License to Kill Gophers

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License to kill gophers by the government of the United Nations. Man, free to kill gophers at will. To kill, you must know your enemy, and in this case my enemy is a varmint. And a varmint will never quit – ever. They’re like the Viet Cong – Varmint Cong. So you have to fall back on superior intelligence and superior firepower. And that’s all she wrote.

-Bill Murray as Carl Spackler in Caddyshack

The Gopher.

Recessions. Policy makers loathe them. The human costs are real and obvious, but they also lose elections. The desire of central banks to forestall recession at all costs reminds us a bit of the war that groundskeeper Carl Spackler had with the gopher in the 1980 movie Caddyshack. [1]For those of us old enough to remember that classic movie, Spackler won a final pyrrhic victory against the gopher by planting explosives throughout the golf course – eventually destroying the very course he’d sworn to protect.

Today, it seems to us that the allegory for the golf course applies to central bank policy as it relates to financial markets. Initially, Spackler tried to use less dramatic methods to find and kill the gopher, but none of them worked. Those methods are akin to traditional rates policy. It is our view that the concept of a natural or neutral rate is anachronistic in a world where QE is global and in which capital can flow relatively freely based on national comparative advantages. Moreover, monetary policy is reflexive in that lower rates (whether through temporary or permanent open market operations) beget lower rates. The neutral rate is dynamically impacted not just by the real economy but also by policy itself.

Indeed, prolonged application of policy will result in an eventual neutral rate of zero in the United States, just as it has in much of the rest of the developed world. Extraordinary measures in monetary policy, like buying equities (à la the BoJ) are akin to the dynamite that Murray’s Spackler eventually deployed. After all, he had “a license to kill gophers by the government of the United Nations.” Indeed, it a united front of central banks that possess the license, as negatively yielding debt globally has topped $15.6 trillion (up from below $6 trillion in the third quarter of 2018). It’s only a matter of time before the course is left unplayable.

The Groundskeeper.

The Fed’s 25 bps ‘insurance cut’ will do little to prevent the eventual necessity of QE – that is, if the Fed’s goal is to prevent a recession at all costs, it will require dynamite.[2]In my view, a 25 bps ‘insurance cut’ now and another 25 bps in September will do little to prevent the U.S. from succumbing to the global economic malaise (all developed market PMIs we track are now in contraction or neutral with the U.S. stagnant at a reading of 50.4). [3] We’re not alone in our assessment that, short of renewed QE, the Fed has little policy room.  MNI reported just prior to the most recent cut that former Fed director of the division of research, David Wilcox, said: “We’re currently at or near a cyclical peak, and yet the policy rate is still only 2.25% to 2.5%. That’s uncomfortably limited. I hope they will take steps to create more policy space for themselves.” In that same interview, Wilcox estimated the Fed was roughly 250 basis points short of policy space to fight the next recession. He noted that the central bank cut its policy rate by at least 500 bps in each of the past three downturns. Cantor’s global market Outlook expressed this very view in January of 2019. Again, it will be difficult for the Fed to forestall a recession without the use of dynamite.

We’ve already written in Epsilon Theory that ‘late cycle’ cuts are usually followed by recessions in the United States. We debunked analogies to 1995 and 1998 in our previous note Cake. It’s no coincidence that Chairman Powell introduced the concept of mid-cycle cut in his latest statement to avoid the perception that the Fed felt an economic downturn was imminent. Market participants cared little about his characterization. They simply wanted more. Just because Chairman Powell called it a mid-cycle cut doesn’t mean it is one. We now face a policy lull in August through September when many things can happen with the U.S. data. Services ISM recently missed expectations and appears to be following its historical course – tracking manufacturing ISM lower but with a lag. The rates markets have most recently been screaming loudly that the slowdown is about to occur here in the U.S., and they have been doing so globally (in Europe and Japan) for much longer.

We expect the PMI data over the next several days to continue to weaken, and we don’t think Chairman Powell will deliver what the markets want to hear at Jackson Hole. Last week, the spread from 3-month to 10-year treasuries inverted to over -40 bps and the 2-10 spread inverted, as I’ve been suggesting it would since January. As they always do, equity markets in the U.S. will eventually ‘get the joke.’ For those waiting for the real economic data to hit them over the head, it will already be too late. The sole bright spot is the U.S. consumer… but it always plays out this way. The consumer spends until s/he hits the credit wall. Lending standards are already beginning to tighten and labor markets are as good as they will get. That means they will only get worse. While lower rates are cushioning the blow from worsening fundamentals, they have never alone forestalled recession. [4] We believe the recent selloff is the beginning of a deeper correction as there is little to prevent the slide that has already begun

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[1] We’d also characterized central banks inability to spur inflation in the same way. We often written that the inability to catalyze inflation is a function of two principal factors: 1) globalization and 2) supply side effects. Globalization allows for the importation of deflation as capital and labor migrate to lower cost geographies, as the theory of comparative advantage suggests.  Monetary policy, which sets the cost of capital, sets the stage for a world in perpetual productive asset overcapacity – mostly in the developing world.

[2] Of course, the other groundskeeper ahead of the presidential election might be fiscal policy makers. However, with a divided House there is little that the president can do from a policy perspective (like a payroll tax deduction) that would forestall the slowdown. Even a ‘resolution’ of the trade war won’t do the trick as the root causes of the global slowdown are structural issues in places like Europe, Japan and China.

[3] Don’t be fooled; the U.S. economy is reliant on the global economy through a more complex global supply chain than ever before. About 39% of S&P revenues come from outside the United States and the global financial markets are inextricably intertwined.

[4] My one caveat to this assessment would be an immediate renewal of QE in the United States that drove long rates to close to zero. A renewal of QE in Europe is important, but until it includes high yield bonds and equity, it won’t have an efficacy. In the meantime, U.S. high yield has been a massive beneficiary of low global rates.

The World ‘Twixt Ought To and Is

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I don’t like the word ‘abstractions’ very much because most people don’t think in abstractions. That is too difficult for them. They think in stories. And the best stories are not abstract; they are concrete.

– Sapiens, by Yuval Noah Harari

I remember that there was always a street preacher on the college green at Penn. Like all prophets in his own town, he was never well-received.

Now, this was back in the days before veganism and keto were really things, and I think Crossfit had only just been invented. So the only means available to students to scream into the void “I am myself!” and “I am very intellectual!” and “Somebody please notice me!” all at once without expending any real effort were smoking and militant atheism.

My God, did this man take some abuse. And by God did he earn it.

Not because he was the giant-offensive-placards kind of street preacher (he wasn’t). Not because he was the hell-and-damnation kind, either (he wasn’t). Because he had a knack for getting himself into debates with college students. Not only that – because he allowed the students to badger him into taking ridiculous and strident positions on irrelevant topics that irrevocably damaged whatever true purpose he sought to achieve.

I was there on the periphery of a small crowd of eager, dickish young minds one day when our preacher passionately described how dinosaur bones were put into the earth by God to confound the wisdom of man and test his faith. Some mustachioed tankie was really feeling his oats (again, avocado toast being some years away at this point) and engaged him on the specific mechanics of God’s intervention. How, exactly, do you think that God worked this miracle, minister? Does he intervene in real time with the instruments which measure the quantity of carbon-14? If so, are you specifically making the argument that God adjusts how both beta radiation measurement tools and spectrometers counting carbon-14 atoms function? Or is the composition of the bone itself changed?

Within any religious community, there are legalistic subcultures which find positively nonsensical hills like this to die on. Around those hills, all sorts of uncomfortably specific explanations to tie everything together are built as hedges, take root and flourish. Want a nonsensical pseudo-scientific analysis of ancient Greek vernacular to argue that the wine Jesus miraculously created was just non-alcoholic grape juice (lamest miracle ever, by the way) to justify prohibition-as-doctrine? Somebody will be your huckleberry. Want a church-run webpage which takes serious intellectual issue with a famous musical’s farcical contention that God would punish a five-year old for stealing a maple-glazed donut since God would clearly only punish the child if he were eight? Huckleberry.

For most people of faith, these behaviors are powerfully cringeworthy. For all the secular protestations of their acolytes, the communities built around financial markets and economics are no less religious. They are no less prone to building edifices of oddly confident and hyper-specific speculation around their pre-existing models for predicting behaviors. And for most professional investors, they ought to be no less cringeworthy.

Please be seated. Let us begin our sermon today with some soggy, religious garbage from Nobel Laureate Paul Krugman.

There’s been a lot of speculation about why the stock market reacts so strongly to trade policy news — way out of proportion to the direct economic impacts of Trump tariffs. Today’s surge after Trump’s decision to delay some tariffs deepens the mystery. The best going explanation of the tariffs/market link was that markets took tariff announcements as indications of broader decision process; to be blunt, how crazy Trump is. Hard-line announcements suggested more radicalism to come, softer announcements more rationality. But this was obviously a defensive move to avoid price hikes before Christmas, not a change in Trump’s world view or improvement in his decision-making. So why respond so strongly?

– Nobel Laureate Paul “Nobel Laureate” Krugman – who has a Nobel Prize btw – via Twitter (8.13.2019)

Now, this is extremely stupid.

I don’t mean to be mean to Dr. K, who is not stupid. The unfortunate reality, however, is that most very smart people tend to have deeply stupid opinions and ideas about a great many things. Sadly, many of those same opinions and ideas often become articles of faith over which that person drapes his reputation, intellect and mental models which successfully supported earlier ideas and opinions.

It is pretty easy to unpack the three articles of faith at play here. Krugman has in his head a model for which each of the following is true:

  • Daily marginal price-setting behaviors are predictable as the output of mostly-rational optimizers;
  • Trump is objectively crazy; and
  • Trump’s craziness is so profound (and market participants are so ill-disposed to care about anything else) that changes in Paul’s perception of that craziness can explain functionally all of the daily variance in asset prices.

Let no one tell you that living in 2019 is not a joy.

Consider: you, dear reader, can watch in real-time as a Nobel Laureate publicly grapples with confusion that a multi-trillion dollar market might deviate for a single day from his single variable, Perception-Of-Trump’s-Craziness-based model. Consider further that you may watch him work out – again, in full view of the public – that the market must clearly have overestimated the extent to which a simple Christmas reprieve on tariffs ought to have reduced the value of their Perception-Of-Trump’s-Craziness variable.

This is God-burying-dinosaur-bones-to-piss-off-Neil-deGrasse-Tyson level crazy. This is Jesus-becoming-the-hero-of-the-party with-grape-juice level nuts. This is God-punishes-eight-year-old-donut-thieves-but-not-five-year-olds level insane.

And yet this kind of bizarre model-clutching lunacy is not just a possibility. It is an inevitability when you live in a world of prediction, in which your aim is to find The Answer to questions for which even a shred of epistemic humility would tell you that your model is shit.

It doesn’t really help that we’ve created academic and professional environments in which we respond to models that don’t produce The Answer by making adjustments to reflect what they missed most recently, calling it Bayesian Updating, finding a time horizon, data set and parameters for which we can get an acceptable p-value, and publishing a new paper.

Or y’know, launching a new fund.

The prelates of the preposterous aren’t the only characters in our world, however. We also have to contend with the agnostic – the person whose response to the difficulty of knowing everything is to believe that we cannot possibly know anything. Epsilon Theory was founded to ceaselessly harass and make fun of the religious pole (which we hope you understand we mean in an entirely secular sense) but to offer hope to those drawn to the desperation of the agnostic pole.

We respect the difficulty of active management. In our own portfolios, we happily use index instruments in many markets. But we don’t believe that it is possible to be a passive investor any more than it is possible to be a passive citizen or a passive friend or a passive partner or passive father. We will make decisions, and those decisions will explicitly or implicitly express views about the world and the way that it works and is working.

We reject the learned helplessness of the Long Now.

By rejecting that learned helplessness and embracing that we are all active investors, however, we will inevitably discover that there is an embedded layer of belief at work in nearly every investment strategy – a phantom model which exists between the ought to of our investment philosophy and the is of its results. That layer is, very simply, what we believe will cause an actual person (or computer programmed by a person) participating in the price-setting process for a security to change what price they are willing to pay or accept for that security.

The fundamental investor has in their head a model of the world in which they may predict how prices will change based on some assessment of the business today and in the future. Even beyond any fallibility in their own assessments and predictions, the phantom model between ought to and is – for them – is a set of assumptions about what other investors care about, what kind of information they will respond to, and over what time horizon.

Many of those strategies systematic and discretionary alike can be shown to work over many markets and many horizons. And yet, every investor with a shred of intellectual honesty will admit their concerns when going live with some new approach:

I am worried that the conditions under which I built the case for my strategy, whether the mental models and discretionary heuristics built over a long, successful career, or the systematic backtests I similarly produced, are a reflection of some state of the world that will not be the future state of the world.

Our skepticism about backtests, simulations and historical results is our acknowledgment of the phantom model in an emotional sense, to be sure. But it must also be an intellectual acceptance of the massive mathematical erosion in true explanatory power when our partially correlated models pass through an additional layer of partial correlation. We can’t always explain it away with “over a long enough time horizon” hand-waving in defense of our management fee annuity stream.

(Apologies if you did not know before now that the people who run money for you refer to you as an annuity stream. They do. Not figuratively. They literally say that in meetings.)

The problem for active investors (i.e. all investors), the problem I grappled with for so much of my career, and the problem I still grapple with at times in my own mind, is how to demonstrate epistemic humility about this loss in explanatory power without descending into agnostic nihilism. I have come to believe that there are three – and only three – ways:

  1. Parsimony – Adopting extraordinarily high standards and requirements for the addition of a model or framework for making predictions. This is the contribution of the AQRs and Bridgewaters of the world.
  2. Ensembles – Incorporating ensembles of models to composite concepts without excessive reliance on any one framework. This is the contribution of Two Sigma, our friends at Newfound and the discretionary work products of a small number of especially process-oriented minds.
  3. Concretion – Reducing the number of layers of abstraction between process and models on the one hand, and the Thing for which they are a representation, on the other.

Why do we study common knowledge – narratives? Because we think that studying, identifying and measuring the existence and effects of narratives can be a force for concretion of our investment theses. Can broader adoption of narrative analysis techniques, in fact, deliver on the promise of concretion? Can we better understand how, when and why different facts and events will matter to the marginal market participant in the price-setting process?

I don’t know. I think so. Our historical examinations of the question have produced promising results, but I fear that I am still an agnostic nihilist at heart.

Now, if you are thinking that narrative-as-force-for-concretion is a contradiction, then very well, it is a contradiction. Narrative is an abstraction from the real world, from cash flows, and from the long-term value creation potential of assets and intellectual property. But Narrative is also a concretion of the observable evidence of what the crowd believes that the crowd believes, what they care about and what they are paying attention to.

We are large, we contain multitudes, et cetera et cetera.

Soros’s quip about observing instead of predicting – that is concretion. It is a kind of process which permits decision-making based on observation, with fewer phantom models ‘twixt ought to and is. Taleb’s famous observation “don’t tell me what you think – show me your portfolio” is concretion, too, albeit a concretion of the phantom model of the language we use to describe why we own something. It is an indictment of manager surveys and the like, which are reflections of first level thinking rather than the thinking that drives actual asset price-determining decisions at the margin.

But while the Taleb heuristic is effective as a thought experiment into the importance of skin in the game, it is less useful (and was never intended) as a specific model for understanding the spread-crossing tendencies and response profiles of various investors to new information. For one, as anyone who has examined the positions of fund managers very often will tell you, someone’s positioning will often tell you a great deal about their constraints, their obligations and their boss’s predispositions, and often very little about why their view of price would change in the presence of new information. For another, because a portfolio is a complex thing, two sensible investors may be equally long or short a position for different reasons that would precipitate massively different responses to new information. Knowing what someone’s portfolio looks like is concretive in terms of language, but not at all in terms of a model for predicting future asset prices.

So why the focus on defining narratives through financial media, which we all know to be riddled with Fiat News, often conflicted and frequently produced in service to its purported subject matter? Because it is the only world in which we learn what everyone wishes everyone else to believe. Because it is the only world in which we know what everyone else knows, because we know that they have seen the top-fold of the WSJ and the Dear Sirs of the Financial Times.

Because it is our best chance to map the world ‘twixt ought to and is.

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I’m a Superstitious Man

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I’m a superstitious man, and if some unlucky accident should befall him — if he should get shot in the head by a police officer, or if he should hang himself in his jail cell, or if he’s struck by a bolt of lightning — then I’m going to blame some of the people in this room.

Vito Corleone, “The Godfather” (1972)


Vito Corleone was speaking of his son, Michael, and these were some of the people he intended to blame for an “unlucky accident”.

I’m speaking of a monster, Jeffrey Epstein, and these are some of the people I intend to blame for this “unlucky accident”.

So … I want to be careful with what I am saying and what I am not saying.

I am NOT saying that Epstein was murdered, and I am certainly not saying that he was murdered on the orders of anyone in this picture.

Well, certainly not by Melania or whatever Playboy model Bill was boffing at the time.

JK! JK! I really and truly am not accusing Trump or Clinton of having anything to do with Epstein’s untimely demise, not even in a “who will rid me of this troublesome priest” sort of way.

What I am saying is that sociopathic oligarchs – of which club I consider Donald Trump, Bill Clinton and Prince Andrew to be charter members – are the necessary and sufficient conditions of the specific evil that was Jeffrey Epstein as well as the more general evil of sexual predation of children.

What I am saying is that Epstein’s direct testimony – AND ONLY EPSTEIN’S DIRECT TESTIMONY – had the potential to create a Common Knowledge moment like the one that destroyed Harvey Weinstein through the direct testimony of Rose McGowan.

What I am saying is that Epstein’s direct testimony – AND ONLY EPSTEIN’S DIRECT TESTIMONY – had the potential to create a Common Knowledge moment that could bring down – not just specific sociopathic oligarchs like Mob Boss Donald or Mob Boss Bill or Mob Boss Andrew if they were the specific targets of that testimony – but the entire Mob system of sociopathic oligarchy.

Jeffrey Epstein was the Missionary to bring down the monsters behind the monster, to bring down the SYSTEM of monsters.

Jeffrey Epstein’s books and records are not.

The individual voices of Jeffrey Epstein’s victims are not.

And that’s what makes me angriest of all.

That while the individual victims of Jeffrey Epstein’s crimes will maybe (maybe!) get some smattering of “justice” and recompense from the show trial of a monster’s estate, there will be no Justice served against the monsters behind the monster, that the Mob system of sociopathic oligarchy that CREATED this Jeffrey Epstein and the next Jeffrey Epstein and the next and the next will continue unabated. Untouched. Golden.

“Yay, justice!”

What I am saying is that there are enormous vested interests spread across multiple avenues of violence and power that will not allow that Mob system of sociopathic oligarchy to collapse on a single point of failure like Epstein’s direct testimony.

And so it didn’t.

And so Jeffrey Epstein is dead, victim of an “unlucky accident”.

Was it murder? Was it suicide?

I’m a superstitious man. I don’t care.

Is a murder committed more heinous than a suicide allowed? In its act, sure. In this context? NO.

An “unlucky accident” like this is the ONE THING that a non-corrupt State must prevent. It’s the non-corrupt State’s ONE JOB to keep Epstein alive for trial, and everyone knows that everyone knows this is their ONE JOB.

It is impossible to violate this common knowledge without premeditation and malice, without conspiracy and criminality aforethought. It is impossible to have an “unlucky accident” like this in a non-corrupt State.

I’m a superstitious man. I’m blaming the people in the room.

What room?

The room of violence and power and wealth.

The room of the corrupt State.

The room that is swarmed by the Nudging Oligarchy. The room that is supported and propped up by the apparatchiks and hangers-on and wannabes and “journalists” of District One.

I DON’T CARE how deeply Mob Boss Donald or Mob Boss Bill or Mob Boss Andrew was part of this specific criminal conspiracy, either in its operation or its cover-up.

They are mob bosses all the same, and I blame them all the same, and they are guilty all the same, regardless of their specific interest in this specific crime and regardless of whether this was murder or suicide.

Many readers will think I’m naive when I tell you that I was genuinely shocked that Jeffrey Epstein suffered this “unlucky accident.” As the kids would say, I was shook.

I haven’t felt this way since October 2008 when the US Treasury put the full faith and credit of the United States behind the unsecured debt of Goldman Sachs and Morgan Stanley and JP Morgan and Bank of America.

Then as now, the pleasant skin of “Yay, democracy!” has been sloughed off to reveal the naked sinews of power and wealth and violence beneath. There’s no crisis like there was in 2008. The world isn’t ending like it was in 2008. But I’m telling you that it feels the same to me.

They’re. Not. Even. Pretending. Anymore.

The Nudging State and the Nudging Oligarchy cannot be defeated on a single point of failure like Jeffrey Epstein’s testimony at trial. Or like the bankruptcy of AIG.

The sociopathic oligarchs will win every direct confrontation. That’s what sociopathic oligarchs DO.

But a million effin’ points of failure? A rejection of the ATTENTION that sociopathic oligarchs require, in both markets and politics? A refusal to vote for ridiculous candidates and buy ridiculous securities? A refusal AT SCALE? A modern movement of disengagement from a market casino and an election sideshow in favor of what is REAL?


Yeah, that can work.

What does a movement of refusal and disengagement look like? Start here

And then go here …

The Second Foundation hides in plain sight.

