline speakers at the Future Investment Initiative in Riyadh, would no longer attend. He did not explain Mr. Dimon’s reasoning.

— “JPMorgan’s Dimon Backs Out of Saudi Conference Amid Khashoggi Furor“, New York Times, October 14, 2018

Once again, and just like with Harvey Weinstein, we are seeing widespread private information turned into common knowledge, a transformation that changes everything about behaviors.

With Weinstein, the ubiquitous private information was that Weinstein is a serial rapist. Everyone in Hollywood knew it, but no one acted AS IF they knew it until a Missionary event – in this case Rose McGowan’s and others’ very public denunciations – turned that information into common knowledge, something that everyone knows that everyone knows. It’s the celebrity of the Missionary that drives this transformation, because if the Missionary is famous enough, then everyone must believe that everyone else has heard the news. 

And once that common knowledge was created, once all the private holders of all of Weinstein’s dirty secrets believed that everyone else believed that he is a serial rapist, then everyone’s behavior changed on a dime. His publicists and lawyers and partners and colleagues and board of directors and wife were shocked … shocked! … to hear of his behavior, and certainly would no longer be representing him or working with him or associating with him ever again, even though NOTHING had changed in the information they already possessed.

With Saudi Arabia, the ubiquitous private information was that Saudi Arabia is a thug state and their Crown Prince MBS is a wannabe Bond villain. But no one acted AS IF they knew this until a Missionary event – in this case Turkey’s very public denunciations of the Saudi government’s murder of Jamal Khashoggi – turned that private information into common knowledge, something that now everyone knows that everyone knows.

And once that common knowledge was created, once all the private holders of Saudi Arabia’s dirty secrets believed that everyone else believed that this is one of the most brutal regimes on Earth, then everyone’s behavior changed on a dime. All of these CEOs and Senators and Prime Ministers and movie stars are shocked … shocked! … to hear of this atrocious behavior, and certainly will no longer be attending this gala conference scheduled for next week, even though NOTHING had changed in the information they already possessed.


It’s all a little much, frankly, and it reminds me of how … disappointing … human beings are, particularly in group dynamics. But I get it. The proper forms must be followed. Outrage must be displayed, no matter how inauthentic its “discovery”, once everyone knows that everyone knows that outrages have occurred.

Rusty thinks that this all blows over quickly, that the complicity with the Saudi regime is so widespread and so deep among Politicians and Oligarchs that there’s a brief boycott of a stupid conference, some degree of tsk-tsk’ing from Team Elite Missionaries, some effort to bring those darn rogue killers to justice, and then everything returns to “normal”. He’s probably right.

But I’ll say this. Once common knowledge has been created, it’s impossible to uncreate. It’s impossible to go back to the plausible deniability and bribes and renditions of the ubiquitous private knowledge world. MBS will never again have a “reformer” cartoon. He is now a Bond villain. That’s the common knowledge, and behaviors will change as a result. No more nights on the town with The Rock. No more warm meetings with Oprah.  No more vacations with Jared. No more softball interviews with Tom.

Is that a lot? No. But it’s something. It’s a start.

Locusts’ Lament

After publishing a few In Brief pieces featuring Quid-based narrative maps, we received a number of emails from subscribers asking us for analysis on other topics. 

For those who have read prior notes, you will know that what I usually find most interesting are areas in which otherwise similar topics or words engender very different sentiment and narratives, or in which different universes of authors, commenters and missionaries conjure up different narratives tailored to produce separate responses from distinct audiences. When one long-time reader expressed curiosity about narratives around private equity, I was intrigued. Its results surprised me. But it wasn’t until I checked it against a comparable topic that I found the narrative dimension I really wanted to explore.

First, let’s take a look at the narrative map – as usual, with major cluster names joyfully designated by me with both flippancy and bias – for private equity in 2018.

Like the historical treatment of the big tech stocks in media I highlighted last week, media treatment of private equity in 2018 has been glowing. Of the more than 3,100 news stories referencing private equity this year, the positive-to-negative sentiment ratio was nearly 16-to-1. What is more interesting, perhaps, is that a huge number of these stories are using very similar language, terminology and structure. Shown graphically, you see this as the almost non-existent distance between the various clusters. The stories about what allocators are doing are frequently also about dry powder, and frequently also about operational improvements and valuations. In rare cases, they spare a moment to reference the loss of generational businesses, factories, storefronts, high street shopping districts and jobs.

You would be forgiven – especially after the big tech piece – to question whether my priors about the infrequency of this kind of sentiment about financial topics are inaccurate. So let me show you another narrative map. This time? Hedge funds. Same period. Same sources.


First, let’s talk about the sentiment. Remember how the ratio of positive-to-negative for private equity was nearly 16-to-1? For hedge fund stories, that ratio is about 0.3-to-1. In other words, that’s a 3-to-1 ratio in favor of articles written with negative language, terminology and structure. To be clear, some of that is going to be picked up in periods of bad performance just by factually representing that performance. But interestingly for 2018, hedge fund performance has not been especially bad relative to traditional assets or other alternatives. In fact, some hedge funds are having a decent year.

More importantly, the negative sentiment pervades the stories that cover hedge funds on just about every topic. The same glowing discussions of operational improvements by private equity are all about the uncomfortable language of shareholder activism when it comes to hedge funds. Basically the only clusters with non-toxic sentiment are (1) excited discussion of cryptocurrency fund launches and (2) exposés into how difficult it is to get hedge fund jobs.

Fascinatingly, as you see from the relatively distinct clusters, there isn’t a recurring narrative. Nothing that really creates strong links between all these articles, besides the idea that hedge funds are bad. It is simply a topic about which common knowledge is so strong that just about any pot shot will land. There’s no need for any art – just mail it in. Hedge funds are the range pickers at any driving range in America – an irresistible target, and one for which the attacker is unlikely to ever get anything more than the most perfunctory tsking from another golfer.

You won’t find me or Ben arguing that there isn’t truth in some of the stories. We’re on record, for example, opining that the most positively selected trait for hedge fund PM success is probably sociopathy. But the idea that every activist PM is Gordon Gekko and every MD at a buyout shop is Mother Theresa is pure narrative.

Ultimately, however, this is what the lazy, complacent cartoon formed around a view that has been correct for a very long time looks like. Lest we let all this discussion of narratives get in the way of the facts, let’s recall that hedge funds have had a very bad run of performance in almost every category in comparison to nearly any other alternative strategy or traditional asset class. On an absolute and on a risk-adjusted basis. Private equity has performed much better, and because it is usually treated as an either/or with hedge funds by financial and broad media who don’t really understand the very different roles they play in portfolios, some measure of difference in treatment is appropriate.

But there are still some lessons to be gained here:

  • Hedge fund managers: Start playing some metagame again, for God’s sake. Aren’t half of you supposed to be WSOP headliners?
  • Private equity fund managers: Yes, you’re very smart. Everybody says so. But if you care about the long-term integrity of your franchise and your investments, be especially cautious about believing your own bullshit right now.
  • Allocators to alternatives: I would be obsessively focused on finding hedge fund managers with process that has been resilient to the last 10 years, even if it hasn’t worked, and on private equity managers with humility and introspection about the sources of their success over the last 10 years.
  • Everyone: I would be cautious of consultants or advisers whom you observe painting either strategy with a broad brush today. If someone is pushing private equity to you aggressively as a panacea, or seems to constantly, strangely bring up vague criticisms of hedge funds, you’ve probably found the easy mark the missionaries were looking for. That is usually a good sign that this consultant or adviser is not the guy or gal YOU are looking for.

If you’ve got other topics you’d like us to examine under this lens, be sure to drop them into the comment section here.

Why Ben Sasse Loses the Game of You

Pew Research Center, “Political Polarization 1994-2017”

Ben Sasse, the junior US Senator from Nebraska, wrote a beautiful opinion piece in the Wall Street Journal last Friday, titled “Politics Can’t Solve Our Political Problems“. It’s from a new book, Them: Why We Hate Each Other – And How to Heal, that’s out this week. Here’s the premise from the opinion piece:

More Republicans and Democrats are placing politics at the center of their lives. Both sides seem to believe that a grand solution to our political dysfunction can be found inside politics. If only we could vanquish those evil people waving a different banner, this thinking goes, we’d be on the road to national recovery.

But nothing that happens in Washington is going to fix what’s wrong with America. It’s not that our battles over the Supreme Court, over dignity for accuser and accused alike, over issues like taxes and regulation and immigration don’t matter. They matter a lot. The problem is that our ever more ferocious political tribalism and mutual hatred don’t originate in politics, so politics isn’t going to heal them.

From here, Sasse quotes the usual suspects, like Bob Putnam of “Bowling Alone” fame, to point out the atomization and alienation of modern life in America, particularly if you don’t have Team Elite status. Sasse is spot on in every respect. He concludes with this:

If too many Americans feel like we’re not “in this together” right now, it’s because we’re not. We are screaming at each other, and the country no longer has enough real social texture to absorb and wick away the hatred. The only way out is to rebuild our communities and launch new ones—one person-to-person relationship and one local institution at a time.

I think Sasse is absolutely right in everything he writes in this piece.

Each paragraph echoes an Epsilon Theory note or two that I’ve written, most loudly The Arborist and Sheep Logic and Clever Hans and The Icarus Moment, most recently Things Fall Apart (Part 1). Sasse’s conclusion, that the way to rebuild our political culture must be a bottom-up, non-political movement rather than a top-down, party-driven campaign, is the backbone of what I’ll be writing about in the concluding note of Things Fall Apart.

I also think Sasse is losing the Game of You, meaning that he is losing his identity and authenticity as he tries to salvage a political career.

Why? Because you can’t do what Sasse says you should do from inside the belly of the beast. You can’t build a non-political grassroots movement as a sitting US Senator and a card-carrying member of the Republican party. You can’t practice what you preach.

Sasse has created a cartoon of himself as someone outside the political World-As-It-Is, someone who writes entire books on community and non-political coming togetherness. But at the same time, he is living a life of intense immersion within the political World-As-It-Is, someone who wages actual political campaigns and casts actual votes for partisan policies. 

The Sasse cartoon does not match the Sasse life.

As a result, we have no idea who Ben Sasse IS.

As a result, Ben Sasse is perceived as an inauthentic shill by Democrats and as an inauthentic scold by Republicans. As a result, as Margaret Thatcher famously said, he is standing in the middle of the road and being run over by traffic from both sides. 

As the kids say, I’m just here for the ratio. 

