ET Podcast #9 – Make, Protect, Teach

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


How do we change the world?

Not by corporations and political parties acting on us from the top-down, but by citizens acting for themselves from the bottom-up.

Not as an alienated flock, but as a cooperative pack.

Not with abstractions and transactions, but with making, protecting and teaching.

Let’s gooooooo!



Here’s the classic ET note referenced in the podcast, linked here and taken out from behind the paywall.

The Long Now, pt. 2 – Make, Protect, Teach

My advice? Abandon the political party as your vehicle for political participation.

My alternative? Find your Pack.

My platform? Make – Protect – Teach.


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If you’d like to learn more about our subscription options, including unlimited access to more than 1,000 published notes, private content not available on the public-facing website, and engagement with an active community of truth-seeking investors and citizens, please go here.


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ET Podcast #8 – Leverage and Its Discontents

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

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

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



Three blow-ups in three months: Archegos, Greensill, and Melvin Capital.

What do they have in common?

Insane leverage employed to maximize private gain, provided by lenders that can socialize losses.



We reference three archived ET notes in the podcast, linked here and taken out from behind the paywall.

The Grammar of Risk

Leverage / Illiquidity /Concentration

In a normal market you can handle two. In a bad market you can’t.

By Our Own Petard

We will never – can never – be aligned with our agents.

Sorry.

Oh hell, Martha, go ahead and burn yourself if you want to.

We all need some burns. But they have to be OUR burns


If you’d like to sign up for a free email to let you know what we’ve published in the prior week, please go here. We have about 100,000 email recipients, and your contact information will never be shared with anyone.

If you’d like to learn more about our subscription options, including unlimited access to more than 1,000 published notes, private content not available on the public-facing website, and engagement with an active community of truth-seeking investors and citizens, please go here.


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A Conversation with Howard Marks

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Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.


McLaren P1 supercar
This is not Howard Marks’ car. Or is it?

Today, I’m writing about Howard Marks’ most recent memo, which you can find here: Oaktree Capital – Something of Value.

Major bonus: I sent my note to Mr. Marks as a courtesy in case he had any feedback (because he is a legend and I’m scared of authority figures). He was kind enough to get back to me. He didn’t just reply with a one-line email, he gave me almost an hour of his time. So herein, I combine the original piece I wrote with my notes from a 60-minute phone call with Howard Marks. Enjoy!


Howard Marks has been a great investor and one of the best finance writers in the business for decades. He has been writing must-read investor letters since I was in high school. His latest memo “Something of Value” contains much insight, particularly about why traditional value investing is likely permanently impaired as a strategy and why Growth vs. Value is a false dichotomy.

The Marks letter spans 18 pages so my piece today will scratch the surface. If you have time, go read the memo from Howard Marks first, then come back.

Here is my quick review + summary + partial rebuttal + phone interview excerpts. Just so it’s clear: the indented quotes are from the memo and the left justified, larger font quotes are from our phone call.


Howard Marks on value and efficient markets

With unlimited computing power widely available to most investors in the world, stocks that are cheap on simple metrics like price/earnings etc. are probably cheap for a reason. Unlike pre-internet, when you had to scour annual reports in a library to find company metrics, everyone now has access to detailed company financials. If you want to be a value investor, more imagination is required than simply running a P/E or P/S screener on Yahoo! and buying whatever pops out.

In ye olden days, it was hard to get timely and accurate corporate information and so simply buying cheap things worked because not everyone knew what was cheap. There is no reason to think that should work going forward.

Here is the key quote from Marks’ note:

In the past, bargains could be available for the picking, based on readily observable data and basic analysis. Today it seems foolish to think that such things could be found with any level of frequency. If something about a company can be easily read in an annual report, or readily discovered by a mathematically competent analyst or computer, it stands to reason that, in most cases, this should already be appreciated by the marketplace and incorporated in the prices of the company’s securities. That’s the essence of the Efficient Markets Hypothesis.

Thus, in the world we live in today, investing on the basis of rote formulas and readily available fundamental, quantitative metrics should not be particularly profitable. (This is not necessarily true during market downturns and panics, when selling pressure can cause prices to decouple from fundamentals).

That last sentence is the key—and it should also be stated in reverse. That is: growth can also outperform value during manias and bubbles as buying pressure can cause prices to decouple from fundamentals.

Essentially what this all comes down to is that markets are mostly efficient but efficiency breaks down at times due to behavioral factors. Markets defy EMH and decouple most aggressively from fundamentals during manias and crashes. Despite the wide availability of home computers and financial data, for example, value still outperformed from 2000 to 2007 as the NASDAQ bubble unwound and mean reversion following the dotcom mania (and crash) eventually brought things back into balance.

Value and growth cycle back and forth… Each time value underperforms (like now), prognosticators find a new explanation for why that might be permanent, not cyclical. If anything, though, what stands out to me is that the ratio of the growth and value indices looks to oscillate fairly consistently around 1.00.

Growth vs. Value performance vs. percent of Americans that own a computer
Growth vs. Value performance vs. percent of Americans that own a computer

I initially read the memo as a bit of an assertion that “value is dead”, but that’s not right. Marks explained to me on the phone that that is not what he meant.

“Market inefficiency is mostly cyclical now. In the past it was structural.”

What he meant was that structural inefficiencies that once existed are gone and will never come back. Pre-internet, there was alpha sitting around all over the place. Anyone with a calculator, a basic understanding of DCF, and a strong work ethic could scoop up that alpha because markets were structurally inefficient. Now, markets are structurally efficient and veer into inefficiency only during cyclical periods of extreme emotion. You either need to use a behavioral approach, or you need to understand the companies, industries, and technologies way better than anyone else. That level of understanding requires a much deeper knowledge than one can glean by scrolling through publicly-available data.


Howard Marks on growth

The memo avoids declaring a new paradigm to justify current record-high valuations … but it definitely feels like it wants to declare a new paradigm! For example:

It’s also worth noting with regard to truly dominant companies that are able to achieve rapid, durable and highly profitable growth that it is very, very hard to overprice them based on near-term multiples. The basic equations of finance were not built to handle high-double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter.

The last line is definitely debatable and the entire paragraph is kinda debatable, but not quite the language you see from #truebelievers in presentations for various NEWECONOMYDISRUPTORS™ ETFs. “The shares of frictionless businesses are reasonable to own at any price, multiple, or valuation because super long duration assets have nearly infinite cash flows!”  While this sort of 1999ish statement has now made its way into the mainstream narrative, Mr. Marks stops just short of making it.

The idea that some companies have infinite cash flows discounted at a near-zero interest rate means valuation no longer matters for some companies is the same numerator mistake everyone made in 2000 (near-infinite growth of the World Wide Web… For, like, ever!). To be clear, a) the denominator story now is different from 1999 and b) Mr. Marks never says valuation doesn’t matter, but he gives more than a passing nod in that direction as he suggests there may be a few companies out there right now where almost any valuation could be seen as reasonable. One other note: just because US government yields are at 1.5% or companies can borrow at low rates, that doesn’t mean company WACCs are 1.5%. Take a look at the WACC for a few of your favorite companies. It’s not zero and it’s not even close!

Anyway, I found Marks’ arguments against value more compelling than his arguments in favor of growth, but the whole memo got me thinking.

One big message I took from the memo is that investors should not get married to one style. Trade and invest flexibly using the logic of what style makes sense at any given moment in the regime you find yourself. That does not mean you have to chase the current fashion, it just means you should think for yourself and be flexible. Don’t rigidly declare yourself a value investor or a growth person.

Another takeaway for me is that even the smartest people in the world (like Howard Marks) risk overweighting recent information. This is not a criticism of Mr. Marks, just a hard-to-avoid fact for all human beings. Recent news, information and performance are easier to remember than prior (or future!) performance. I could also be wrong and there is something truly new and different about today’s crop of tech companies. I’m open to that possibility, but I also doubt it. There have always been companies perceived to be dominant and expected to achieve rapid, durable growth as far as the eye can see. As Marks says:

John Templeton warned about the risk that’s created when people say, “It’s different this time,” but he also allowed that 20 percent of the time they’re right. Given the rising impact of technology in the 21st century, I’d bet that percentage is a lot higher today.

Personally, my guess is that the number is still well below 50%. On the phone, I tried to press Mr. Marks on this topic because it’s the most interesting aspect of the letter. When a “value guy” who correctly identified 1999 as a bubble in real time and sidestepped it nods to the idea it might be different this time … that’s interesting!

When I pressed him on the phone he said:

“Yes, you could say I’m struggling with a partial conversion.”

“Drill down and be open-minded.”

His defense of a more open-minded position on “highly-valued” tech is rooted in the idea that you cannot make blanket statements about entire industries without having an intimate knowledge of the firms themselves. The quip he used was:

“All generalizations are flawed, except this one.”

So his feeling is that now, given the enormous growth rates and very low interest rate environment, you need to keep an open mind and understand each individual company, industry and technology. This clearly doesn’t square with the 1999 experience. Even the very best companies in 1999 were terrible investments. For example, if you bought Amazon in 1999 or 2000, you were underwater for 10+ years!

Sure it’s like 1999, but it’s not 1999, it’s 2021

Mr. Marks says we are experiencing something similar to the Internet Bubble in some ways but 2021 is vastly different in other ways. Rates are low and the Fed is not hiking. Some assets are overvalued and in a bubble, but some are not. To make blanket statements like: “stocks are too high” or “tech is overvalued” is not the right approach. He believes you need to drill down and make more granular assessments, whether it’s crypto, tech or old economy stocks.

He did make it abundantly clear that he still believes that valuation always matters. He spent about 10 minutes emphasizing and reiterating that he does not currently believe and will never, ever believe that valuation does not matter.

“Value vs. growth is a false dichotomy.”

Marks said his grandmother used to joke: “What do you like better: summer or the country?” Value vs. growth is not a spectrum, it’s two sides of the same coin.

“It’s not what you buy, it’s what you paid.”

He said: “I’m going to sell you my car, do you want to buy it?” I mumbled for a second and he clarified: “The question makes no sense.” Every asset you buy is a combination of the intrinsic worth of the asset and the price you pay. Looking at one or the other in isolation is dumb. People define “value” as cheap, but they are often talking about price, not worth.

… “carrying low valuation parameters” is far from synonymous with “underpriced” ….

Traditional capital-V Value Investing is all about numbers: ratios, book value, cash flow, price-to-earnings, etc… Meanwhile, Growth Investing is all about the company: Tell me the story, what a great product, DISRUPTION!, huge moat, revenue growth, innovators!, viral founder, and so on. Again, this is a false dichotomy. Good investors should be looking at both, not one set of variables in isolation from the other.

I don’t believe the famous value investors who so influenced the field intended for there to be such a sharp delineation between value investing, with its focus on the present day, low price and predictability, and growth investing, with its emphasis on rapidly growing companies, even when selling at high valuations.  Nor is the distinction essential, natural or helpful, especially in the complex world in which we find ourselves today.  

“A high P/E stock can still be cheap.”

Real value investing is not about buying cheap things. It’s about buying assets for less than they are worth and waiting for the market to agree with your judgment. This might mean buying a stock at 70X earnings when it’s worth 250X earnings. Or it might mean a stock at 0.8X earnings is expensive because it’s going bankrupt. Good investors understand and study the relationship between price and intrinsic value and do not buy assets based on value metrics or growth stories in isolation.