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The Long Now, Pt. 1

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Last year I wrote a series of notes called Things Fall Apart, focused on the transformation of our most important social institutions – small-l liberal institutions like free markets and free elections – from cooperation-allowing games to competition-requiring games. That sounds bloodless and small, but it’s not. It’s literally how society self-destructs in a widening gyre of mistrust and defection.

Today I’m starting a new series of notes called The Long Now, focused on the further transformation of our social institutions into political utilities … into smiley-face Panopticons of self-censorship where our marrow of autonomy and free will is sucked dry by the Nudging State and the Nudging Oligarchy.

Our money, too. Yes, this will be “actionable”, just maybe not in the way you’re used to.

The Long Now is everything we pull into the present from our future selves and our children.

The Long Now is the constant stimulus that Management applies to our economy and the constant fear that Management applies to our politics.

The Long Now is the Fiat World of reality by declaration, where we are TOLD that inflation does not exist, where we are TOLD that wealth inequality and meager productivity and negative savings rates just “happen”, where we are TOLD we must vote for ridiculous candidates to be a good Republican or a good Democrat, where we are TOLD that we must buy ridiculous securities to be a good investor, where we are TOLD we must borrow ridiculous sums to be a good parent or a good spouse or a good child.

It’s all happened before.

Here’s a SJW journalist who saw it clearly in the 1930s and 1940s.

History has stopped.

Nothing exists except an endless present in which the Party is always right.

George Orwell, “1984” (1949)

What Orwell called the Party, I call the Nudging State and the Nudging Oligarchy. I call it Management. Why? Because the future is not – as Orwell had it – a boot stomping on the face of humanity forever. Please. So messy. So … inefficient.

No, the future is a smiley-face authoritarianism, an authoritarianism that is not imposed on us, but an authoritarianism that we embrace.

 It’s not “Yay, Big Brother!”.

It’s “Yay, Capitalism!”, “Yay, Military!”, “Yay, Diversity!”, “Yay, College!” and “Yay, Stock Market!”.

You’re not, ummm, against any of those things, are you? Because that would be … unfortunate. I mean, you helping the terrorists and all.

Things Fall Apart started with the political and ended with the personal. Let’s flip that on its head with The Long Now. Let’s flip it ALL on its head. Because I know a few things about Time.


Tyler Durden, meet Neb Tnuh.

When did the future switch from being a promise to being a threat?

Chuck Palahniuk, “Invisible Monsters” (1999)

I remember exactly when MY future switched from being a promise to being a threat.

It was when my father died suddenly of heart failure in the summer of 1996. He was 62 and I was 32.

There’s something about the dynamic of your father dying suddenly that changes your relationship with the future and with time. Or at least it did for me. Now I was on a trapeze without a net. Now it was All. On. Me. With a baby on the way. Now, to use Palahniuk’s words, the future seemed like a threat, not a promise, where MY death was next in line. For the first time in my life, I felt the pressure of time and mortality, not as some philosophical musing, but for what it IS – an omnipresent pang, a constant bzzt-bzzt-bzzt of that feeling where you wake up with a start and you’re sure that the alarm clock is about to ring but it’s only 3am so you go back to sleep but you wake up again with a start and it’s 3:45 am.

Death inspires me like a dog inspires a rabbit.

Twenty One Pilots, “Heavydirtysoul” (2015)

So right.

See, the threat of the future isn’t a bad thing.

The threat of the future INSPIRES me. The threat of the future DRIVES me.

I’m not moping around waiting to die. I’m not lazing around eating bonbons. The present is for DOING. The present is FLEETING. I’ve got something to SAY before I go. I’ve got a future to SECURE for my children, because in them I can still see future’s promise and not just future’s threat.

This is your life and it’s ending one moment at a time.

Warning: If you are reading this then this warning is for you. Every word you read of this useless fine print is another second off your life. Don’t you have other things to do? Is your life so empty that you honestly can’t think of a better way to spend these moments? Or are you so impressed with authority that you give respect and credence to all that claim it? Do you read everything you’re supposed to read? Do you think everything you’re supposed to think? Buy what you’re told to want? Get out of your apartment. Meet a member of the opposite sex. Stop the excessive shopping and masturbation. Quit your job. Start a fight. Prove you’re alive. If you don’t claim your humanity you will become a statistic. You have been warned.

Chuck Palahniuk, “Fight Club” (1996)

The threat of the future revealed itself to me in 1996 with the death of my father and the birth of my child. One day the threat of the future will reveal itself to you, if it hasn’t already. When it does, you will be CONSUMED by thoughts of the future. You will FEEL the pressure of time more keenly than the younger you could ever imagine.


Time is the fire in which we burn.

Delmore Schwartz, “Calmly We Walk through This April’s Day” (1938)

You’ve never heard of Delmore Schwartz. In 1938 he set the New York literary scene on fire at the ripe old age of 25 with the publication of In Dreams Begin Responsibilities, a brilliant collection of short stories and poems about his parents’ marriage and divorce, and Delmore’s estrangement from them. From their “death”, so to speak. His work is imbued with the failure of the American dream for his generation, with the way in which the Team Elite of prior generations sucked the economic marrow out of the Gilded Age and dominated politics with false narratives. Sound familiar?

Delmore Schwartz wrestled with the threat of the future alone and unloved, and he succumbed to alcoholism and madness. He died in 1966 at the Chelsea Hotel – penniless, childless, friendless – dead for two days before a cleaning lady found his body. He was 52. Time is the fire in which we burn. Or rot.

The threat of the future washed over Delmore Schwartz in 1938 as surely as it washed over me in 1996. As surely as one day it will wash over you. But he never found his Pack.

If you would wrestle with future’s threat … if you would stare back at the abyss, as Nietzsche would have it, or if you would yell at the clouds, as The Simpsons would have it … find your Pack.

But see, that’s only one of the things I know about Time.


As Paul Harvey used to say, here’s the rest of the story.

It was the summer of 1996, early June, and I was teaching a course at Simmons College in Boston to make some extra dough. Jennifer was clerking for a lawfirm down in Dallas, pregnant with our first child. My dad called. He and my mom were in London, where they had rented a small flat for a month. Did I want to come over and stay for a few days? As it happened, I had five days free, perfect for a long weekend trip. I walked down to a cheapo travel agency on Boylston (yes, a physical travel agency), and found a ticket for $600 or thereabouts. Seemed like a lot. I could have afforded it, by which I mean there was room on my credit card to buy it, not that I could really afford it. $600 was a lot of money to me. That said, I hadn’t seen my parents since Christmas, and my dad sounded so … happy. This was a special trip for them, a chance to LIVE in a city that my father LOVED, and this was my chance to share it with them. But $600. I dunno. I called my father and told him that I just couldn’t swing it. He understood. He was a very practical guy. The call lasted all of 20 seconds. You know, international long distance being so expensive and all.

I never saw my father again. He died a few weeks after he and my mother got home.


Yeah, I know a few things about Time.

I know that the moving finger writes, and having writ, moves on.

I know that I would give anything to go back to that week in June 1996 and buy that stupid ticket that I couldn’t “afford” but really I could afford and spend five more days with my father and not do anything special but just BE with him and share a beer at that pub that he mentioned on the phone but that I just can’t remember the name of no matter how hard I try and it’s weird but that’s what bugs me most of all.


What do I know about Time?

Yet instead of living in the Now and investing for the Future, we are nudged into “investing” for the Now and “living” in the Future.


We are told that the economic stimulus and the political fear of the Long Now are costless, when in fact they cost us … everything.

The Nudging State and Nudging Oligarchy will tell you “TINA!”. They will tell you that There Is No Alternative.

I tell you this is a Lie.

I tell you this is Sheep Logic, the intentional training of human intelligences to pursue myopic, other-regarding behaviors even unto death, through the vehicle of the Long Now.

What is the alternative to the Long Now?


PDF Download (Paid Subscription Required): The Long Now, Pt. 1

The Spanish Prisoner

PDF Download (Paid Subscription Required): The Spanish Prisoner

It’s an interesting setup, Mr. Ross. It is the oldest confidence game on the books. The Spanish Prisoner. Fellow says him and his sister, wealthy refugees, left a fortune in the home country. He got out, girl and the money stuck in Spain. Here is her most beautiful portrait. And he needs money to get her and the fortune out. Man who supplies the money gets the fortune and the girl. Oldest con in the world.

– David Mamet “The Spanish Prisoner” (1997)

Mark Zuckerberg is not The Spanish Prisoner. He’s the guy running the con.

Seven or eight years ago, I was on a commuter flight, sitting in an aisle seat. Two rows ahead of me, across the aisle on my right, a guy was arguing with his wife/girlfriend. It wasn’t a ferocious argument, but any sort of personal disagreement is noticeable in these circumstances, and it had been simmering since I noticed them boarding the plane.

There were two other things I noticed when they sat down. The wife/girlfriend had the husband/boyfriend’s name – Randy – tattooed on the back of her neck, and Randy had the letters T – R – U – S – T tattooed on the fingers of his left hand. I remember smiling to myself when I saw this. Obviously these two were from a very different background than me, but I really appreciated the public display of commitment they had made by getting these tattoos. I remember thinking to myself that I bet their relationship was a strong one, even though the disagreement seemed to simmer throughout the flight.

The plane landed and we all stood up. And then I saw the letters tattooed on Randy’s right hand.

N – O – O – N – E

All of a sudden, I was pretty sure this guy’s name wasn’t Randy. All of a sudden, I was pretty sure this relationship wasn’t likely to last.

I feel like I have TRUST NO ONE tattooed on my hands today, and if you’ve been working in finance for more than 10 years, I bet you feel exactly the same way.

Used to work for Bear? I know you feel this way.

Used to work for Lehman? I know you feel this way.

Used to work for Citi? I know you feel this way.

Used to work for Merrill? I know you feel this way.

Used to work for Deutsche Bank? I know you feel this way.

Yeah, we’ve all got these tattoos today. We have them as a reminder, as a figurative reminder (or literal in the case of “Randy”), that we really really really shouldn’t trust anyone AGAIN.

Because we need a reminder. Because we want to trust again.

Jimmy Dell: I think you’ll find that if what you’ve done for them is as valuable as you say it is, if they are indebted to you morally but not legally, my experience is they will give you nothing, and they will begin to act cruelly toward you.

Joe Ross: Why?

Jimmy Dell: To suppress their guilt.

– David Mamet “The Spanish Prisoner” (1997)

Jimmy Dell is the con man in the 1997 David Mamet movie, played by Steve Martin in his finest dramatic role. In lines like above and below, Jimmy builds a personal trust with the mark by calling his attention to the lack of trust in business relationships. Effective consultants do this a lot, speaking of confidence games.

Jimmy Dell: Always do business as if the person you’re doing business with is trying to screw you, because he probably is. And if he’s not, you can be pleasantly surprised.

That’s the thing about the Spanish Prisoner con. It doesn’t work on saints. It doesn’t work on people who forgive and forget, who turn the other cheek and have an unending reservoir of faith in their fellow humans. It also doesn’t work on sociopaths. It doesn’t work on people who truly trust no one, who can lie to themselves and others without consequence or remorse.

The Spanish Prisoner con works best on smart and accomplished people who think they have TRUST NO ONE figuratively tattooed on their hands, who think they’re too clever to be fooled again, but end up only being too clever by half.

The Spanish Prisoner con works best on coyotes.

Who is a coyote? A coyote is a clever puzzle-solver who really has the best of intentions. Who really wants to be successful for the right reasons. Who really wants to accomplish something of meaning in the world. Who is smart and aware and nobody’s fool. Who has been beaten up professionally a bit and has a healthy skepticism about the business and political world.

And who is just a little bit on the make. 

The defining characteristic of the Spanish Prisoner con is that the mark believes he is doing well while doing good. The mark believes that he is doing the right thing, that he’s the good guy in this story. And if the liberated Prisoner is financially grateful, or if the Prisoner’s sister is grateful in her own way if you know what I mean and I think you do … well, that seems only fair, right?

Now the Spanish Prisoner doesn’t have to be an actual person that needs rescuing. That’s a con for the rubes. The Spanish Prisoner is what Alfred Hitchcock called a MacGuffin – anything that serves as an Object of Desire for the mark, anything that motivates the mark and furthers the narrative arc of the con.

In fact, the most effective MacGuffins are rarely simple signifiers of wealth like an rich Spanish dude. No, the most compelling Spanish Prisoners are Big Ideas like social justice or making America great again or resisting the Man. That’s what gets a coyote’s juices going. Especially if there’s also a pot of gold associated with being on the right side of that Big Idea.

The most successful con operators are the Nudging State and the Nudging Oligarchy. Why? Well, partially because you’ve gotta have some heft to credibly commit to rescuing a Big Idea from the clutches of whatever Big Baddie has it now. But mostly because running the con for money is just thinking waaaay too small.

The Nudging State and the Nudging Oligarchy don’t need your money. They already have it!

The con here is to gain your trust – again – so that you willingly hand over your autonomy of mind. So that you accept without thought or reflection the naturalness of your current relationship to the State and the Oligarchy.

You’d never fall for this con if it were part of a straightforward commercial arrangement like a job or a purchase. Please! You’re much too savvy for that. You have TRUST NO ONE tattooed on your hands, remember?

But for the chance to help rescue a Big Idea …

But for the chance to make a few bucks or enjoy yourself a bit more as part of doing the right thing …

There’s not a coyote in the world that can resist that bait. And that’s why once you start looking for the Spanish Prisoner con, you will see it everywhere.

Libra, the cryptocoin promoted by Facebook, is a Spanish Prisoner con.

What’s the Big Idea? Why it’s banking the unbanked. It’s facilitating cross-border remittances. It’s bringing the benefits of crypto to the global masses. ALL OF THIS IS TRUE. So far as it goes.

And if it facilitates e-commerce along the way? if it’s possible to make a few bucks or enjoy some greater conveniences as part of Facebook and its partners executing on this Big Idea? Well, what’s wrong with that?

What’s wrong is that this is how Bitcoin dies.

This is how a censorship-embracing coin replaces a censorship-resistant coin. This is how the State and the Oligarchy co-opt crypto. Not with the heel of a jackboot. But with the glamour of convenience and narrative.

And in a few years it will all seem so natural to you.

Using government-approved electronic money will be the water in which you and your children swim. You will not be able to imagine a world where a censorship-embracing coin is not everywhere.

Yay, capitalism!

Libra was designed to co-opt Bitcoin.

Libra was designed to allow government oversight over your economic transactions.

Libra was designed to provide a transparent regulatory window and control mechanism over your money.

Libra was designed for Caesar.

From the Libra consortium:

This is why we believe in and are committed to a collaborative process with regulators, central banks, and lawmakers to ensure that Libra helps with the kind of issues that the existing financial system has been fighting, notably around money laundering, terrorism financing, and more. At the core, we believe that a network that helps move more cash transactions – where a lot of illicit activities happen – to a digital network that features regulated on and off ramps with proper know-your-customer (KYC) practices, combined with the ability for law enforcement and regulators to conduct their own analysis of on-chain activity, will be a big opportunity to increase the efficacy of financial crimes monitoring and enforcement.

“Boo, terrorists!”

A year from now, the narrative story arc regarding “criminal activity” through cash transaction networks AND censorship-resistant transaction networks like Bitcoin will be louder, not softer. In three years, it will be deafening.

Libra and its e-commerce convenience, together with its Big Idea skin of helping The Poors … that’s the carrot.

The “Boo, terrorists! narrative … that’s the stick.

Will Bitcoin itself be outlawed? Maybe. But I really doubt it. It’s too useful as a societal steam valve, now that we’ve got Libra and (soon) other Oligarchy-sponsored and State-supported cryptos in circulation.

What does Bitcoin become in a world where state-approved e-money is in wide circulation?

It becomes an act of effete rebellion, like a non-threatening tattoo on your upper arm that you can cover up with a shirt if you like.

Bitcoin becomes a signifier of Resistance rather than a tool of Resistance.

Owning Bitcoin will make you a Bad Boy! or a Bad Girl! … a safe malcontent that the Nudging State and Nudging Oligarchy are delighted to preserve.

What’s my message to the true-believers who continue to see Bitcoin as a tool for Resistance?

For the next fifty years, you get to play the role of the grumpy old man yelling at clouds.

You know, the role that gold true-believers got to play for the past fifty years.

It’s a miserable way to live.

It’s a miserable way to live for two reasons.

First, and most crucially, this role that the Nudging State is laying out for you is steeped in negative energy. You will find yourself rooting for catastrophe. You will find yourself hoping for decline and collapse. You will find yourself conflating justice with loss and comeuppance. You will take on sadness and schadenfreude as your resting psychic state. Trust me when I say that I know of which I speak. Negative energy is deadly. That is not a figurative statement. It will literally kill you.

Second, you’ll be infested by raccoons, which will be tolerated if not encouraged by regulators, in exactly the same way they are tolerated if not encouraged by regulators in gold-world. Sure, you’ll have the occasional show trial of egregiously aggressive security frauds and Crypto-Funded Criminals ™, but the run of the mill hucksters and con men will walk with impunity.

Because this is what ALWAYS happens.

The money quote from Too Clever By Half:

And that brings me to what is personally the most frustrating aspect of all this. The inevitable result of financial innovation gone awry, which it ALWAYS does, is that it ALWAYS ends up empowering the State. And not just empowering the State, but empowering the State in a specific way, where it becomes harder and harder to be a non-domesticated, clever coyote, even as the non-clever, criminal raccoons flourish.

That’s not an accident. The State doesn’t really care about the raccoons, precisely because they’re NOT clever. The State — particularly the Nudging State — cares very much about co-opting an Idea That Changes Things, whether it changes things in a modest way or massively. It cares very much about coyote population control.

It’s all about coyote population control. It always is.

Is there a way out of this for Bitcoin? No. Co-option by the State and Oligarchy was the Doom of Bitcoin from the beginning.

I mean … I say “Doom” like it’s going to be hurled into the fires of Mordor, but that’s not it at all. There will still be true-believers and raccoons alike generating tradable narratives. You’ll still be able to make money by trading Bitcoin on these narratives (and altcoins, too, I’d expect, although I have no idea how you generate a compelling altcoin narrative these days).

It’s not like Bitcoin is going to go away.

But Bitcoin is going to be permanently diminished in its social importance by the adoption of Libra and other Oligarchy-sponsored and State-embracing crypto currencies. Bitcoin will never again mean what it used to mean.

You know … just like gold was permanently diminished in its social importance by the adoption of Oligarchy-sponsored and State-embracing fiat currencies. Just like gold will never again mean what it used to mean.

I wrote this note six years ago. It was the first Epsilon Theory note to get widespread recognition. You’ll see hints – more than hints, actually – of all the big ET themes over the past few years, particularly The Three-Body Problem.

The core of this note is a quote by Bob Prince, Bridgewater’s co-CIO and an actual prince of a guy. I just think he’s wrong when he says this:

The relationships of asset performance to growth and inflation are reliable – indeed, timeless and universal – and knowable, rooted in the durations and sources of variability of the assets’ cash flows.

I think Bob Prince is wrong in exactly the same way that JP “Jupiter” Morgan was wrong when he said this:

Gold is money. Everything else is credit.

If you get nothing else from Epsilon Theory, get this:

There are no timeless and universal relationships between asset performance and ANYTHING.

The only determinant of price for a non-cash-flowing thing is Narrative. Actually, the only determinant of price for a cash-flowing thing is Narrative, too, but we can save that argument for another day. And what I am saying about these non-cash-flowing things is this:

The introduction of Libra changes the Bitcoin narrative in exactly the same way that the introduction of fiat currency changed the gold narrative. And by change I mean crush.

That makes me sad. That makes me angry. I am convinced that it is part and parcel of a Spanish Prisoner con game. But I refuse to give into the negative energy of that realization AND I refuse to give up on the Big Ideas that I believe in.

So what do I do?

I con the con man.

I know what Mark and Sheryl and all the other Davos-going Team Elite sociopaths are about.

I see what they are offering me and I TAKE it. Without hesitation. Without remorse. I take it just as they are trying to take from me … in full sociopathic bloom.

And what do I give them in return?


Do I care about banking the unbanked and cross-border remittances? Yes, I do. Very much. So I will TAKE the protocols and the KYC procedures and everything else Libra offers, and I will USE all of that to further the social justice goals that I maintain. And they will get NOTHING from me in return. I will keep my autonomy of mind. I do NOT forget what they are trying to steal from me. I do not ALLOW them to steal that from me.

I refuse to give them my trust.

And I will look for every opportunity to destroy their Little Kingdom.


Do I really have TRUST NO ONE tattooed on my hands? No.

I trust lots of people. I trust my pack.

But Mark and Sheryl and Christine and Jay and Donald and Barack are not in my pack. And they never will be.

Trust no one? No.

I just don’t trust THEM.

Take back your vote.

Take back your distance.

Take back your data.

It’s that simple. And that difficult.

As wise as serpents. As harmless as doves.

  PDF Download (Paid Subscription Required):  The Spanish Prisoner

Life in the Gyre

I been watchin’ you watchin’ her watchin’ herself in the mirror.

High Tone Woman, from Somewhere Down in Texas by George Strait (2005)

I wanted to write something about Andy Ngo.

Andy is an independent journalist who was badly beaten by members of Antifa last weekend. He writes for Quillette, a provocative, liberal centrist publication that you will probably see (oddly) described as conservative. His public actions haven’t made him a saint in the eyes of everyone, but he didn’t deserve to be physically assaulted.