Dig into the comments on this tweet or the comments on the WSJ piece itself, and two facts immediately pop out. First, there is very little engagement from potential book buyers here. I mean, 614 retweets? Only 1.6k likes? I don’t know who’s publishing Sasse’s new book, but they’ve gotta be extremely nervous right now. Second, the comments themselves are FAR more likely to slam Sasse than to support him, from BOTH sides of our political divide. To use the language of A Game of You, Sasse’s timeline is dominated by rage engagements, not mirror engagements. Again, that’s a huge problem for a politician trying to sell books.

To be clear, I’m not saying that Ben Sasse is an inauthentic human being, either as a shill or as a scold. In fact, if I were a betting man (and I am), I would place a significant wager that he is, in fact, a VERY authentic guy. I don’t think it’s possible to write the books that he’s written and to live the life that he’s lived with his family without being an authentic person whose core identity is in-line with what he wrote in this WSJ opinion piece. I really don’t. 

What I’m saying is that Ben Sasse’s chosen career – professional politician – is no longer sustainable or compatible with his professed identity. It used to be highly compatible. Whether as shtick or strategy or True Belief, beautiful speeches about coming together as Purple Americans used to be the surefire avenue for the Presidency. Used to be. 

But as I wrote in Things Fall Apart (Part 1), if you’re an incumbent centrist politician today, Republican or Democrat, you have exactly two choices.

  • You remain silent and just go with the party flow, clinging on for dear life against primary challengers, holding your nose at the party excesses, apologizing to your donors and your spouse in private, and hoping that one day the party comes back to you. You tell yourself “apres moi, le deluge.” Or in English, “sweet Jesus, have you seen the racist moron / lunatic communist who would take my place if I quit?”, and you’ve got a big enough ego to believe that sort of excuse as you slowly sell your soul.
  • You quit.

That’s it. Those are your options. Paul Ryan took Door #2. So did Jeff Flake. So did Bob Corker.

So should Ben Sasse.

Dogs, Dog Food, and the Curse of Some Talent

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. 

“Pulp Fiction” (1994)

We’re a week into the relaunched Epsilon Theory, and I’ve got mail.

I was wondering whether both you and Rusty have what Taleb calls f*** you money? Enough for yourselves and your needs and wants that you are not counting on Epsilon Theory to be financially successful in order to be happy? 

Will you keep writing as long as you still have something to say, or if ET is not paying the bills like you expect will you shut shop and do something else?

Regards, M.

Hahahahaha! Hooo-boy, that’s a good one. Ummm, no, neither Rusty nor I has f*** you money. We are all in with Second Foundation Partners and Epsilon Theory, meaning that we are risking everything to make this work. Yes, we’ve secured enough funding to give us plenty of runway to make it work, but if we’re wrong about the business model for Second Foundation … well, then, we’re wrong, and we’ll have to pick up stakes and pursue our dream and talents in some other form.  It’s the same story as thousands of other start-ups and thousands of other entrepreneurs in America today, no better and no worse. And we wouldn’t have it any other way.

Here’s a lesson I learned in my early start-up days. It was told to me by a very successful entrepreneur and occasional angel investor, and I didn’t believe it at the time. Now I know it’s the Truth with a capital T.

“Ben,” he said, “I’ve got a lot of money and I’ve got a lot of rich friends. We could probably fund this idea of yours for a long time with the 3 F’s – family, fools and friends. But that would be a big mistake. You need to know if a professional VC will invest in this. You need to know if real customers will pay you money for this. You need to know if dogs will eat the dog food you’re serving up. Because if dogs won’t eat the dog food, you shouldn’t do this, even if you’ve got funding secured for years, even if you can fund it all yourself.”

Like I say, this didn’t make me happy at all when I heard it. I thought this was the angel investor’s way of blowing me off, and maybe it was. But he was absolutely right.

Entrepreneurs should fully expose their ideas to the steely gaze of real investors and real customers as soon as humanly possible.

And if your great idea dies under that steady stare, it dies.

Be grateful for that.

Why? Because the great tragedy for an entrepreneur is NOT a failed idea. You will have other ideas! No, the great tragedy for an entrepreneur is a zombie idea, a business that has no chance of growth and vibrancy, but is kept alive through some witch’s brew of too much friendly capital and too much misplaced hope.

Stealth mode? 99 times out of 100 it’s a crock, a smart sounding excuse for hiding behind a non-competitive curtain. Self-financing? Ditto. The courage of an entrepreneur isn’t risking your own money. Of course you’re doing that. That’s the necessary condition, not the sufficient condition. The sufficient condition is risking your identity in the very public arena of competition and capital.

It’s the Curse of Some Talent, when you’ve got an idea or a venture that seems great to you, but isn’t quiiiiite great enough to make it in the cold cruel world. But you remain convinced it’s SUCH a good idea, you remain convinced that you really really do have the talent to make it big, and you’ve got the resources to keep going. That’s how one year turns into two. That’s how two years turns into ten, a decade of meh, all because you didn’t listen to what the world was telling you, all because you couldn’t bring yourself to put down the merely good idea, all because you never forced yourself to dream the NEXT idea.

As Marsellus tells the some-talented boxer Butch in Pulp Fiction when he’s arranging for Butch to take a dive in his next fight, “if you were gonna make it, you would have made it before now.”

Marsellus is absolutely right.

If it’s truly a great idea, Epsilon Theory will succeed commercially.

And if it doesn’t – if the dogs don’t eat the dog food – then no matter how much I believe it’s a great idea whose time has come … it’s NOT. I will be WRONG, and I must have the courage to confront that possibility today and that reality tomorrow, if it comes to pass. 

And all the f*** you money in the world won’t change that.

What does Clear Eyes, Full Hearts mean for an entrepreneur?

It means seeing your business venture for what it IS, not what you hope. It means seeing your business venture through the eyes of real investors and real customers, not just through the eyes of people who care about you. It means having the courage and the strength of identity to pull the plug and admit failure publicly if your great idea is, in truth, merely an okay idea. It means having the courage and the strength of identity to know that you will have another great idea in the future, and that one may truly be a great idea. Or not. But if not, there will be another. And another. Because you’re not just a person of Some Talent. In some way, shape or fashion, some field, endeavor or profession, you are a person of Talent. Period.

I’m not saying to give up on your dreams. I’m not saying to quit easily. I’m saying that you should see clearly what the world is telling you, and have the strength of character to evaluate fairly and accept graciously what you see.

Here are two representative emails that show what I’m seeing and evaluating with Epsilon Theory.

Hi Ben,

I have not joined as a “member”.  However, I feel like I am a pack member. I read every article that comes out, and have binge read almost your entire archive.  You have affected my thinking, hopefully it is more critical than before I started reading ET.

I cannot figure out why you allow spammy clickbait ads on your website.  For example, with Edge, here is the ad that showed up after I took the above screenshot [Motley Fool ad].  It just does not seem consistent with your message.  Could there be a bigger bunch of raccoons than Motley Fool?  This ad is the antithesis of ET of everything I understand ET to be for, and yet here they are on your website.

When I read your Membership Options, I see that the $20 per month is necessary to get rid of the ads.  The rest of benefits of a membership are not compelling to me.  The free offering, plus twitter feed, is all I need.  I will probably continue to read your material in spite of the ads and trackers.

Best, N.

Here’s a guy who clearly finds ET to be valuable, who has read almost everything I’ve written, which is A LOT. And yet he’s willing to pay … nothing for that value. What he needs is the free offering. Oh, and can you do something about all those crappy ads that are interfering with my free reading experience?

Look, I get it. Dogs don’t only eat dog food. This is a dog-eat-dog world, too. We’re all transactional “takers” when it comes to the Internet and content, including me. We’ve all been well and truly trained to expect everything for free, all the time. So let me be really clear about this.

Do you have to subscribe with a paid membership to be a bona fide member of the Epsilon Theory pack?


But you have to be willing to balance your “needs” with the needs of the pack. Meaning that the pack doesn’t exist unless Epsilon Theory is commercially viable. Meaning that a true pack member is delighted to see ads on the website, even Motley Fool ads. Meaning that a true pack member wants to pay his or her fair share for keeping Epsilon Theory strong, either with a paid subscription or with their tolerance (and occasional click) of ads.

The Big Gamble that Rusty and I are making is this: we are betting that there is a critical mass of people who WANT to pay for useful online content and WANT to support a community of like-minded truth-seekers. They’re not FORCED into paying. They’re not TRICKED into paying. They WANT to pay.

N. does not WANT to pay. If the world is only comprised of N.’s, if there is no critical mass of non-N.’s, then Rusty and I will lose our bet.

On other hand …

Good afternoon Ben,

I was prompted to sign up for the Premium Membership of Epsilon Theory yesterday after reading and then re-reading your introductory essay “Clear Eyes, Full Hearts”, in which you explain your purpose for Epsilon and your motivation for contributing your thoughts and insights to the evolving debate around the state of body politic and our markets, and indeed our very way of life. I felt moved to offer you the best gesture of support a market participant can make by purchasing a subscription and making my very small contribution to your so valuable effort. 

Thank you for your writing and thank you for creating a forum in which lucid thinking, free from short term partisan imperatives and a commitment to personal integrity in a free and liberal social economy form the framework for intelligent debate and thoughtful reflection. 

Good luck and best wishes – S.

So far, judging from the email flow, for every N. who doesn’t get it, there are about 100 S.’s who do. So far, there’s a critical mass of people who WANT to pay, either in their money or their ad-welcoming time and attention. We’ve quintupled our web traffic since we went independent two months ago. We’ve got something special happening in the comments and participation on the site, a quality of response and engagement that doesn’t exist anywhere else on the internet.

All this may change. The human animal is nothing if not … disappointing … over large numbers and long periods of time. But for now at least, here at the beginning, we are seeing clearly the start of something different. And we think something great.

We are Second Foundation Partners, the publishers of Epsilon Theory, and we are committed to real change in the practice of investing and the practice of citizenship. We are a completely independent voice for change, with no obligation to anyone but our readers, our clients, and our partners – our pack.

We invite you to join us, not just because we can help you become a better investor, but because ALL of us can help ALL of us become better citizens. This is the power of the crowd watching the crowd. It builds cathedrals, it starts revolutions, and it darn sure moves markets. It’s the most powerful force in the social world, and we invite you to help us figure it out.

If this is your pack … if Epsilon Theory is useful to you as an investor or a citizen … we hope you will join us.

All the best, Ben

We Were Soldiers Once … And Young

A boy passes an oil field set aflame by retreating ISIS fighters ahead of the Mosul offensive in Qayyarah, Iraq.

I get a lot of mail. Every now and then, though, I get an email that I can’t handle, that is asking questions that are so deep and so profound about what it MEANS to live in a fallen world, that is written with such keen yet unpolished first-hand observations … that I have no choice but to publish it.

Those emails are almost always by soldiers.