Even famous so-called value investors like Ben Graham and Warren Buffett made as much or more money in growth as they did in value. I did not know that! Super interesting.

Graham went on to achieve enviable investment performance although, funnily enough, he would later admit that he earned more on one long-term investment in a growth company, GEICO, than in all his other investments combined.

Buffett, the patron saint of value investors, also practiced cigar butt investing with great success in the first decades of his career, until his partner, Charlie Munger, convinced him to broaden his definition of “value” and shift his focus to “great businesses at fair prices,” in particular because doing so would enable him to deploy much more capital at high returns.

This led Buffett to invest in growing companies – such as Coca-Cola, GEICO and the Washington Post – that he could purchase at valuations that were not particularly low in the absolute, but that he found attractive given his understanding of their competitive advantages and future earnings potential.  While Buffett has long understood that a company’s prospects are an enormous component of its value, his general avoidance of technology stocks throughout his career may have unintentionally caused most value investors to boycott those stocks.  Intriguingly, Buffett allows that his recent investment in Apple has been one of his most successful.

“Don’t place arbitrary or artificial constraints on your portfolio. It’s not about being best at a particular game, it’s about choosing the game you can win.”

Unless you are forced by mandate, don’t corner yourself into a particular style. Just like in trading I say it’s best not to be a breakout trader or a mean reversion guy or anything similar… In investing, it’s best not to pigeon-hole yourself as a value guy or a growth woman etc. Intellectual flexibility and adaptation lead to long-term outperformance, not the expert application of a single investing style.

This is relevant right now with regard to the bullish ESG story. ESG investing might be the best thing to do ethically, but from an investment point of view it’s hard to imagine the thing that everyone in the upper echelons of finance loves (and is actively and publicly signaling it loves) will outperform the things that everyone thinks are icky. I mean, Philip Morris is one of the best-performing stocks of all time, and a big part of this is because for much of its existence, people would not touch it.

 “No asset is so good that it can’t be overpriced.”

Marks started at Citicorp in 1968, in the midst of the Nifty Fifty bubble [1] and that experience (like my 1999 experience) puts him always on alert for bubbles. Here’s a quick excerpt from a 2018 Wharton piece:

Marks recalled that when he took a summer job in Citibank’s investment research department in 1968, investors were crazy for the “Nifty Fifty” — 50 large-cap, blue-chip growth stocks in America that included IBM, Xerox and Coca-Cola. He said they were selling for “astronomical” prices of 80 to 90 times earnings. That compares with the average price-to-earnings (P/E) ratio for the S&P 500 in the post-war period of about 16 times earnings.

Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.

Formative experiences shape behavior for decades. Everyone forms strong bonds to salient early-life experiences, whether those experiences involve investing or life outside finance. If you grew up in the Great Depression, you reuse aluminum foil. If you grew up in the 70s, you scrimp on gas.[2] If you came of age in 1999, you might find the smell of highly-valued tech particularly pungent. As a general rule, these sorts of bias are bad.

Marks noted in our conversation that this predilection for bubble detection can be both a blessing and a curse. While it might save you from going all-in levered long at the most egregious moments of euphoric overvaluation, it can also lead you to be too cynical. It can lead to gigantic missed opportunities.

While the idea that some companies can be good investments at what appear to be sky-high valuations didn’t resonate much with me because I feel the same thing was said in 1999, it did resonate with me big time when Marks said his partial conversion on the 2020 disruption economy is in some measure motivated by this realization:

“I was too skeptical in the past. Skepticism can lead to knee-jerk dismissiveness.”

When he said those words, my brain lit up a bit because I have suffered from the same bias of excess dismissiveness many times. Healthy skepticism is great. Reflexive cynicism and dismissiveness is bad. Marks’ comment hit home for me and the conversation may have influenced my less skeptical view of NFTs a few weeks later (see AM/FX: The metaverse contains infinite Pop-Tart® cats). If I was wrong about the iPhone and I was wrong about bitcoin (and Twitter… Who’s ever going to use that???)… Maybe next time I should be more open minded? And perhaps less wrong?

The risk, of course, is you end up on the other end of the spectrum—that’s not good either!


Reflexive cynicHighly skepticalHealthy skepticRational optimistUnrealistically
optimistic / gullible
Pollyanna

I have been too far left on this spectrum, and so has Howard Marks


While I want to be less knee-jerk dismissive overall, my observation right now is that there is a large swath of the investment community wearing the Growth Investor blinkers and that has put them too far to the right on the spectrum from cynic to unrealistic optimism and beyond.

These investors see booming top line growth and economic disruption and low rates as far as the eye can see but ignore the other side of the equation. They see a McLaren P1 and think: “Wow, I want that!” and then pay Howard Marks $22 million for it when it’s really worth more like $2 million.

Marks is worth around $2B, so I am assuming this is the car he drives. I could be wrong.

Meanwhile, value investors are looking for 1992 Toyota Tercels they can buy for $800 and resell for $2,000. The right philosophy is to look at all the cars and see which ones you can get for less than fair value.

McLaren P1 - good value at $450k / overpriced at $22m

Easier said than done in the stock market, obviously, but I think it’s a good framework.

In ten years, I bet we will look back at many of the outsized investment winners of 2020 and see them as flukes. Separating skill from luck is notoriously difficult in finance. Evaluating the performance of any strategy or fund manager by how it, he or she performed in 2020 could be the epitome of Taleb’s fooled by randomness. I think “persistent investing skill” and “performance in 2020” are more likely to be inversely than positively correlated.

Many fund managers who delivered stellar performance in 2008 left investors disappointed in 2009. It is the aggregate performance of managers and strategies over multiple years that matters, not 2020 outcomes.

Anyway, a lot to chew on here. I thank Howard Marks for the memo and for being so generous with his thoughts and his time. There is no reason he needed to spend an hour talking to me on the phone, and I sincerely appreciate that he did.

Finally, Mr. Marks suggested I check out this 1962 Warren Buffett interview, just for fun. It is fun!


[1] A year or so before man landed on the moon and 18 months before the letters “LO” were transmitted over the ARPANET in what is widely viewed as the birth of the internet.

[2]> See: Malmendier and Shen, Scarred consumption (2021) https://voxeu.org/article/scarred-consumption and Severen and Benthem, Formative Experiences and the Price of Gasoline (2019) https://www.nber.org/papers/w26091


Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.


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ET Podcast #7 – Inflation Investing

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

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

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



We’re going to Pack-source a slate of investment strategies for an inflationary world.

Here are five tentpoles to organize and support that effort, five sets of questions we must answer.

What should we think about …

1) US Treasuries?

2) US Housing Market?

3) Narrative of Central Bank Omnipotence?

4) Fiscal Policies and Inflation Expectations?

5) Real Assets and Abstracted Securities?



If you’d like to sign up for a free email to let you know what we’ve published in the prior week, please go here. We have about 100,000 email recipients, and your contact information will never be shared with anyone.

If you’d like to learn more about our subscription options, including unlimited access to more than 1,000 published notes, private content not available on the public-facing website, and engagement with an active community of truth-seeking investors and citizens, please go here.


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The Best Way to Rob a Bank

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The best way to rob a bank is to own a bank.

I think that the collapse over the past week of Greensill Capital has a lot of systemic risk embedded within it, particularly as the fraudulent deals between Greensill and its major sponsors – Softbank and Credit Suisse – come to light. And that’s not even considering Greensill’s second tier of sponsors – entities like General Atlantic and the UK government – all of whom are up to their eyeballs in really dicey arrangements.

Yeah, that’s Lex Greensill at Buckingham Palace in 2019, receiving a CBE (Commander of the Order of the British Empire) from Prince Charles for … wait for it … “services to the British economy”. LOL.

And yeah, that’s former UK prime minister David Cameron, positively beaming in this photo that his publicist chose for the 2018 announcement that he would be joining his good friend Lex Greensill as a “special adviser” to the company, keen to assist with the company’s mission to “democratize” supply-chain finance and “transform construction finance with Big Data and AI”. I mean, that’s what the white paper says, so it’s gotta be true.

Today, David Cameron is waking up to headlines like this in the UK press:

Hope all those free rides on Lex’s personal fleet of four private jets (all bought by Greensill Capital’s German banking subsidiary and leased back to Lex, btw) were worth it, David.

Is this a Madoff Moment for the unicorn market? Honestly, if you had asked me a few weeks ago, I would have told you that a Madoff Moment was impossible in our narrative-consumed, speak-no-evil market world of 2021. Now I’m not sure. We’ll see, but I think this has legs.

By all rights, Greensill – the eponymously named investment bank started by former Citigroup and Morgan Stanley banker Lex Greensill in 2011 – should have been shot between the eyes in 2019. That’s when their “supply-chain finance” loans, in this case to the steel and energy companies of the UK’s “Savior of Steel”, Sanjeev Gupta, blew up Swiss asset manager GAM’s $11 billion flagship fund, the Absolute Return Bond Fund (ARBF).

It’s a story as old as capital markets … Greensill lent Gupta a lot of money, Greensill wined and dined and private jetted ARBF portfolio manager Tim Haywood, and so naturally Haywood bought as much of the Greensill-originated loans as humanly possible, topping out at 12% of ARBF NAV. LOL. The loans, of course, were not as they seem, Gupta’s companies were nowhere near as solid as they were represented, and GAM ended up firing Haywood and seeing their stock price crater. Lots of people lost lots of money … end of the road for Greensill, right? Nope.

Enter Masayoshi Son, CEO of Softbank, who ended up putting $1.5 billion into Greensill in 2019 through Softbank and then another $1.5 billion into Greensill through the Vision Fund, becoming Greensill’s largest investor and diluting the prior largest investor – General Atlantic – from a 15% to a 7% position. And then the fun begins.

Since that 2019 rescue, Greensill has lent billions of dollars to Softbank and General Atlantic affiliates (mostly Softbank, but GA looks plenty stinky here), loans that were then bought by Credit Suisse funds and laundered by Greensill’s German bank subsidiary. Now when I say ‘laundered’, I don’t mean that metaphorically. The German banking and markets regulator, BaFin, has suspended Greensill’s banking license and referred the case for criminal prosecution.

Here’s an example of how the scam worked. Again, it’s a story as old as capital markets. In early 2020, Greensill lent Softbank portfolio company Katerra $435 million. The company ran into … errr … operational difficulties, and Softbank ponied up $200 million in additional capital last December. For its part, Greensill wrote off the $435 million loan in exchange for … again, wait for it … 5% of common equity. LOL. The $9 billion valuation for Katerra (I am not making this up) was determined by Softbank, of course, and so the Greensill German bank subsidiary reported on its balance sheet that all was well. A $435 million senior loan, secured by trade receivables, was exchanged for a 5% equity position in a bankrupt company, with no loss reported. Seems fair!

As always, the best way to rob a bank is to own a bank.

Second best way is to find a really big bank to buy up all the crap loans you originate, and that’s where Credit Suisse comes in. After the GAM debacle in early 2019, there was zero question that the loans Greensill had been selling to Credit Suisse for years were just as stinky as the loans they had sold to GAM. And yet Credit Suisse did … nothing. Actually, that’s not fair. They purchased MORE of the securitized loans from Greensill than ever before. They marketed their funds HARDER than ever before.

I’m sure it’s just a coincidence that Softbank put $500 million into the Credit Suisse funds after their 2019 Greensill investment.

I’m sure it’s just a coincidence that Credit Suisse was the lead advisor to Greensill when they raised hundreds of millions in new capital at a valuation of $7 billion all of … [checks notes] … four months ago.