I wanted to write about how most media outlets weren’t talking about the attack in the way they would if Ngo’s politics were different. Because that’s how it felt to me. So I looked at our database of media coverage of other attacks on journalists that have taken place in the last year or so.

What I felt to be true, well, wasn’t.

Clear eyes. The attack on Andy – in no small part because of the graphic video capturing it – has gotten more coverage in the first three days of its aftermath than almost any attack on a journalist in the United States in 2019. More than coverage of journalists in D.C. being knocked down by Capitol Police, or a longtime Sacramento Bee cameraman receiving similar treatment. More than a journalist who took similar injuries from objects flying out of a car (hurled with epithets) when covering dueling pro-choice / pro-life rallies. More than the recent injuries to journalists covering the Memphis police protests. In fact, the only event in 2019 with comparable coverage was the attack on the press pool – and a BBC cameraman in particular – at a Trump rally in February.

We will be the first to say that quantity of coverage isn’t necessarily what is most important. Is there a cohesive narrative indicative of a collaborative desire of missionaries to tell readers how to think about this event? Can we spot the affected language we call Fiat News – opinions parading as fact – in news stories about it? Is there a detectable bias embedded in the qualities of the language used to discuss this event relative to similar ones? Yes. Yes. And yes.

And while demonstrating each of those things is what drew me to the topic, when I saw the narrative structure, it wasn’t what struck me. What jumped out at me was just how much of the coverage of this issue was about others’ response to coverage of the issue. In other words, more than just about any topic we have researched, somebody looking for news about these events was just as likely to instead find ‘news’ that would tell them how the curious case of Andy Ngo was really a symbol of virulent right-wing whataboutism equating childish antics to Nazism, or how it was really an example of mainstream left-wing hypocrisy and indifference to violence and bad behavior if perpetrated against the ‘right kind’ of people. And then it was media outlets trumpeting the content of media outlets making the opposite claim. In other words, if you felt what I felt and wanted to have a mirror engagement with the confirmatory story, or a rage engagement with the people getting it wrong, you had a host of articles to choose from.

How many?

By our estimate, roughly 40% of the 273 articles in our data set written about Andy Ngo between June 29th and July 1st have principally been about the coverage of the event and responses to that coverage by other outlets and people.

Source: Quid, Epsilon Theory

Missionaries have been shaking their fingers at us to tell us how to think about issues for a long time now. That is not new. But increasingly, what we are being told isn’t just how to think about issues. We are being told what other people think, how others are covering the events and how everyone else is all wrong. We aren’t even allowed to figure how we’re going to start fighting about some dumb thing. By the time we’ve read a single fact about a story, the ring is built, our gloves on, Michael Buffer already halfway to his car, and the bell still ringing.

It isn’t that there isn’t truth in these claims. I still believe personally that most large outlets were aggressively dismissive of Ngo’s victimhood for political reasons, and I think there’s substantial evidence in language of their coverage to indicate it. I think a lot of people of a different political persuasion would still think – in good faith – that it is ridiculous that we are even talking about this when psychotic, racist white nationalists are out there running people over.

The problem is that when the information we consume ceases to be information about things that happened, and is transformed into information about how important people perceived those things or how the other side is being hypocritical about their coverage or opinions of those things, we descend another layer into the Panopticon – watching the crowd, watching the crowd watch itself. The more of this kind of information we unwittingly consume, the more we unwittingly live our lives in a world in which our reality is defined by the second and third levels of the Common Knowledge Game. Even when we think – even when we know that we are right.

We can’t avoid being in the Widening Gyre. But we can avoid being of it.

It’s not all political theatre.

Let me give you an example. When I was preparing this essay, the New York Times was so sure that I needed to see this article that they paid for the pleasure of putting it on my screen:

What is it?

Well, it’s a promoted tweet from last year, which probably means that the New York Times has a marketing and social media department that has determined that paying for 30-something dads who search for “real metal Tonka trucks” and “foam airplanes with long wings” on Amazon and post dad jokes on Twitter to see this article has a positive ROI.

The article itself, of course, includes zero descriptions of how parenting is any different from what it used to be. The descriptions are of how specific parents have said that they feel they have to do different things for one reason or another. This isn’t the kind of Fiat News we’d usually see in your classic feature piece, trying to guide in a newsesque way in how you think about some Big Social Issue. Instead, it’s news that provides you with reminders that this is how other people are thinking correctly about this.

It sounds melodramatic, but under any reasonable interpretation, the New York Times is literally trying to sell subscriptions to parents by preying on their fear that they will miss an article that will tell them how other parents are defining what parents are supposed to do. It’s a less obtrusive version of Black Mirror’s Fifteen Million Merits, with more nudges and less Big Brother. Click-bait, sure, but more subtle and far more powerful. Don’t mute your audio, or else you’ll be subject to a penalty.

Image result for fifteen million merits don't look away

But no, it also isn’t always gentle nudges. The media-as-principal has determined that vanilla Fiat News isn’t enough, that guiding how you think will be most effective by telling you how other people are thinking about things, how they are getting it wrong, etc. The pattern is everywhere.

It is evident in the editorial selection of news articles and how they are written. Here, for 2015-2018, are the percentages of articles in the New York Times, Washington Post, CNN and Huffington Post – the most socially important left-leaning news publications in the US – which specifically reference Fox News.

Source: Quid, Epsilon Theory

Fox itself, probably as influential and powerful in right-leaning circles as each of those outlets combined in their own milieu, is selling the same thing. The growth is not so dramatic, but part of that is – I think – because the narrative of a general left-wing bias in media was already well-established as the network’s raison d’etre.

Source: Quid, Epsilon Theory

What does this mean? It means that, relative to only four years ago, you are twice (or more) as likely to encounter a ‘news’ article telling you what tragedy the opposing political side isn’t treating the same as they did a different one, a response ‘news article’ which snidely references the first with as many scare quotes as possible, and then a set of third articles which just cover all of the most virulent social media posts the dueling articles spawned.

Oh, think that last one was a throwaway joke?

Yeah, that’s happening, too.

If your response to this is, “Yeah, but that’s just reflective of growth in Twitter and social media in general – it’s just an indication that it is being embraced more broadly by public figures,” well, yeah, no kidding. Y’all, the point isn’t necessarily to convince you that people are doing something wrong here. It’s to show that this is happening. To argue that we can stop predicting and start observing. Some statement or dispute on social media is now newsworthy. A public figure condemning X on Twitter but not condemning Y is now a news event. A random jackass replying to AOC with a racist remark is now a fully fleshed-out feature piece about the New Right Wing, and a search that yields a community college professor who liked a post about punching Nazis is now a wholesale indictment in print of the Lunatic Left.

The peril of this new Panopticon? Fewer of the facts we are provided are divorced from opinions, sure. But fewer still are untarnished by the light shining back on all of us, telling us what the crowd thinks and what it ought to think. Missionaries are taking our Common Knowledge into their own hands.

And it’s working.

Think for a moment about the coverage of the events on America’s southern border. When is the last time you read such a story that was not at least partly meta-commentary about contrasting media treatment of the events? OK, give yourself a little test. How many asylum-seekers have been detained so far in 2018? Just an estimate. Roughly what percentage have come from Guatemala? What about other countries? What are most of them fleeing? How do the conditions and US border policies as currently enforced compare to those of other developed countries?

Cool, cool. OK, now who tweeted out a border photo-shoot in a white outfit? What did some political leaders compare the detention camps to? Who took issue with those characterizations? What biased newspapers and networks have been ignoring and downplaying the current situation in the detention centers? Which biased outlets ignored it during the Obama Administration?

I think I know which set of questions the average news-following American would be able to answer and which they wouldn’t. There’s a reason: because the latter, increasingly, is what is produced and consumed. And whether that tendency plays the role of the chicken or the egg in all this, this is happening because it’s increasingly the content that gets shared. In our query of detention facility-related news this year, here are 5 articles from the top one-half of 1% in shares across social media:

Bank of America will no longer do business with companies that run detention centers [CNN]

Wayfair employees plan walkout to oppose furniture sales to migrant detention facilities [Boston Globe]

Alyssa Milano Promotes Fundraiser for Illegal Alien After Mocking Veteran’s Border Wall Crowdfund [Breitbart]

Ocasio-Cortez presses case that U.S. is running ‘concentration camps’ at border amid Republican outcry [Washington Post]

Many in media changing their tune on border ‘crisis’ after claiming it was ‘manufactured’ [Fox News]

I’m not saying that these topics aren’t newsworthy.

But the fact that the ‘what everyone else is thinking/saying/doing’ articles spread like viruses – when reporting of simple facts does not – matters. It is changing the kind of information we get through incentives alone. There is nothing – nothing – a media outlet can do to better position its franchise than to frame every story as being about the hypocrisy or bad behavior of some opposing group. It is squelching the already short supply of pure, unadulterated, fact-based news we have available to us.

Second- and third-degree Common Knowledge posing as news is doing something else, too:

It is killing good faith. It is killing our collective willingness to believe the benevolent / benign intentions of our fellow-citizens.

Some of that is happening through the subtler – if we can even call it that – Fiat News-like stories above. Some of it is happening through much more transparent means. Consider, for example, the below image, which began to make the rounds yesterday (collected by Heather Heying) about the Andy Ngo affair.

It would be an extremely, er, powerful assertion from the American Spectator – except it was never made. The American Spectator never published this article. You could say it was fake news of the type meant to mislead some number of people on simple facts, but I don’t think so. This image exists to break down any lingering belief that the information being circulated outside of our curated on-narrative sources comes from a place of good faith. Here’s the real one below.

I am not ignorant to the fact that much of what we do on this website is the identification of what we see as common knowledge and active narratives. But the danger isn’t in thinking about the second- or third-degrees of the Common Knowledge Game. We should do that. We must do that. The danger lies in treating the second- and third-degree information that we receive as first-degree fact, rather than how we or someone else would like us to interpret the import of those facts.

And the more we allow others to do that interpretation for us, even when it seems sensible – no, especially when it seems sensible – the less sovereignty we retain over our own thoughts, and the further the gyre of our divided politics widens.

The Half-Happy Horror

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The Judgment of Solomon, Gaspar de Crayer (c.1620)

Optimization is a scourge.

I say this as someone who is as addicted to efficiency as anyone I know. I have a chart – not a mental chart, but an actual on-paper chart – of which of the three specific routes I should take to my office by day and time. I almost never schedule same-day meetings because I find it disruptive to planned periods of work on certain projects. I set up a mise en place for making Kraft Mac & Cheese for my kids, for God’s sake. My biggest average allocation to public markets in non-taxable accounts for several years has been to risk parity. Much of the rest has sat in systematic trend-following and behavioral premia strategies. I am an optimizer, y’all.

Yet I have also spent my career as an allocator to investment strategies observing what both explicit and implicit goal-seeking does to investors and their processes.

I’m not really talking about the robustness of objective-function optimized portfolios to changes in key variables or estimation methodologies, although just a shred of epistemic humility in portfolio construction would go a long way with some quants. I’m also not really talking about the mean-variance frontier-plotting and JP Morgan GTTM-driven Monte Carlo slides I see being put in front of clients (and which I have, from time to time, put in front of them myself). Feel seen? Throw a rock in the air and you’ll hit someone guilty.

But what I really mean is this:

Our need to manage common knowledge about multiple competing objectives in an optimization-centric framework makes us into professional cartoonists.

The Lip-Service Cartoon

I’m not saying anything outlandish here. If you’re a professional investor, you’ll be familiar with this – especially the lip-service cartoon. This is the one where we pretend – and ask everyone else to pretend – that our secondary and tertiary objectives or constraints are conveniently totally achievable without impacting our primary pursuit, even when they’re not.

I have written about this recently in context of post-secondary education, where optimization’s effects are obvious. The stories we tell about college are that it ought to serve three objectives, usually all at once:

  • College should broaden horizons, providing a foundation of historical, philosophical, aesthetic and scientific knowledge and the critical thinking needed to process problems raised by or answerable using that knowledge;
  • College should prepare students to enter and be successful in a profession; and
  • College should provide an environment for the socialization, personal growth and independence of young adults.

In practice, by any realistic measure of revealed preferences American universities don’t really optimize for any of these things. As we have argued, we think they mostly target maximizing the signal sent about the underlying intellectual, temperamental and socioeconomic and demographic traits of their degree-holders, because, well, that’s what our culture has permitted and what alumni donors demand.

Is it true that critical study of history, philosophy and language can improve the quality of thinking? Of course it is! If you’ve been reading Epsilon Theory very long, you will know that we believe the same Big Ideas tend to permeate almost every area of human activity, and that identifying those variants and their memetic attachments in the wild can be a meaningful advantage to our thinking. You’ll also know that we are passionate about the human importance of art and creation. The cartoon isn’t in recognizing the importance of these things. It isn’t even in recognizing that they may have some value for multiple objectives. The cartoon is in our pretense that coursework in music theory and the emergence of proto-Celtic language and cultures from other Beaker societies will be just as important to professional pursuits or personal growth of young adults as it is to living an enriched life. By corollary, however many hours you spend studying Kant, it won’t make you as good at your job as spending the same amount of time doing that job or preparing more directly for it.

To maintain the cartoon, we must pretend that it will.

Our pressure to create these cartoons can be traced to our sensitivity to common knowledge about those secondary and tertiary objectives that we are ‘balancing’. It is untenable – unacceptable – to be seen as not seeking out those objectives, and it is desirable under almost every governing narrative of the Zeitgeist to be seen as pursuing them. The inevitable result is that they get only as much of our energy and attention as is necessary to maintain the cartoon.

If you want to see this in financial markets, look no further than the methods your value managers provide for avoiding value traps (which will, I assure you, be disregarded as not being relevant in this particular case when it suits them), most ESG overlays, and almost every risk report provided by a non-integrated risk team to the portfolio management team. Pro-tip: the more a PM you are interviewing goes on about how much having daily access to these risk statistics has really changed their thinking, the more full of shit they are.

In fairness, it isn’t that they’re lying – it’s that the cartoon permits them to act as if the balancing of multiple objectives is serendipitously bereft of any tradeoffs. Their process is just that good.

The Measurement Cartoon

Sometimes our cartoon isn’t that we wave our hands at potential tradeoffs between our objectives, pretending that some magical alignment of our ideas permits the kind of synergy never found in nature. Instead, the cartoon is the pretense that we have the capacity to measure what those trade-offs are, even when we don’t.

The most inevitable cartoons of this variety, I think, are those built around liquidity. Our industry gets the occasional reminder that liquidity matters, such as with the recent Woodford business in the UK, or the Third Ave blow-up a few years back. After those events, there’s usually a 12-18 month cycle in which people Really Care about it. They add a few more questions to their DD questionnaires, and once the answers from fund managers congeal around some standardized answer, the questions largely stop, other than in the most perfunctory way. That is, until the SEC passed 22e-4, a rule establishing the requirement for a liquidity risk management program for open-end investment companies. It requires the mapping and publishing of position liquidity in four different categories.

In this case, we have a rule requiring the creation of a cartoon, and lest anyone is laboring under any delusions here, that’s exactly what investors will get. I’ve provided below a helpful example of the rule, its standards, the cartoon responses investors will receive and the real response investors would get if the industry were concerned about telling them the truth:

The point, of course, is not that liquidity isn’t important. When it matters, it matters a lot. And when it matters a lot, things are happening that are often not quantifiable in ways that will make sense under any objective quantification scheme in a normal environment. Asset class flows, manager-specific flows, market direction and available position-level liquidity are all pro-cyclical. As has almost always been the case, these cartoons will tell a happy story about liquidity to investors…until it’s too late. In other words, the value ascribed to a liquidity bucket is an ephemeral, practically useless figure that gives false comfort and context to manager and investor alike.

There are other examples of how we optimize for multiple objectives by turning a complicated secondary objective that deserves our respect into a cartoon we hand over to ALPS, BNY or our internal risk management team. Highly leveraged funds whose managers have ever uttered the words ‘Cornish-Fisher expansion’ to a client, you are correctly detecting side-eye. In all such cases, there’s nothing disqualifying or wrong about using guideposts or systematic measures, but when we optimize for some key objective (return or volatility-adjusted return) and explain away others (maintaining adequate liquidity) by constructing a cartoon to ‘measure’ them away, we’re gonna have a bad time.

The Mitigant Cartoon

In still other circumstances, we know that we can’t measure a secondary thing we care about, so the hand-waving takes a different form. We don’t have measurements. We have mitigants.

To be fair, mitigants are real things. AND they are often the basis of cartoonish abstractions that allow us to dismiss important things we ought to honestly, fully consider. We know that excessive leverage and concentration in this strategy creates potentially outsized risks to the portfolio, but worry not: in portfolio transparency we have a powerful mitigant. We know that there’s an unusual capital structure which could permit the intentional impairment of our class of interest, but the principal is a public personality with long-term clients in the same class. These are strong mitigants, you see.

The problem with mitigant cartoons – and what distinguishes them from actual mitigants, is that they are among the most basic tools of confirmation bias. They provide ready answers to our concerns which, like our other cartoons, miraculously seem to support the unbridled pursuit of whatever our primary objective was in the first place.

When we build too much of our thinking around optimization instead of good-faith, knowingly messy, honest evaluation of conflicting facts and circumstances, we will inevitably find that all of our problems become just-so stories. They will perfectly explain, measure or mitigate away the things we have to be seen to care about but don’t. They will perfectly support our single-minded pursuit of the things we do care about.

The Half-Happy Horror

Look, the idea here isn’t that we can’t walk and chew gum at the same time. An incredible share of life is obviously about finding balance between conflicting things, priorities and ideas – whenever it’s possible to do that, that is. The idea also isn’t that we shouldn’t adopt systematic methodologies -quite the opposite, as I frankly think these tendencies to optimize are stronger for those who don’t constrain their processes to rules (yes, it is clearly quite possible to systematize predispositions in such rules, too).

The idea is simply that optimization of decisions involving multiple objectives and constraints – whether fully systematic, rules-based or discretionary – is the kind of thing that should always cause the responsible investor and citizen to step back. Especially when the alternative is often a solution that will make everyone half-happy, which in a zero-sum game is no solution at all.

What can that person do?

  • We can (try to) be honest with ourselves. If we have a constraint, a risk, or a secondary objective in our strategy we’re trying to balance with another, are we giving them lip service? Are we draping them in unwarranted quantification so that we can consider them ‘solved’? Are we clothing them in ‘mitigants’ so that we can check the box and move on?
  • We can focus on ANDs. The language we use to talk about multiple objectives often betrays our attention and the considerations we would just as soon wave our hands at. In my experience, it is critically important to start from a place that considers all facts as ANDs, rather than presuming their relationship to one another.
  • We can try to simplify our decisions. Where possible, simplifying decisions and our responses to them so that we truly can focus on a narrower set of objectives – not through abstraction, but in truth – can help a great deal. With portfolios, maintaining a lens to conceptualizing pools of capital as serving discrete objectives can be an effective management tool.

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In the Trenches: Cake

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What’s next for U.S. equity markets, and what historical analogs might provide some insight? There are plenty of bullish pundits citing renewed monetary policy easing as a catalyst for higher equities – some even suggesting a melt-up could yet occur. While a surprise (at least to us) cut this week could propel equities higher for one last gasp, I’d not chase. Since my 2019 Outlook, I’ve been suggesting a ‘tale of two halves’ narrative for risk assets.[1] In it, my team and I described a first half characterized by a correlated risk-on resulting from improved central bank communication, more reasonable valuation, and more favorable optics around China trade. This has largely occurred. In particular, our mid-year target for the S&P 500 was and remains 2,800, while our year-end target remains well below street consensus at 2,500.

The recent rally in U.S. equities is largely a result of market participants believing they can have their rate-cut cake and eat it, too.

Market participants’ Pavlovian response to a cut of any kind – regardless of context – has been well reinforced over the past ten years. As my team and I have pointed out, and as Figure 1 illustrates, a cut now would bode ill (as a signal rather than a cause) for the U.S. economy over at least the next year. Will the Fed cut in June? While in play, we don’t think the Fed will cut, as it would amount to preemptive action.[2] There are three relevant precedents upon which market participants have relied to justify such preemptive Fed action.

Some argue that market conditions are analogous to 1995, when the Fed cut preemptively. I disagree. In our BIG Picture piece entitled Fed Reaction Function (dated April 20, 2019), my team and I presented our view that current conditions did not resemble 1995, and we continue to hold that view. As Figure 2 shows, when the Fed decided to cut in 1995, economic conditions were significantly worse than they are today. ISM manufacturing was deep in contraction, and at 5.6%, the unemployment rate was significantly higher than it is today. That said, the view has consistently been that the Fed will cut if equity markets risk-off by more than 15% or if there is a hard turn in the economic data, neither of which have occurred quite yet. Such conditions will likely manifest later in the year, especially if rates markets are as predictive as we think they are. It’s a matter of when – not if.

Eurodollar futures markets (ED1 – ED3 = 40bps) are implying an 80% chance of two cuts between June and December. This suggests the Fed is too tight relative to economic conditions (Figure 3). The correlation between 10-year rates and ISM manufacturing show that ISM will move into contraction in the near future (Figure 4). Nonetheless, we don’t believe that the Fed will move before that happens – nor should it. The equity markets and rates markets are severely disconnected, and that disconnect is the result of expectations for market intervention from the Fed, upon which markets have become far too reliant. My expectation is that equity market volatility will precede the Fed’s next move. Certainly, with the S&P 500 at ~2,900 amidst a global slowdown and flat U.S. earnings, the risk-reward appears poor to owning U.S. equities.