There’s a long tradition of the soldier/writer, going back to Xenophon and the Anabasis (March of the Ten Thousand). Xenophon wrote his chronicle 2,500 years ago, and it’s as fresh and as meaningful a book as any you will read today.

Yeah, tell me again how far humanity has “progressed” over time.

There are too many outstanding soldier/writers to even begin to list here. And by soldiers I don’t just mean warriors, but also firefighters and police … protectors all. In hopes of starting a conversation, I’ll call out two books that have been particularly meaningful to me – Matterhorn, by Karl Marlantes, and Young Men and Fire, by Norman Maclean.

I’m publishing these unpolished emails (actually, one comment and one email) verbatim, with zero editing by me. I’m doing this because, like I say, they’re asking questions (either explicitly or implicitly) that I can’t answer.

I’d like to ask YOU, the Epsilon Theory reader, to join in this conversation so that WE can figure this out TOGETHER. I know that sounds corny and hokey to some, but this is what being a pack is all about.

And yes, I know that posting a comment here requires a Premium subscription. That’s entirely intentional, because I have yet to meet a troll or a creep who’s willing to pay real money to spew online. But if you want to comment here and you can’t afford the subscription, then email me at and I’ll post your comment for you.

Here’s the first soldier story, the very first comment to appear on Epsilon Theory:

Just wanted to say thank you. Grew up dirt poor but smart as shit and got sucked into the worst of our narrative-driven ‘elite’ institutions (Ben Bernanke was my econ professor – vomit).

Went to actual war a few times in the interim for my troubles. I remember being on a patrol base in Iraq, late 2008, a few random explosions here and there to punctuate the discussion of the US economy falling apart. Telling my soldiers (a bunch of 18-year-old kids from shithole places in the south and midwest like me) how those guys knew what they were doing, necessary to save the economy, yadda yadda yadda. They called bullshit, I disagreed at the time. They were right. Heaps and heaps of bullshit.

Wife has a similar story. Both of us spent the better part of a decade wasting our lives ‘changing the world’ for big tech and big law. We lit it all on fire a few years ago and haven’t looked back. Have a three-year-old daughter now and have tried to live something close to what you have here since she came around. Couldn’t put it into words as well as you have. Godspeed.

P.S. You should read the Stormlight Archive if you can spare time for a fantasy epic- best encapsulation of how to be a decent human in a fallen world I’ve read in a very very long time. 
 – Joseph McConnell

And here’s the second soldier’s story, a long email that deserves your attention. And mine.

Hello Dr. Hunt. I am hardly an investor or acolyte of the financial industry but have been following Epsilon Theory since sometime in 2016 prior to the election. I’m not sure if I initially stumbled onto one of your podcasts or perhaps it was that photo of the Iraqi boy on a red bicycle, framed by an oil-field inferno near Mosul, that crossed my twitter feed. Either way, I recognized the hallmarks of an honest broker and have followed ET since. Honesty seems to be a universal characteristic among outsiders.

I am writing to say that I would like to be among your pack, however, I am still presently trying to adopt or adapt to the context of civilian life in America. You see, I too am another ex-military officer who not so long wore a uniform and participated in many things that can only truthfully be described as worse than useless. I took note that the very first comment beneath Clear Eyes, Full Hearts, Can’t Lose was scribed by a fellow service member who has similarly abandoned the path of conformity. In my own case, I joined the Army in 2006 already aware that it was a substantially harmful context to try and work within. Even today, I still cannot fully account for the impulse that makes me seek out those places I don’t really belong, but it sounds close enough to some instinctual version of Kant’s do right and perish.

The experience of deploying to Afghanistan is what forced me to finally acknowledge that the decision-making driving so many absurd outcomes in this century was not something that could be significantly affected or influenced from abroad. I hardly used to give a whiff about US domestic policy until its effects became unavoidably concrete. My youthful conceit was that I always preferred and sought to live outside of the US. No surprise, I wasn’t born in the US and spent much of my formative years in other countries. But it was quite a failure of imagination on my part to have successfully separated the realms of foreign and domestic for so long. Historical reality, more commonly referred to as war, managed to kill off that notion. And soon after returning from deployment, my coping mechanism of choice became a steadfast search for better information sources to reveal something about what the hell was happening in our new millennium? Accountability has gone out of style. All institutional and even individual failures are being administrated out of existence. Creditors and shareholders afforded the status of super-citizens. And at some point human determination itself became wholly irrelevant to the infallible logic of markets.

When did this all happen? Wasn’t somebody supposed to be guarding the walls of our social contract while my generation was still crawling towards maturity? Or have we been doomed since Karl Polanyi found a name for the total transformation of societies into markets. Ya know… I watched the movie Network (1976) at some point during my ROTC college years, but the relevance of Ned Beatty’s speech to Howard Beale’s character didn’t really sink in at the time. ( I even had a few great professors during my time as an undergrad, including my military history instructor, who did right during one of our after-class discussions and actually told me the answer to the following question: What is the most significant threat to US national security? I responded with typical noise like nuclear proliferation or domestic terrorism or long term ecological devastation. But then he just told me—the greatest threat to our security was a majority of Americans not understanding how the world works. It’s stuck with me ever since. Although it took me quite a awhile longer to really consider the scope of its implications. And still longer yet to consider that I should attempt to do anything about a global security environment that what was inherently being shaped by a collection of pathologies and power at home.

Afghanistan repaired that deficiency. Pretty soon I was devouring obscure panel discussions on youtube with hilariously small numbers of views. Podcasts like Dan Carlin, Radio Open Source, and even the wayward likes of Joe Rogan became far more compelling than anything to be found on NPR or NYTimes. Mark Blyth, Ambassador Chas Freeman, Andrew Bacevich, Barbara Ehrenreich, David Dayen, Walter McDougall, Thomas Frank, and numerous others like yourself became the voices I could assign some measure of trust. Quite an education and minus any insultingly inflated tuition fees. The end result of which, in addition to the incredible narrative arc that culminated in the 2016 election, ultimately convinced my wife and I that we needed to set aside our old desire to transition into foreign aid/development work. Somehow, dealing with the same set of troubles here at home seemed the only honest thing left to do. Besides, neither of us are crass enough to tell anybody in exotic foreign locales how to fix themselves when our own house was on fire.

So, we decided to stay in the relative liberal refuge of the Pacific west coast and have once again been trying to put ourselves to use. My wife has always remained the more practical between us and immediately returned to work as a nurse. I struck out to support all manner of progressive campaigns and activist candidates that want to see something better for people being preyed upon by this increasingly abusive economy. Not surprisingly, I put in my share of support for Sen. Sanders in the lead up to 2016 and have continued on other like-minded efforts since. That guy others like him represented the same sort of leadership and courage that I recognized in people of conviction with whom I had served in uniform. Nevertheless, I still largely remain an outsider to any sort of excessively branded party politics. And thus far I haven’t been successful in being co-opted into either civilian public service or paid political work. Ideological discipline, or let’s be blunt and call it conformity, has never been one of my strong qualities. Even though I was damn good at soldiering, that was only because I carried a good reason with me in addition to a heavy pack. When that reason retired, so too did I from the military. Too soon to have any actual retirement either.

Presently, my particular mixture of ardent loyalty and stark realism has only been tolerated in a volunteer capacity. Evidently, transitioning into administrative or technical public service in my state or locality seems to pretty much require the same academic pedigree as any civilian who never did time in the military. Also, I think some of us veterans remind technocrats a little too much of what failure looks and sounds like. I certainly know the value of losing, and the way I encounter hardship and loss is quite different from those who suddenly felt that the world became dangerous as of November 9th, 2016. Maybe it’s from getting onto a Blackhawk for the last time every time, or maybe from growing up in places with intense human suffering and poverty, but I seem to have a far more horrific sense of humor than the most of the urban metropole really wants to hang around with. Let alone alongside of. Thus I have not found my pack even among the crowd trying to steer our way back to some socio-political balance. Reading your missives on a regular basis is not helping either.

Or maybe they are. I very much appreciate the cold water assessment of Things Fall Apart and the burgeoning attempt to try and organize around a process. Not because I was a military staff officer who dealt in doom and gloom predictions and applying a deliberative decision-making process, but because I actually do believe that the rifts America is experiencing are here for good reasons. Hefty chunks of people are being discarded and dismissed by an economy that finds little competitive logic in engaging with them in any dignified or humane manner. The utterly stunning growth and advancement of the 20th century truly was incredible but appears to have been built upon the relatively low-hanging fruits of modernity. The last vestiges of shared experience that nurtured sufficiently broad solidarity and national identity were surrendered right along with the US manufacturing base. And in the National Intelligence Council’s most recent unclassified assessment, aptly titled Paradox of Progress, its introduction describes a human world that is operating on countless competing realities.

One other tidbit of wisdom that I remember sharply from college days came from French ex-resistance fighter turned philosopher Jacques Ellul—complexity will become the greatest enemy of democracy. I can’t assign any tremendous blame upon a majority of Americans who didn’t magically upgrade themselves to better understand and adapt to an unprecedented rate of progress. As Rick Perlstein once commented, “I respect the aristocracy of learning… but there has to be a place for people who, you know, aren’t brilliant.” I do not reserve any such comparable forgiveness for a majority of elected officials who purposefully misunderstand or misrepresent the world we live in. As such, they proliferate a world that would just as soon delete entire communities and populations like obsolete data from a computer recycle bin. Ever since last year’s 500th anniversary of Luther’s theses I’ve been wondering where would any new set of reforms be nailed to? There is no more church door, no more physical location where flesh and blood human beings can assert ourselves as the proper source of how we wish to encounter our fate. I remember a guy named Rory Stewart who once traversed across all of Afghanistan and later Iraq on foot. He eventually became an British MP and years before Brexit remarked that “there is no power anywhere” in modern Britain. Such it is with our own constituents and fellow citizens being attacked by their inboxes and other abstractions. Most are left to defend themselves only with five physical senses and an assortment of antiquated public institutions. At least those feudal pitchforking serfs could generally determine that power was consolidated in some baron’s nearby castle.