I’m sure it’s just a coincidence that Credit Suisse and Greensill found a Japanese friend-of-Softbank insurer, Tokio Marine, willing to put a wrapper around the Greensill loans so that Credit Suisse could market these Greensill lending facilities as … one more time, wait for it … a safe-as-houses money-market fund.

Money quote from an investor in this $10 billion Credit Suisse fund family, per the FT:

“You thought you were in an arm’s length arrangement where all your fellow investors had a pure financial interest,” he said. “Imagine you then found that, in fact, some of your co-investors were funding themselves.”

Yep, imagine that. Like I say, it’s a story as old as capital markets. Here’s a fun fact. Did you know that Credit Suisse has paid more than $9 billion since 2009 in legal penalties and settlements?

But then the house of cards came tumbling down. Something spooked Tokio Marine (they’re now putting the blame on a “rogue underwriter”), and once the insurance wrapper came off, Credit Suisse professed shock … shock, I tell you! … as they suspended redemptions from the funds (LOL) and announced a hard-hitting internal investigation into how it was possible that this could have happened. I’m sure they’ll find a “rogue portfolio manager”. And then Credit Suisse dropped a dime to the German bank regulators, BaFin, who after the Wirecard debacle were apparently only too eager to show that they weren’t totally corrupt and incompetent.

So here we are. The ECB is now asking whether or not the situation is “contained”.

Will it be contained? Will all this be swept under the rug? Probably. Apollo is apparently going to buy the shell of the Greensill trading platform for less than $100 million (down from $7 billion a few months ago), and bury this as deep into the bowels of the Earth as it is possible to be buried. Pretty much all of the Greensill directors have resigned and claimed the Sgt. Schultz / Hogan’s Heroes defense (“I see nothing! I know nothing!”), including Lex’s brother (I guess Elon is not the only one who likes to keep board seats in the family). So I am certain that we will hear this week from the ECB and other bank regulators that the situation IS, in fact, contained.

And I’m also certain we’ll be treated to another barf bag Softbank earnings deck this quarter, where Masayoshi Son waves his hands with extra vigor to explain away the Greensill “investment”. Here are some of my personal faves from last year’s virtuoso performance in narrative construction after the Wework debacle. Again, I am not making this up.



Then again … maybe Lex Greensill is feeling a wee bit abandoned by his erstwhile friends at Softbank or General Atlantic or the UK government. Maybe Gupta’s GFG steel business or some of these Softbank/Vision Fund companies can’t find short-term financing to replace their sweetheart deals at Greensill, and lots of people lose their jobs. Maybe there’s a bad email at Credit Suisse. There’s always a bad email.

So maybe this won’t be swept under the rug after all. And if it’s not …

This is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.


94+

A Freaky Circle

21+

Source: Thor Ragnarok

A quick but important note: We don’t have a dog in this fight. But we are conflicted. We have subscribers at almost all of the firms being mentioned. Our principals have done business with many of them. We’ve been clients of some, too. We like most of them. On both sides. We also don’t really care what any of them think. Make of it what you will, but clear eyes, even with us.


THOR: How did you…

KORG: Yeah, no. This whole thing is a circle. But not a real circle, more like a freaky circle.

THOR: This doesn’t make any sense.

KORG: No, nothing makes sense here.

Thor: Ragnarok (2017)

The whole of Thor: Ragnarok is pretty outstanding, as far as action-comedy films go. But the prison scene is almost certainly my favorite.

The premise is absurd. Thor – the guy in the picture above who isn’t a walking rock, if superhero movies aren’t your thing – is trying to escape a room that is plainly a circular hallway by dashing forward. It is a silly thing to do in the first place. Most circles boast that pesky feature whereby moving forward in one direction always brings you back to where you started. This room, however, is further designed so that running in one direction on the circle apparently doesn’t permit you to run all the way around the circle. You are, perhaps randomly or perhaps predictably (the audience never learns, exactly), transported back to where you began.

Why go through the trouble of creating a freaky circle whose magical affectation simply recreates the most basic identifying feature of a garden-variety circle, that is, that trying to go forward will only bring you back to where you started? As Korg and Thor both observe, the whole gag doesn’t make any sense.

All of which is why it’s perfect. And why it’s a perfect meta-joke. The freaky circle makes sense neither as a prison element nor a plot element. Making it both, however, makes it work for both. You, the audience, now feel a bit of the “Wait, what? Why?” confusion that Thor felt. Brilliant. Absurd.

But for all its absurdity, doesn’t it also feel a little bit familiar?

After all, the usual shenanigans of our financial world bear the same garden variety features that they ever did: too-big-to-fail gain privatization and illiquidity/loss socialization. A half dozen institutions discovering how to leach value via transactions and flow on every novel method to “democratize investments“. The rest of the nominal agents of the investment and corporate world leveraging the prudent man rule to capture as much value from principals as possible before the music stops, all under the guise of “yay, alignment.”

Nothing new under the sun and all that.

And yet somehow the ways in which each of these garden variety features manifest has been made so impenetrable, so arcane, so purposefully complex that we’re left to wonder why they even bothered with the layers of artifice in the first place.

In other words, it’s freaky circles as far as the eye can see.

But I think that you, Korg, Thor and I got something wrong. It does make sense if we think less about what it means for us and more about what it means for the designer of the room. And there is only one possible reason why the designer of the circular prison – or, say, the construction finance lender who was transforming their industry using AI and Big Data – would create a Rube Goldberg device that caused us to end up in exactly the same place we were going to end up anyway.

They do it because it is helpful to them that it doesn’t make any sense to us.


We wrote about it briefly before – but I just keep coming back to this Dyal – Owl Rock SPAC tie-up.

I’m still not sure what to make of it.

As we explained in that prior piece, Dyal is a private equity manager that, through funds it raises from the capital of big institutional asset pools (think pensions and university endowments), buys stakes in the management companies and general partners of other asset managers. It has a particular expertise buying stakes in private equity and credit shops.

Here’s what we wrote about the “Blue Owl” deal in December:

The TLDR is this: one of Dyal’s funds bought a minority stake in one of the biggest private credit shops in 2018. Their funds bought a minority stake in a big direct lending / BDC sponsor firm earlier this year. The latter (HPS) formed the sponsor to a SPAC (Altimar) that has made a proposal that would merge the former (Owl Rock) with Dyal (the GP), its minority private equity investor.

Russian Nesting Deals, Epsilon Theory, December 3, 2020

This was weird enough on its own. But if there’s a strong signal for “you’re on to something” here at Epsilon Theory, it is when publishing something brings a paucity of attention in our comment section and social media – but a lot of direct attention from people in the industry. And this one did exactly that.

Sure enough, within a matter of weeks, we read of not one but two lawsuits from portfolio companies the Dyal funds had bought stakes in – Sixth Street Partners and Golub Capital – seeking injunctions against the proposed merger/IPO with the SPAC sponsored by the Dyal affiliate.

If this is not your world, know that these are not tiny shops. This isn’t a single-store franchise in Des Moines standing up to corporate. Once upon a time, Sixth Street may have been your usual spin-out-half-of-a-Goldman-desk-in-2009-and-see-what-happens story, but the erstwhile special sits team that formed this company has built something really big and really successful. Different backstory for the Golub team, but same end-game. This is a huge private credit shop.

While we’re at it, you could say the same thing for Dyal. Their ideas for how to exploit the underserved market need for liquidity for the owners of asset manager GPs germinated well after those of Petershill (Goldman) and roughly around the same time as those of Blackstone. Who are Goldman and Blackstone? Yeah, in this niche, that’s the universal Jeopardy question to the answer, “The two firms you absolutely would not want to compete against if building a new investment industry-focused private equity business from scratch.” Even so, Dyal still built a leadership-level position. Theirs is a ridiculous achievement. They’re absolutely enormous. Good for them.

Same for Owl Rock. The placard on this particular door hasn’t been around very long, but anyone who doesn’t know Doug Ostrover doesn’t know anything about this corner of our industry.

And so, because these are all legitimate Big Boys, and because these firms in question are already in partnerships with one another that must work, the internecine lawsuits themselves are a Big Deal.

The basic contention of both Sixth Street and Golub is that (1) they have a consent right to the transfer of ownership in their companies and (2) there are demonstrable breaches and/or reasons to believe that breaches of confidential information would be inevitable and endemic to the contemplated post-merger business model of Blue Owl – the contemplated Dyal/Owl Rock entity. In other words, Sixth Street and Golub think they get to vote on the deal, and they think there’s no way that Dyal, their financial sponsor – which as Blue Owl will now be a direct competitor in the credit space – can credibly say they can or will abide by confidentiality requirements about their activities.

I have no idea if the former claim is true.

Most private equity investments take place through a series of limited partnership vehicles. It is certainly quite common for a private equity partnership to require consent to transfer an interest from one limited partner (LP) to another. The same is true for most direct private equity investments in companies. Likewise, a change in control of the management company with an advisory agreement with a fund will usually trigger a consent or proxy process among the fund’s limited partners. Securities laws governing investment advisers require it, in fact, although since the client is technically the fund and not its limited partners, there IS an aggressive posture a private equity manager might take that runs an end-around on LPs. They rarely do so, and usually proceed with the usual LP consents. After all, if the purpose of the change in control is to create equity value for the private equity manager, there’s no quicker way for a company reliant on raising new funds to destroy that value than to piss off their big LPs. In this case, the LPs are being asked to consent, so that’s not really the question.

The question is whether a change in control of the management company to your usual private equity limited partnership would trigger an affirmative consent right for the underlying investments of that partnership. That would be really unusual. Then again, what Dyal is doing involves a level of partnership that is really unusual in private equity, and they are, in a sense, potentially in the same business as the companies they acquire. It is entirely reasonable that the purchase or operating agreements might contemplate such a consent right, and entirely reasonable that they might not, but without reading the actual, unredacted documents it is impossible to know.

As to the second claim? Look, you do a deal like this because you want a public market for your interests. Maybe because you want more independence and upside that currently belongs to your parent. Maybe because you know that when it comes to scale in this industry, more is almost always better. The reason you have to tell limited partners in the funds you manage that you are doing a deal (since one does not really tell one’s clients “duh, because I want cash for my super-illiquid equity interest some day, you dummy”) is because of “resources” and “access to deal flow.” All of which makes it sort of awkward when you also have to say to portfolio companies and courts, “We will prevent any sharing of information that would constitute competition with our own portfolio companies.”

Sort of like telling your clients “We will never use flour” and then issuing a press release that says, “We are excited to launch our new bread-making business.” They aren’t literally contradictory, but I mean, c’mon. Some lawyers are gonna make the tiresome expression “robust controls” do a hell of a lot of work in the next few months.

So maybe they get some kind of injunction and maybe they don’t. In any case, no matter how strongly you might feel about it, my gut feeling is that no one’s gonna stop a deal over the latter claim. Courts and regulators have created such a powerful narrative around “yay, robust controls!” that even if one party is literally telling their own LPs that doing things the controls would make really, really hard is the justification for doing the deal, our collective willingness to believe that information will not be shared in Bad Ways knows no bounds.

As for the former claim – which, again, may or may not have merit – Dyal has made their position abundantly clear:

Sixth Street is attempting to assert the existence of a consent right that we believe simply does not exist. We appreciate the broad support from investors, partner managers, and other key stakeholders. The strategic combination is tracking towards a close in the first half of this year.