Looking at another potential historical precedent, I also do not believe that the current situation is analogous to the early 1970s when President Nixon appointed Arthur Burns as the Chairman of the Federal Reserve. While we will leave the reader to his or her own conclusions about the similarities between Donald Trump and Richard Nixon, it would appear that Chairman Powell is far less naïve than the academic, Burns. On February 1, 1970, Burns, known as a Republican loyalist, took office. Preceding the 1972 election, Nixon is alleged to have instructed Burns to cut rates.  Burns lowered funds starting in mid-1971 from 5.75% to 3.5% into March of 1972; GDP growth picked up to 5.6 % in 1972 from 3.3% the year prior. Inflation rates rose to 5.3% from 3.6%. This may have helped exacerbate the impact of the oil shock, which occurred as a result of an OAPEC oil embargo, which was retaliation for U.S. aid to Israel during the Yom Kippur War. While clearly there was a complex brew of potential causes, this policy period was followed by a considerable amount of asset volatility.

Lastly, the kind of central bank coordination that occurred in February 2016 at G20 is unlikely. Recall the backdrop from 2015 into 2016. A burgeoning China slowdown and fears of an aggressive devaluation of the yuan catalyzed two selloffs – one in late summer of 2015 and the other in early 2016. Complicating the U.S. backdrop was a U.S. earnings recession and a rise in default rates amongst energy companies that risked sparking a broader U.S. default cycle.  The G20 meeting that year was in February in Shanghai. At the time, my team and I failed to appreciate just how aggressive and coordinated the global central bank policy response would be. After a largely correct markets call for 2015, we failed to pivot bullishly enough on this stimulus. Could we be making the same mistake here? We don’t think so.

For one thing, global central bank balance sheets are no longer expanding in aggregate. Figure 5 shows that 2015 equity market volatility (green lower panel) was quickly suppressed by an expansion of global central bank balance sheets (on a stable Fed balance sheet). Now conditions are quite different with the ECB no longer buying new bonds and the Fed selling its holdings. While rates volatility caused by higher rates has abated this year, rates are considerably higher here in the U.S. than in the rest-of-the-world and most developed market central banks remain on hold after only recently being in normalization mode.[3] Lastly, there is no longer a post-crisis chorus of Kumbayah coming from world leaders. Instead, the world’s largest economies are embroiled in what appears to be a prolonged trade war. This makes coordination more difficult especially because many central banks are not independent of the governments engaged in the trade dispute. Lastly, we do not think the Fed wants to hand President Trump a rate cut into the G20 meeting simply because he asked for it. There must be an objective basis for Fed action.


Will we see a change in Fed’s modus operandi in June that results in a cut? We believe a cut in June would require a philosophical change in approach, as we would take it to be a preemptive move influenced by the executive branch. This is why June is such an important meeting. Were it to cut, policy would begin the slide down a slippery slope – a slide back to ZIRP and back to QE (quantitative easing). While we hold the unfortunate belief that all central banks will be at zero interest rates and aggressive QE (including the Fed) in the not-so-distant future, we also think the Fed wants to resist moving in that direction too quickly. Why? For one, the Fed understands the inadvertent redistributive effects of its policy decisions.

Wages compensate labor. Interest compensates owners of capital – credit investors, in particular. As a result, rate cuts, which set the cost of capital, implicitly make a wealth redistribution decision from credit investors to labor (in the form of lower unemployment). Moreover, not only do central bank decisions lead to wealth redistribution from creditors to labor, but low rates typically also discriminate against credit investors in favor of equity capital providers (as the ‘Fed model’ implicitly acknowledges). Moreover, a central bank decision to maintain low rates effectively discriminates against retirees in need of income; thus, there is an additional, unintended demographic consequence. Overall, current workers and equity investors tend to be favored over retirees and credit investors.

The unintended redistributive impact of Fed (and all central bank rate policy) comes largely without explicit legislative authority outside the Federal Reserve Act. Thus, in our view, the Fed still recognizes that the bar for central bank action in a capitalist economy should be relatively high. Historically, the Fed has generally viewed it as such through its data dependent approach and through its mandate to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”[4] We would also note that “moderate long-term rates” seems to exclude both extremely high rates as well as extremely low rates. With the current condition of policy (as shown by Figure 6), the Fed would appear not to have cause to act just yet. Indeed, it’s our view that the Fed will eventually be compelled to move back to ZIRP (zero interest rate policy) over the course of the next couple of years as yet lower rates are required to maintain even the most meager of growth rates. Because we believe the Fed wishes to maintain precedent as well as its independence, it will remain reactive to the data – at least for June – but the data continues to evolve as we foresaw it in the beginning of the year.

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[1] The 2019 Outlook was published on January 4th, 2019.

[2] To be clear: I do think U.S. economic conditions will warrant a Fed cut in late summer and another in fall. My team and I have been arguing strenuously since mid-year 2019 that global economic conditions were beginning to deteriorate and the U.S. economy would follow late this year.

[3] While true, the lean is clearly much more dovish than just a month ago, and emerging market central banks have already started to move with Russia, for example, cutting for the first time in 2-years.

[4]  Statement on Longer-Run Goals and Monetary Policy Strategy, adopted effective January 24, 2012; as amended effective January 29, 2019.

After All, We Are Not Communists

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If Don Corleone had all the judges and the politicians in New York, then he must share them, or let us others use them. He must let us draw the water from the well. Certainly he can present a bill for such services; after all… we are not Communists.

– Don Barzini, “The Godfather” (1972)

I catch a lot of grief for all of the Godfather references I make, but for men of a certain age it remains the most powerful cinematic if not cultural touchstone we’ve got. It’s also just really good narrative art.

This dinner of the Five Families is the heart of the Godfather story arc. It’s where Vito realizes the scope and power of the plot against him (“It was Barzini all along!”), and where he sets in motion a strategy of revenge and redemption that plays out over a decade through his son, Michael.

Vito Corleone played a mean metagame, the big picture game-of-games that can define a life. Vito was a clever coyote who, unlike most clever coyotes, didn’t allow himself to be blinded by the passion of whatever immediate game was thrust upon him, but was able to excel in the long game. In this case, the really long game.

What drove Vito in his metagame play?

What was his motivation?

“I worked my whole life, I don’t apologize, to take care of my family. And I refused to be a fool dancing on a string held by all of those big shots.”


I was at a dinner of about 20 Epsilon Theory pack members down in Houston last month. I’ve been doing a couple of these meet-up dinners of late, and I intend to do a lot more over the next 12 months. I got a question at this dinner that I had never been asked before, a question that – like Vito’s dinner with the other Dons – forced me to crystallize my metagame.

Hey, Ben, I think what you’re saying about society and politics and finding your pack is really important, and you say it really well. Why are you wasting your time talking so much about markets and investing? Why aren’t you writing full-time about what’s truly important?

It’s a question that I’ve thought about a ton, but never talked about publicly. So here goes.

My goal in all things, but especially my metagame, is to act non-myopically and in a way that treats others as autonomous ends in themselves. It should be your goal in all things, too. You know the drill … Clear Eyes, Full Hearts, Can’t Lose.

Acting with a full heart means two things: acting for Identity and acting for Cooperation.

Or as Socrates would have said, Know Thyself, and as Jesus would have said, Do Unto Others As You Would Have Them Do Unto You.

See, there’s really nothing new under the sun. Everything we write in Epsilon Theory has been written before – and better – by teachers who lived hundreds or even thousands of years ago. All you’re getting here is old wine in a new bottle. It’s just really, really great wine. And a half-decent bottle with Godfather quotes or farm animal stories on the label. You could do worse.

What’s my Identity?

I am a solver of puzzles and a player of games. This is who I have always been, from my first childhood memories. This is my motivation. This is my intrinsic spark and reward. This is my Aristotelian entelechy, to use a ten-dollar phrase. This is my I AM, to use the Epsilon Theory lingo.

The market is the biggest puzzle there ever was. That’s why I can’t stay away.

So in keeping with my Identity and our metagame at Epsilon Theory, today I want to share with you a puzzle that I think Rusty and I are solving. Not solved, because a) that’s impossible in a three-body problem like the market, and b) it’s still early days in the Narrative Machine research program. But we’ve completed enough testing and research to have convinced ourselves at least that we are onto something cool and important.

This is the market puzzle that we introduced in March with this note:

It’s our effort to apply our narrative research to an actual, honest-to-god practical investment question – can you measure the structure of financial media narratives in a way that gives a useful signal for underweighting or overweighting big market structures like S&P 500 sector ETFs?

At the conclusion of that note, after laying out our research thesis and the way we were operationalizing our tests, I wrote this:

So I’m not going to talk about results until I can do it without telling a story, until I can show you results that speak for themselves. It’s like the difference between qualitatively interpreted narrative maps and algebraic calculations on the underlying data matrix … the difference between what we THINK and what we can MEASURE.

I know, I know … kind of a tease. But today I think we have results that DO speak for themselves, so that’s what I’m going to let them do.

First a recap on our test procedures, although I’m going to keep this really brief because you can read more in “The Epsilon Strategy”.

In addition to measuring the Sentiment of each article within a batch of financial news articles (something everyone does and we think is better thought of as a conditioner of narrative than as a structural component of narrative), we also measure the “weight” of one narrative structure relative to all the other narratives within a universe of media – what we call Attention – and the “center of gravity” of a narrative structure relative to itself over time – what we call Cohesion.

These are massive data matrices that we are evaluating, so the narrative map visualizations that we often publish in Epsilon Theory notes should be thought of as tremendous simplifications (2-D flattenings of many-D matrices) of the measurements we’re taking here. Still, I’ll incorporate some visualizations where I can.

For example, on the left is a 2-D visualization of the Attention score of the Utilities sector in December 2014. Every faint dot (also called a node) in the graph is a financial media article talking about the S&P 500 in some way, shape or form. There are thousands of these nodes, of course, clustered by all the different topics that drove stock market narrative that month. The dark nodes, few and far between, scattered among several different clusters, are the articles that are about the Utilities sector.

On the right is a 2-D visualization of the same data query and the same data sources for January 2015. What’s pretty clear even in this inherently truncated visualization is that the narrative Attention paid to the Utilities sector – the amount of media drum-beating about the Utilities sector – is much higher in January than in December.

We think this is a short signal for February 2015, by the way.

To be clear, we have ZERO insight into the fundamentals of the Utilities sector going into February 2015. We are NOT actually reading any of these media articles, and we really DON’T CARE what everyone’s opinion about the Utilities sector might be. All we know is that the financial media is shouting at investors to focus their attention on the Utilities sector in January 2015 … or at least shouting in a relative sense to how they were talking about Utilities in the prior month … and we believe that all this shouting has an effect on investor behavior. We believe that investors probably plowed into the Utilities sector in January 2015, so we want to be short (or underweight) this overbought sector in February 2015.

We came up with eight testable hypotheses like this, based on states of the narrative-world as measured by Attention, Cohesion, and Sentiment, and we ran a five year backtest on each hypothesized strategy for its signals in overweighting or underweighting S&P 500 sectors on a monthly basis. Importantly, we came up with the hypotheses before we did any backtesting or simulations, and we did zero tweaking or retesting after we did any backtesting or simulations. These sector rotation strategies are deductively derived, based on our professional intuition of investor behavior and our professional knowledge of how the Common Knowledge Game works.

Also importantly, these are slow-twitch strategies, where we take our measurements at the end of each tested month to generate a signal for the following month. All of the financial media articles are publicly available. There’s no massaging of the data or change in the search queries over time. There’s no discretionary input. We are testing on the Select Sector SPDR ETFs, each of which have no appreciable liquidity constraints, and we take into account ETF fees in our performance simulations. We do not take into account trading costs, although we would expect these to be minimal.

Of the eight hypothesized narrative-driven sector rotation strategies, we found that six of them “worked”, meaning that in our backtest simulations they generated excess returns over the S&P 500 and had an information ratio > 0.6 (again, I’m going to let our findings speak for themselves, so if you need a primer on “information ratio” and some of the other terminology here, that’s on you). We then took a simple, non-optimized equal weighting of each of the six working strategies to create an unconstrained “Beta-1” portfolio strategy, meaning that we let the individual strategies do whatever they signaled as far as underweighting or overweighting the individual sectors relative to their baseline S&P 500 sector weights, and then we added whatever vanilla S&P 500 index long or short exposure was required to make a fixed portfolio net exposure of 100% long. So if you’re keeping track of these things, the unconstrained Beta-1 portfolio of strategies averaged about 12 separate sector signals per month, an average gross exposure of around 200%, and is the rough equivalent of a 150/50 strategy. 

Now before I show you the results of the portfolio simulation, I want to say the following really clearly. I’m not saying this as boilerplate, and I’m not saying this in tiny text or in ALL CAPS, both of which are signals for you to stop paying attention. These are simulated, backtested returns. You could not have invested in these strategies. You cannot today invest in these strategies. Even if you did, there is no guarantee your results would reflect those of the backtests I’m going to show you. We have treated all of this as a research puzzle we are trying to solve, and so should you.

We understand that many investors are not allowed to be short anything, even an S&P sector ETF, so we also modeled a constrained long-only portfolio of strategies, where we cap all underweights at zero exposure, creating a 100% gross exposure, 100% net exposure portfolio strategy, with no shorting of any sector ETF. As you would expect, the performance statistics are muted compared to the unconstrained version, but still quite powerful.

Crucially, these excess returns are uncorrelated to all major factor categories – Momentum, Value, Low Vol, and Quality.

So there you have it.

We think we are identifying a novel and predictive signal of investor behavior from our systematic measurement of narrative structure in publicly available financial media.

Now, savvy readers will note that I started this note by talking about metagames and Identity, but cut that discussion short to get into the meat of this investment research puzzle that I think we are solving. Savvy reader will ask themselves if there’s another shoe to drop here. Savvy readers would be right.

What’s my metagame?

Let’s start with this blanket statement: I will do anything for my pack. I’ll be the patsy. I’ll make unreasonable sacrifices. I’ll give away the store if that’s what’s required. But here’s the thing – my pack would never require this of me. At every level of my pack, from nuclear family to the ET epistemic community, we do unto each other as we would have each other do unto us.

To put it in Kipling’s poetic terms about the pack, we drink deeply, but never too deep.

To put it in Dungeons & Dragons terms, we are lawful good but not lawful stupid.

So hell yes, we’re going to charge money for access to and information about our investment research. Second Foundation Partners is a completely independent company. It’s me and Rusty doing a high-wire act with no net. Our research and puzzle-solving is not only an expression of our Identity … it’s also how we preserve our independence so we CAN write about more than markets and investing.   

If you’d like to draw water from this research well, you’ll need an ET Professional subscription. It’s the only place we will be sharing our insights and plans for developing the Narrative Machine for investment applications.

Because after all, we are not Communists.  

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In the Flow – Chef’s Knives

It's easy to get waaaay too precious when it comes to professional kitchens, whether we're talking about restaurants or a trading desk.

But credit default swaps are like chef knives. They're not an affectation, but a necessary tool for so many tasks. Even if you don’t cook or trade a portfolio professionally, you’ll want to own a good knife and you’ll want to know the mechanics and the rationale of a CDS trade . . .


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A Song of Ice and Fire

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Every winter, we lose something here on Little River Farm. It’s like a tithe that nature takes, year after year after year. This winter was particularly tough. Polar vortex and all that, I suppose.

None of the bees made it.

Sigh. I’ve lost hives before. It happens. But it’s never easy. Never anything but sad. They work SO HARD at staying alive through a New England winter and they’re all boxed away for months and you can’t open the hive to check on them because that would weaken them for sure and it wouldn’t do any good anyway and so you wait and you worry and you do all you can to set up windbreaks and you don’t know if they’re hanging in there and it finally gets warm enough to crack open the hive and get them some help and … death. Nothing but death.

Always go to the funeral.

We respect our animals in life and in death. Especially in death. So I remove the bee husks and the old comb and I make a small fire and I give them to the flames. Because it doesn’t seem right to put bees into the ground. They are of the air in life, and they should be of the air in death.

And we begin again. Always.

But this isn’t a note about beginning anew after a polar vortex of a winter. Well, it kinda is, so hold that thought in the back of your head. But the narrative structure for this note isn’t about winter and ice and the tithe of death. It’s about winter and ice and the miracle of life.

There were two animals I was certain the winter would take from us, and those are the goldfish that live in the horses’ outdoor water trough. Yes, we put goldfish in the water trough last spring. The horses are careful not to eat them or drink them in, and the goldfish are great at keeping the trough clean. Not industrially clean, of course, but fingernail clean. The way a real, living farm should be.

I figured this was a brick of ice in the dead of winter. I figured there was no way on god’s green earth that two little fish could sit outside in what amounts to a big pail of water through a Connecticut winter. Good lord, we had DAYS and DAYS of sub-zero temperatures this January. And yet … there they were, glints of orange-red swimming around in the trough here in late March.

A miracle? Yes. But not the kind of miracle you’re thinking of. Not the miracle of some sort of cryogenic suspension, where the goldfish are like Captain America, thawed out from a giant block of ice after 40 years, ready to pick right back up fighting supervillains or eating algae or whatever it is one does after resurrection.

No, the miracle here is the non-linear nature of water.

See, we all know that when gases or liquids get colder, they get denser. They get heavier. The molecules in the gas and the liquid are less energetic as they cool off. They bounce around less. They sink. This is why pool water and lake water and ocean water gets colder the deeper you go. It’s a perfectly linear relationship … the colder the water, the heavier the water … the colder the water, the more it sinks.

But when water gets to 4 degrees centigrade, this nicely linear relationship between temperature and density stops happening. In fact, it REVERSES. It’s not only non-linear, it’s non-monotonic (a ten-dollar word that means reversal). As water gets colder than 4 degrees centigrade, it no longer gets heavier. It no longer gets denser. It no longer sinks.

Instead, this miraculous substance called water gets lighter as it nears its freezing point. It’s still a liquid. There are no solid ice crystals forming here that have a different density than liquid water. It’s still exactly the same substance in form and chemistry and everything else at 3 degrees centigrade as it was at 4 degrees centigrade, but somehow it is now lighter than it was before. And so it rises. And it rises still more at 2 degrees centrigrade. And still more at 1 degree centigrade. And so ice does not form at the bottom of a Connecticut pond or lake or water trough, but instead forms at the top of a Connecticut pond or lake or water trough, where it forms an insulating barrier against the cold air reducing the liquid water temperature still further. That’s how the goldfish survived. There was liquid water at the bottom of that deep horse trough, even as the polar vortex raged above.

Without this non-linear, non-monotonic property of water, life as we know it would hardly exist.

Every Ice Age would be every bit as much an extinction event as a giant meteor of death. Every lake or pond above or below a certain latitude would be as lifeless as the moon.

It’s a miracle of life that liquid water – the foundation of life on our planet – gets lighter instead of heavier right before it changes state into solid ice.

There’s no reason why this non-linear property of water should exist.

And yet it does.

If you were predicting the behavior of water from a theory of thermodynamics, there is no way you would predict 3-degrees cold water would be lighter than 4-degrees cold water.

And yet it is.

Facts don’t care about your feelings? Yeah, yeah … cute. Here’s the far more serious truth:

Facts don’t care about your theories.

The only way to learn the non-linear nature of water is through empirical observation, through actually living with water and ice rather than simply theorizing about water and ice. Because once you SEE that very cold water becomes lighter rather than heavier, then you KNOW that there must be something WRONG with your theory of thermodynamics, because this behavior is IMPOSSIBLE within a theory of thermodynamics. There must be something ELSE acting on the behavior of water than thermodynamics, something BIGGER and more FUNDAMENTAL than thermodynamics.

In the case of H2O, it’s the asymmetric positioning of the two hydrogen atoms connected to the single oxygen atom. It’s the atomic structure of the water molecule that creates the miracle of life.  

Same thing with economics.

Because money, like water, is non-linear.

Because you think you can explain and predict human behaviors around money based on a macro theory of monetarism (the supply and price of money), and usually that’s true, but sometimes it’s not.

Because there is a more fundamental theory of money – an atomic structure theory of money based on human risk-taking and human social narratives – that subsumes and improves on your macro theory of monetarism.

Does lowering the price of money from 8% to 7.5% create more risk-taking? Does it increase the velocity of money through the real economy as corporate and household risk-takers are willing to borrow and spend and invest MORE at 7.5% than they were at 8%? Yes.

How about lowering the price of money from 7.5% to 7%? Yes.

7% to 6.5%? to 6%? to 5.5%? to 4%? Yes, yes, yes, and yes.

It’s a nicely linear relationship.

It’s exactly as one would predict from a theory of molecules and thermodynamics monetarism and macroeconomics.

So I understand why central bankers believe that lowering the price of money from 1% to 0.5% would act on risk-taking in the same linear fashion. And from 0.5% to 0%. And in the case of Europe, from 0% to negative interest rates, and from slightly negative interest rates to really negative interest rates. They have a linear theory of monetarism and macroeconomics. Lower interest rates have a specific and direct relationship with risk-taking economic behavior and expectations. The lower the interest rate, the greater the spur to “inflation”, by which central bankers mean risk-taking economic behavior.

Inflation not being spurred? Lower the price of money more.

Inflation still not being spurred? Lower the price of money still more.

Inflation STILL not being spurred? Lower the price of money MOAR.