So I applaud all attempts like yours to look at the systemic wreck we are facing with a notion to nonetheless stay human along the way. Although I have more options and flexibility than many others of my peer group, I continue to find it challenging to adapt to a good path from here. Public service would still suit my personality and abilities well, although hiring managers can tell that I’m not well-suited to just pretend we can patch-work our way along until a liberal notion of “normal” returns via the ballot box. A gentleman writing for The Baffler recently commented how the Colorado River Research Group is recommending that authorities and organizations no longer use the term drought to describe the ecological changes happening in the American southwest. That term suggests a temporary deviation from normal. Aridification is much more appropriate. (

Returning to more schooling remains available through the GI Bill, yet I have grown intensely skeptical at the lack of meaningful output from academia. Also the aforementioned tuition scam really is insulting. Last year I worsted myself sufficiently to pursue a law degree but was so late in applying that the local university could only use me to pad its waitlist. Given the drift of the American courts especially during the past few weeks, I’m having a hard time seeing how leveraging the law will involve anything more than playing piecemeal defense against the growing exercise of consolidated power. At best, the training and credential are likely something that would be still recognized by the professional class for some other eventual employment. But I am trying to identify additional viable options that may answer the moment. I’ve never had a problem doing things I didn’t particularly like as long as I could identify a right reason for it. But it’s certainly grown harder to find those reasons than it was in 2006 when I joined the Army.

This evolved into quite a message and I thank you for reading all the way through. I hope it has helped to betray whether I may be one of the pack and perhaps that can lead toward something useful. Because I chose to pursue a path that is not frequented by many intensely thoughtful individuals, conversing directly with others like yourself has been disappointingly rare in my professional life. So I would greatly value hearing your thoughts on how an ex-Army officer in good health with no debts and a loving wife might continue to fight the good fight. I don’t think it’s overstating to say that deciding to stay in America was the most dangerous assignment we could have adopted. Thus far, the only two instances of a firearm being directly targeted at either of us have both befallen her in the line of duty as a healthcare professional. So I’ll take whatever cleared eyed advice I can get for how to survive and thrive in our great and terrible US of A. Hopefully with full heart and full life along the way.
 – T.E.

Your comments and thoughts are welcome. Please.

When Good Words Go Bad

More than four years ago – when Epsilon Theory was still young – Ben wrote a marvelous note that discussed the importance of the meaning of words. Called The Name of the Rose (after the movie, the book and the Shakespearean reference, in that order, I think), Ben’s piece remains a must-read. It is the origin essay of our repeated encouragement to call things by their proper name.

Ben’s essay was also an early call to Clear Eyes and Full Hearts. Pursue with full hearts, he exhorts, communication with one another at the lowest possible level of abstraction. Walk with clear eyes, he cautions, knowing that those we encounter may communicate in heavily abstracted language, desiring to influence us to act against our best interests.

The complicating factor is that words also change meaning for innocent reasons. It’s something linguists call semantic shift. I don’t think it’s fair to ascribe ill intent to anyone for the fact that the last person who legitimately felt awe when he said awesome or awful was decades ago. We write about narrative, and so you, dear reader, should know that we are probably a bit wired to commit Type 1 errors on this topic. We are prone to occasionally see narrative and intent behind natural shifts in meaning. Mea culpa.

Even so, it can still be interesting to observe how words align with differences and changes in narratives among different participants in social, political and economic dialogue. For example, I’ve noticed anecdotally that the implication attached to a couple of words – acronyms, actually – seems to have changed a bit over the last year. So I took a closer look at it, and I think it’s true:

FANG and FAANG appear to be transitioning into pejorative terms.

Here’s why I think so.

First, a couple of Quid-based narrative maps. Each of these maps shows articles which referred to each of Facebook, Amazon, Netflix and Google, but did not use the term FANG or the Apple-inclusive FAANG. The map on the left is from all of 2017, and the chart on the right is since June of this year. The topics and their connectivity have changed. For one, these articles aren’t talking nearly as much about privacy, our trust in these companies or their reputation. Their sentiment, however, has remained very positive, and has even improved slightly. For every such article in 2017, there were five scored with positive sentiment for each negative one. In Q2 2018, that number was five-and-a-half.

Not much there.

Now take a look at the articles over the same periods which did use the terms FANG or FAANG. Like with the Fang-less group, we observe some shift in the major topics. In particular, Q2’s articles were far more likely than either the fang-less articles OR 2017 to start linking the concepts of privacy, reputation, valuation and what was going on in markets. More importantly, the sentiment of these articles declined by a lot. Articles referencing FANG/FAANG were just under twice as likely to be positive as negative in 2017. In the more recent period, more articles were negative than positive.

We have to acknowledge the obvious chicken-and-egg question here. Does the inclusion of the word FANG/FAANG in an article simply set it off as a piece that is likely to be from a markets-related publisher? Sure, although recall that the first set are articles that must reference ALL of the members of the group in the same article, so there is more overlap in sources than you might think. Does a bias toward markets-focused publishers mean that the negative sentiment shift is mostly representative of those articles covering weaker market performance of these stocks more than articles that are more generally about the companies and their products? In part, although it is worth noting that the ratio doesn’t change if you exclude the October stub period. More importantly, we don’t just observe that negative sentiment shift within stories about markets. The shift is taking place in articles about content, streaming and privacy. The shift is taking place in articles about the outlook for these companies that don’t really reference market activity.

What does all this mean?

  • I don’t think there’s enough to say it means that there’s a negative general narrative forming around the big tech companies.
  • I do think it is interesting to observe that as broader media seem to be developing fatigue and drifting away from any narrative about these companies that is linked to privacy, anti-trust and regulation, market-related news seems to be much more frequently integrating these concepts into the stories they are telling about price, valuation and market activity.
  • I do think it’s worth observing that FANG and FAANG have shifted to terms with negative meaning, even (in my opinion) beyond their relationship to market activity.
  • I don’t know if that’s part of bias or intent by any party to promote a narrative.
  • I do think that I would be asking “Why am I reading this NOW?” when I saw these terms used for the time being.

Why Am I Reading This NOW? 10/12/2018 Edition

In the spirit of Ben’s In Brief from last Sunday – Why Am I Reading This NOW? – I thought I would share a few others that popped up in my daily news routine today.

Uber CEO pulls out of Saudi conference after journalist’s disappearance – CNN – 10/12/2018

Richard Branson pulls out of $1bn investment talks with Saudi Arabia over missing journalist” – Independent – 10/12/2018

Report: Turkey has proof showing Saudi journalist Kashoggi was killed – CNBC – 10/12/2018

Silicon Valley’s Saudi Arabia Problem – NY Times (Opinion) – 10/12/2018

This story has been percolating a bit, and for good reason. Some of the implications of this situation are positively vile, and there’s no indication that any of this is ‘fake news.’ It is, frankly, far more encouraging than discouraging that prominent personalities and leaders are starting to take a stand on this kind of behavior from S.A. But if you’ve been paying any kind of attention to the Arabian Peninsula over the last few decades, shock and surprise at the murder of a journalist are, shall we say, odd reactions, if long overdue. So why am I reading this NOW?

Behind Market Turmoil, Potentially Good News” – WSJ – 10/12/2018
Interest rates are far below historical definitions of normal. Optimistic analysts believe the economy could have years left to run, and that the stock market selloff will prove to be a temporary bout of indigestion.

“Sector Focus” section of (10/12/2018)

There’s nothing wrong with the sentiment or content in the WSJ piece or the Barron’s section here. Most sell-offs do prove to be temporary. As a rule, most economic environments DO have years left to run. But announcing these truisms as ‘good news’ above the fold on the web edition? And sure, Delta hanging in there is an interesting story, and…yeah, I guess things could obviously be a lot worse. But why am I reading this NOW?

“Treasury Secretary Mnuchin describes Wall Street’s 2-Day plunge as a ‘natural correction:’ economic fundamentals strong” – Lead story on, Banner Headline on, Chyron on CNBC – 10/12/2018

I won’t insult your intelligence by even posing the question, y’all. They are clearly just interested in making sure you didn’t miss this important…news.

FOX News First Alert: Kanye-Trump meeting drives Hollywood crazy” – Fox News – 10/12/2018        

Analysis: Why Kanye’s lunch with Trump was a disaster” – CNN – 10/12/2018

“T.I. says his patience with Kanye is dead and gone” – CNN – 10/12/2018

Sometimes the question is ‘Why am I reading this at all?’

How the Red Sox Eliminated the Yankees, Inning by Inning” – NY Times – 10/10/2018

Why I am reading this NOW? Because the Yankees stink on ice. Thanks, Boston – shoot it, Houston Texas, go Astros!

Complacency and Concern in Robo-Land

Both Ben and I have had a lot of conversations about robo-advisors lately. I wrote an ET In Brief piece a few days ago to discuss some of my own thoughts about Vanguard moving into the periphery of the space. Robos have also come up in discussions with early-stage and VC investors, individual high net worth investors, traditional competitors and staff from the robo-advisors themselves.

The sentiment I’ve gotten from these discussions? Concern.

In some cases, that’s exactly what you’d expect. Traditional wirehouses and RIAs obviously dislike the model, because even if it isn’t directly competing away all that much business, it is starting to influence margins. But among fintech investors and company principals we have spoken to, the level of concern is similar, even if the issues are different. I am hearing about painful customer acquisition costs, rapidly accelerating competition eroding whatever margins there might have been, and a general sense of fear about what a real downturn in equity markets – if such a thing ever happens again – would do to a client base whose stickiness has yet to be proven.

Maybe I’m wrong, and maybe I’m projecting, but I haven’t had a positive conversation about robo-advisors with anyone in months.

So I thought it would be interesting to run the topic through Quid’s natural language processing engine, as Ben and I have been known to do from time to time. It clusters news stories from a wide range of sources around general themes based on various measures of similarity, links them to other nodes, and then qualifies the language to assign sentiment.

Below is the Quid map for Q2 and the beginning of October 2018 for robo-advisors. The boxed categories are mine.

My first observation is that when the financial and general media cover robo-advisors, the stories they tell cluster around one of two distinct Narratives:

  1. Robo-advisors are an exciting part of a machine-learning and AI-fueled set of innovations, including blockchain applications, that will revolutionize banking (the 3 clusters on the right).
  2. Robo-advisors are forever changing how financial services companies marry product, technology and advice (the 3 clusters on the left).

The only strong topical link between these two similar but clearly distinct Narratives? Millennials. C’mon.

My second observation, and probably the more important, is that the news treatment of robo-advisors isn’t just positive. It is incandescent. Of all the stories written, Quid’s engine categorizes fewer than 3% as carrying generally negative sentiment. That is very, very unusual for anything relating to financial services. In fact, I’m not really sure that I’ve ever seen it before.

I don’t have a strong take from this, other than to say that topics where different sources have vastly different perspectives tend to be the most interesting. It may also simply be the case that my anecdotal evidence is exactly that – just anecdotal, and not at all representative.

But I don’t think so.

The Narrative Giveth and The Narrative Taketh Away

I wrote this note back in April. Here’s the money quote: 

My view: the inflation narrative will surge again, as wage inflation is, in truth, not contained at all.