Statement by David Wells, Outside PR for Blue Owl, as quoted in Institutional Investor

That may be true, too! The funny thing about it, though, is that at least some of this “broad support” appears to be a wee bit engineered. I know it would have been better to make a “manufactured consent” reference, but if you’re jonesing for Chomsky, you’re reading the wrong Epsilon Theory co-founder.

What do I mean by “a wee bit engineered?”

Well, the parties that the PR guy is presumably referring to (other than other portfolio companies) are, namely, the limited partners of the various Dyal and Owl Rock funds, the voting shareholders of the Altimar SPAC and the shareholders of the various Owl Rock-sponsored BDCs. In other words, a lot the people who do get to vote on the deal. OK, the people who get to vote on advisory contracts that are conditions to close the deal. Same difference.

Thing is, a number of the largest limited partners in the Dyal and Owl Rock funds and a couple of the largest shareholders in the Owl Rock-sponsored BDCs who have the effective right to consent to the transaction are also companies who own a piece of an Owl Rock management company holding entity. Little perk of being willing to seed private BDCs with a 9-digit wire transfer. In other words, there appear to be a range of institutions who may not necessarily be aligned with other LPs and shareholders.

In most cases, those institutions probably have an unencumbered right to vote, but even if they decided because of affiliation concerns or conflicts not to do so or to do so at a capped level, a non-abstention non-vote (i.e. where you just sit on the ballot) is still helpful to one leg of the 1940 Act’s proxy rules. And if even that weren’t true, it remains true that narratives of “unfairness” or “imprudence” begin with the big, credible institutions – or they do not begin at all. Because the fiduciary rule is built around this concept, the implied consent of the largest, most credible institutional players not only removes the risk of assent, but may even create risk to dissent.

Who are those institutions? For the most part, really sharp, well-run places with good folks running them. Like the State of New Jersey.

Source: New Jersey Division of Investments, December 2020 Monthly Director’s Report

And Rhode Island.

And maybe Oregon. Truth be told, I’m not sure if Oregon took Owl Rock up on the management company stake or not, although it seems to me they certainly would have been eligible for it at a $150 million commitment to ORCC III. Fun fact: they announced that commitment at the same time they announced a $125 million allocation to a Sixth Street European specialty lending fund. Small world.

Probably South Carolina, too, although if so, perhaps they’ve made the decision to merge that management company interest into the line item reporting their LP commitment on CAFRs. There are plenty of sharp allocators down there, so it seems like a reasonable assumption.

In short, Asset Manager A is merging with Asset Manager B, into whose equity securities Asset Manager A has already caused its own clients to invest, and to whom Asset Manager A has caused others of its own clients to lend money to, and is doing so through the acquisition by a SPAC sponsored by Asset Manager C, into whose equity securities Asset Manager A has also caused its own clients to invest, meaning that clients of Asset Manager A who had intended for their capital to be deployed on an arms-length basis are now effectively becoming both creditors and equity owners of Asset Manager A by merits of their enlistment of them as a vendor, and effectively both paying and receiving transaction fees and expenses to and from Asset Manager C, respectively. And this is able to happen, at least in small part, because Asset Manager B has granted equity ownership that would gain value in a transaction involving Asset Manager B to very large investors in their products who accordingly have a significant say in the outcome of a vote involving a transaction involving Asset Manager B.

Or, in the immortal words of Ray Stevens:


Source: Some YouTube Video of the Ray Stevens classic “I’m My Own Grandpa”

Alternatively, if you are a small LP or BDC investor who is wondering what is going on here, and you weren’t large or important enough to merit getting a seed deal, let me translate the message to you:


Oh no! Anyway Blank Template - Imgflip

But here’s the real conundrum:

I’m pretty sure there’s not anything illegal going on here.

Unless there’s a real cause embedded in the agreements among these parties, I’m not sure there’s anything tortious going on here.

Hell, I’m not even sure there’s anything wrong going on here.

When Owl Rock gave all those big pensions and endowments effective GP ownership for their seed investments, what they were doing wasn’t unusual. It certainly wasn’t illegal. It was an entirely rational response to the power of a large block of capital with an appetite for risk. It is a power (because of my seat, not relatively unimportant me) I have some experience wielding. In my prior life, we squeezed external manager fees into oblivion because we could and because we felt that we should. We bought a stake in Bridgewater for Texas Teachers, an opportunity that came to us because we were a huge, strategic, long-term limited partner. An opportunity you probably didn’t get to see.

We got to negotiate better structures than the deals you probably got, not because we were smarter or more charming, but because we were representatives of a $100 billion+ pool of assets. We also selected a hedge fund seeding / incubation partner whose offering included potentially getting us GP stakes in various funds in the same way all these big pools of capital did. I’m a big fan of the guys at Reservoir we ended up hiring to do exactly that.

There is nothing inherently nefarious about offering those deals. And nothing inherently nefarious about accepting them. Maybe you disagree. Fine, in which case I am nefarious, because I not only accepted these deals, I demanded them as a representative of an asset owner.

Nor is there anything inherently nefarious about the big institutions who will participate in the Altimar PIPEs that will grease the gears of this whole construction, or whatever benefits were offered to them in exchange for their support. Yes, even though it’s Koch and whatever other bogeyman some might be tempted to summon to make all this seem blatantly evil, which it isn’t.

Still, if you are a smaller institutional limited partner in some of these funds wondering why you’re being jawboned about why “this is going to give us access to so much more in-house expertise!” and why “these lawsuits are no big deal!” and why “this isn’t a distraction, we are still aligned with you!”, so vote vote vote, I hear you.

And if you were a retail investor in the public BDC because you liked the yield and felt like your interests were served by the mutual self-interest of other equity owners, but then discovered that maybe some owners were more equal than others, and that maybe the goal of the adviser affiliate hired by the BDC wasn’t just to maximize the returns of the BDC but of the adviser, and that maybe you’d like to express that with your vote, and that maybe you’d like to join with other BDC investors in doing that since clearly they’re in the same shoes with you and…oh.

I hear you, too.

If I were a ‘partner manager’ with business overlaps, I would probably be hopping mad, and that’s without even being party to any of the ‘partnership’ discussions. And yet, if I were a limited partner in one of the funds managed by the advisors in question, I would probably still vote yes on my proxy for the new advisory contract. First, because the GPs in question are really good at what they do and, in some cases, just about the only game in town. A no vote isn’t going to get me those cheap co-investment rights on the next fund, and that probably matters more to my stakeholders than whether some not insignificant conflicts are being appropriately managed – or even that it is possible to manage them. Second, because the problem here, at least in my opinion, isn’t that the people here are bad or that they’re doing extremely bad things for investors.

The problem is that investors in 2021 are sold on a meme of markets in which equity owners and limited partners are “protected” by the mutual self-interest of other equity owners and limited partners (and boards, LOL) without taking into account that nested ownership structures allow powerful institutions to create incentive structures which manufacture…er…compliance for enough of the “important” participants to eliminate the effective agency of small institutions and individuals.

The problem is that we have decided to vest immense power into narratives about “incentives” and “alignment” and the ability to have “robust controls”, when we know that each of those things is fragile to any change in assumptions about the underlying aims of the principals and agents involved. Here’s a rule of thumb for you: they want a clear path to liquidity, and everything else is just pretty words.

The place this game leads us toward is a circular prison. Those who were sold on the “democratizing power” of vehicles like BDCs and SPACs that give “access to asset classes previously only open to big institutions” will realize that, as with every other investment, the sponsors will take their cut, and the big asset pools will take their cut, and the GPs that end up having lent money to themselves with their clients’ money will take their cut, and at the end of the day, what you get is whatever they couldn’t claim.

Same as it ever was.

The only difference is that the artifice through which all of this is achieved is far more obtuse, far more engineered, far more designed for the purpose of allowing those parties to do those things without opposition. I’m not saying that the Blue Owl transaction is unique. Quite the contrary. I am saying it is par for the course in outcome, except that its very structure is designed to distract or abstract from the manifold conflicts embedded in it to make that outcome more likely. It is a freaky circle, a thing which ends up at the same place but accelerates and ensures its outcome.

And makes us wonder what the hell is actually going on.

I DON’T know what that outcome will be for Dyal limited partners. I DON’T know what it will be for Owl Rock limited partners or shareholders in its various BDCs. I DON’T know what it will be for Dyal portfolio companies. These are really good investment firms with really smart people. If anyone can make a weird-ass, convoluted deal work, it’s them.

What I DO know is that everything we are telling limited partners and shareholders about the democratization and alignment of their interests across markets, not just for this particular deal, is complete nonsense.

If you know how to parse those two truths, please let me know.

21+

The Fed’s Kryptonite

6+

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



Overview

Last November in Blue Wave I wrote:

“The coming stimulus isn’t a panacea! It means massive deficits will persist. They will require higher taxes and incredible amounts of US Treasury issuance. Higher TAXES and rising LONG-YIELDS (all else equal) are the price for stimulus. The former drags on growth and earnings while the latter will require a Fed response that occupies its balance sheet. If the Fed does not act, higher yields will derail risk assets, just as they did at the end of 2018.”

For months, I’ve written that equity market participants have been ignoring the possible tradeoffs that come with massive stimulus: higher taxes and higher yields. I have strongly suggested that stimulus won’t place the economy back on some exceptional pre-pandemic growth trajectory. Sustainable growth comes from innovation and productivity gains – not from stimulus checks. Moreover, I have argued that the Fed’s ability to stimulate (asset prices or the economy) has been limited because rates and yields are already so close to zero. For some time, I have reasoned the risk of a rise in yields has been asymmetrically high.[1] Now that I believe the risk of non-transitory inflation is elevated without the durable and sustainable growth to justify it (a change in view), the Fed is confronted with an even thornier problem. In stark contrast to my view, the popular meme has suggested fiscal policy wouldn’t have any negative impacts, and equities would continue to rise on the multiple expansion that low rates would assure.[2]

Yesterday, as the 10-year yield hit 1.6%, equities sold off. How much higher might yields go? Something as seemingly straightforward as the impact of inflation on bond yields is the subject of debate in academic circles. Thank goodness I’m not an academic; I care about what makes sense rather than about defending any particular school of thought. The first order effect of inflation on yields (‘reflation’) has merit, but it has its limits. Based upon Fisher’s real rate of interest framework, and despite the obvious shortcomings of his Quantity Theory of Money (QTM), this idea is generally accepted.[3] However, one must consider other factors. Ultimately, the analysis of yields must center on market participants’ expectations for the Fed’s reaction to both inflation and Treasury supply. Said differently, term premia depend largely on uncertainty around the future path of rate policy. For now at least, it appears the current pace of Fed purchases isn’t keeping yields in check. Under current circumstances, inflation is the Fed’s kryptonite.