But it’s not working, people. Lower and lower interest rates are demonstrably not spurring risk-taking economic behavior in the real economy. Lower and lower interest rates are empirically not spurring inflation.

When the price of money gets really cold low, like close to zero degrees percent low, risk-taking behavior changes. The rational risk-taker in a zero interest rate world does NOT invest in property, plant and equipment. The rational risk-taker does NOT borrow more and spend more to invest in the future. No, the rational risk-taker believes the central bankers who say that interest rates will be ultra-low forever and ever amen, that future growth rates are moribund and miserable, that our world persists in a long gray slog of deflation just as far as the eye can see.

What do rational risk-takers do in a zero interest rate world? They buy back stock. They buy profitless revenue. They engage in financialization.

They minimize risk and maximize return. They are greedy AND they are fearful. They demonstrate the atomic behavior of rational greedy/fearful human beings since the dawn of freakin’ time.

THIS is water.

This is profit margin without labor productivity growth.

This is the zombiefication and the oligarchification of the US economy.

This is the smiley-face perversion of Smith’s invisible hand and Schumpeter’s creative destruction.

This is the profoundly repressive political equilibrium of an entrenched State and entrenched Oligarchy that masks itself in the common knowledge of “Yay, capitalism!” and “Yay, military!” and “Yay, college!“.

That’s a thick layer of ice above us, growing thicker by the day. But we are still the goldfish on Little River Farm, still swimming in a small pocket of water, not yet encased in a solid block of ice. We aren’t yet the bees. Not yet. What must we DO to avoid the bees’ fate? What must we DO to end this winter that is imposed on us?

We have to Break the Wheel.

We have to break the tyranny of ideas that nudge us into service to the entrenched State and the entrenched Oligarchy, without replacing those ideas with a tyranny of our own.

How do we do THAT?

Well … I know it’s all the rage to rip the Benioff/Weiss screenplay in the post-George RR Martin seasons. I’m pretty bummed myself. But this line by Tyrion in the finale shows the way.

What unites a people? Armies? Gold? Flags?


There’s nothing more powerful in the world than a good story. Nothing can stop it. No enemy can defeat it.

How do we Break the Wheel?

Not by revolution. Not by dragon fire. It didn’t work for Daenarys, and it won’t work for us.

We break the wheel with a better story, with a better theory.

Because that’s what a theory is … a story about how the world works.

By the way, this is how science works. By the way, it’s always science that breaks the wheel.

The story of the Masters is that the market is a macro clockwork machine, governed by linear, mechanistic “laws”. I have a better story.

I tell you that the market is a BONFIRE.

From We’re Doing It Wrong:

Fire is not magic. Fire is not somehow separate from science or rigorous human examination. We know how to start fires. We know how to grow and diminish fires. We know how to put fires out. In a technical sense, Ray Dalio, you can classify fire as a machine.

But you’d never think that you could possess an algorithm that predicts the shape and form of a bonfire.

You’d never think that if only you stared at the fire long enough, and god knows humans have been staring at fires for tens of thousands of years, that somehow you’d divine some formula for predicting the shape of this or that lick of flame or the timing of this or that log collapsing in a burst of sparks.

No human can algorithmically PREDICT how a fire will burn. Neither can a computer. No matter how much computing power you throw at a bonfire, a general closed-end solution for a macro system like this simply does not exist.

But a really powerful computer can CALCULATE how a fire will burn. A really powerful computer can SIMULATE how a fire will burn. Not by looking for historical patterns in fire. Not by running econometric regressions. Not by figuring out the “secret formula” that “explains” a macro phenomenon like a bonfire. That’s the human way of seeing the world, and if you use your computing power to do more of that, you are wasting your time and your money. No, a really powerful computer can perceive the world differently. It can “see” every tiny piece of wood and every tiny volume of oxygen and every tiny erg of energy. It “knows” the rules for how wood and oxygen and heat interact. Most importantly – and most differently from humans – this really powerful computer can “see” all of these tiny pieces and “know” all of these tiny interactions at the same time. It can take a snapshot of ALL of this at time T and calculate what ALL of this looks like at time T+1, and then do that calculation again to figure out what ALL of this looks like at time T+2.

This is an atomic theory of markets. This is the intuition and the technology roadmap to provide a better theory. It’s not that macroeconomics and monetarism are wrong … there’s no such thing as right or wrong when it comes to theory. It’s that macroeconomics and monetarism are not as USEFUL a theory as one formed organically from the risk-taking economic behaviors of actual economic actors.

Look, central bank cultists will never change their beliefs that they are the thin blue line between order and chaos, or that academic economics is the One True Path for enlightenment and the maintenance of that thin blue line. Change isn’t going to come from attacking the Fed or from a snarky blogger. I mean, I did just call them cultists.

No, no …  change will come from a Fed economist reading this note (on her gmail account, of course) and dropping the assumption – because it IS an assumption – that, for all prices of money, there is a monotonic relationship between change in the price of money and change in the velocity of money employed for productive economic purposes. Change will come from this economist allowing for the possibility of a non-linear and non-monotonic relationship between interest rates and inflationary behaviors at very low interest rates, loosening her stochastic assumptions accordingly, and then TESTING this possibility against the actual empirical evidence of the past ten years. Change will come from this economist presenting her findings from within the proper academic forms as an extension and progression of what came before, so that the institutional imperative to self-servingly mansplain our place in the world (you’re welcome!) can be maintained.

Daenarys and her city-destroying dragons couldn’t break the wheel. Moana and her Maui-tolerating wayfinding could.

In a thousand small steps … this is how theory changes. This is how science advances. This is how progress is made. This is how the story that we tell ourselves about who we are evolves into something that subverts institutions from within, not something that attacks institutions from without.

As below, so above.

To be honest, it’s a longshot that we’ll be able to pull this off. After all, we’re not characters in a Disney movie. Or even an HBO show.

One of my favorite authors, Kurt Vonnegut, wrote a lot about theory and non-linear systems and humanity’s place in all that. You wouldn’t know it from a cursory read, because he could spin a yarn, but that’s what most of his books are about. Cat’s Cradle is the novel most obviously connected to my particular theme, as the plot is driven by the invention of a substance called ice-nine, an isotope of water that freezes at room temperature and replicates itself in any ordinary water it touches, thus spreading ice throughout all the liquid water in the world. You know, kinda like negative interest rates.

Along the way to the end of the world, there’s a nihilist religion called Bokononism to explore, with this wonderful quote:

The Fourteenth Book is entitled, “What can a Thoughtful Man Hope for Mankind on Earth, Given the Experience of the Past Million Years?”

It doesn’t take long to read The Fourteenth Book. It consists of one word and a period.

This is it: “Nothing.”

Vonnegut would probably say we don’t stand a chance against the Nudging State and the Nudging Oligarchy, armed to the teeth with narrative-controlling instruments that promote their Wheel-preserving ideas, convincing us to sign away our autonomy of mind.

Like how the narrative of Yay, capitalism! subverts our liberty (and responsibility) to Make.

Like how the narrative of Yay, military! subverts our liberty (and responsibility) to Protect.

Like how the narrative of Yay, college! subverts our liberty (and responsibility) to Teach.

Yeah, he’s probably right.

But then again, Kurt, why did you write?

It’s why I write, too.

I’m publishing this note on Memorial Day for a reason. You get it. I know you do.

We are the human animal.

We are non-linear.

We ARE a song of ice and fire.

It’s a song that has built cathedrals and fed billions and taken us to the moon.

It’s a song that can do all of that and more … far, far more … if only we remember the tune.

The Pack remembers.

Yours in service to the pack, – Ben

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In the Flow – You Are Here, May 2019

Each month we update our five narrative Monitors and summarize the main findings from each.

The big reveal for May? There’s a tremendous amount of narrative complacency out there, particularly on Trade and Tariffs, which means this market has a long way down if the narrative focuses on negotiation failure. It’s not focusing there yet, but that’s what you want to watch for . . .


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Wage Growth, Groucho Marx Edition

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Every week, ET Pro subscribers get something like this – an original piece of research and analysis with a perspective that you can’t find anywhere else.

Every month, ET Pro subscribers get updated narrative data and analysis on five core market risk monitors – Inflation, Central Bank Omnipotence, Trade & Tariffs, US Fiscal Policy, and Credit Cycle.

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The ET Pro service is $2,950/yr, with a 30-day full refund trial period, and we’re happy to work through a soft dollar provider. Any remaining time on an ET Premium subscription will be applied as an upgrade. We’ve designed ET Pro to be used by investment teams, allowing up to three simultaneous log-ins with the same credentials, and of course we’re happy to discuss more specific research applications and how you might incorporate them into your current investment or allocation processes.

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Wage Growth, Groucho Marx Edition

The Secret of life is honesty and fair dealing. If you can fake that you’ve got it made.

These are my principles, and if you don’t like them … well, I’ve got others.

I’m not crazy about reality, but it’s still the only place to get a decent meal.

A child of five could understand this. Send me someone to fetch a child of five.

Last March, I wrote a long note on the cartoon that labor statistics present, called The Icarus Moment. To set the scene:

Once you start looking for these cartoons, you will see them EVERYWHERE.

It’s not a Karl Marx world of alienation. It’s a Groucho Marx world of alienation.

The cartoon of our monthly theater regarding labor statistics, particularly wage growth, rests in the fact that they are reported as hourly wages. Even though the majority of wages in 2019 America are paid biweekly against an annual salary, the Bureau of Labor Statistics (BLS) reports ALL of our wages as if they were paid hourly. Why? Because in 1915 America, when the theater of labor statistics began, this was how most people got paid. Even today, the abstracted idea of hourly wages connects with people more effectively than the abstracted idea of weekly wages. Put that together with bureaucratic inertia, and that’s why this cartoon exists.

But here’s the problem with the hourly wage abstraction. It requires introducing a new data estimation into the mix, one that has nothing (or at least very little) to do with the real-world concept we’re trying to represent, which is whether you’re taking home more money today than you did this time last year. That additional layer of abstraction is the average length of the work week.

The root data collected by the BLS consists of the weekly wages paid by US businesses to their employees. That number is then divided by the total number of people being paid, and the result is the average weekly wage for Americans. Here is that abstracted data for the past 7+ years.

source: Bureau of Labor Statistics

But instead of reporting the annual percentage change on a month-to-month basis, the BLS also calculates the “average work week” so that they can maintain the cartoon of hourly rather than weekly wage reporting. Here is that abstracted data.

source: Bureau of Labor Statistics

For the past 7+ years, the average work week has averaged 34.45 hours, with a range from 34.3 hours to 34.6 hours. That’s 2,067 minutes, ranging from 2,058 minutes to 2,076 minutes. Here’s a graph of that.

source: Bureau of Labor Statistics, Epsilon Theory

This is not a variable. This is a constant.

From a statistical perspective, given the inherent errors of measurement, any month-to-month difference of 6 minutes here or 6 minutes there is a totally random event.

Measured changes in the average work week are not real.

And yet they have very real effects on the narrative.

Here’s the year-over-year wage growth data from the singly-abstracted measure of weekly wages:

source: Bureau of Labor Statistics

These are the “true” results, or at least the most basic abstraction of what we’re after.

And now here’s the year-over-year wage growth data from the doubly-abstracted measure of hourly wages:

source: Bureau of Labor Statistics

These are the results that are reported to us and create the political and investment narrative.

And now here’s the difference in the two data series, with weekly wage increases subtracted from hourly wage increases. The numbers here are how much the reported wage growth result overstates or understates the actual wage growth result.

source: Bureau of Labor Statistics, Epsilon Theory

In 2016, reported wage growth massively overstated actual wage growth. Wage stagnation going into the 2016 election was actually much worse than you were told. Did this make a difference in the Midwestern states that swung the election, in that actual labor conditions were worse than everyone thought they were? I think yes.

In 2018, reported wage growth massively understated actual wage growth. Wage growth all last year was actually much better than you were told. Did this make a difference in the current Fed/Wall Street/White House narrative that inflation is dead and the easy money punchbowl can be maintained without consequence? I think yes.

What does all this mean for our investments? Here’s the money quote from The Icarus Moment:

Honestly, I still don’t have a good answer to this question.

Do I invest on the basis of what I can see happening in real-world or do I invest on the basis of what I can see happening in narrative-world?

Ultimately, I STILL think that real-world wins out.

But the path for that … the timing of that … it’s utterly narrative dependent.

Groucho would understand.

In the Trenches: Less Is More

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Narratives can be powerfully emotive influences. Overplayed narratives often lead to extremes in investor sentiment, and extreme sentiment may reverse quickly alongside a change in the narrative.

It has done so twice since mid-year 2018.

Late last year, markets collapsed as the narrative shifted from Fed as dovish father to the Fed as a deadbeat dad. The sub-narrative also changed from one of synchronized global growth to one of synchronized global slowdown. The narrative reversed yet again early this year upon the return of the Fed as a dove.

While U.S. equity markets over-reacted to the Fed’s hawkish December communication, they are now doing the same in response to its dovish pivot.

We see little in the way of catalysts to new U.S. equity market highs as sentiment begins to wear thin on a rollover in data into the second half of the year and as the Fed remains on hold – as it should.

The new narrative around the Fed as dove has helped create some striking cross-asset dislocations. Global rates markets are telling a slowdown story. The U.S. yield curve inverted from 3-months to 10-years just a month ago, even after the Fed pivot. Both JGBs and Bunds are either negative or close to it. Funding markets are also showing signs of strain, as funds trade above IOER more and more often. [1]

Importantly, the dollar has been strengthening despite little change in real rate differentials. Its strength looks to be a product of a U.S. economy that remains strong relative to the rest of the world. The dollar’s strength will also have deleterious impacts on emerging markets (EMs), which are responsible for most of global growth. Economic performance in Europe has on balance continued to deteriorate, even as China stimulated its way to PMI expansion for March (and for April which fell closer to contraction once again). Japanese and European PMI’s have been abysmal, and the rates markets in Europe and Japan reflect it.

Yet, U.S. equity markets just made a new high.

How to reconcile this? What has really changed since January that should lead to a sustained rally in equities beyond current levels?

The bullish narrative for U.S. equity risk makes sense only if one accepts a narrative that the Fed will proactively move to prevent a U.S. slowdown before it happens.

The bullish narrative further presumes that the current global slowdown will somehow miraculously reverse or somehow not touch U.S. growth. (We have argued that U.S. growth will fade alongside its developed market peers as the benefits of the tax cuts wane). With the exception of Japan, central banks generally have been and remain reactive rather than proactive. Before central banks act preemptively using a Japanese-style modern monetary theory (MMT) approach, two things must happen. First, they must lose their relatively well-defined, current mandates. Second, they must lose their independence. We don’t expect this to happen to the Fed until after the next risk repricing is complete. Thus, even though Fed Funds futures markets remain convinced of a cut at well over a 60% probability, market participants ought to be more skeptical.

Former Minneapolis Fed president Narayana Kocherlakota wrote a Bloomberg opinion piece to the contrary the other day, arguing the Fed mandate is broad enough to move away from ‘patient’ and towards proactive. This is simply a bad idea.

He writes: “Ultimately, though, the policy shift could help investors avoid getting lulled into the kind of complacency that leads to ‘Minsky moments,’ such as the 2008 financial crisis. And it would certainly help Main Street, by refocusing the Fed’s efforts on ensuring a stable economy.”

Kocherlakota demonstrates a profound lack of understanding about what caused the 2008 crisis, but that’s a topic for another time.

For today, let’s take his argument to an extreme. Under the ‘full employment’ mandate and at the first sign of any wobble, the Fed could create reserves, and then use them to buy Treasuries. The Treasury sale proceeds could then be earmarked to fund social programs established to guarantee each citizen a job. Kocherlakota’s argument creates a slippery slope towards a central bank that lacks independence and fosters social agendas at the pleasure of incumbent politicians. The hurdles required for each ‘wobble’ in the data would likely be lower and lower until finally anything would qualify.

Last Thursday, Bloomberg wrote an entertaining story about how I am Wall Street’s biggest bear, and Robert Burgess picked it up in his opinion column last Friday. [2] While I am bearish now, I’m neither a bull nor a bear by nature. What I AM is a skeptic of popularly accepted narratives.

As a result, my views have been responsive to the more volatile conditions that may be associated with late cycle equity markets. Further, it’s my belief that late 2018’s volatility was not a denouement; rather, it was the beginning of a deeper slowdown. Let’s take a look at 1995 and 1998 as possible analogies supportive of the narrative that the Fed will cut proactively. In 1995, the Fed cut in response to a string of government statistics that showed a sharp slowdown in business activity, on the heels of a catastrophic Japanese earthquake in early 1995, and after the Tequila crisis late in 1994. In 1998, the Fed cut in response to LTCM’s collapse and the Russian financial crisis. In my view, neither analogy is durable. [3]

There are two major differences: the monetary policy mosaic and globalization.

In stark contrast to the present, 1995 Fed funds were 6%. Today, the Fed has little room to cut already so close to zero, and it has just recently normalized after 9 years of extraordinary policy intervention, which included quantitative easing (QE). Its peer central banks are similarly low on ammunition outside of renewed QE. Moreover, prior to cuts in 1995 and 1998, the Fed had quickly hiked from 3% to 6% on funds at 50bps per month over the course of only a year. This contrasts to a much slower pace of recent hikes (at 25bps per hike over 3 years).

The other important difference is globalization. For example, the Eurozone did not exist, and emerging markets accounted for only a small proportion of global growth (30% versus over 60% today). Thus, neither the European Central Bank (ECB), which did not exist, nor the People’s Bank of China (PBoC) were relevant central bank actors. Even the now frenetic Bank of Japan (BoJ) was sleepy. What’s the point? The Fed has other banks in its corner that are doing some of its work for it. It needs to lead the way towards normalization.

Today, the BoJ stands in an extreme position and currently in stark contrast to the Fed. The BoJ appears to act proactively at the slightest sign of trouble since the global financial crisis. Japan’s central bank is not independent, and its approach has been in response to criticisms it was slow to act after its debt bubble burst in the early 1990s. All things considered, Japan’s strategy hasn’t worked well, as GDP has averaged only 1.4% since September 2009 despite a balance sheet that has grown by $4 trillion dollars since mid-2018 (now $5 trillion). The increase of roughly $365 billion dollars/year is about 7% to 10% of GDP ($4.9 trillion nominal GDP 2018). Since early 2016, after the Shanghai Accord, both 10-year and 2-year JGBs began to yield less than zero. 2-year yields in Japan have yielded no more than 15bps since late 2009. Thus, we are in the fourth year of both 2 and 10-year bonds with negative yields and in the 10th year of near-zero short rates.

Were a recession or equity market panic to lead to a bid for the Yen, Japan might have nothing left but to sell newly created Yen reserves and buy U.S. Treasuries. We’ve had conversations with those close to the Japanese central bank, and they’ve indicated this is an option they might consider.

In contrast, the Fed’s just not there yet on MMT; American exceptionalism prevents it… at least for now. Eventually, as we wrote in our previous Epsilon Theory’s In the Trenches, all of the world’s central banks will eventually buy many different classes of private and publicly held assets. At that point, all central banks will likely have lost their independence and social policy will no longer be an implicit goal but rather an explicit one. It’s simply a matter of when rather than if; however, it’s no time soon.

Indeed, we remain fairly convinced that the Fed will not cut this year. Equity market performance has been just too strong and the data remains just good enough. The Fed will react only if risk assets and the economic fundamental data justify action. U.S fiscal stimulus (the fumes from tax cuts) will prop up U.S data just for long enough to prevent Fed action while the rest of the world is continuing to slow. Inaction is the Fed’s only logical choice right now.

In a world moving towards BoJ-style modern monetary theory (MMT), one might argue that cycle analysis itself is anachronistic. This is the most persuasive challenge to many of the arguments made here. Indeed, because of QE and globalization, things are different this time. Yet, market participants ought to be skeptical that the Fed is willing to proactively prevent all business cycles just yet.

Monetary policy was never designed to set capital costs over long periods of time. That’s what free markets do best. When intervention lasts too long, it creates distortions and bubbles. These distortions were acknowledged in Austrian business cycle theory (ABCT), which views business cycles as the consequence of excessive growth in credit often due to the artificially low interest rates set by a central banks. Historically, the lenses that create these distortions tend to shatter.

I would expect nothing different this cycle, as the Fed will not act preemptively enough to stop the excess its own policies have already created. Sadly, if the Fed and ECB finally decide to go all-in and become proactive rather than reactive, markets will no longer be markets. Markets will no longer price assets or risk based on market information. Social policy will set asset prices. All central banks would then become political, as Japan’s central bank and China’s central bank already have – unless there is a concerted effort to stop it.

At times, less is more when it comes to policy.

This is one of those times.

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[1] We have written and CNBC has now reported Fed officials are considering a new program that would allow banks to exchange Treasuries for reserves, a move that could bolster liquidity during difficult times and also help the Fed shrink its balance sheet. This conversation has occurred as Fed Funds has risen above IOER. As reported, proponents of the so-called standing repo facility see the program as a relatively risk-free way of giving banks a release valve in times of financial tightness, while also allowing the Fed to pare back its bond holdings with minimal market disruption. We view the standing repo facility as a stealthy form of quantitative easing. Indeed, one form of QE is the conversion of long-dated treasuries into Federal Reserve Notes.