This is what is happening today. This is why rates have ratcheted up so sharply, hitting stocks in general and tech stocks most of all. Everyone knows that everyone knows that inflation is happening in the U.S. Everyone knows that everyone knows that the Fed is going to keep tightening to “stay ahead of the curve”.  This is today’s Common Knowledge, and the Common Knowledge Game can work just as strongly to the downside as to the upside.  

To be clear, I don’t know the inflation Truth. I don’t have any sort of special insight into the balance of real-world inflationary pressures and inflationary reliefs that combine to make real world prices run hot or cold. But I do know the inflation Narrative. It’s a Narrative that the Fed, the White House, and Wall Street are each pushing, each for its own purposes. And for a market that has run on Narrative rather than reality for the past 10 years, that will be enough.

The Narrative Giveth and The Narrative Taketh Away (April 10, 2018)

No farm animals today. I’d say no TV or movie quotes, but sometimes I can’t help myself. We’ll see. Instead, a quick note to email subscribers about what I think is one of the most unstable (meaning big ups and big downs) markets we’ve seen in eight years.

The day-to-day and intraday market swings over the past six weeks have been absolutely ferocious. There really hasn’t been a big aggregate change in market levels since the middle of February (down a bit), but that modest overall decline masks a ton of ups and downs along the way, particularly over the past two weeks. If I were a betting man (and I am), my large wager would be that anyone running a tactical strategy, discretionary or systematic alike, has been whipsawed in an ugly fashion. These are the times that try traders’ souls.

So here’s the Epsilon Theory take on what’s going on.

This market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Or, as they are typically represented in cartoon form, interest rates and growth.

This market, like all markets, will go up if either cartoon can be represented with a positive narrative. That is, even if the Fed is raising interest rates, so long as they’re doing it “for the right reasons” (meaning robust growth in the real economy), then the market can go up. Likewise, even if real economic growth is anemic, so long as that means that the Fed “has got your back”, then the market can go up. This last bit — uber-accommodative central banks the world over — is why the S&P 500 is up more than 300% over the past eight years despite enormously disappointing global growth and productivity metrics.

This market, like all markets, needs a positive narrative on risk (the price of money) or reward (the real return on capital) to go up. Any narrative will do! But when neither risk nor reward is represented with a positive narrative, this market, like all markets, will go down. And that’s where we are today.

Does the Fed have our back? No, they do not. They’ve told us and told us that they’re going to keep raising rates. And they will. The market still doesn’t fully believe them, and that’s going to be a constant source of market disappointment over the next few years. In the same way that markets go up as they climb a wall of worry, so do markets go down as they descend a wall of hope. The belief that central bankers care more about the stock market than the price stability of money is that wall of hope. It’s a forlorn hope.

Is there a positive growth narrative? Well, there WAS … not just in the U.S. but everywhere in the world, and it went under the heading of “synchronized global growth”. With the tax cut passed in December, you could absolutely make the case that we were off to the growth races, and that was, in fact, THE narrative behind the amazing January for markets.

Two negative narratives have derailed all this — Inflation and Trade War. The first strikes at the “real” aspect of real economic growth. The second strikes at the absolute or nominal level of that growth.

The inflation narrative hit markets in force after the January jobs report of February 2, where wage inflation came in “hot”. It subsided with the “Goldilocks” jobs report of March 9, where wage inflation was “contained”, and the jobs report of April 6 did little to reignite the inflation narrative. But here’s the thing. The wage inflation numbers for the past two months are wrong, crucially flawed by random differences in work-week hours from last year to this year (for more, read “The Icarus Moment”). On an apples-to-apples basis (eliminating the impact of spuriously estimated work-week hours on average hourly earnings), I estimate wage inflation in February was about 2.9%, not the reported 2.6%, and wage inflation in March was north of 3.0%, not the reported 2.7%.

My view: the inflation narrative will surge again, as wage inflation is, in truth, not contained at all.

The trade war narrative hit markets in force in late February with the White House announcement on steel and aluminum tariffs. It subsided through mid-March as hope grew that Trump’s bark was worse than his bite, then resurfaced in late March with direct tariff threats against China, then subsided again on hopes that direct negotiations would contain the conflict, and has now resurfaced this past week with still more direct tariff threats against and from China. Already this weekend you’ve got Kudlow and other market missionaries trying to rekindle the hope of easy negotiations. But being “tough on trade” is a winning domestic political position for both Trump and Xi, and domestic politics ALWAYS trumps (no pun intended) international economics.

My view: the trade war narrative will be spurred on by BOTH sides, and is, in truth, not contained at all.

Of these two claims — that both the inflation and the trade war narratives are here to stay and, frankly, you ain’t seen nothing yet — I want to dig in a bit more here on the inflation narrative claim, as that’s the narrative that’s taken a back seat over the past six weeks or so. It’s also the narrative that, over time, I think will have the larger impact on investors’ portfolios. In a very real sense (still no pun intended), getting the inflation question right is the ONLY question that a long-term investor or allocator MUST get right in order to succeed.

So here’s what the Narrative Machine is showing me about inflation.

The methodology of the Narrative Machine is described in the Epsilon Theory note by the same name. It’s a natural language processing (NLP) analysis of a large set of market relevant articles — in this case everything Bloomberg has published that talks about inflation — where linguistic similarities create clusters of articles with similar meaning (essentially a linguistic “gravity model”), and where the dynamic relationships between and within these clusters can be measured over time.

Source: Quid, Inc. For illustrative purposes only. Software used under license.

What you’re seeing above is the Bloomberg narrative on inflation from April 2016 through March 2017, where each of the 1,400 dots is a separate Bloomberg article that contained some mention of U.S. inflation, and where the dots are colored by publication date (blue early in the 12-month period, red late in the 12-month period). There’s meaning associated with the size of each individual dot or node, too, but not particularly useful meaning for this analysis. What’s most important here is the geometry within and the distance between the clusters of articles, each associated with “inflation and …” Trump or the Fed or gold or whatever category you see named above. This is a prototypical “complacent” narrative network, where a substantial percentage of articles are unclustered, and the clusters that exist are distant from each other, tenuously connected, and on the periphery of the narrative superstructure. When you read the individual articles here, they are ABOUT Trump or the Fed or gold or whatever, with inflation being a subsidiary topic of interest. Inflation per se is just not a particularly relevant narrative for the market over this period.

In contrast, what you’re seeing below is the Bloomberg narrative on inflation from April 2017 through March 2018. Not only do you have 2,400 unique articles in this year-over-year period, a 75% increase, but more importantly you have strikingly more narrative cohesion across the published articles. Entire narrative clusters have come into being over the course of the past 12 months, clusters like “strategists” that are in the geometric heart of the entire interlaced network, meaning that they are providing a gravitational core to the narrative superstructure. Moreover, these new clusters are truly ABOUT inflation, where this is the core topic of the article, not a side issue. It’s a difference in meaning and sentiment associated with the unstructured data of the individual articles that a human cannot possibly capture in the aggregate, no matter how voracious and comprehensive a reader he is, but is processed and visualized in a few seconds by the Quid NLP algorithms. In the NLP equivalent of time-lapse or stop-action photography, you can actually see these clusters come into existence over time and exert their gravitational pull on the entire narrative superstructure, providing what I think is an important systematic approach to visualizing and measuring market-moving structures of sentiment. THIS is the power of AI. It won’t make your regressions run any faster. It’s not particularly helpful in working with structured data at all. But it changes everything in how we SEE the ocean of unstructured data in which we all swim.

Source: Quid, Inc. For illustrative purposes only. Software used under license.

I’ve color-coded the article nodes by date (bluer = older, redder = more recent) to show this time-lapse effect in a single snapshot of the network. Because this is a “gravity model”, it’s meaningful that the more centrally located articles within the superstructure tend to be redder or more recent articles. Also meaningfully, the clusters themselves show this effect. Look at the blow-up of the network below, and you can see how the more recent (redder) articles in the “markets” cluster are more centrally positioned than the older (bluer) articles in the same cluster. What all this means is that the inflation narrative is becoming not only stronger (more articles, new clusters) but also — and I really can’t emphasize this point enough — the inflation narrative is becoming more coherent and “gravitationally stable” over time. The growing strength and coherence of these Narrative Machine visualizations show the creation of powerful common knowledge around inflation, where everyone knows that everyone knows that inflation is rearing its very ugly head.

Source: Quid, Inc. For illustrative purposes only. Software used under license.

Six months ago, in a note called “Harvey Weinstein and the Common Knowledge Game”, I wrote this:

The core dynamic of the CK Game is this: how does private knowledge become — not public knowledge — but common knowledge? Common knowledge is something that we all believe everyone else believes. Common knowledge is usually public knowledge, but it doesn’t have to be. It may still be private information, locked inside our own heads. But so long as we believe that everyone else believes this trapped piece of private information, that’s enough for it to become common knowledge.

The reason this dynamic — the transformation of private knowledge into common knowledge — is so important is that the rational behavior of individuals does not change on the basis of private knowledge, no matter how pervasive it might be. Even if everyone in the world believes a certain piece of private information, so long as it stays private — or even if it becomes public information — no one will alter their behavior. Behavior changes ONLY when we believe that everyone else believes the information. THAT’S what changes behavior. And when that transition to common knowledge happens, behavior changes fast. …

My pick for the big idea that gets taken down? The idea that inflation is dead. We all know it’s not true. We all know in our own heads that everything is more expensive today, from rent to transportation to food to iPhones. But it’s not common knowledge. Not yet.

The “not yet” is now. The stage is now set for an explosive market re-evaluation of inflation and its impact on the price of money and the real return on invested capital. This is no longer a complacent crowd. This is now a highly focused crowd. The crowd is now watching the crowd in regards to inflation. Everyone knows that everyone knows that inflation is an important issue. The only thing missing is the Missionary statement, the little girl crying out that the Emperor has no clothes. That’s when common knowledge crystalizes into behavior. That’s the freak-out moment for markets.

What is the crystalizing Missionary statement? I think it’s wage inflation in a future jobs report.

In exactly the same way that random observations of work-week hours have artificially depressed the average hourly wage inflation cartoon reported by the BLS over the past two months, there is a 100% chance that random observations of work-week hours will artificially magnify the wage inflation cartoon reported by the BLS in some future months. This is not an opinion. This is, as they say, math.

For example, if the 12-minute difference in the March 2017 work-week (34.3 hours) and the March 2018 work-week (34.5 hours) had been reversed, the reported wage inflation last Friday would have clocked in at 3.3%. Let me repeat that. Three-point-three percent. That is an Emperor-has-no-clothes moment.

When will we get this “shockingly hot” wage inflation number? I have no idea. That’s what it means to have a random number series as part of your cartoonish data estimation process. It’s random. Again, this is math.