Discussion

Let’s discuss three forces that may move Treasury yields; they are interdependent. First, there’s inflation. Next, there’s Treasury supply. Third, there’s the Fed reaction function, which ultimately plays the most crucial role. What about the idea taught in college neoclassical economics class that the interest rate is the clearing price for money at which savings equals investment?[4] This kind of market determined interest rate equilibrium exists only in a reserve constrained regime (i.e. –gold standard), in which the monetary policy authority does not set the price (i.e. – interest rate). Today, the Fed serves as a monopolistic price setter of interest rates. By deciding how it conducts OMOs (open market operations; i.e. – the scope and duration of Treasury purchases), the Fed influences bond prices and sets interest rates. Quantitative easing is a form of OMO that acts directly on long yields, whereas traditional OMOs (in a system with fewer reserves) acted on short-duration Treasuries.[5] Consider this: theoretically, if there were no Treasury issuance, the Fed could simply create reserves and use those reverses to directly fund Treasury deficits.[6] It could do so without Treasury issuance and without creating reserves to buy those Treasuries. However, Treasury issuance and the Fed’s operations around it are the principle determinant of yields across the curve. QE was a game changer.[7]

Inflation is the only wildcard that might interfere with its game plan. As I discussed in my most recent paper Inflation Perspiration, I’m now concerned about inflation for the first time since the GFC ended. Fed communications that it intends to tolerate inflation above target under its new average inflation targeting framework will only go so far. It’s rarely had to deal with fiscal policy stimulus well in excess of what is necessary to close the output gap. Exacerbating this dynamic are still challenged supply chains. We are seeing this in semiconductors. Commodities, too, are screaming inflation, as the fiscal stimulus and supply chain disruptions are global in scope. The Fed might want to have a conversation with the executive branch to indicate that a policy mistake could lead to inflation that forces a hike or leads to higher market yields about which the Fed decides to do nothing. Markets do that: they correct for interventions by acting in unforeseen ways. In this case, the reflexivity is occurring in yields. In coming days, it will be interesting to see whether or not the belly of the curve begins to flatten. The belly tends to move first, and if 5-year yields begin to pick up relative to 10s, then it may indicate that expectations about the probability of a hike are increasing. If 5-10 continues to steepen, it could indicate that the rise in 10-year yields is more about fears about supply.[8] Either way, long-duration yields and term premia reflect uncertainty around the path of future rate policy.

Bond Yields: Inflation

Let’s first consider inflation and how it might work to impact Treasury yields by first order effect through inflation (Fisher). Consider this identity:

i = r* + E(π) where i = nominal rate, r* = the real rate, and E(π) = expected inflation.

One needn’t accept QTM, for this framework to be useful. By this definition, an inflation expectation is built into nominal yields, but it’s important to recognize that this expectation may be adopted over time as inflation becomes self-reinforcing. Arguably, yields represent the opportunity cost associated with 1) choosing saving versus consuming or 2) choosing one form of savings versus another.[9] What is the market mechanism by which yields adjust to inflation? When some economic actors perceive durable or storable goods as being more expensive in the future, their preference may shift from saving (in the form of Treasuries) to buying those goods now. That is to say, the fixed income from the Treasuries will buy less of the same refrigerator later. For this reason, they might sell Treasuries, convert them to cash, and use the cash to buy a fridge. As these expectations are adopted, more market participants sell their Treasuries, this will result in successively lower prices for Treasuries (higher yields) until the yield is eventually high enough that it meets the market expectation for inflation. A new market consensus about future inflation brings yields to a new equilibrium (all else equal and with no government intervention).[10] This is but one dynamic.

The owner of Treasuries foreseeing inflation may also decide, rather than change his/her preference to consume rather than save, to change the form of savings. Logically, s/he may wish to own an asset whose stream of cash flows (unlike Treasury bond) changes with inflation. Perhaps commercial real estate with short term leases or LIBOR based loans might fit that bill. Even when reframed as Keynes might, the reason for this change in ‘liquidity preference’ is because that person wants to transform the Treasury into cash and (quickly) redeploy the cash into an asset that benefits from inflation. No matter how it’s cast, it seems plausible that yields may rise with inflation because the cash flow from Treasury ownership is less valuable in real terms.[11] In this way, inflation, disinflation and deflation may still exert some power over yields. In turn, as yields rise as part of this dynamic, this may tighten financial conditions enough to reflexively control demand-driven inflation without Fed intervention.[12] Perhaps, the Fed will allow that now.

Bond Yields: Reaction Functions

There’s a second order effect of inflation: it causes the Fed to react – creating uncertainty around the future path of rates and yields. It’s likely even more important than inflation’s first order impact, as the Fed has an arsenal of tools designed to manage rates and yields (including unlimited reserve creation as part of QE). Thus, what rising long-yields and greater term premia are saying is that the bond market expects inflation to prompt the Fed to raise rates. Mathematically, yields over ‘n’-periods are given by the geometric average of the short rates that prevailed in each period. Thus, if the expectation is for persistently low short-rates, long-yields should be anchored to that expectation.

There’s another way to think about this through bond market dynamics. If bond investors are confident the Fed won’t hike, they will buy the long-end and sell short the short-end to fund the purchase. In turn, this carry trade arb knocks down long yields towards funds. The more certain market participants are that Fed funds in anchored, the less term premium remains after the arb occurs. The risk to the carry trade always comes from a change in the cost of funding (short rates). This arbitrage is a form of duration transformation, and so is QE. When the Fed ‘quantitatively eases,’ it takes the following steps: 1) it creates excess reserves (i.e. – issues FRNs or cash); 2) it creates a reserve liability on its balance sheet; and 3) it buys Treasuries with the excess reserves. All of this effectively funds short (issues FRNs) to buy long and transforms the duration of longer-duration Treasuries into that of cash (i.e. – none). The Fed’s willingness to do this ‘arb’ is only constrained by its own expectations about inflation!

For this reason and others, the Treasury yield curve likely does not steepen as much as we’ve seen it historically. We usually see 3-month 10-year spread above 300 basis points at its widest. We’ll be lucky to see it above 200 basis points this cycle. It certainly can’t bull steepen anymore with funds at zero. The bear steepening will be self-moderating because the market and economy can’t take a move much above 2% on the 10-year, as the regression in Figure 1 shows. Lastly, were the steepening to persist for too long on persistent inflation, the Fed might be forced to hike, but it would be more likely that higher long-yields would do the Fed’s work for it. Bond volatility hit its low last September and again in March. Exhibit 2 of the Appendix may provide some context for just how much bond volatility the Fed is willing to tolerate. It seems like the MOVE index could go back to the 90, which is the regression prediction.

Bond Yields: Taper Tantrums

The Fed reaction function is also important when it comes to absorbing Treasury supply.[13] ‘Taper tantrums’ are yet another way to characterize what happens when there’s uncertainty about the path for future policy. This is what market participants generally talk about when they speak of the ‘taper tantrums’ during periods like 2013 and 2018.[14] In 2018, yields rose to 3.25% at the end of the year. It wasn’t Fed policy in reaction to inflation that did it, it was the Fed’s attempt to normalize its balance sheet. It perceived inflation was persistent enough for it to begin selling its Treasuries just prior to maturity. PCE had been above 2% since July 2018, so the Fed maintained its confidence about taper in its December meeting. A taper tantrum followed this stubborn communication around the trajectory of policy. Equities sold off, and yields reflexively fell in response to this risk off. This led to an early 2019 inversion of the U.S Treasury yield curve. Because financial markets and the banking system, upon which the economy relies, don’t function well with an inverted curve, the Fed does not tolerate it for long.

Figure 1 shows the downtrend in 10-year yields since 1994 (RH; orange). That downtrend is banded by a regression at 1SD (yellow) and 2SD (red). The regression suggests that about a month to 6-months after an extreme (2SDs) in yields, equity market corrections occur.  We observed this in early 2000, mid-2007 and 2018. In turn, a yield curve inversion often follows, and the Fed is often forced to cut. That cut normally results in a bull steepening. It’s also interesting to observe that yields typically fall after the initial and extreme move above trend only to rebound to just above the trend prediction (blue dotted), just as they did in 2001 and 2008. Yields appear to be doing something similar now. In those instances, equity selloffs persisted. Here’s where the reflexivity comes in again: if equities sell off further, they may do some of the Fed’s work for it. Capital may flow back into Treasuries from equities and may drive 10-year yieldsdown – perhaps, even enough that the Fed does not need to increase the pace of bond purchases. The difference now is that yields are already so close to zero in the ZIRP (zero interest rate policy) world.

Convexity hedging is another reaction function, which is often discussed when yields begin to rise quickly. This one is market based. At times it’s overblown, but in light of how active the mortgage market has been at such low rates, it’s worth discussion here. Unlike most bonds, mortgages demonstrate negative convexity. Convexity is the rate of change in duration when prices change. When rates fall, mortgages tend to be prepaid and refinanced. This shortens portfolio duration (negative convexity). As rates rise, and holders of mortgage securities see the duration of their portfolios increase, they sell Treasuries to shorten the duration of their portfolios. Exacerbating the dynamic now are low bond yields; convexity is higher when interest rates are lower. Thus, smaller moves in yields mean a bigger change in portfolio durations and require more Treasury sales. At times, this activity may exacerbate moves in the Treasury market. The Fed plays a role here, too, as it owns ~35% of the MBS market and it does not hedge.

Bond Yields: Equities

I have often rebutted the argument that low rates and yields mean higher P/Es as a matter of logic. They don’t, and higher yields because of inflation without durable growth are unwelcome in equity markets. First, low yields do not drive multiples higher. Only lower yields can do that. Near the S&P’s recent high, the 10-year yield was at 61bps. Last I check ed, Fed funds have been near zero for quite some time. Second, P/Es (once converted to equity yield) can’t be compared to Treasury yields until after adjusting for inflation. Only when real yield moves lower is inflation good for equities relative to Treasuries. Currently, real yields are creeping higher. Third, an assessment of P/Es requires not just a comparison to real rates, it also depends on what market participants require as an equity risk premium (ERP), which moves with expectations for earnings.[15] Surprisingly, required real ERP for equity investors has been increasing since 1990. As it has since July, Exhibit 1 of the Appendix shows that ERP (red) looks quite expensive. It is currently about 1.5SD rich to the regression prediction line (lower ERP indicates less premium and, thus, more expensive).

Not all equities will be impacted alike if inflation presents more persistently than most believe. Mature large, cap technology companies whose revenues streams from the cloud and subscription software services and whose cash flows are more like bonds than equities may be impacted more than growth technology names. Likewise CRE REITs whose portfolios have sticker, long-term leases and utilities won’t fair as well in an inflationary environment. Cyclical commodity and energy companies could benefit, albeit, eventually inflation makes life difficult if costs can’t be passed through to customers. Small caps, in particular, remain recklessly overvalued as retail flows have inflated their values.


Conclusion

The economy and markets are highly sensitive to interest rates and yields. The equity market’s reaction to 10-year yields at just over 3% in 2018 seems to provide some anecdotal evidence of this. The Fed will try to avoid persistently higher yields at all cost; normally QE would enable the Fed to fund short to buy long and keep bond yields under control. However, inflation complicates its motives. Profligate fiscal policy, unlike monetary policy, can be quite effective at prompting an inflationary overheat if the stimulus significantly enough exceeds the amount of the output gap. The first two rounds of stimulus have largely filled that gap. With annualized fourth quarter 2019 GDP at $21.75 trillion versus annualized fourth quarter 2020 GDP at $21.49 trillion, down 1.2% year-over-year, there is a good chance that another $1.9 trillion in fiscal spending will put year-over year GDP growth up between 6% and 7%. Moreover, the release of 50% of pent up savings (currently 13% of disposable income) could release another $250 billion into the economy.

Inflation caused by demolition of the output gap could be exacerbated by supply chains that are just now starting to heal from a supply-side shock. In semiconductors, the cause of the current shortage is a mixture of factors: demand spikes for consumer electronic products like laptops due to the pandemic-driven WFH trend, slowdowns in chip production also caused by the pandemic, bottlenecks due to an outsource of chip production to firms like Taiwan Semiconductor Manufacturing Company (TSMC), and lingering effects from the trade war. These shortages alongside a rally in commodity prices (supported by global stimulus especially in China), could make inflation more persistent as supply chains take time to heal. The Fed is in a tough spot. Where’s Lois Lane when you need her?