[2] Robert Burgess wrote: “Investors are most pessimistic on the Americas, followed by Europe and then Asia. Cantor Fitzgerald strategist Peter Cecchini embodies the current sentiment. In a week when the S&P 500 Index closed at a record of 2,933.68, Cecchini boosted his year-end target for the benchmark, but only to 2,500 from 2,390, according to Bloomberg News’s Vildana Hajric. For those without a calculator handy, the new forecast represents a 15 percent drop from current levels. “We do not foresee an inflection in U.S. economic growth or S&P earnings growth in the second half as global growth continues to slow and costs rise,” Cecchini said. “We also do not foresee a Fed cut as likely. With slower growth and a Fed that is slow to cut, we think equities will struggle in the second half.” It’s not like Cecchini is some foaming-at-the-mouth bear; he rightly urged investors to buy the dip in January after the big sell-off in late 2018.”

[3] Perhaps, a better analogy might be the coordinated global central bank response that began in February 2016 to stabilize the Chinese yuan. The so-called Shanghai accord came in response to two prior shocks in global equity markets in response to fears of a devaluation of the Yuan. Central banks acted in concert with the Chinese authorities to assure that capital could flow into China and prevent a destabilizing depreciation. It worked, and likely prevented what could have been a broader default cycle here in the U.S. on the heels of defaults in the energy industry. I, for one, was too bearish in 2016 on an analogy to pervious default cycles. So could 2019 be a repeat of 2016? It doesn’t seem likely. Central bank policy was synchronous back then, and there was no trade war division. Balance sheets were expanding and central bankers were not in normalization mode. No major pivot was required. Moreover, at that time, there was no fiscal stimulus in the United States. Thus, U.S. growth was arguably more fragile were a global shock to occur. We think a bigger wobble in financial asset markets and the domestic economy is needed (and should be required) before the Fed cuts rates.

In the Flow – It’s Toasted

When Donald Trump tells you that there’s no inflation, that up is down and black is white, that monetary policy … It’s toasted! … you’ve gotta believe him, right? Right?

Actually, for investment purposes, you do. When everyone knows that everyone knows that inflation is dead, that IS the common knowledge. And the common knowledge must be respected . . .


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Starry Eyes and Starry Skies

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Source: Strange Planet by Nathan W. Pyle

I remember when I first knew where I wanted to go to college.

I also remember the look on my dad’s face, sitting on a bed in the Holiday Inn in Cherry Hill, New Jersey. I could tell he was struggling with whether we could manage it. It would mean taking out about $25,000 in federal loans in my name. About $60,000 in his. We had never even considered taking out loans for me to go to college before. This was more debt than the mortgage my family had taken out on our house. A campus visit and a childhood spent building up credibility as a sober-minded, serious kid later, and we would be in for 85 grand. If I could get in, I knew, I had to do it. I had earned it, you see.

No, I deserved it.

So did 45 million other starry-eyed young Americans. At the (often literal) push of a button, we created debt now amounting to more than $1.6 trillion out of the ether to give each of us what we declared we deserved: Validation. Credibility. Credentials. All we had to do was reach out and take it. All we had to do was believe the myth.

And yes, Virginia, the importance of post-secondary education in America IS a mythone of our most powerful.

No, that doesn’t mean that college and its attendant experience don’t hold intrinsic value. It also doesn’t mean that the credential offered by these institutions isn’t a real currency. It means that the Common Knowledge underlying that currency is far more powerful than whatever the truth about college is. It means that the stories we tell about college are more important in almost every way than the facts. It means that whenever we talk about college in America, we are nearly always talking about the meme of college!

College! is a meme of equality, something we raise our hands for because we believe in the importance of socioeconomic mobility, the American Dream.
College! is a meme of human progress, something we raise our hands for because we believe that expanding education, research and knowledge will power ingenuity, innovation and prosperity.
College! is a meme of meritocracy, something we raise our hands for because we believe that talent and hard work cross all biological, social, racial and gender boundaries, and that systems which reward merit permit the destruction of those artificial constraints.

The Myth of College is an idea which permits us to declare it to be synonymous with these principles. The consequence of this declaration is that we may also declare that any opposing idea denies those principles. You don’t hate equality, innovation and merit…do you?

We hold up our ‘Yay, College’ signs in the same way as we do ‘Yay, Military’, ‘Yay, Capitalism’ and ‘Yay, Equality’ signs, because not doing so is to say that we oppose the right-sounding principles that form the basis of the myth. And just like ‘Yay, Capitalism’, well…capitalizes on our desire to signal our deeply held belief in the power of rewarding economic risk-taking to convince us to permit distortions in economic risk-taking, ‘Yay, College’ exploits our belief in equality, innovation, merit and education to convince us to permit distortions in the capacity of our university and degree system to deliver ANY of those things.

The myth has also driven us to create a system of laws and policy that have, in turn, produced a very real student loan crisis. As a political issue, this is far more powerful and far more connected to the political zeitgeist of 2019 than most people want to believe. It is a case for Clear Eyes and Full Hearts.

The Value of College

Neither particularly clear eyes nor an especially full heart are needed to recognize that educational attainment has been on a steady, long-term rise in the United States for more than half a century. This is a good thing. In 1950, only 34% of American adults had finished high school. Today, that’s about how many have completed at least a bachelor’s degree program. There are all sorts of studies documenting other positive developments in educational attainment, too, not least the convergence of opportunities across gender and, to a lesser extent, across racial and socioeconomic boundaries.

But what is the right level? Leaving aside the Myth of College for a moment, do somewhere between a third and a half of jobs in the United States require what an undergraduate program teaches? I don’t know. Sorry. It’s not an objectively answerable question, and the responsiveness in what those programs teach to what is perceived as being needed complicates the question further.

I am happy, however, to give you my opinion. I think the number of people who need to attend college from a knowledge and skills perspective is far, far less than one-third of adults. Yes, engineering professions and those in biomedical and applied sciences require a base of knowledge that takes time to accumulate. Same for those preparing for post-graduate research and teaching roles across subjects. I think that you can make an argument for elementary and secondary education on the basis of the breadth of subject knowledge that is theoretically required, too. Based on 2016 data, those subjects account for about 22% of undergraduate degrees granted, plus however many you want to count as being necessary to refill post-graduate teaching posts – a vanishingly small figure.

In all, I am confident there is a vocational need for four-year college for no more than 10-15% of adults. Am I saying that the tens of millions of programmers, financial analysts, writers, designers, bankers, managers, accountants, product marketers and sales personnel out there could function at equivalent or higher levels with less than a year of focused vocational training, if such a thing existed? Yeah, that’s exactly what I’m saying. Am I saying that only 10-15% of adults should go to 4-year universities? No!

Look, preparing for a career isn’t the only reason you might think about spending four years at a university. But most of the reasons we provide are also conflations of the type that are so common when we deal with other abstractions, myths and memes. In other words, because these ideas have become attached to the Myth of College, it takes little more than a rhetorical flourish to shut down criticism of the value of post-secondary education. Simply assert that someone who is skeptical of our approach to post-secondary education opposes these ideas!

What are these ‘conflations’ and ideas? How about ‘it’s about discovering yourself’, as if one couldn’t achieve that by traveling the world? I am sure you’ve heard ‘it’s about learning how to think critically’ or ‘learning how to problem solve in a group setting’ or ‘developing confidence and communication skills’, too, as if college is somehow better equipped than other settings to deliver these lessons. We are also fans of ‘it is an important opportunity to network’ or ‘to build lifelong friendships’, which are great, but also tautological rather than fundamental (i.e. college is important because others consider it important).

There is one reason – and in my opinion, one reason only – to attend college that does not relate to vocation, preparation for a life of research or teaching, or the fact that a critical mass of one’s age cohort is already there: 

Because college permits us to be wrong, offensive and awkward in exploration of new and uncomfortable ideas and knowledge in a setting with low consequences.

Now, you would be forgiven for wondering whether universities are committed to this one critical, indispensable function. I think most still are. This function alone, for many – for me – would justify the investment of 5% of life and 10% of lifetime earnings. It is huge. Truly. It also has almost nothing to do with why most people choose college. Even if we grant credit for ‘to be intellectually challenged and stimulated’ below, most of the reasons people go to college are either things 4-year college isn’t unusually well-suited to deliver, or else vocational in nature.

Source: Hobson’s International Student Survey, 2017

If that’s one part of the story, we can find a lot of the rest in selected degrees. In the 19th Century, American universities were institutions that turned liberally educated student-philosophers into lawyers and clergy. In the early-to-mid 20th Century, American universities swapped out clergy for businessmen, and started teaching women to be teachers, but otherwise were much the same. Today? American universities are officially in the business of vocational training for white-collar professions.

Source: National Center for Education Statistics (categories by Epsilon Theory)

The Co-Option of Credential

Except even that isn’t exactly true. Here is what I think is true:

The Myth of College is that it grants invaluable life experience, broadened horizons and deeper skills that no other 4-year experience for a young adult could match.

The Zeitgeist of College is that it is now (grudgingly) really about preparing workers for long and prosperous careers.

The Reality of College is that it sells a license to use a credential.

What do I mean by a credential? I mean the portfolio of Useful Signals that are sent by the achievement of a university degree. Beyond the attachment to the ideals of the Myth of College, much of that signal, I think, exists in our Common Knowledge about what traits a student needs to be admitted to that particular degree-granting institution. You know, intelligence, creativity, breadth of talents, work ethic, having the correct parents and grandparents, things like that. Much of whatever is left exists in the signal from completing the degree. Can you follow instructions? Are you comfortable pulling all-nighters? How do you feel about sitting at a desk with a laptop for 60 hours a week?

And no, like the related question of what share of jobs truly requires the skills gained in four-year college, the question of the share of the observable value of a college degree we can attribute to skill gain vs. credential is neither provable nor falsifiable. So, doubt it and tout the anecdotally valuable lessons of a college education all you want.

But if you do doubt it, you’ll have to explain why all the private equity partners, lawyers, former actors and celebrities caught up in the admissions scandal paid that kind of money to get their kids admitted. Would you have us believe it’s because they really wanted little Jimmy to discover who he was? To be able to recall Black-Scholes on demand? You’ll have to explain, as Bryan Caplan suggests in The Case against Education, why, if the value of college is really in the knowledge and experience, more locals don’t just audit lectures to reap all the benefits. You won’t get caught. I promise. You’ll have to explain the sheepskin effect, why college graduates out-earn high school grads as janitors and bartenders, and all sorts of other things, too.

Regardless of whether you think a degree is valuable because of some intrinsic skill and knowledge gain, or because of the signal value of the credential it offers, the degree itself IS unquestionably valuable. It is socially, economically and politically valuable. And despite all the growth in degrees granted by US universities, the income premium those degrees offer has been stable. College grads earn about 75-80% more than their high school graduate peers.

Source: US Bureau of Labor Statistics, FRED

Except there’s a problem with this, too.

There is an income premium from university degrees, but also emerging evidence of an evaporating wealth premium after we have adjusted for family size and life cycle. The below exhibit comes from research conducted by the St. Louis Fed’s Center for Household Financial Stability. White college graduates born in the 1980s and afterward do make more money than their high school-only peers, but it isn’t translating into net worth in the same way that it did for prior generations at comparable life and family stages.  

Source: Center for Household Financial Stability

Things are even worse for college-educated black Americans. On the basis calculated by the St. Louis Fed, cohorts beginning as early as the 1960s have enjoyed almost no net worth advantage against their high school-educated peers.

Source: Center for Household Financial Stability

Why did the erosion in college’s net worth premium begin earlier for minorities? There are probably a lot of reasons, ranging from fewer investment services offered to underbanked black communities for much of this period, to predatory lending practices that have routinely sucked wealth out of those communities on a disproportionate basis. What most whites consider standard financial services products have simply not been available on the same basis to blacks and Hispanics.

But I think there’s more to the story – and this IS a story I’m telling you, not a fact. I think that the growth in credentialism has also created an arms race among institutions and a greater separation of the credential value of so-called elite institutions from the rest. I think that legacy policies and other admissions structures have effectively shut many minorities out of capturing this premium. And there IS a premium to getting Team Elite stamped on your passport.

Source: Washington Post, Wonkblog

But leave net worth differences between demographic groups in each age cohort aside. Are the post-1980 cohorts intrinsically lazy, irresponsible and unwilling stewards of assets? Or is there, perhaps, a less stupid (if still only partial) explanation for the slow disintegration of the college degree net worth premium?

Source: Epsilon Theory, NACE/CRB, National Center for Education Statistics

What Happened to College?

So how and why did the college credential rapidly grow, then lose its power to drive differences in wealth, all while keeping all the attendant mythology intact?

The credential value of the university degree became Common Knowledge at the same time that the economic means to significantly expand secondary and post-secondary education in the US became a reality, and at the same time that agricultural and manual labor went into secular decline.

Good-intentioned Americans who wanted their children (parents) or their charges (educators) to experience better, more prosperous lives rightfully and justifiably celebrated college specifically – and education more broadly – as the engines which produced social mobility, wealth, career prospects and lifestyles that were better than those experienced by each generation’s parents

Similarly good-intentioned Americans went into public office with visions of expanding this dream to include more and more people for whom these early efforts were insufficient. We created lending programs, guarantees and a system of laws to permit the extension of almost limitless credit to aspiring students and their families – and to make much of that debt nearly impossible to discharge. Because everyone deserves to go to college.

In doing all of this, the values we ascribed to ‘college’ became narrative. That narrative became the Zeitgeist. That Zeitgeist became the Myth of College. And in our obsessive celebration of the Myth of College instead of the direct celebration of its wondrous underlying traits, we unwittingly granted our university system unabridged letters patent to oversee the right of Americans to earn a good living.

In short, we created a guild. You know, what the Romans called ‘collegia.’

Like guilds, our universities set the terms of trade in their credentials. They decided who could participate and who could not. They accumulated power and prestige through levies assessed on any who wished to practice a trade for which they held the patent. No, our modern guilds couldn’t keep us from learning what they knew – give me three weeks, kids, and I’ll teach you what you need to know to be a banking analyst –  but they could absolutely withhold their credential, the thing which allowed those trades to be practiced.

What did they do with this power, you ask?

They did this. They extracted every ounce of the credential premium for themselves as a license fee.

Don’t blame the parents, guidance counselors and high school principals who genuinely wanted their kids to have better lives than they did (even if some of their other behaviors belie that sentiment). Don’t blame the good-intentioned politicians who saw expanding this dream as good public policy. Don’t even blame the universities for simply following the opportunity the market provided. Okay, blame them a little bit. But truly, blame all of us. Because it really took all of us to create the Common Knowledge which imbues our most prized traits in a single social institution.

And no, college debt isn’t the sole cause of whatever is (not) happening to the net worth of college graduates. Timing of favorable investment environments, the inability of these generations to acquire real estate assets, and the concentration of jobs with these remarkable income differentials in cities with extreme rent costs all play a role, too. Obviously. Still, feel free to take “We didn’t JUST create a system to extract wealth premium from college students through debt-fueled, brutal college cost inflation, we ALSO pulled forward financial asset returns to benefit existing asset owners through the use of extreme monetary policy and extracted a portion of that wealth premium through NIMBY housing policies in every major US city outside of Texas” for a test spin and see how it feels.

The worst part, at least in my book, is that each one of these actions has abused our collective belief and trust in beautiful principles attached to our various cultural myths (Yay, Capitalism! Yay, Local Culture! Yay, Home Ownership! Yay, College!) to permit interference in those markets designed to suit one social group over another.

People, we sold a generation of starry-eyed students a ceiling on their potential and called it a starry sky.

What Happens Now?

Now we’ve got to figure out what to do about the hell we created on the paving stones of good intentions.

What are those problems?

  1. Unnecessary Productivity Loss: We lose an average of 2-3 years of productive, asset-building, creatively valuable years of happiness and freedom across each generation of Americans by effectively forcing millions of Americans to pay a toll to post-secondary educational institutions that they neither need nor wish to pay.
  • Constraining Paths to Prosperity: Through hundreds of billions in non-dischargeable debt, we are stifling the traditional paths to prosperity for just about anyone who won’t inherit money from their parents, or who doesn’t strike it rich in an entrepreneurial venture.
  • Distortions Relating to a Generational Wealth Gap: We are creating a generational wealth gap that presents meaningful risks to various capital and non-financial asset markets, and most importantly, entrepreneurial risk-taking.
  • Hampering Household Formation: We are piling on top of already challenged demographic trends with an additional bias toward later and less frequent household formation, which has both social and economic implications.  

Some people of a similar political persuasion to me would say the right answer is to do nothing. It’s sad, sure, but all those people signed on the dotted line. The market says this is what a degree is worth, and so families can choose to pay it or not. Either way, they live with the consequences. I hear you. I paid my college loans and feel the temptation to go full geroff-my-lawn about those grousing today. Except there is nothing natural about this market. The price students paid / are paying for these credentials is a reflection of decades of public policy permitting and encouraging the extension of credit for college to anyone and everyone who requests it. The demand side of the market has been aided by the artificial impact of twelve years of publicly funded curricula, messaging and ‘education’ designed explicitly to feed as many students as possible to the guilds of post-secondary education. It is a distorted market. 

Others, like Senator Warren, have said that the solution is ‘jubilee’, to make college free (or much cheaper) and to permit the discharge of significant quantities of debt. There are shades of MMT here, and you will hear some make the very stupid argument that the important thing is that the proposal isn’t really an outlay but rather the elimination of a non-cash government asset. Oof. Look, this is a good-intentioned policy that sees the plight of tens of millions of Americans and searches for a direct solution. I’m empathetic. Proposals like Warren’s would begin to address some of the structural problems created by historical government interference in the market for education noted above. We can’t pretend the money comes from nowhere – no matter how you look at it, it would be a tax on asset owners. It’s a tough thing for me to get me to believe that layering on more public policy will ever fix the distortions caused by public policy, but maybe it’s time for an intergenerational compact – a Boomer-Millennial summit of sorts to figure out how we share responsibility and commitment here.

Alas, it’s moot, anyway. The Jubilee proposals don’t just fail to get to the root of the problem. They exacerbate it – grievously. The biggest underlying social problems above are (1) that we are railroading entirely too many students into college programs whose skill gains could be provided much more efficiently in alternative, less time-consuming and less expensive ways than four years at Whatever Private College, and that (2) a combination of public policy and our collective cultivation of the Myth of College have permitted guild-like universities to raise tuition to demand a kingly share of any wealth premium offered by the credentials they confer. The debt problem is a problem in-itself, but it is also a subsidiary problem caused by these two problems. Guess how much the like of Bucknell, Tufts and SMU will adjust their planned annual tuition hikes over time in response to a policy providing $50,000 in debt jubilee or college cost reductions? If you answered $50,000 (or more), you win a free subscription to Epsilon Theory. Congrats.

I don’t have a full answer, because I can’t have a full answer. The student loan crisis is the kind of Big Deal that requires us to come together to decide what our compact with one another is going to be, if it’s possible for us to do that kind of thing any more. I will tell you that I think any real answer that isn’t just good-sounding election season political theater will have at least these traits:

  • Moves college lending outside of government purview and off government balance sheets;
  • Permits charging off college debt and really, truly assigns those losses to capital; and
  • Extracts cost limitation agreements and expanded commitments to fund underserved / lower income student costs from universities in exchange for the ability to retain not-for-profit status.

And yes, I’m dead serious about that last one. I believe challenging the assumption of university entitlement to not-for-profit status is the sine qua non of ANY solution to the student loan crisis.

As for the Myth of College? I don’t know how we move away from it. Y’all, both conservatives and progressives love to talk New Artisans and the Glories of Welding. One group just talks about it over a beer at the bar, and the other listens to it on This American Life. Same damn thing. But rejecting credentials remains a for-thee-and-not-for-me kind of thing. There IS no first-mover advantage to saying that you and yours are choosing to build lives based only on true things like what you know and how hard you work rather than a credential. Clear eyes, folks. This is another competition game, another stag hunt.

Whatever we decide, the issue IS coming to a head. I worry that it is going to come to a head in the ‘just do something’ variety that will lead us to a policy error which aggravates the core problem instead of resolving it. Education, colleges and the student loan crisis sit at the very center of our non-financial zeitgeist. Below is a network map of all the non-financial articles in the LexisNexis Newsdesk database over the last year, arranged by the similarity in the use of language. The highlighted cluster in the right graph? That central cluster is the one that’s all about education, colleges and student loans.

Quid Network Graph – Non-Financial Stories (4.20.18 – 4.20.19)

Source: Quid, Epsilon Theory

The language we use to write and speak about education is powerfully connected to everything else we write and speak about for two reasons. First, it is powerfully connected because education is topically connected. Health care institutions are attached to colleges. University research studies influence industry, technology and commercial research. Graduates take jobs in industry. But its powerful connection is also the result of similarity in the meaning we attach to education, and how that meaning is shared with topic-crossing ideas like justice, creativity, discipline and progress.

That is what I mean by the Myth of College. It’s a real thing, and it will take all the full hearts we can manage to dispose of it. It is no trivial task to do those things while celebrating the principles like innovation, creativity, hard work, passion, equality and opportunity that we have attached to the Myth of College as synonyms, principles which we have allowed the credential to parade as part of itself. It will be the work of a generation. Our grandchildren are worth the effort. They deserve it.