But here’s the last 6+ years of the data series so you can see for yourself what the year-over-year comps are for work-week hour estimations, or as I like to call it, ROUND (RANDOM (34.3 , 34.6), 0.1).

We won’t hit any prior year 34.5 readings until the end of calendar 2018, where a random reading in the historical range is most likely to present a real shocker, but any of the next five months have a year-over-year comp where the wage inflation number, which I think is now above 3%, is at least more likely to be accurately represented via the average hourly wage cartoon.

To steal a line from Game of Thrones (see, told you I couldn’t help myself), we’re now at the point where the catch phrase is about to shift from “Inflation is Coming” to “Inflation is Here.” And if that’s married with disappointing growth from say, oh, I dunno … a TRADE WAR WITH CHINA … well, that’s not just inflation, that’s stagflation. And that’s the market equivalent of the Night King and the White Walkers running rampant over all of Westeros. Is that the most likely scenario? No. Is it a scenario that we need to take seriously? Absolutely.

So what’s to be done?

Well, it’s time to stop thinking about what inflation means for your portfolio, much less stagflation, and start doing something about it. And yes, I know our inflation-investing muscles are severly atrophied. Time to start flexing those muscles. Time to start exercising those muscles. Because you’re going to need them.

For an allocator, I think the core inflation-investing muscles are real assets, broadly defined. I wrote about this two years ago in “Hobson’s Choice”, and I wouldn’t change a word today. More broadly, the premise here is to push back from the table games here at the doubly-abstracted Public Market Casino, get closer to real cash flows from real things for real people, and think “pricing power, pricing power, pricing power” in every bit of analysis that you do. You’d also be well served to start reading Rusty Guinn’s new Epsilon Theory series, “Investing With Icarus”, which is just getting off the ground and will have a lot more to say about all of this.

Gell-Mann Amnesia

Westworld (1973)

“Briefly stated, the Gell-Mann Amnesia effect is as follows. You open the newspaper to an article on some subject you know well. In Murray’s case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward—reversing cause and effect. I call these the “wet streets cause rain” stories. Paper’s full of them.

In any case, you read with exasperation or amusement the multiple errors in a story, and then turn the page to national or international affairs, and read as if the rest of the newspaper was somehow more accurate about Palestine than the baloney you just read. You turn the page, and forget what you know.” 
– Michael Crichton (1942-2008)

That’s Michael Crichton, the physician turned novelist turned director, talking about his physicist friend Murray Gell-Mann, who discovered (and named) the quark. Crichton pretty much invented the techno-thriller genre of books and film, starting with The Andromeda Strain, which is one of the most influential books in my life, for sure. Crichton is probably best known for his Jurassic Park novels, but take a look at his bibliography sometime … it’s astonishing how much influence he has had on modern American culture, period. That cover photo on this note, from the 1973 version of Westworld, is one of Crichton’s, too.

I’ve written about the Gell-Mann Amnesia effect before, but I wanted to highlight it in a standalone Brief. Why? Because I think it’s the primary driver of the social pathology we have today regarding media in general and social media in particular.

If you or your company has EVER been the primary subject of a newspaper article, you know exactly what Crichton is talking about. The article is simply wrong. Not just wrong in minor detail, but wrong in motivation, cause, implication, fundamental facts … everything. You read it and you think, “how can I get this travesty of an article edited/retracted/rewritten? how is it possible that the writer got this situation so wrong?”

And yet, despite having this searing experience with media articles where we actually have meaningful personal knowledge, we believe without hesitation the next story we read where we don’t! 

We are hard-wired to respond to Missionaries, and when I say hard-wired I truly mean that in a biological sense. It’s what makes Fiat News – the projection of opinion as fact – work. It’s what powers the Trump Train and the Team Elite Club alike. It’s not that facts don’t matter. They do! But the presentation by a Missionary that a statement is a fact is enough to make it a fact within the Common Knowledge Game. That IS the Common Knowledge Game. All it requires is an effective Missionary.

Everyone is in on the secret. Everyone is in on the act. Everyone who can is playing the Common Knowledge Game as a Missionary. And everyone who can’t is being played.

That includes Michael Crichton, too. One of Crichton’s less remembered novels and films is Disclosure, starring Michael Douglas and Demi Moore in the 1994 film. Here’s a still from that movie, taken as the Michael Douglas character realizes he has been set up for a false (?) accusation of sexual harassment.

It’s a must-watch movie for anyone trying to figure out what the hell happened to all of us during the Kavanaugh hearings, and it’s a movie that a critical thinker can’t watch today without squirming in discomfort. Why? Because not only is the central plot twist the construction of news and information, but so is the central plot twist of the movie-as-a-thing.

Let me put it this way, Michael Crichton was married five times and famously would have had some … errr … difficulties in a post-Harvey Weinstein Hollywood.

Disclosure is not just a movie ABOUT the construction of Narrative.

Disclosure IS a movie that constructs Narrative, a very particular Narrative that served the interests of the Hollywood studio system and the men, like Weinstein and Crichton, that it made so wealthy and so powerful.

This is Narrative creation. This is one of the best examples I’ve got of nested metagames. This is why it’s so important to consume EVERYTHING with a critical eye. Because we are being played, constantly and by everyone. Even in our entertainment. ESPECIALLY in our entertainment. It sneaks up on us without our conscious awareness, because its purpose is to sneak up on us without our conscious awareness.

And what’s the dominant entertainment in the world today? It’s not Hollywood any longer. It’s not movies. It’s social media.

Clear Eyes, friends. Clear Eyes.

Et in Arcadia ego

“And I said: Don’t you know that he said I will foller ye always even unto the end of the road…Neighbor, you caint get shed of him”

– Blood Meridian, by Cormac McCarthy

And rear a tomb, and write thereon this verse:

‘I, Daphnis in the woods, from hence in fame

Am to the stars exalted, guardian once

Of a fair flock, myself more fair than they.’

– Eclogues, No. V, by Virgil

There is a field at the end of a lane in Tennessee that sits long abandoned. A rusting livestock gate is held fast to the fence by heavy gauge wire, twisted by hand to keep it from swinging open. It may be that a caretaker once allowed sheep to graze here to keep the brambly bushes at bay. They have been absent for some time.

The name of the lane is Caldwell Cemetery Road. At its end is a graveyard of graveyards, a field of broken monuments and faded inscriptions set into soft Tennessee limestone. There are perhaps a dozen raised tombs besides. One hopes they are architectural and not sepulchral, because most are now little more than broken lean-tos, exposed on at least one side to the world and the elements. Far to the back of the burial ground, through tall weeds and bushes, a broken headstone lies on the grass. Rev. W. G. Guinn, it reads, born August 15, 1795. He was my fourth great-grandfather.

His son, one of the last of his short dozen children, died at 41. A few years later in 1892, that son’s wife dragged their seven children between the ages of 7 and 21 to Texas, where they became tenant farmers. It was a steep fall. You see, the Rev. William Guinn was an Important Man.

You would not go very wrong to say that the Methodist minister in the deep antebellum south was the most important man in town. While the Calvinists have since given way to the Baptists there, the swelling masses of pioneers and settlers who braved the Great Wagon Road through the Great Appalachian Valley of Virginia were, as a rule, Scots-Irish. Which meant that they were Presbyterian. Which meant that they were one camp meeting and a preacher on a horse away from being Methodists.

The preacher in a small town officiated marriages. He was the trusted arbiter of disputes. He was a voice of civil authority in letters to far-off politicians and governments. He blessed new homesites and new businesses. His church on Sunday would house the most concentrated version of a dispersed community. His home often served as the orphanage, homeless shelter and welfare office. All of this was true for the Rev. Guinn, beyond which he served as postmaster, justice of the peace and in many other roles over the course of his life. He may not have been the richest man in town. He may have been the most important.

And now his grave is forgotten and his monument broken, the fatal cracks no doubt caused by the fall of some ancient tree themselves already smoothed by rains and time. How long did it take for people to forget that they had even forgotten him? One generation? Two? Thirty years? Fifty?

There is a phrase I hear from time to time among investors and allocators: ‘our time horizon is infinite’. It is a phrase used to justify performance over other-than-infinite horizons, often very fairly. It is a belief used to justify illiquidity in investments, often very fairly. It is an expression sprinkled casually over all manner of short-termism and knee-jerk responses from boards, committees, bosses and constituencies. But within that truth, there is another that we should remember:

Your time horizon is not infinite. Your institution’s time horizon is not infinite.

To those who would roll their eyes and respond, “It might as well be. For all intents and purposes, it is effectively infinite,” please accept this amendment:

Your time horizon is not effectively infinite. Your institution’s time horizon is not effectively infinite.

‘Et in Arcadia ego’ is a stylization of a theme from Virgil’s Eclogues: even in Arcadia, there am I. The I, my friends, is death. Even in paradise, death is coming, and death is there. Even for our great institutions, for our university endowments and our great charitable foundations, death will come. This isn’t fatalistic. It isn’t morbid. It isn’t bearish. It can be bullish! It can be optimistic! Like a fire through the floor of a stagnant forest, the death that comes for these institutions may be their reformation into something newer and better. It may be great or small changes in the way society is ordered. It may be a change in their mission brought about by its achievement! One day we will conquer the diseases foundations have been established to research, and even that will be a death of a kind.

There are other deaths we cannot avoid. Smaller ones. Changes in governance. Changes in law. Changes in tax schemes. Changes in securities law and regulation. Changes in student loan markets. Changes in philanthropy and in centers of wealth. These are all a death for us as investors, because they may change what we ought to be doing, and because they may invalidate the strategies we employed before. Amid those deaths, we have one governing rule: 

Your time horizon is the shortest period over which you may be forced by circumstance, behavior, prudence, constituencies, governments or outside forces to sell what you own.

This may still be a very long time! And so it may be the case that this reality should have no influence on our portfolios. But it must have an influence on our frameworks, our process and our risk management. It should color our strategic asset allocation reviews, and it should be part of the language of our engagement with oversight boards and other constituencies.

If I may be permitted a post-script, it is my personal belief that it should have one more effect: Our great universities and grand foundations should be spending more of those endowments to better execute their missions today. A lot more. Et in Arcadia, ego.

Punting and the Tyranny of Risk Memes

Last Sunday, with just under six minutes remaining on the clock in overtime, the Dallas Cowboys faced a 4th down and 1 from their opponent’s 42-yard line. Jason Garrett, the Dallas coach, sent out his punting unit. In a matter of minutes, they would go on to lose to their in-state rival Houston Texans.