Appendix

Exhibit 1: ‘Real’ Equity Risk Premium (blue) Shows Equities Are > 1SD Rich versus Trend

Exhibit 2: BofA MOVE Index versus the VIX

Disclaimer

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


Notes

[1] Please see Check In: To Infinity and Beyond, August 17th, 2020 and see Exhibit 2 of the Appendix.

[2] I have continuously asserted that low rates alone do not lead to multiple expansion; only lower rates can do that and only assuming that risk premia stay constant. So close to the zero bound, traditional policy is stuck.

[3] As Eric Tymoigne of the Levy Institute argues: “Changes in interest rates do not reflect changes in the opportunity cost induced by inflation in the present/future consumption arbitrage, they reflect changes in uncertainty that affect the stock equilibrium between liquid and illiquid assets.” As it turns out, this statement is far less profound than it first appears because, as he later states, “[the] condition of indifference [due to expectations for changes in interact rates] may include the concerns about inflation via the introduction of an inflation premium in nominal rates, but these concerns are included in the broader concerns of liquidity and solvency.”

[4] This identity holds in a closed economy.

[5] The plethora of system reserves necessitated a shift to the use of IOER as the Fed’s principal tool to manage to the funds target rate.

[6] Of course, this isn’t the way the system works!

[7] QE also helps the Fed signal its commitment to its policy to keep rates anchored.

[8] The two are not mutually exclusive as long-yields are the geometric average of short-yields.

[9] Keynesians disagree on what I take to be a technicality.

[10] This of course, assumes that different market participants have different expectations for inflation. I don’t see this as a fallacy of composition, as this is often the way markets work as they move in and out of equilibria, which are something of an academic fiction and if they do exist are usually short-lived, as George Soros argues in his Alchemy of Finance.

[11] As I will point out, it is the comparison of real 10-year yield to earnings yield that may make equities less attractive relative to bonds as inflation rises – but only if real yields are rising, too. There are also other factors to consider.

[12] On the other hand, some believe that most inflation comes from supply shortages that tighter financial conditions will only exacerbate by constraining supply further (i.e. – limiting the availability of loans that might be used to increase capacity). This is the flip side of the argument I’ve been making that low rates create overcapacity that keeps inflation low.

[13] This could also be looked at as constraining the supply to non-Fed buyers.

[14] Risk-asset markets rallied significantly because the Fed was focused on lowering yields on MBS, and that QE program purchased mostly MBS securities. This program had palpable economic impact through lower borrowing costs for homes. Recall that this program was announced in September 2012, and while focused on MBS, it also helped keep longer-dated yields down – that is, until the Fed announced a taper in June 2013. The 10-year yield rose quickly in expectation of taper and the Fed was ultimately forced (in September 2013) announce no taper would occur and the 10-year yield fell again throughout 2014.

[15] ERPf =E/Pf – (Y – E(π)) where E/Pf is the forward earnings yield, Y is the nominal yield, and E(π) is expected inflation.


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ET Podcast #6 – The Business of Wall Street

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

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

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



Very little of investing today is buying and selling shares of common stock in individual companies. Instead, we buy and sell what Wall Street calls “products” – mutual funds, ETFs, options, REITs, SPACs, etc.

Dave Nadig, who literally wrote the book on ETFs, helps us understand the history and future of the business of Wall Street.



If you’d like to sign up for a free email to let you know what we’ve published in the prior week, please go here. We have about 100,000 email recipients, and your contact information will never be shared with anyone.

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The Third Rail Switch

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Karl Rove, presenting to the California GOP (Source: LAist)

For most of the last 40 years – at least since Tip O’Neill or one of his aides coined the term – the third rail of US politics has been Social Security.

It is strange to think about. We are all MMTers now, after all, and what’re a few trillion dollars among friends? In 2021, entitlement reform is a third rail in the same way that a high-voltage power line is a third rail. Sure, it will electrocute you, but who is going to go through the trouble of getting to it? We didn’t stop talking about entitlement reform because people were too afraid of it. We stopped talking about entitlement reform because neither of the two parties has even the faintest interest in it.

Yet even during its heyday, I would argue that Social Security was never really America’s third rail. Politicians talked about it all the time, even if half of their conversations consisted of calling it a third rail. A true third rail would be an issue or policy that everyone was too afraid to even bring up in that context. It would be a topic we were too afraid to discuss at all.

I think there are a handful of these topics. Teacher unions are one of them.

And that third rail status might be changing, if only for a short while.


The California GOP held its spring convention over the last few days. Now, hope springs eternal for the GOP in California in the same way (if far less credibly) that it does for Democrats in Texas. In a big state, there is always some narrative to spin about a huge population group that can be turned – or turned out – to shift historical voting behaviors. That is especially true if you’ve got at least one well-known hotbed of traditional opposition (e.g. anything north of Chico, or the People’s Republic of Austin, respectively) in the state.

In his address to the convention, Karl Rove expressed a typical flavor of this optimism. He argued that a diverse working class could be brought into the Republican fold in California. It was not too dissimilar from the arguments Donald Trump himself relied on in 2016. But this time, Rove and other speakers were light on mentions of former President Trump as a mechanism for achieving this electoral flip. Instead, they suggested the promotion of narratives around the various misdeeds and missteps of the San Francisco School Board, teacher unions and Thomas Keller superfan Gavin Newsom.

Politico covered some of this in an article over the weekend.

CAGOP: Putting TRUMP in rearview mirror? [Politico]

…The convention was largely devoid of any mention of the single biggest influence and driver of enthusiasm in the party’s grassroots over the last four years. Republican strategist Karl Rove failed to even mention Trump’s recent tenure in the White House — and suggested that the San Francisco School Board may be more on voters’ minds this year.

Now, I don’t know if Rove is correct. Speaking personally, I suspect that avoiding the mention of Trump in either a favorable or unfavorable light probably reflects more of a Roveian keep-your-options-open strategy than any kind of well-considered view on Rove’s part about what is going to matter to voters in any coming elections. At any rate, you don’t need me to develop your own opinion on the reality of how state GOP conventions are grappling with the World After Trump.

What I DO know is that in Narrative World, Rove isn’t entirely wrong. School boards spending time renaming Abraham Lincoln Middle School or something while many teacher unions oppose safe school re-openings and make fun of parents who ‘want their babysitters back’ absolutely makes for a powerful narrative. Is that narrative powerful enough to move teacher unions out of third rail status?

It is early, and the switches on this rail are very hard to throw.

On the one hand, the generally public sector union-friendly Democratic party has a decent control on power at the federal legislative level and in many states. On the other hand, you could observe that many of the same things are true about national media – and the narrative structure of teacher unions present in national media has changed over the last several months.

A lot.


To establish a baseline, we can take a look at just five years ago, in 2016. At that time, our analysis of linguistic centrality indicates that there were three distinct narratives about teacher unions: (1) unions in our area are fighting for a fair contract, (2) unions are joining the fight against testing obsession and (3) teachers and students alike are harmed by the underfunding of schools. While coverage obviously includes op-eds and editorials that were not always supportive, in general these were sympathetic, linguistically distinct, regionally cohesive narratives.

To visualize this in part, take a look at the network maps below, each of which roughly approximates our analysis of these narratives using the software from our friends at Quid. Nodes are individual articles about teacher unions in 2016. Bold-faced nodes generally represent those we have identified as being about a particular narrative, framing or topic. As usual, similarly colored clusters are very linguistically similar. Closeness and connecting lines also indicate dimensions of linguistic similarity. North, south, east and west have no meaning outside of distance and connectivity. The short of it is the same as above: these were generally central, distinct, internally cohesive narratives about teacher unions. When outlets wrote about each of these topics, they tended to use the same language, talking points and phraseology.


Source: Epsilon Theory, Quid

Through 2020, on the other hand, while there were distinct articles about each of these topics, in our judgment they had no influence on the narrative structure of teacher unions. In 2020 there was one narrative: “districts are discussing how and when to re-open schools.” That the nodes are nearly all in bold (i.e. that they are part of this framing) is not an accident. The topic permeated practically every discussion about teacher unions in 2020.


Source: Epsilon Theory, Quid

For the first 5-6 months of the pandemic, I would describe most of the coverage as sympathetic. By September, we think it can be observed anecdotally and subjectively that a meaningful change had taken place. We also think the data bear it out. Why do we think that?

Because there was no topic that became more about the role of teacher unions in American society than coverage of the resistance to re-opening put forward by the unions serving the Fairfax County Public Schools in northern Virginia.

Because that topic, local as it was, became among the most central, most interconnected clusters of the coverage of teacher unions in 2020.


Source: Epsilon Theory, Quid

It is a small cluster, to be sure – after all, this is only one among thousands of school districts in the United States. But we think this debate framed how the narrative of teacher unions in the pandemic would shift in late 2020 into 2021. In short, by Q4 of 2020, we think the narrative began to transition from “districts are discussing how and when to re-open schools” to “why are teacher unions opposing re-opening?”

In YTD 2021, this framing – no longer mostly confined to Fairfax County – had spread, as narratives do, to all corners of coverage. The threat of strikes in Chicago. Debates over teacher vaccination policy nationwide. Varying opinions of President Biden’s One-Day-A-Week plan. And yes, the same raging debates in California.


Source: Epsilon Theory, Quid

Readers’ opinions may differ on the reality of school openings. I’m guessing they probably changed a bit over time, too.

In my own town, I was supportive of closures in March. By July, I felt confident enough in the data to support elementary school openings but was suspicious enough of high schools that I considered them a legitimate superspreader risk. By mid-September I’d generally come to the conclusion with more data that my view was wrong – too conservative. By then I believed that high schools with appropriate precautions outside of raging hotspots could – and in my area where my opinion matters, should – re-open. Today, I have some concerns about high schools in emerging B.1.1.7 areas, but none that rise to the level of changing my mind.

Maybe your path was similar. Maybe you felt more comfortable with broad re-openings sooner. Maybe it took you some time. Maybe you’re not there yet.

No matter what you believe about the reality of school re-openings or the role teacher unions have played in school re-opening policy, and no matter how that belief changed over time, in narrative world the switch on this third rail has been flipped.

For better or worse, for the first time in a very long time, everybody knows that everybody knows it is now possible to openly discuss and debate the social role of teacher unions. That doesn’t mean that anything about the relationship schools have with these unions will change. It means that it can change.

I remain concerned that this is a conversation that can and will be easily co-opted by those with a political interest in creating conflict between groups that have every reason to be aligned. Still, we are where we are. In the same way that narrative shaped a conversation about the role of police going forward in 2020, this narrative can shape a conversation about the role of teacher unions and public sector unions more broadly. My money is still on the status quo.

But I’ve been wrong before.


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ET Podcast #5 – Gnostic Nationalism

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

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

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Every political movement has a political philosophy, and for Trumpism and MAGA it’s the Dominion theology of the charismatic/Pentecostal church.

Neither the rise of Donald Trump nor the attack on our Capitol can be understood without an examination of this faith and its constructed political narratives.

There is a schism in the American evangelical church, and its dynamics will shape the future of this country.

Believe it or not.



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34+

ET Podcast #4 – Hunger Games

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

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

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



What’s happening with Reddit and Gamestop and Robinhood is a revolution, but not the revolution you think.