PDF Download (Paid Subscription Required):  Starry Eyes and Starry Skies

Notes from the Diamond #7: Hittin ‘Em Where They Ain’t (Part 2)

David A. Salem
Twitter: @dsaleminvestor

Log of notes in series available here
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Part 2: Addition By Subtraction

Trivia Question #7 of 108.  Taken as a group, the 51 countries or dependencies comprising Asia are home to a bit more than half of the world’s 44,000 or so listed companies.  What is the median number of sell side research analysts following the roughly 22,000 Asia-based firms just referenced?  Hint: the correct answer equals the number of no-hitters pitchers in Major League Baseball (MLB) have thrown on their birthdays, which itself equals the number of times two batters on the same team have “hit for the cycle” (single, double, triple, home run) in the same game.  As regular readers know, approximately 220,000 MLB games have been played since big league competition commenced in the 1870s.  Answer appears below.

Pre-Game Jitters.  Tired of waiting for the best MLB player of this and perhaps any generation — 27 year old Angels outfielder Mike Trout — to make his next appearance in MLB’s best ballpark?  Me too.  Frustrated it’s taken me so long to take this swing at the curveball I left hanging in Part 1 of this post when it got published several weeks ago? Me too.  Skeptical I can smack the curveball just referenced — i.e., outline investment policies conducive to the achievement of plump real returns over the next few decades of Trout’s blessed existence — or indeed convey useful thoughts of any kind via sentences comprising fewer words than the number of times Trout reached first base on walks in 2018 (a stunning 122 times in 608 plate appearances)?  Can’t blame you: as a guy who’s spectated many games in the ballpark alluded to above without wishing any would end sooner than they did, I have a natural if unfortunate tendency to craft sentences that run longer than most readers presumably prefer.[1]

Mike Trout

Obviously, there’s nothing I can do to accelerate Trout’s next appearance at Fenway (on August 8).  But I can scratch the other itches hinted at above — codifying concisely policies conducive to long-term wealth enhancement — and do so below via a series of tenets, none of which comprises more words than Trout’s age when he and the Angels inked recently the largest contract ever awarded a pro athlete: a deal that’ll pay Trout a total of $432 million pre-tax from 2019 through his age 38 season in 2030. 

Of course, since no one knows for sure how the economy and inflation let alone tax rates will evolve between now and 2030, no one knows for sure what goods and services the roughly $17 million per year in after-tax dollars Trout stands poised to earn under current tax schedules will buy him over the course of his newly-signed 12-year contract.  If, for example, inflation over the next dozen years runs as hot as it did during the most inflationary 12-year span in US history (1970 – 1981), the $17 million in after-tax income Trout is slated to pocket in 2030 will buy him the equivalent of a mere $7 million in goods and services if purchased today, CPI inflation having eroded the dollar’s purchasing power by roughly 60% over the 12 years ending  1981.[2]

Adding insult to potential injury, quite apart from potential surtaxes on certain outlays a highly compensated pro like Trout might reasonably be expected to make from time to time (e.g., hefty levies on fuel for private jet travel), wealth taxes of the sort proposed by certain politicians of late could prevent Trout from amassing even as remotely as much real wealth over the next 12 years as he would if the dominant zeitgeist for this interval were to resemble that of the 12 years beginning in 1981, i.e., disinflation and generally reduced tax rates.[3]    

Similar anxieties confront most individuals, families and indeed institutions that have already amassed substantial wealth as 2019 unfolds, including well-endowed non-profits that IMHO would be unwise to assume their investable wealth or current income produced by same will remain untaxed indefinitely. 

Indeed, even if the wealth just referenced is subjected to little or no explicit taxation in coming years and beyond, it could as noted above be subject to the implicit tax known as inflation: to currency debasement of the sort that, along with other ugly and corollary trends, led ultimately to the appointment of the investment maven on which Part 1 of this two-part paean to Hittin ‘Em Where They Ain’t focused: Yale CIO David Swensen.  (Part 1 focused as well on a baseball maven discussed further below: Branch Rickey.)  Other observers may disagree, but I doubt Yale would’ve hired a 30-something finance geek with no investment experience to run its endowment in 1985 if it hadn’t suffered a 60+% erosion in endowment purchasing power over the prior 35 years. 

What Trout Needs.  Like all investment home runs of which I’m aware, the riches that Yale has garnered by tapping Swensen as its CIO 30-odd years ago constitute just if not inevitable recompense for deducing correctly that the perceived risks of such a move exceeded the actual risks.  This isn’t to say that the latter were non-existent: Swensen might have proven inept in crafting investment policies responsive to Yale’s presumed needs, or the policies he ultimately devised might have proven infertile if the investment zeitgeist that subsequently unfolded had been different.  To Swensen’s credit, and Yale’s great and good fortune, the investment model he built embodied nicely if somewhat unwittingly an attribute inherent in all sound approaches to conscious risk-taking: asymmetry

“Heads I win, tails I don’t lose.”  That’s the ticket, we’d all agree, as reflected among other happy investor tales in this arresting fact: for more than a quarter century following Swensen’s assumption of his current post, a key tenet of his model essentially proved fallacious, with high quality bonds of the sort Swensen’s model disfavored producing returns roughly equal to marketable stocks as a group.  Of course, Swensen didn’t invest in the broad stock market during the quarter century in question (1985 – 2010), nor has he done so since.  Rather, he’s employed more or less exclusively active equity strategies, with a hugely profitable tilt toward privately-traded equities, including venture capital. 

The undeniable fact that such strategies bent but never quite broke Yale nor Swensen when they produced large unrealized losses in 2008 – 2009 merely reinforces the point made above respecting asymmetry: wittingly or not, Swensen has deployed Yale’s endowment in a manner that’s caused its unitized as well as total value to grow materially in real terms since 2009 under conditions resembling in certain ways those that caused such values to shrink materially in real terms over the 30-odd years preceding Swensen’s appointment as CIO, i.e., “guns and butter” fiscal policies coupled with large dollops of central bank largesse. 

Where would Yale’s finances and in turn Swensen’s reputation be today if such largesse hadn’t materialized over the last decade?  Reasonable people can reasonably disagree in answering that counterfactual question.  Ditto for a question that’s top of mind for me if not also you and should certainly be top of mind for investment pros fortunate enough to be advising Trout on the deployment of his investable wealth: will the dominant investment zeitgeist over the multi-decade horizon under discussion here be marked by the continuance of such largesse on a more or less globalized basis?  I  doubt it, but I wouldn’t bet the ranch against it.  Rather, I’d do what all fiduciaries worthy of the name try earnestly to do when engaged in policy-making: craft policies likely to produce tolerable results at worst across the widest plausible range of market scenarios and pleasing results at a minimum if the scenario or zeitgeist deemed most probable does indeed unfold.

Less is More.  What zeitgeist did I deem most probable in formulating the policies commended below — an investment model if you will intended to function effectively over a time horizon rivaling the span that’s elapsed since Swensen activated “the Yale model” many years ago?  Truth be told, I didn’t spend much time crafting a best guess or base case scenario for the global economy and capital markets when building the model below — not because scenario planning isn’t valuable if done astutely but rather because ET’s co-founders have shown convincingly in their writings that less is almost certainly more for investors seeking to divine economic and market trends in coming years and beyond.

Indeed, so convinced or more precisely humbled am I by Ben Hunt’s core message in Three Body Problem — “there is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns” — that I’ve adopted a base case scenario even leaner than that sketched by Ben in his masterful notes on zeitgeists entitled You Are Here and This is Water.

Specifically, while not questioning Ben’s perspicacity in divining all four phenomena flagged in the nearby box, the worldwide and necessarily long-term prism through which I ponder policy options makes me wary of policies premised on a fully globalized and sustained flowering of the first three trends. 

This isn’t to say that I think the trends Ben espies will peter out or reverse in the foreseeable future.  Indeed, I think such trends could very well accelerate, especially in the US and Old Europe, and more particularly if Rusty Guinn’s forebodings in Free Range Kids / Free Range Capitalism prove prescient; as Rusty notes, if taken too far, the ongoing transformation of capital markets into utilities could render investors as a group “utterly incapable of determining whether we should provide capital to a business or government venture, and under what terms.”

As for the fourth element of Ben’s perceived zeitgeist as summarized above — the displacement of cooperative games by interminably competitive ones — I’ve assigned a high probability to this condition in crafting the policies outlined below.  Fortunately and crucially, the less sound this premise actually proves in coming years and decades, the better I would expect the investment program sketched below to perform.  That may seem delusional — most attempts to exploit perceived asymmetries in capital markets produce strikeouts or singles rather than extra base hits or homers — so the onus is on me to defend the assertion just made.  I try to do just that as the modeling exercise below unfolds — one that begins logically (for a series exploring parallels between investing and baseball) with a favorite example of less being more in baseball.

Addition by Subtraction.  As regular readers will recall, Note #1 in this series opened with a trivia question concerning a Hall of Famer catcher who posted a 75-3 record as a pitcher in high school.  The rocket arm that made Johnny Bench (MLB 1967 – 83) nearly invincible as a high school hurler spawned ultimately a seemingly odd stat for Bench as a big league catcher: a relatively low number of runners nabbed stealing bases via throws from Bench.  The throws themselves were unfailingly swift and accurate, as one might expect from an athlete who’d practiced them countless times as a youngster albeit over twice the 127’ span between home plate and second base on a regulation diamond.  (Bench’s father and first baseball tutor knew well how to show young Johnny tough love.)  In fact, Bench’s arm strength became so widely respected in MLB circles that managers of opposing teams nixed base stealing attempts by all but their swiftest players when doing battle against Bench’s Cincinatti Reds.

Though such circumspection by Cincy’s opponents didn’t prevent the “Big Red Machine” from winning six divisional titles plus four league and two world championships during Bench’s 17-year playing career, it did boost opponents’ odds of beating the mighty Reds.  Addition by subtraction, one might call it: achieving more by doing less — by shunning endeavors in which one lacks a reliable edge or would otherwise confront unattractive odds.[4]

Edge and Odds.  I haven’t canvassed creatures fortunate enough to inhabit Little River Farm to ask how often Farmer Ben mutters “edge and odds” as he tends to their needs, but judging from how often Dr. Hunt chants that mantra in human interactions I’m guessing they’ve heard it many times indeed.  With good reason: in addition to pursuit of attractively asymmetric returns — the stated if sometimes unachieved aim of active managers and the only legitimate reason to invest in broadly diversified indexes like the S&P 500 on a buy-and-hold basis — savvy investors logically seek to focus their energies on opportunity sets in which they have an actionable edge in exploiting favorable or mispriced odds.[5]     

Millions of words having been written or spoken about “edge” in investing, I’ll say nothing about it here except that I’m defining it for purposes of this model-building gambit as know-how useful to the generation of above-market net returns if and when applied in an effective manner.  As noted above — and this is crucial to the model commended below — “edge” as just defined is most productively applied to markets in which an investor enjoys favorable or mispriced odds. 

Successful examples of such productivity include the two mavericks on whom Part 1 of this post focused.  As the first MLB GM to add black and Latino players to the talent pool from which his teams drew, Branch Rickey enhanced hugely his odds of assembling world-beating rosters; and while MLB franchises not headed by Rickey weren’t long in expanding imitatively their own talent pools, by the time they took such steps Rickey and his subordinates had developed a valuable edge in discerning which players of color most merited pro contracts. 

Similarly, David Swensen has enhanced Yale’s odds of partnering with market-beating managers by tilting Yale’s portfolio toward asset classes in which manager returns tend to be most dispersed; and while other allocators (big and small) weren’t long in expanding their own portfolios to include such holdings after Swensen showed the way, by the time they ramped up allocations to private equity, venture capital and other size-constrained niches favored by Yale, Swensen and his subordinates had developed a big edge in discerning which PE and VC managers most merited funding.  Fortunately for Swensen, and regrettably for allocators keen to be “like Yale”, this edge compounds over time, with Yale being a coveted client for managers seeking to maximize time spent investing by minimizing time spent fundraising.  Ain’t no better way to do that at present than to have Yale serve as one’s bell cow.

Pinpointing the Problem. And there ain’t no better way to convert a big fortune like the one Trout is poised to amass into a small one than to invest in volatile but potentially high returning assets without knowing them well enough to avoid ill-considered sales during inevitable bouts of punishingly poor returns.  What might Trout do to avoid such impoverishment?  Presuming as I do that he lacks the time if not also peculiar personal qualities needed to gain and hold an edge in investing, Trout should do what most individuals, families and institutions logically do when deploying substantial wealth: delegate the task to trustworthy pros who walk the talk set forth above — who focus their mental bandwidth and in turn clients’ capital on opportunity sets in which they have or can develop an actionable edge exploiting favorable or mispriced odds.

Tautologically, no opportunity set or selection universe meeting the criterion just specified can be boundless, because no pro’s or team of pros’ circle of competence is boundless (Herb Washington’s diverse talents notwithstanding).  Conversely, no person’s or team’s investment edge in a given asset class or sub-class is so acute that they can safely be relied upon to achieve the ambitious aims conjectured here (5+% annualized real returns over a multi-decade span) without doing one or both of two things: (1) deploying at least some capital outside their chief hunting ground or (2) violating liquidity and volatility constraints typically applied in the stewardship of substantial fortunes. 

Accordingly, when crafting limits on how capital under their ultimate control might be deployed, thoughtful principals strike a sensible balance between edge and odds, preserving needed flexibility while also keeping the breadth of assets or strategies deemed eligible for use within bounds consistent with the time-tested principle of knowing what you own and owning what you know.  After all, the seemingly boundless skills of an all-star allocator like Swensen or an all-star baseballer like Trout notwithstanding, in investing as in athletics, no one knows it all — not even Bo. [6]

Even Bo Don’t Know It All
Mike Trout (MLB 2011 – present, at left) and Bo Jackson (MLB 1986 – 94) earning their pay as centerfielders.  Jackson starred in “Bo Knows”, Nike’s wildly popular ad campaign for cross-training shoes circa 1989-90 that depicted Bo excelling at multiple sports and other pursuits including guitar-picking and musical theatre. The on-field plays pictured here both ended in catches by the players shown, natch.

Admiring Tackling the Problem.  Assuming the long wind-up above hasn’t caused Rusty ET faithful to dismiss me as a charlatan for merely Admiring the Problem, I’ll tackle the challenge conjectured here by outlining as concisely as I can the game plan I’d propose if Mike Trout or other well-endowed principals sought my best thinking on means of achieving 5+% real returns over the next few decades. 

As promised at the outset of this note, none of the tenets comprising my game plan contains more words than Trout’s current age of 27.  Nor do any of these tenets address directly the concern most commonly raised when I’ve shared the blueprint below with US-domiciled principals seeking my counsel, such as it is: shouldn’t investors who pay their bills in US dollars invest primarily in dollar-denominated assets?  My answer, in a nutshell: not necessarily — not if one assesses currency risk as we all should on a rigorously look-through basis, dissecting all anticipated liabilities to reveal the currencies underlying such potential outlays while dissecting similarly the currencies underlying assets available for investment.  Of course, the latter task is often easier said than done, with the true attributes of even seemingly straightforward assets like dollar denominated S&P 500 index funds differing greatly from their perceived attributes due to the geographic breadth of constituent firms’ operations.

Hold that thought — and the corollary thought that currency shifts tend to be accompanied over time by offsetting valuation shifts — as I outline my preferred investment analog to the convention-busting views on baseball that Rickey felt compelled to serve up in the Life magazine piece celebrated in Part 1 of this note.  Like Rickey, and indeed like Swensen when he submitted his preferred approach to capital deployment to Yale’s trustees for their initial approval back in the day, I recognize that what follows might be “most disconcerting” to many allocators; like Rickey — from whose Life piece I drew the self-aware red flag just quoted plus the following phrasing — I’ve “come upon [a method for deploying capital] that has compelled me to put different values on some of my oldest and most cherished theories.”  As will be seen, the game plan I’ve devised owes much to contemporary thinkers and doers who’ve displayed Rickeyesque cheek in challenging what Rickey referred to unflatteringly as “considered opinion”.  Here’s the plan, with its key tenets listed from most general to most specific and with noteworthy premises underlying such tenets appearing beneath each:

Tenet 1 – Create and maintain a sub-portfolio comprising cash, or liquid investments reducible thereto, in proportions equal to at least three years’ net cash needs under worst case conditions.

In theory, cash is a drag on returns of equity-oriented portfolios like the one commended here.  So too is an all-purpose hedge viewed even more skeptically by most allocators: gold.  Unwilling as I am to deem impossible over the multi-decade planning horizon conjectured here either of the disasters that can befall equity-oriented portfolios — depression-induced deflation or very high rates of unanticipated inflation — I deem it imprudent to “park” less than the equivalent of three years’ net cash needs in the “low returning” assets just mentioned, with a bias toward high quality debt instruments whose currency profile resembles closely that of the net cash needs such hedges seek to defray.

Tenet 2 – Favor ownership over creditorship, with the maximum feasible bias toward the only type of equities worth owning on an indefinite basis: stocks of owner-operated companies (OOCs).

Though further research on this all-important topic remains to be done, studies done by Steve Bregman and his colleagues at Horizon Kinetics  (HK) suggest that more than 100% of the vaunted “equity risk premium” that Yale’s equity-centric approach to endowment management presupposes is attributable to OOCs.[7] You read that right: exclude OOCs for purposes of comparing stocks’ long term rewards to bonds’ and the latter take the crown.  Needless to say, as has happened with every verifiably superior investment (or baseball!) gambit ever devised, the excess returns or “alpha” derivable from OOCs will likely get arbitraged away in due course.  That caveat having been filed, there are parts of the world where the supply of OOCs (listed as well as private) continues to expand invitingly — geographies that the investment model commended here rather fancies, as will be revealed shortly.

Tenet 3 – Maintain a very high bar for private investments, accepting long-term lock ups only when doing so provides exposures to specific forms of capitalistic activity not obtainable via other means. 

Venture investments occasionally clear this bar, though less frequently than most allocators currently clamoring for such exposures surmise.  As discussed in prior notes in this series (here and here), private equity (PE) investments clear the bar under discussion here even less frequently — a dirty little secret about the current apple of many an allocator’s eye that’s becoming less secretive by the minute as a young investment pro with Rickeyesque gifts for clear thinking and writing intensifies his assault on “considered opinions” respecting PE.  If you’re among the rapidly shrinking universe of allocators not yet exposed to Dan Rasmussen’s admirable assaults on such opinions, you’d do well to get acquainted with same via the musings posted on his firm’s website, including especially Dan’s fine essay in the Spring 2018 edition of American Affairs

To be sure, the company attributes that Dan and his team have come to fancy, including small market caps, limit how much capital he or other investors using similar screens can deploy without causing potential returns to sink below tolerable levels.   Since these screens, like the OOC-focused (and partially overlapping) screens that Bregman et al at HK employ, work at least as well outside the US as within it, Verdad deploys capital on a global basis — just as HK does, and just as Rickey did when populating his innovative farm system for the St. Louis Cardinals nearly a century ago.

Tenet 4 – Favor equity investments in companies employing or serving primarily people with abundance as distinct from scarcity mindsets.

For reasons flagged in multiple works by another Rickeyesque researcher — demographer par excellence Neil Howe —the US and major European economies generally flunk the test just articulated:  like not a few “rich” families with which I’ve had the pain privilege of interacting, the world’s “richest” nations at present (measured by GDP per capita) comprise an overabundance of individuals who lack the skills or drive needed to generate fresh wealth commensurate with their appetites and social ambitions. Small surprise then that the “widening gyre” and related societal maladies that Howe as well as Ben and Rusty discuss so arrestingly in their writings are most conspicuously manifest in corners of the global economy characterized by (1) relatively but perhaps unsustainably high per capita incomes (2) rising dependency ratios (i.e.,  retirees relative to working stiffs like me if not also you) and (3) relatively high debt ratios (i.e., unpaid bills for goods and services consumed previously). 

Add to the potentially toxic mix just described such intractable problems as the Eurozone’s fatally flawed currency union, America’s unsustainably undemocratic approach to self-government, and corporate America’s unsustainable addiction to the “financialization” whereof Ben speaks unlovingly, and it’s tough for any investment pro worthy of that label to defend non-zero policy allocations to US stocks as a group or to their European counterparts.[8] 

N.B.: I’d include non-zero allocations to Japanese stocks in the list of dubious policy fixtures just furnished but my own studies of evolving business and societal norms in Japan plus insights into same provided by my go-to guy on such matters (Andrew McDermott of Mission Value Partners) suggest that abundance trumps scarcity in most Japanese mindsets, i.e., expectations are low relative to most plausible outcomes (however unexciting such outcomes might be).  

Tenet 5 – Apply the tenets set forth above to the narrowest universe of eligible investments that gets the job done.

Having test-driven the investment model now unfolding with several savvy principals before finalizing this note for publication, I know that while Tenet 5 might appeal to my arborist friend Ben (for reasons outlined here), it won’t sit well with many readers.  After all, diversification being the “only free lunch” available to investors — or so financial economists would have us believe — why would thoughtful principals view less as more respecting assets eligible for purchase? 