It was a monumentally and objectively bad coaching decision. It would have been a bad decision for any team in the league. It was an even worse decision for the Cowboys, a team with a quarterback/running back combination with a historical success rate of 94.7% converting 4th and 1 situations. As ESPN pointed out later that evening, that is a marginally higher success rate than the rate at which kickers have converted extra points since they were moved to the 15-yard line. If you are not a fan of American football, the extra point is typically regarded as a mere formality – an early chance to visit the restroom.

Because of their location on the field, the punt’s value was also lower. A punt into the end zone would cause a touchback and yield only 22 yards of field position. Because of this risk, punters in this situation are often accordingly more conservative, targeting higher punts that terminate around the 10-15 yard line to avoid the touchback. For the Cowboys on this day, a well-executed kick still netted only 32 yards of field position. In exchange for those 32 yards of field position, the coach of the Dallas Cowboys rejected a play which – for this team – had the success rate of an extra point, and which would have provided multiple additional opportunities to advance into scoring range. You could spend hours mining historical scenarios, splits and advanced statistics for some kind of support for the decision. You won’t find it.

The press conference that follows is inevitable and all too easy to predict. The coach will explain away the decision with the sort of milquetoast response we simultaneously demand and bemoan from entertainers. You know you will hear a variant of ‘We believed in our defense’. It’s a nonsense statement, of course, since the defense could just as easily make a stop at the 42-yard line if they failed to convert. You will hear an appeal to experience and being ‘on-the-ground.’ You will hear a plea that ‘every situation is different’ and a vague allusion to what was ‘unique about that situation’. But that isn’t the point. The point, like with so many memes and narratives, is to make us sit down and shut up. The meme used to produce this response was field position!

The coach who summons this meme wants to be seen as wise – a sage, prudent leader. And it works. Every time. No one ever got fired for punting for field position! Oh sure, the media and fans will criticize him for 3-4 days. It will get mentioned the following Sunday, and then never again.

Risk-related memes are everywhere in the investment industry, too. Like the memes in football, most are built on sage-sounding ideas.

The risk management! meme is probably the most popular. It shuts down discussion by subtly implying that others in the conversation are not sufficiently focused on prudently managing risk. If you want to get someone to stop arguing with you in an investment discussion, just imply that they aren’t being prudent. One senior investor at a prior stop in my career loved responding to well-considered investment recommendations from younger investors with some variant of, ‘It’s not about the doing all the good deals, but avoiding all the bad ones.’  It’s not that there isn’t some shred of truth in this. It’s that everyone in the room who hears this knows that the discussion is over, ended by someone who wasn’t prepared to discuss the actual merits of the investment.

Most others are built around the client’s best interest! meme. Want to get a sharp, ethical professional on your team to sit down and shut up? Imply he or she isn’t considering what is best for the client. It doesn’t have to be true. Once this meme enters the room, other discussions stop. Other considerations end. Don’t you care about the client? 

These memes are so powerful because our true obligations to prudently manage risks and act in clients’ best interests are so sacred. Like any other meme or narrative, they force us to take a side. To signal.

But make no mistake. When we take score – and we do – the institutions that allow executives and PMs to use risk memes to get staff to sit down and shut up will be the losers.

Every time. 

How to Lose the Game of You

This is a guy with 5.4 million followers. He’s an astronaut. He’s a patriotic American. And he’s so worried about people thinking badly of him … his identity is so wrapped up in social f’ng media … that he’s lost himself in the Game of You.

Do I think that Winston Churchill was a flawless guy? Of course not. He’s got a lot to answer for, in words and deeds. AND he is deserving of high praise. AND he was an inspirational leader, deserving of many many requotes. Not BUT, but AND. What do I mean by that? Read this great Rusty Guinn piece on The Power of AND to get my point.

This is also a good time to highlight another Rusty Guinn classic, maybe my favorite piece that he’s written, The Two Churchills.

Here’s the bottom line. We are all smart enough to hold more than one thought in our brains at the same time. We are all wise enough to make up our own damn minds. And most of all this:

Your autonomy of mind and spirit cannot be taken away by the State, the Oligarchy or the Mob. But you can give it away.


The Italian Job

il Giornale (August 3, 2012)

I wrote “Finest Worksong” in September, 2014 (reprinted below). Here’s the money quote: 

At some point in the not so distant future there will be an anti-Euro realigning election in Italy. 
And that will wake the Red King.

And here’s the money chart that is driving all of this. 

Source: Bloomberg L.P., World Bank

This is an 18 year chart of per capita GDP for Italy (red), France (green), the U.S. (blue) and Germany (yellow), from World Bank data using constant 2005 dollars, normalized at January, 2000. The takeaway is pretty obvious.

The average Italian is no better off today than he or she was 18 years ago.

The average German is MUCH better off today than he or she was 18 years ago.

But wait, there’s more. This data is just taking the aggregate national GDP dollar amount and dividing by the number of citizens in the country in question. It doesn’t take into account any changes in the distribution of that aggregate GDP across those citizens. What we know for a fact is that the distribution of goodies in the post-GFC Financial Asset Bubble has been unevenly distributed in favor of those who … you know, actually own financial assets. In other words, it’s not only that the average (mean) Italian is no better off today than he or she was 18 years ago. More importantly for the politics of Italy:

The median Italian is WORSE off today than he or she was 18 years ago.

What’s driving everything in Italian politics today? THAT.

What’s driving the market swoon in Europe today? THAT means the Red King is waking up.

Can Mario Draghi put the Red King back to sleep? He did four years ago. It’s going to be a lot harder today. 

My advice? Prepare your portfolio for the Red King NOT going back to sleep.

And yes, Epsilon Theory can help you with that.

Finest Worksong

Take your instinct by the reins
You'd better best to rearrange
What we want and what we need
Has been confused, been confused
– REM, “Finest Worksong” (1987)

The politics of dancing
The politics of oooh feeling good
– Re-flex, “The Politics of Dancing” (1983)

The fault, dear Brutus, is not in our stars, but in ourselves.
– William Shakespeare, “Julius Caesar” (1599)

In theory there is no difference between theory and practice. In practice there is.
– Yogi Berra, (b. 1925)

Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. …

Indeed, the IMF’s expectation for long-run global growth is now a full percentage point below what it was immediately before the Global Financial Crisis. …

But it is also possible that the underperformance reflects a more structural, longer-term, shift in the global economy, with less growth in underlying supply factors. 

– Fed Vice Chairman Stanley Fischer, “The Great Recession: Moving Ahead”, August 11, 2014

There is one great mystery in the high falutin’ circles of the Fed, ECB, and IMF today. Why is global growth so disappointing? There are different variations on this theme – why aren’t businesses investing more? why aren’t banks lending more? – but it’s all one basic question. First the Fed, then the BOJ, and now the ECB have taken superheroic efforts to inflate financial asset prices in order to bridge the gap between the output shock of 2008 and a resumption of normal economic growth. They’ve done their part. Why hasn’t the rest of the world joined the party?

The thinking was that leaving capital markets to their own devices in the aftermath of the Great Recession could result in a deflationary equilibrium, which is macroeconomic-speak for falling into a well, breaking your leg, at night, alone. It’s the worst possible outcome. So the decision was made to buy trillions of dollars in assets, forcing all of us to take on more risk with our money than we would otherwise prefer, and to jawbone the markets (excuse me … “employ communication policy”) to leverage those trillions still further. All this in order to buy time for the global economic engine to rev back up and allow private investment activity to take over for temporary government investment activity.

It was a brilliant plan, and as emergency intervention it worked like a charm. QE1 (and even more importantly TLGP) saved the world. The intended behavioral effect on markets and market participants succeeded beyond Bernanke et al’s wildest dreams, such that now the Fed finds itself in the odd position of trying to talk down the dominant Narrative of Central Bank Omnipotence. But for some reason the global economic engine never kicked back in. The answer? We must do more. We must try harder. And so we got QE2. And QE3. And Abenomics. And now Draghinomics. We got what we always get in the aftermath of a global economic crisis – a temporary government policy intervention transformed into a permanent government social insurance program.

But the engine still hasn’t kicked in.

So now villains must be found. Now we must root out the counter-revolutionaries and Trotskyites and Lin Biao-ists and assorted enemies of progress. Because if the plan is brilliant but it’s not working, then obviously someone is blocking the plan. The structural villains per Stanley Fischer (who is rapidly becoming a more powerful Narrative voice and Missionary than Janet Yellen): housing, fiscal policy, and the European economic slow-down. Or if you’ll allow me to translate the Fed-speak: consumers, Republicans, and Germany. These are the counter-revolutionaries per the central bank apparatchiks. If only everyone would just spend more, why then our theories would succeed grandly. 

Hmm. Maybe. Or maybe what we want and what we need has been confused. Maybe the thin veneer of ebullient hollow markets has been confused for the real activity of real companies. Maybe the theatre of a Wise Man with an Answer has been confused for intellectually honest leadership. Maybe theoretical certainty has been confused for practical humility. Maybe the fault, dear Brutus, is not in external forces like Republicans or Germans (or Democrats or Central Bankers), but in ourselves. 

Let me suggest a different answer to the mystery of missing global growth, a political answer, an answer that puts hyper-accommodative monetary policy in its proper place: a nice-to-have for vibrant global growth rather than a must-have. The problem with sparking renewed economic growth in the West is that domestic politics in the West do not depend on economic growth. What we have in the US today, and even more so in Europe (ex-Germany), are not the politics of growth but rather the politics of identity. At the turn of the 20th century the meaning of being a Democrat or a Republican was all about specific economic policies … monetary policies, believe it or not. You could vote for Republican McKinley and ride on a golden coin to Prosperity for all, or you could vote for Democrat Bryan and support silver coinage to avoid being “crucified on a cross of gold.”

Today’s elections almost never hinge on any specific policy, much less anything to do with something as arcane as monetary policy. No, today’s elections are all about social identification with like-minded citizens around amorphous concepts like “justice” or “freedom” … words that communicate aspirational values and speak in code about a wide range of social issues. Don’t get me wrong. There’s nothing inherently bad or underhanded about all this. I think Shepard Fairey’s “HOPE” poster is absolute genius, rivaled only by the Obama campaign’s genius in recognizing its power. Nor am I saying that economic issues are unimportant in elections. On the contrary, James Carville is mostly right when he says, “It’s the economy, stupid.” What I am saying is that modern political communications use neither the language nor the substance of economic policy in any meaningful way. Words like “taxes” and “jobs” are bandied about, but only as totems, as signifiers useful in assuming or accusing an identity. Candidates seek to be identified as a “job creator” or a “tax cutter” (or accuse their opponent of being a “job destroyer” or a “tax raiser”) because these are powerful linguistic themes that connect on an emotional level with well-defined subsets of voters on a range of dimensions, not because they want to actually campaign on issues of economic growth. Candidates have learned that while voters certainly care about the economy and their economic situation, the only time they make a voting decision based primarily on specific economic policy rather than shared identity is when the decision is explicitly framed as a binary policy outcome – a referendum. Even there, if you look at the ballot referendums over the past several decades (Howard Jarvis and Proposition 13 happened almost 40 years ago! how’s that for making you feel old?), the shift from economic to social issues is obvious.