This isn’t a “democratization” of Wall Street. You were played. Again.

It’s a revolution in Common Knowledge. And that changes everything. Again.



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If you’d like to learn more about our subscription options, including unlimited access to more than 1,000 published notes, private content not available on the public-facing website, and engagement with an active community of truth-seeking investors and citizens, please go here.


9+

When Does the Game Stop?

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

Pete published this yesterday (Feb. 1) on his website.



Takeaways

The current state of equity markets is part of a broader progression over many years, as was the South Sea bubble, which has many lessons applicable to current circumstances.

How Did We Get Here? What’s happening now in equity markets isn’t the product of some paradigmatic democratization of finance. It’s likely just another bubble that will end badly. In my view, the behavior fueling the bubble is the culmination of many factors as follows:

  • Monetary Policy. Monetary policy action has given retail and professional investors alike comfort that the Fed has their backs at all times. Despite the fact that policy space is non-existent, the chant ‘don’t fight the Fed’ is burned into peoples’ minds. Pavlovian responses are hard to break. Low rates have also enabled companies to issue inexpensive debt (as Apple just did) to buy back shares and increase share scarcity. Notwithstanding this scarcity, low rates do not lead to ever-higher valuation multiples. It takes lower-and-lower rates to do that. At zero, they can go no lower.
  • Fiscal Policy. Fiscal policy choices are almost always made to pander to political bases, but the extremely polarized environment has made decisions even less objective. Politicians should stop trying to get ‘likes’ and start leading by making adult choices. The fiscal policy driven explosion in money supply (M2) has helped fuel the manic demand for equities. The pandemic has made for hard choices, and the next phase of relief is a make or break decision for the economy… and not in the way most may think.
  • Technology. Social media has generally brought extreme behaviors to normalcy – whether its pornography, racism, gambling, or otherwise. Markets simply reflect the broader societal trend and have become more like casinos. That doesn’t mean the behavior or opinions should be censored, unless there is an overwhelming public purpose. For every retail investor who says F&*K IT I’M IN, there will be others – some professionals – who say F&*K IT, I’M OUT. That’s the mechanism that will correct for the current misbehavior. When markets lose credibility and rationality, investors tend to opt out.
  • Might the Game Continue? Surely, it could for some time. In particular, new stimulus (supplementary direct deposits) could continue to fuel the speculative bubble in equities despite the substantial economic tradeoffs in the form of higher taxes and rising yields.[7] Clearly, those in love with equities now aren’t considering much beyond the next time they see a confetti bomb. Even this only delays the inevitable.
  • May I Make a Suggestion? I implore legislators to consider revising the income limits for the stimulus checks. Give more to the lower income families who need it most. The $150,000 joint AGI limit on stimulus checks is absurd (at more than twice the median household income)! It may make you popular, but it’s profligate and irresponsible. At least some portion of it is being used to speculate in equity markets, and it risks overheating not only equity markets but the economy. If the latter happens, the Fed will need to raise rates sooner than it has guided (i.e. – it’s almost never guidance), and that will be a cataclysmic occurrence for markets and the real economy. Target the measures to necessities: rent forbearance, food, healthcare, unemployment assistance, small business loans, etc.

Overview

Recent price action in OTC equity markets and in roughly a dozen names with high short interest is the culmination of a broader progression. It amplifies the observation that many markets – equity markets in particular – now have little to do with the fundamentals of underlying assets.[1] What Bitcoin has in common with GameStop is the idea of asset scarcity paired with a vague narrative that ‘something big’ is happening. Shorts squeezes occur on limited supply. As the argument goes, Bitcoin is in limited supply.[2] Its success, and the reason for it, has emboldened speculation in equities. Some market participants have discovered that the value of the chairs go up the fewer chairs there are. Here’s the problem: eventually there’s just one person in a chair. The rest have nada. This kind of speculation based on scarcity isn’t new. It happened in Holland in 1636 in tulips. It happened again in 1719 with the South Sea Company… and again and again.

This is more than just a sexy story about everyman beating the big dogs.[3] It has real and broad implications. Importantly, overvaluation and mispricings in equity markets have impacted pricing in corporate credit markets. In a number of cases, companies have smartly used irrationally overpriced equities to refinance debt and maintain unprofitable operations.[4] Reflexively, this delays the repricing in equities as bankruptcy risk is diminished. A new generation of arrogant, day traders is only partly responsible. They will eventually learn – just as we all have at some point – the hard way. We’ve seen it before, and it should come as little surprise. Whether you trade out of Mom’s basement, from a nice living room with a couple of kids running around, or in a suit on Park Avenue, markets don’t discriminate. As far as they’re concerned, stupid is as stupid does – eventually, at least. Just wait … the game will stop. It’s a matter of when not if.[5]

Has the market’s malfunction finally become so obvious that the credibility of equity markets is at risk? Targeted short squeezes are not a new phenomenon nor is gamma (or leverage) in options markets. Their most recent manifestation is new. The recent squeeze serves as a convenient and plausible explanation for recent hedge fund de-grossing and last week’s market selloff, but it’s far from the only cause. Credibility in markets is essential and fragile. Paired with extremely bullish sentiment, an already extant valuation bubble, high corporate leverage, extremely high retail margin levels and institutional gross exposures, uncertainly around new virus strains, and little visibility around earnings, the end of the recent squeeze (when it finally happens) could serve as a catalyst for a broader de-risking.[6] Bubbles can pop at any time and for any reason with post facto attributions typically pointing to the most recent and obvious event.

Confetti

There’s an expression popular in Brazil: “Estou rindo para nao chorar.” It translates: “I’m laughing, so I don’t cry.” It’s laughable that the same politicians that want more regulation are now complaining about Robinhood curtailing activity when it was regulatory capital requirements that necessitated it. Those requirements serve an important public purpose; they assure the stability of the financial system. Moreover, politicians are complaining about payment for order flow, but that’s precisely what allows for commission free trading. In other words, without institutions paying for Robinhood’s flow, because Robinhood has no significant revenue directly from its online clients, it could not exist. While not surprising, it’s somehow still frustrating to hear visceral responses from the likes of AOC and others designed exclusively to pander to their bases without having even a remote understanding of market structure.

The fact that Citron’s Andrew Left and other media named short players have ‘capitulated’ may be a signal that the game is about to stop. Short interest will fall just as the pool of greater fools buying those same overvalued stocks begins to dwindle. As fewer short players participate, ‘borrow’ will loosen and diminish the scarcity. When the pool of speculators is finally exhausted – and it will be – it will be a lesson hard learned for those still in the trade. That’s what markets always do eventually; they humble all of us over time. It’s simply part of the learning curve over a long enough period of time. (Day trading for a few years does not qualify). Ultimately, markets punish those who make overly emotional or uninformed decisions. In this case, it’s taking more time than usual because of the sheer number of social media participants, most of whom haven’t seen a real selloff. The South Sea Bubble, too, was a populist event based on the public being ‘given access’ to an asset previously reserved for the elite; it took nine years to build and popped in a year.

What we’ve been witnessing is not some democratization of investing, it’s the kind of mob behavior that is almost always associated with bubbles and the catastrophe that follows. A Bloomberg story articulated it well: “The absurdist morality tale over the unalienable right of Redditors to pump up meme stocks and punish Wall Street has obscured a more reckless impulse.”[8] In order for a company like GameStop to experience a continued rush in its stock price, a few things would need to happen over time. First, it would need to generate far more revenue and quickly perform unlikely operational miracles. Revenue has fallen almost 50% from 2012 to 2021 and even optimistic projections have it rising only modestly for 2022 and 2023. Because of irrational equity markets, it could certainly do at-the-money (ATM) equity offerings as AMC has done to take advantage of its current equity valuation. That could buy it more time to fight the secular decline in its business and help it to reinvent, but no matter who joins the Board, the Chew-ification of the company has massive risk. It will take time. I participated I the restructuring of Atkin Nutritionals long before Rob Lowe became spokesman. It’s slog.

I had no idea that this was ‘a thing,’ but according to the above referenced story, Robinhood sends confetti to users when they trade: “Whenever Robinhood sends confetti to app users who place a trade, for example, it’s ‘kind of like with slot machines, they’re so colorful and loud and noisy,’ Mothner said. ‘Those little jolts feed the desire to keep going.’” Like just about everything on social media, the rush is fueled by bravado and ‘likes,’ which are pretty ephemeral. Retail may be ‘winning’ against the ‘elite’ now, but that doesn’t frame the conflict properly. We are all losers against the rest of the world if our free market system for pricing risk loses credibility. Ever hear of JT Marlin? The new Boiler Rooms are simply the online stock forums. Pump and dump is alive and well; it’s just been reinvented in a more insidious form. Eventually, thoughtful investing will return, but only after those who can least afford to lose money, lose it.

Gamma Hammer

There’s been some suggestion that the short squeeze impacting mostly hedge fund short positions is causing a broader hedge fund de-risking. It’s certainly a sexy narrative to suggest that retail traders are forcing a broad deleveraging amongst hedge funds, but is it true? Well, it’s almost impossible to know. However, market sentiment can be fragile, as Lu Wang and Melissa Karsch wrote: “Wednesday’s plunge widened to encompass stocks in the broader category of ‘recent winners.’ First among those was the ARK Innovation ETF (ticker ARKK), which surged about 150% last year with wagers on momentum-driven tech stocks.”[9] I’d written about how ARKK was a posterchild for the foolishness afoot in my last piece Fantasy World. Also according to the same authors in a different story, Goldman clients experienced the biggest one-day decrease in gross leverage on Thursday. Still, at 237%, leverage sat in the 96th percentile of a one-year range.[10] There could be more de-risking to come especially because margin leverage at retail accounts is also at all-time highs.

Leverage has proliferated in other ways. Options are, indeed, one of them. When a customer (retail or otherwise) comes in to place an order to buy an out-of-the-money option, a market maker (as opposed to an agency participant) will sell that customer the call option. That short call may sit on the market makers balance sheet; if so, the market maker is at risk. A short call is synthetically equivalent to short stock. The farther out of the money the option’s strike price, the lower the delta to that option (i.e. – its share equivalent). Nonetheless, in order to offset its short exposure, the market maker will usually buy the share equivalent of that option in underlying shares – creating a bid for the shares and potentially driving up the price. If the underlying price moves closer to the strike price for that option, the customer  may begin making money while the market maker may begin losing money (all else equal) – unless it buys more shares. In fact, gamma is the leverage on an option that makes the owner synthetically longer (and the market maker synthetically shorter) as the underlying stock price approaches the strike price. The market maker must buy more shares in response to this change.

As a squeeze occurs, this impact is exacerbated because it happens quickly – forcing the market maker to aggressively buy shares. This is how the power of the retail crowd was amplified – through leverage. It’s a temporary impact and not a paradigm shift. Now that this dynamic is well-known, the game is likely to stop as market makers aren’t dummies (just the opposite). They will take steps to hedge or modify their participation in irrationally priced securities. Some brokerages have already done so. They must protect their own capital positions in a highly regulated environment. As for some hedge funds, the squeeze in their short share positions may have prompted a temporary de-leveraging as prime brokers required more capital and eliminated margin on impacted names and potentially impacted ones, but this specific effect won’t be the singular reason for a broader selloff. This is not to say a broader selloff won’t occur, as the equity markets find themselves precariously positioned. Sometimes it doesn’t take much to break the back of sentiment.