They’d do so because, presuming sensible cash flow planning of the sort embodied in Tenet 1 and asset selection consistent with Tenets 2 – 4, the chief if not sole risk of the investment program sketched here is the potential jettisoning of inherently sound strategies during their inevitable bouts of disappointingly low returns (a/k/a whipsaw).  Such bad spells are inevitable because plump net real returns of the sort targeted here (5+% annualized over meaningfully long horizons) can’t realistically be achieved without potentially prolonged periods of below-target returns.[9] 

The most reliable means of guarding against whipsaw is to know what you own and own what you know.  As previously noted, the only reliable means of meeting such standards is to limit one’s universe of eligible investments to the maximum feasible extent.  By my lights, the optimal universe for deployment of the total return-oriented or non-hedging part of the portfolio contemplated by the framework extolled here is one hinted at in Trivia Question #7 posed at the outset of this note: Asian equities.  Leaving aside Asian nations that are off limits to western investors, or have too few or too thinly capitalized public companies to merit inclusion here, the median number of sell-side analysts following the ~22,000 stocks of Asia-domiciled companies alluded to in TQ #7 is zero.  This compares to the corresponding median of seven analysts for the roughly 4,000 listed companies in the US at present (down from roughly 8,000 since I sank into money management in the early ‘80s).

How many of the ~22,000 Asian stocks referenced above meet all of the criteria embodied in the tenets propounded above?  I don’t have a verifiably accurate answer to this question, for two reasons: first, because the criteria are somewhat subjective, with Tenet 4 (favoring abundance mindsets) serving as the poster child for such subjectivity; second, because I know what I don’t know (yet), namely many things I need to know about Asia in order to gain and hold an edge deploying capital in that region.  Strike that: taking Tenet 5 to a logical and IMHO entirely justified extreme, if granted unfettered discretion to shape the universe of assets eligible for purchase within the total return segments of long-term portfolios of the sort conjectured here, I’d enhance my odds of both avoiding whipsaw and gaining an edge relative to other investors by focusing my attention and capital on private as well as publicly-traded companies domiciled in but a dozen of Asia’s 51 nations and dependencies, as follows:

Sources: Worldometers; IMF.  Figures rounded for presentation purposes.  Readers inclined to @me for swallowing seemingly the demographic kool-aid served up by promoters of investment schemes focused on “emerging markets” (EM) should take due note of Japan’s inclusion in the opportunity set furnished above.  Like Ben, who bashed demography-driven EM schema during his ET Live! chat with Rusty on April 2 (premium subscription required), I’m inclined to short rather than go long on investment schema premised primarily on rapid population growth.   

Surrendering Preconceived Ideas.  “If the baseball world is to accept this new system,” Rickey noted in the heretical essay on baseball stratagem referenced repeatedly in this post, “it must first give up preconceived ideas.  I had to.  The [system] outrages certain standards that experienced baseball people have sworn by all their lives.”  The investment paradigm sketched above will outrage some readers, methinks, especially those who view the world’s biggest national economy at present [the U.S.] as the “safest” place to deploy capital and, as a corollary, the biggest economy making the above cut as an unsafe place to deploy capital. 

Truth be told, I myself generally view China as such, due largely to its suspect fidelity to the rule of law.  That said, the scarcity mindset growing increasingly prevalent in the US and Old Europe poses different but clear and present dangers to the rule of law! in such geographies, with the meme just mentioned (rule of law!) serving as shorthand for the intricately woven but increasingly frayed fabric of legal, commercial, social and political norms on which investors in US- and Europe-domiciled companies have customarily relied to safeguard and indeed nurture their ownership stakes.  All of which is to say that, while I’m as opposed to non-zero fixed or policy allocations to Chinese stocks as I am to such rigidities respecting US or European equities, I certainly wouldn’t exclude Chinese stocks from my hoped-for circle of competence (defined broadly to include Asia- or China-focused managers deploying capital entrusted to me). 

Nor would I pursue policies entailing unduly high bars to the ownership of equities denominated in currencies issued by any of the countries comprising my self-selected opportunity set, China not excepted.  Indeed, convinced as I am that Ben has divined rightly that “competitive and single-play games” have displaced “cooperative and multi-play [ones]” in international politics and economics, I’d assign better-than-even odds to the US dollar’s displacement as the world’s dominant reserve currency within the next quarter century or so.  I doubt the Chinese yuan or indeed any other currency excepting possibly gold will ascend to the throne that USD seems destined to vacate, of necessity or choice.  But I’m reasonably confident that by the time Mike Trout takes his rightful place in baseball’s Hall of Fame a decade or two from now, the global economy will be divided into three major currency blocs, with China, Germany and the US each spearheading the bloc in which their national currencies sit. 

I’m reasonably confident too that the scarcity mindset increasingly manifest in American politics and economics will produce ultimately a material downward revision in the US dollar’s value relative to both gold and a sensibly weighted basket of its “trading” partners’ currencies, with “trading” defined broadly to include services as well as goods.  Obviously and perhaps sadly for Americans lacking overseas holdings or other means of profiting from dollar debasement, USD devaluation to the degree divined here would generally flatter the Asia-centric investment program delineated above, spawning as it likely would currency-related gains on non-US stocks even after factoring in valuation shifts commonly associated with major currency moves. 

(If you’re unfamiliar with how and why such shifts occur, you should be especially wary of any raccoons investment pros seeking to manage your money for a fee while assuring you they have everything under control.  “Investing is simple,” one often hears, “but not easy.”  In fact, effective investing is neither simple nor easy, least of all for investment pros forced unavoidably and unendingly to balance their own pecuniary needs against their clients’ wants and needs.)    

Finally and not obviously, in the unlikely event that America scores decisive victories in the “competitive and single-play games” in which it seems destined to participate in coming years and beyond, I’d expect the Asia-centric investment program endorsed here to produce long term returns not merely matching but likely besting those produced by US-centric alternatives.  Why?  Because the restoration of Pax Americana that such victories would both presuppose and promote would almost surely put strong and steady winds into the sails of the Asian economies identified in the table above, including especially India (my single favorite target for capital deployment in coming decades) as well as smaller Asian nations likely to fare better on balance if Uncle Sam’s traditional values of liberty and justice for all triumph ultimately over Uncle Xi’s evolving ethics, such as they are.  Heads I win, tails I don’t lose.  That’s the ticket, we’d all agree — even if we can’t agree on the surest means of dialing such asymmetry into capital allocation protocols. 

Indeed, mindful as I am that the policy prescriptions proffered here may create a “widening gyre” (to quote Ben quoting Yeats) of opinions within the ET Pack respecting prudent approaches to capital deployment, I’ll try in my next note to inject centripetal forces into the mix by presenting to the Pack the single best metric known to me for gauging long term investment success.  By my lights, it’s as relevant today as it was when its principal modern proponent first drew it to my and other investment wonks’ attention in 2005.  Mike Trout was a young teenager playing baseball for free back then; and the so-called sabermetrics revolution that’s changed materially the metrics baseball cognoscenti employ for gauging ballplayers’ worth had only recently commenced.  As will be seen, just as sabermetrics is rooted in methods devised many years earlier by the great and good Branch Rickey, the money metric I’ll discuss approvingly in Note #8 is rooted in methods of gauging financial abundance devised long before the first MLB game was played 143 springtimes ago.

PDF Download (Paid Subscription Required): Notes from the Diamond #7 – Hittin ‘Em Where They Ain’t (Part 2)

On Deck

In search of excellence when gauging excellence

[1] Many lovers of sport including some lovers of baseball think MLB games have become too long and devoid of action since computer-based analytics came to the fore in pro baseball several years ago.  I share such concerns, with a carve out for games unfolding glacially at Fenway, and plan to discuss them plus potential remedial measures in a future note.

[2] You can check my math here, applying to Trout’s newly contracted pay package the 52% effective tax rate I’ve assumed here or whatever alternate rate you deem sensible given the idiosyncratic manner in which salary payments received by peripatetic entertainers like Trout get taxed.  Like rock stars on tour — which Trout essentially is — MLB players pay state-level income taxes pro rated to the number of days they play in a given state each season, taking credits against their home state’s levies.  As a New Jersey resident for tax purposes, Trout is poised to fork over a minimum of at least 9% of his pay in state taxes, with half or more of his salary being subjected to the ~13% tax extracted by the state in which Trout and his Angels teammates play half of their regularly scheduled games each season: California. 

[3] As Ben Hunt wrote when elevating the term to its rightful place as a key concept in Epsilon Theory (here), “zeitgeist” “is the macro scale of our social lives as investors and citizens.”

[4] Bench’s extraordinary gifts as a ballplayer are captured nicely in the brief profile posted here.

[5] Though capitalization weighting stocks for passive investment purposes is demonstrably inferior to other portfolio construction methods on a pre-tax basis, even a cap-weighted index like the S&P 500 has displayed historically and will likely continue displaying asymmetry of the sort alluded to here: the longer one lengthens the time periods over which returns are examined, the higher the percentage of positive outcomes rises.  Hence, even if the odds of investing in broadly diversified portfolios like the S&P 500 aren’t mispriced (and good luck diving inflection points in such mispricing), they are unarguably favorable in positive payoff terms for truly long-term investors.  The defects of cap-weighted portfolios are catalogued cleverly in a 2006 paper by Jason Hsu posted here and in a 2018 research note by Jason and his former Research Affiliates colleagues Rob Arnott and Vital Kalesnik posted here.

[6] Using the least-worst available metric for gauging baseballers’ on-field contributions to their team’s success (a cumulative measure known as Wins Above Replacement or WAR), Trout’s achievements as both a batsman and outfielder since his big league career commenced at age 19 in 2011 have already elevated him to a Top 150 spot in MLB’s all-time list of players ranked by WAR: when his ninth season as a big leaguer commenced in March 2019, Trout had compiled a lifetime WAR of 64, which is roughly equal to the median WAR for the 261 players (including four 2019 inductees) comprising baseball’s Hall of Fame.  Think Trout will join their ranks eventually?  Me too, especially since he’s already 16th in WAR all-time among center fielders, ahead of nine of the 19 such players who’ve been elected to the Hall.    

[7] As noted in its white paper on OOCs, HK defines an “owner-operator” as “a principal or an owner — often a founder — who is directly involved in the management of a corporation in which he or she maintains a significant portion — ideally the majority — of his or her wealth.”

[8] “Unsustainably undemocratic” as used here refers to the inevitable reformation of arrangements that today give roughly 30% of the American electorate a de facto veto (via the US Senate) over laws governing the residual 70%.  Of course, the same imbalance is manifest in US presidential elections decided ultimately by the electoral college — an artifact of logrolling by America’s founding fathers whose eventual elimination could and likely will entail political if not also social unrest inimical to the interests of passive investors in broadly diversified portfolios of US stocks.

[9] Ping me via if you’d like to review data supporting this assertion.  Alternatively, take a look at the characteristically fine Wall Street Journal piece that my pal Jason Zweig crafted after he laid hands on the data in question.

This is Water

PDF Download (Paid Subscription Required):  This Is Water

There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes “What the hell is water?”

David Foster Wallace (2005)

It’s the perfect description of a Zeitgeist … the water in which we swim.

We can’t see it. We can’t hear it. We can kinda sorta feel it, if we focus really hard, but only kinda sorta. All the same, because it’s part of a social system and not a physical system, WE create it. Not in a conscious fashion. We can’t set out to create a Zeitgeist.

But we can be nudged.

It’s like a stadium crowd holding up cards for the TV audience. They can’t see the picture they’re making … they have no idea what it looks like or what their role in its making might be. But they’re told/asked to do it. So they do.

THIS is a Zeitgeist.

What’s the matter, Ben? You got a problem holding this card up over your head? It’s for the troops. You support the troops, don’t you? Don’t you?

Yes, I support the troops. And yes, I have a problem with this.

Why? Because I don’t trust the State and the Oligarchy to use the common knowledge of “support for the troops” – the crowd watching the crowd express a public act of allegiance to the military, so that everyone knows that everyone knows that yes, it is right and proper to support the troops – for the right reasons.

Instead, I suspect that they will use my voluntary “support” (hey, no one forced you to hold up that card) to justify things like … oh, I dunno, a trillion dollars wasted and 2,000 kids dead to fight a war in freakin’ Afghanistan. Because, you know, otherwise “the terrorists win”. Otherwise we lose “credibility”. JFC.

It’s exactly the same thing with capitalism.

In exactly the same way that all of us sit in our citizenship stadium and get nudged to hold up a card creating a common knowledge display of “Yay, military!”, so do all of us sit in our investor stadium and get nudged to hold up a card creating a common knowledge display of “Yay, capitalism!”.

What’s the matter, Ben? You got a problem holding this card up over your head? It’s for capitalism. You support capitalism, don’t you? Don’t you?

Yes, I support capitalism.

AND I have a problem with holding up this card.

You should, too.

Because we can’t trust the State and the Oligarchy to use our support for the right reasons.

In You Are Here, I wrote that the investment Zeitgeist is changing in three ways.

  • Deflationary expectations, now 40+ years old, are becoming inflationary expectations.
  • Cooperative and multi-play games in both international politics and domestic politics, now 70+ years old, are becoming competitive and single-play games.
  • Modern capital markets, now 150+ years old, are becoming political utilities.

Time to add a fourth.

  • Capitalist productivity, now 200+ years old, is becoming capitalist financialization.

What is financialization?

Financialization is profit margin growth without labor productivity growth.

That sounds like a small thing, but I tell you it is EVERYTHING.

Financialization is squeezing more earnings from a dollar of sales without squeezing at all, but through tax arbitrage or balance sheet arbitrage.

Financialization is the zero-sum game aspect of capitalism, where profit margin growth is both pulled forward from future real growth and pulled away from current economic risk-taking.

Financialization is the smiley-face perversion of Smith’s invisible hand and Schumpeter’s creative destruction. It is a profoundly repressive political equilibrium that masks itself in the common knowledge of “Yay, capitalism!”.

Financialization is a global phenomenon. In China, it’s transmitted through the real estate market. In the US, it’s transmitted through the stock market.

Financialization is the zombiefication of an economy and the oligarchification of a society.

Here’s the foundational chart for these strong words.

source: Bloomberg

This is a 30-year chart of total S&P 500 earnings divided by total S&P 500 sales. It’s how many pennies of earnings S&P 500 companies get from a dollar of sales … earnings margin, essentially, at a high level of aggregation. So at the lows of 1991, $1 in sales generated a bit more than $0.03 in earnings for the S&P 500. Today in 2019, we are at an all-time high of a bit more than $0.11 in earnings from $1 in sales.

It’s a marvelously steady progression up and to the right, temporarily marred by a recession here and there, but really quite awe-inspiring in its consistency. Yay, capitalism!

It’s a foundational chart for this note because I believe that the WHY of earnings margin growth in the 1990s and early 2000s is fundamentally different than the WHY of earnings margin growth since then.

WHY do we get three times as much in earnings out of a dollar of sales today than we did 30 years ago, and twice as much than we did 10 years ago?

The common knowledge answer is technology!.

By which I mean that the common knowledge answer is the meme! of technology as opposed to any actual technology. By which I mean that we can’t exactly say why technology would improve earnings margins and efficiency over the past decade, but we believe it MUST be technology. Somehow. Of course it’s technology. Everyone knows that everyone knows that it’s technology that makes anything in the world more efficient. So we mumble something-something-technology whenever anyone asks a question like this. And yes, This Is Why We Can’t Have Nice Things.

Here, hold this card up over your head. It’s for technology and progress. You support technology and progress, don’t you? Don’t you?

I used to believe this, too. I used to believe that corporate management was getting better and smarter over time, that they were making constant process improvements and technology-based productivity enhancements to squeeze more and more profits out of the same sales dollar.

And I think this used to be true. I think that during the 1990s and early 2000s – the so-called Great Moderation of the Fed’s Golden Age – when we actually had significant advancements in labor productivity year after year after year, corporate management was, in fact, able to drive earnings margins higher for the right reasons. I think the driver of profit margin growth over this period was actual technology, as opposed to the meme of technology!.

But I don’t believe this is true anymore. I don’t believe that technology and productivity advancements have been responsible for earnings margin improvements for the past decade … for some years before the Great Financial Crisis, in fact.

Here, take a look for yourself.

See, the Fed was convinced that an easy money policy would lead to corporate management investing more in technology and plant and equipment … you know, all of those things you need to drive productivity. All of those things you need to drive a 1990s style recovery, with earnings margin accretion for the right reasons.

Instead, corporate management followed the Zeitgeist.

They always do. It’s the smart move.

This is a chart of Labor Productivity growth in the US for the past 30 years. It’s how much more stuff we make or services we provide from a unit of labor. It’s how much we’re growing for the right reasons, by applying capital investment in plant and equipment and technology to work smarter and more efficiently. It’s how we generated earnings efficiency and margin growth for the right reasons in the 1990s and early 2000s. It’s how we’ve been reduced to squeezing tax policy and ZIRP-supported balance sheets for earnings efficiency ever since.

This chart IS the failure of monetary policy for the past decade.

This chart IS the zombiefication and oligarchification of the US economy.

Why do I rail at the Fed? THIS.

Trillions of dollars in QE, and all we got for it was this lousy t-shirt. Yes, I’m going to get this productivity chart put on a t-shirt.

The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? Why in the world would management take the risk — and it’s definitely a risk — of investing for GAAP earnings when they are so awash in easy money that they can hit their pro forma narrative guidance by simply buying profitless revenue? Why in the world would companies take any risk at all when the Fed has eliminated any and all negative consequences for playing it safe?

That’s from Gradually and Then Suddenly, written in July 2017. It’s worth your time.

What’s changed since I wrote that note is that the barge of monetary policy, both in the US and everywhere else in the world, has done a 180 and is now chugging back down the easing river. No central bank in the developed world is looking to tighten today, and if anything we’re on the cusp of fiscal policies like MMT, or at least trillion dollar deficits forever and ever amen, to accelerate the shift in the modern Zeitgeist towards fiat EVERYTHING.

This is not a mean-reverting phenomenon.

This doesn’t get better going forward. It gets worse.

But wait, there’s more …

source: Bloomberg

This is a chart of the S&P 500 price-to-earnings ratio in yellow, the belle of the narrative ball, together with its forgotten cousin, the price-to-sales ratio in blue.

When we grow profits through productivity growth – when our “supply” of earnings is directly connected to the same operations that generate sales – P/E and P/Sales multiples go up and down together. When we extract excess earnings through financialization – when our “supply” of earnings increases for no operational reason connected with sales – the P/E multiple becomes depressed relative to the P/Sales multiple. As the kids say, it’s just math.

Why is this important? Because a P/E multiple deflated by financialization doesn’t mean what you think it means.

How many times in the past ten years have you heard that the market is not expensive on a valuation basis? And what you’ve heard is right, as far as it goes.

Because the market narrative of valuation is completely dominated by the vocabulary of earnings, not the vocabulary of sales.

Sure, the S&P 500 P/Sales ratio is near an all-time high, but who cares about that? The S&P 500 P/E ratio today is right at 19 … neither crazy low nor crazy high … and we ALL care about that. But here’s the thing:

Without financialization, my guess is that the S&P 500 P/E ratio today would be 28.

Good luck selling that to a value investor, Wall Street.

Here, hold this card up over your head. It’s for value and a reasonable earnings multiple. You support value and a reasonable earnings multiple, don’t you? Don’t you?

But wait, still more …

source: Bloomberg

This is a chart of S&P 500 buybacks per share (in blue) imposed over the ratio of S&P 500 earnings-to-sales in green. You’ll see that share buybacks spike after profit margins spike. You’ll see that share buybacks spike before and during recessions.

When do stock buybacks accelerate dramatically?

In 2006 and 2007, when management is rolling in record profits and profit margins, despite meager productivity growth.

In 2018 and 2019, when management is rolling in record profits and profit margins, despite meager productivity growth.

This is not an accident.

Here’s the past five years so you can see the temporal relationship more clearly.

source: Bloomberg

Stock buybacks are what you DO with the excess earnings you’ve made from financialization.

Why? Because stock buybacks are part and parcel of the financialization Zeitgeist. They’re part and parcel of the tax-advantaged issuance of stock to management, which is then converted into tax-advantaged income for management through stock buybacks.

Here, hold this card up over your head. It’s for alignment of interests between management and investors. You support alignment of interests between management and investors, don’t you? Don’t you?

What does Wall Street get out of financialization? A valuation story to sell.

What does management get out of financialization? Stock-based compensation.

What does the Fed get out of financialization? A (very) grateful Wall Street.

What does the White House get out of financialization? Re-election.

What do YOU get out of financialization?

You get to hold up a card that says “Yay, capitalism!”.

So what do we DO about this?

I’ve got three answers, one for your life as an investor, one for your life as a citizen, and one for your life as a human being.

As an investor, my answer is this: Adapt.

How? First read this.

And then take this to heart.

What are the Narratives I am being told?

What are the Abstractions presented to me?

What are the Metagames I am playing?

What are the Estimations shaping my outcomes?

Am I acting to promote Reciprocity?

Am I acting in a way that reflects my Identity?

Why? Because Clear Eyes, Full Hearts, Can’t Lose.

As a citizen, my answer is this: Resist.

How? First read this.

And then take this to heart.

Take back your vote.

Take back your distance.

Take back your data.

As a human being, my answer is this: Find your pack.

We’re all little fish.

We’re all swimming in the same smiley-face authoritarian waters of “Yay, military!” and “Yay, capitalism!”.

I tell you, brothers and sisters, we’re all we’ve got.

But I also tell you, we are all we need.

Yours in service to the pack. – Ben

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In the Flow – Risk Management with ET Pro

Whether you’re a trader or a portfolio manager or a financial advisor or an allocator, ET Pro can help you identify both the inflection points and the trajectory of the market Zeitgeist – particularly the question that any long-term portfolio owner MUST get roughly right in order to succeed: are we in an inflationary or deflationary world, and how quickly (if at all) and in what ways is that world changing . . .


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