Both the Republican and the Democratic Party have entirely embraced identity politics, because it works. It works to maintain two status quo political parties that have gerrymandered their respective identity bases into a wonderfully stable equilibrium. The last thing either party wants is a defining economic policy question that would cut across identity lines. But until the terms of debate change such that an electoral mandate emerges around macroeconomic policy … until voters care enough about Growth Policy A vs. Growth Policy B to vote the pertinent rascals in or out, despite the inertia of value affinity … we’re going to be stuck in a low-growth economy despite all the Fed’s yeoman work. I know, I know … what blasphemy to suggest that monetary policy is not the end-all and be-all for creating economic growth! But there you go. At the very moment that elections hinge on the question of economic growth, we will get it. But until that moment, we won’t, no matter what the Fed does or doesn’t do.

What reshapes the electoral landscape such that an over-riding policy issue takes over? Historically speaking, it’s a huge external shock, like a war or a natural disaster, accompanied by a huge political shock, like the emergence of a new political party or charismatic leader that triggers an electoral realignment. In the US I think that the emerging appeal of national Libertarian candidates (all of whom, so far anyway, have the last name Paul) is pretty interesting. The 2016 election has the potential to be a watershed event and set up a realignment, if not in 2016 then in 2020, which hasn’t happened in the US since Ronald Reagan transformed the US electoral map in 1980. And yes, I know that the conventional wisdom is that a viable Libertarian candidate is wonderful news for the Democratic party, and maybe that will be the case, but both status quo parties today are so dynastic, so ossified, that I think everyone could be in for a rude awakening. It’s a long shot, to be sure, mainly because the US economy isn’t doing so poorly as to plant the seeds for a reshuffling of the electoral deck, but definitely interesting to watch.

What’s not a long shot – and why I think Draghi’s recently announced ABS purchase is a bridge too far – is a realigning election in Italy. 

I like to look at aggregate GDP when I’m thinking about the strategic interactions of international politics, but for questions of domestic politics I think per capita GDP gives more insight into what’s going on. Per capita GDP gives a sense of what the economy “feels like” to the average citizen. It addresses Reagan’s famous question in the 1980 campaign with Jimmy Carter: are you better off today than you were four years ago? It’s a very blunt indicator to be sure, as it completely ignores the distribution of economic goodies (something I’m going to write a lot about in future notes), but it’s a good first cut at the data all the same. Here’s a chart of per capita GDP levels for the three big Western economies: the US, Europe, and Japan.

Source: World Bank. For illustrative purposes only.

The Great Recession hit everyone like a ton of bricks, creating an output shock roughly equal to the impact of losing a medium-sized war, but the US and Japan have rebounded to set new highs. Europe … not so much.

Let’s look at Europe more closely. Here’s a chart of the big three continental European economies: Germany, France, and Italy.

Source: World Bank. For illustrative purposes only.

Germany off to the races, France moribund, and Italy looking like it just lost World War III. I mean … wow. More than any other chart, this one shows why I think the Euro is structurally challenged.

First, why in the world would Germany change anything about the current Euro system? The system works for Germany, and how. Alone among major Western powers, the politics of growth are alive and well in Germany. “But Germany, unless you lighten up and embrace your common European identity, maybe this sweet deal for you evaporates.” Ummm … yeah, right. The history books are just chock-full of self-interested creditors with sweet deals that unilaterally made large concessions before the very last second (and often not even then).

Second, why in the world would Italy accept anything about the current Euro system? The system fails Italy, and how. The system fails other countries, too, like Spain, Portugal, and Greece, but these countries are in the Euro by necessity. Their economies are far too small to go it alone. Italy, on the other hand, is in the Euro by choice. Its economy is plenty big enough to stand on its own, and with a vibrant export potential, an independent and devalued lira is just what the doctor ordered to get the economic growth engine revved up. Short term pain, long term gain.

Why doesn’t Italy bolt? Lots of reasons, most of them identity related. Also, let’s not underestimate the power of cheap money to keep the puppet-masters of the Italian State in a Germany-centric system. The system may fail Italy as a whole, but if you’re pulling the strings of the State and can borrow 10-year money at 2.5% to keep your vita nice and dolce … well, let’s keep dancing.

Still, nothing focuses the electoral mind like the economic equivalent of losing a major war. At some point in the not so distant future there will be an anti-Euro realigning election in Italy. 

And that will wake the Red King.

In the meantime, Draghi will go forward with his ABS purchase scheme, a brilliant theory that will deliver frustratingly slim results quarter after quarter after quarter. Until the politics of growth are embraced outside of Germany, European banks will remain reticent to lend growth capital to small and medium enterprises. Until the politics of growth are embraced outside of Germany, large enterprises with plenty of cash and access to cheap loans will remain reticent to invest growth capital. Maybe a little M&A, sure, but no new factories, no organic expansion, no grand hiring plans. The thing is, Draghi knows that he’s pushing on a string with the ABS program and that growth won’t return until the fundamental political dynamic changes in France in Italy, which is why he is calling both countries out by name to institute “structural reforms”. But in typical European fashion this entire debate is Mandarin vs. Mandarin, with almost all of the proposals focused on regulatory reform rather than something that must be hashed out through popular legislation. So long as economic policy reform is imposed from above … so long as we are engaged in modern-day analogs of Soviet Five-Year Plans … I believe we will remain stuck in what I call the Entropic Ending – a long gray slog of disappointing but not catastrophic aggregate economic growth. That’s not a terrible environment for stocks, certainly not for bonds, and the alternative – economic reform based on the hurly-burly of popular politics, is almost certain to be a wild ride that markets hate. But to get back to what we need (real growth) rather than what we want (higher stock prices) this is what it’s going to take. Elections always matter, but in the Golden Age of the Central Banker they matter even more.

Mailbag: Deadly. Holy. Rough. Immediate.

A challenging question from reader David S. He quotes from and responds to an excerpt from Deadly. Holy. Rough. Immediate.

“Over very long periods, you will generally be paid based on the risks an average investor (including all of his liquidity sensitivities, his investment horizons, etc.) would be taking if he made that investment.” (from Deadly. Holy. Rough. Immediate.)

Isn’t this idea built on risk spreads, building up from the risk-free rate?  But in a world where central banks set risk-free rates for other reasons, is the concept of a risk-free rate even coherent?  In other words, does anyone really think Italian government debt is safer than U.S. government debt right now?

Again, it’s a useless theoretical question.  I think risk spreads work; will continue to work; and, even if I felt otherwise, I wouldn’t be foolish enough to try to predict the timing.  But how solid is the theoretical foundation on this one?

Over a sufficiently long horizon, I’d say it’s about a 6 out of 10 (which is about as good as it gets in this game).

There are probably more finance papers on the topic of the relationship between risk and return, or premia for the fancy among us, than any other. Many of them are purely empirical (e.g. what are the long-term Sharpe ratios of different asset classes over various horizons?). Many are purely theoretical (e.g. how should markets with mostly rational actors function to price risk?). Some are a bit of both (e.g. how much of variability in stock prices is driven by changes in expectations vs. changes in discount rates?). Even as a Hayekian who thinks that prices separate us from Communists and the animals, I’m kind of with you. To practitioners, the explanations and frameworks offered by these papers are often unsatisfying.

Over many very long horizons, the data will show you that the Sharpe ratios of major asset classes are similar. In other words, the relationship between the variability in price and long-term returns above a risk-free rate appears to be pretty consistent across assets. You’ll hear this factoid a lot in defense of the idea that long-term risk-adjusted returns of assets should be comparable if investors are at all rational. But this is one of those cases where I think we’ve got to be a little bit skeptical of a surprisingly geometric cow. One exaggerated example?


Their long-run Sharpe ratio is not far off from those of financial assets (this obviously depends on horizon – you’ve, uh, gotta go back for this one). But any sort of attempt to build a theory about why our return expectations for commodities should have anything to do with how volatile their prices are ends up looking like a dog chasing its tail. The practitioner sees this, because he sees how much of a commodity’s price changes are directly driven by non-economic actors, substitutability, seasonality, weather, extraction costs, storage costs, hedgers, etc. Plus, y’know, supply and demand.

This is part of the reason why many practitioners do NOT treat commodities – and this includes things like Bitcoin and other cryptocurrencies, by the way – as investable asset classes. We may have some expectation of their rise, but it is hard to determine in any meaningful theoretical way why we should expect to be paid with returns in any proportion to the risks we are taking on by owning them. Incidentally, I don’t think you need to believe there is a commodity risk premium to justify holding commodities in a portfolio. I would say the same thing about cryptocurrencies if I believed there was a state of the world in which they wouldn’t be treated as a highly correlated speculative asset in any kind of sell-off event for risky assets.

This isn’t just a commodity phenomenon. To David’s point, I think it is obvious that there is a portion of the risk we take in owning financial assets – stocks, bonds and other claims on cash flows – that we probably ought not to expect to be paid for either, or at least for which the smooth, ‘rational actor’ transmission mechanism between risk and the price demanded for it is perhaps not-so-smooth. Low-vol phenomenon, anyone? A half dozen other premia? But prices for financial assets are also hilariously overdetermined. That means that if we line up all the things that influence those prices, we will explain them many times over. It’s a topic that occupies the entire lives and careers of people smarter and more dedicated to the subject than I am, so I hesitate to give it the short shrift I am here. But in the interest of responding somewhat substantively, let me tell you in short what I think:

  • I think that the risk differences caused by placement in capital structure and leverage should have a pretty strong long-term relationship with return, because they describe an actual cash flow waterfall connected to economic reality. This is why I feel confident that I’m going to be paid some spread – even if it isn’t completely proportionate – for risks I take by owning risky financial assets.
  • I think that the risk differences caused by country and currency have a weaker relationship with return. You’ll be able to find examples where this isn’t true, but in general, capital markets still exhibit very local characteristics. Assuming that the differences in realized risk between markets in two countries will give us reliable information about how participants in those markets are pricing their relative risk may be pretty unrealistic.

In practice, I think that the first bullet alone is powerful enough to make it a foundational principle of portfolio construction. Perhaps the most important. I also think it is strong enough that it matters even if you think that a significant portion of price variability and movement is driven by abstraction, game-playing and narrative.

P.S. Folks, if you’re thinking about writing me that volatility isn’t risk, please don’t.