Going South

Remembering a bit of history might help us learn from its mistakes. In the 18th Century, England was a class-based society (some might say it still is). The lower classes did not have access to markets unless permitted to do so by the elites. Such opportunities were scarce. Until 1711, when the South Sea Company formed, England had been engaged in the War of Spanish Succession. Spain and Portugal were in control of most of South American trade. Parliament looked for ways to fund its war efforts. They included two lotteries – yes, lotteries. The lotteries lost credibility when it became clear the government was providing a deferred annuity instead of a lump sum prize that it had funds to pay. The government also owed a significant sum to various private creditors, including debt owed to the public through those lotteries. The company was endowed with the exclusive right to trade with South America, under the assumption it would be able to do so after a treaty was signed.

In return for this, The South Sea Company underwrote the English National Debt. In other words, the existing national debt was cancelled and restructured as equity in the new Company, which issued shares to the former creditors with the promise of about a 6% dividend. The purpose of a series of conversions between the company’s formation and into 1719 intended for debt holders and annuitants to receive a haircut to their principal in exchange for shares. They converted an illiquid investment into shares that could be readily traded. Unsurprisingly, shares backed by the implicit government guarantee were considered safe – despite the lack of cash flow. The paper form also provided for a convenient way to hold and move money – far easier than coinage. A final conversion occurred in early 1720 alongside a delay in the dividend.

To increase confidence after the dividend deferral, the company talked up its stock based on the value of its potential trade in the New World. The share price rose from £128 in January 1720, to £175 in February, to £330 in March and to £550 at the end of May. A credit backstop of £70 million made available by the Parliament and King may have made this investment seem all the more bullet proof – despite the fact the company was not generating significant revenue and the validity of trade routes remained in international dispute. According to Historic UK, the frenzy spread to other companies:

“One company floated was to buy the Irish Bogs, another to manufacture a gun to fire square cannon balls and the most ludicrous of all ‘for carrying-on an undertaking of great advantage’ but no-one to know what it is! The country went wild, stocks increased and huge fortunes were made.”

We all know how it ended; fortunes were lost and then some. There was no one specific catalyst for the collapse except that reality eventually collided with the hype. There were no greater fools left to buy the shares of a company that could not deliver on its promises, and scarcity alone was not enough to maintain its value.

Aside from the scarcity effect, there are a plethora of other similarities between the speculation of today and during the South Sea bubble. One of the most obvious similarities would seem to be the involvement of the government, which throughout history has had a penchant for distorting incentives and giving people a sense of empowerment only to make to leave them in the cold. A second would be the involvement of a public that bought the bogus narrative late in the game. As Bloomberg reporters Greifeld and Ballentine wrote about GameStop’s impacts:

“The mania quickly spread to other meme stocks like BlackBerry, AMC Entertainment and Express, which each soared to highs unseen in years. The surge in trading activity, and the tremendous volatility it caused, prompted Robinhood and other online brokerages to restrict purchases of some of the Reddit-fueled names, sparking outrage on both sides of the aisle in Congress, and sowing darker, conspiratorial motives among WSB users.”

This sounds eerily familiar to what happened 300 years ago. There is also no coincidence that government sanctioned gambling made the populace then comfortable with this kind of risk taking.

There are also some important differences. One of them is that the retail investors on Reddit and elsewhere may be bag men and not even know it. Levels of sophistication on these forums vary widely. Anybody can start a meme that gores viral. Nobody knows their intention.[11] Unlike 300 years ago, there is no fraud being perpetrated by the companies or the hedge funds that are at the center of the anger. In contrast, the South Sea Company did perpetrate such frauds by over brokering its prospects. This is what the plethora of SEC and FINRA regulations to protect retail investors is designed to do. It was never contemplated to protect retail investors from themselves unless there’s fraud. This problem is far thornier as it involves First Amendment rights. The forum users are likely misleading each other – I’m guessing in most cases innocently and unwittingly. While the collapse of the South Sea bubble led to systemic issues and suicides, standing alone, the current mania would be unlikely to result in a market de-grossing. However, this was already likely to happen given the fantasy world in which equities currently exist. The condition has simply been laid bare in a unique way this time around.

Conclusion

Unfortunately, nobody likes it when their parents tell them they are being reckless, but wrapping the car around a tree and barely getting out alive often does the trick. It’s part of growing up and part of learning to invest. I was 18 once, and it happened to me. I learned to pay attention while driving. Many of my peers who are far more bullish than I – that’s pretty much all of them – are relying on a burst in GDP and earnings to support higher index price forecasts. Let’s get real. It’s the stimulus you’re relying on. That’s it. GDP will likely spike because of it. The extent of the spike is an exercise in finger wetting. SA strong GDP print won’t be the driver for equities. GDP hasn’t mattered for a long time, and I doubt it will change risk appetites much in 2021.

Earnings on the other hand are where I believe the disappointment will come. While for years they haven’t mattered much either, the stark reality now is that the Fed can’t act within its non-emergency framework to help support risk assets. All else equal, only lower rates boost asset values; rates are zero and bond yields are close. I also believe an extraordinary risk exists in too much fiscal stimulus to the wrong recipients. This could lead to a further overheat in the equity markets and in the real economy. The latter could necessitate a hike long before the Fed is ready. That is one sure fire way to prick this bubble and to hurt Main Street in the process. Sometimes less is more, Nancy, Chuck and Mitch. Be macro-prudential and not grandiose. I know it’s hard.


Disclaimer

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


[1] Newbies Discover Penny Stocks and 1 Trillion Shares Get Traded. https://www.bloomberg.com/news/articles/2021-01-14/one-trillion-off-exchange-shares-traded-is-latest-froth-marker

[2] This part of the narrative around Bitcoin makes little sense as it can be readily substituted for by other forms of crypto. At some point, the manufactured scarcity narrative will likely fall apart.

[3] Many Reddit forum users and others are far more sophisticated than often characterized with some encouraging groups to ask their brokers not to lend out shares – increasing scarcity and exacerbating the squeeze.

[4] AMC, in particular, provides a spectacular example of how a company uses the equity markets to continue to fund itself and maintain ultimately unsustainable levels of leverage. The company has done what any smart operator might. When equity markets are open, it issues shares. It has been doing so using the ATM (at-the-market) process, which makes dilution to existing shareholders less obvious. It has raised over $800 million in proceeds, which has provided it with ample liquidity for at least this year. Thus, despite a business in secular decline and a pandemic, it now has about $1.4 billion in cash.

[5] I wrote my first piece entitled Robinhood Rally in September of 2019. It pointed out the importance of retail investing in boosting equity valuations. Also see: https://www.businessinsider.com/stock-market-crash-3-pieces-investing-advice-stock-market-bubble-2021-1.

[6] Interestingly, most bubbles pop when leverage forces losses. ‘Gamma’ is just a fancy way to talk about the leverage an options creates for its holder or a counter-party to that holder.

[7] What drives rising long-dated yields is a more complex discussion, which most mischaracterize. However, when speculation is in force, market participants tend to eschew long-duration risk free assets for equities. This leads to a rise in risk-free long-dated yields – just as the converse occurs on risk-off. This is not in fact driven directly by inflation, which has no direct way to impact long yields. Counteracting this effect is the Fed’s messaging about inflation and rate policy staying low for longer (i.e. – the Fed reaction function). Because long yields are the geometric average of short yields over time, this keeps long yields low. Carry trade arbitrage is the mechanism for it (buy long fund short). Uncertainty around future policy is the most important reason for term-premia to exist. Should the economy overheat because of excess stimulus, the expectation could change relative to the trajectory of rates, and yields could rise.

[8] GameStop Mania Is Delivering a Dangerous Rush to the Reddit Mob, by Katie Greifeld and Claire Ballentine. “But what’s been obscured of late by the morality tale over the unalienable right of Redditors to pump up meme stocks as a way to redistribute wealth is this: that many of these mostly young men, cooped up with little else to do during the pandemic, have banded together for the pure, unadulterated rush of gambling and hitting it big, again and again.”

[9] https://www.bloomberg.com/news/articles/2021-01-27/hedge-fund-favorites-are-telltale-leaders-in-broad-stock-selloff

[10] https://www.bloomberg.com/news/articles/2021-01-29/hedge-fund-pressure-lingers-with-short-sellers-targets-rallying

[11] Meet the GameStop investor upending the stock market with cat memes, reaction GIFs, and fundamental analysis. https://markets.businessinsider.com/news/stocks/gamestop-investor-deepfuckingvalue-roaring-kitty-reddit-stocks-wall-street-2021-1-1030022004. Perhaps at $4 it made sense!


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Portrait of a Very Serious Investor

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Hello again, ET readers! I have been struggling with a lack of inspiration on the writing front recently. Fortunately, recent events have jolted me out of my creative malaise. Today, I am writing to share a cartoon I have been sketching.

Meet the Very Serious Investor.

Back in the halcyon days of 2012, during the sturm und drang surrounding the US budget deficit and credit downgrade, Paul Krugman began using the phrase “Very Serious People” to describe politicians he deemed better at sounding serious than developing policy solutions. As another blogger once put it: “being Tom Friedman means never having to say you’re sorry.”

Love or hate Krugman, I’ve always found this a useful little cartoon. Recent events have caused me to extend it to the concept of the Very Serious Investor (pictured above). Very Serious Investors are a direct product of the Wall Street money machine. For the Wall Street money machine greases its gears with credentialism. If you have made your career in finance, you are almost certainly aware that credentialism and its attendant rituals are essential to the smooth generation of fee income.

There is a difference between sounding correct and being correct about a thing. The business of investing (as opposed to the actual act of making money in financial markets) is much more about the former than the latter.

Very Serious Investors, and the discipline of Very Serious Investing, are first and foremost rent-seeking. The Very Serious Investor wears the face of a risk-taker. An optical resemblance to risk-taking is of critical importance to Very Serious Investing. In actuality, Very Serious investing is focused on the extraction of large and (relatively) predictable revenue streams via “heads I win, tails you lose” (HIWTYL) fee structures.

The best thing that ever happened to Very Serious Investors was the transformation of markets into political utilities.

Now, no Serious Investor will ever admit this in conversation. There are appearances to be maintained. There are fists to be shaken at a burdensome regulatory state. Clouds to be shouted at while justifying charging 1.5 and 15 on market beta to LPs (even Very Serious Investors are not immune to some fee compression these days). There are compelling stories about top stock positions to be told.

Through all of this, it is of the utmost importance that the seriousness of investing be conveyed. Investing is not some game to be played. It is not a source of amusement or crass “lulz.” Investing is a science to be practiced by a properly-credentialed, properly-educated, properly-connected professional. Such professionals ought, in turn, to be compensated in a manner befitting their station and breeding.

Thus, the Very Serious Investor is quite disturbed by recent goings-on in illiquid, small cap stocks with high short interests. These happenings represent an assault not only on the Very Serious Investor’s livelihood, but his entire cosmology. For the Very Serious Investor, this offends the natural order of things. Imagine! People placing profitable discretionary trades in the financial markets when they lack even a single Ivy League degree. How dare the plebians challenge their betters?

 Ordnung muss sein.

The Very Serious Investor couches his objections in the language of finance.

“stocks divorced from fundamentals”

“inefficient capital allocation”

“significant mispricings in the cost of capital”

By dazzling the unwashed masses with his scientism, the Very Serious Investor endeavors to put them in their proper place. What matters most to the Very Serious Investor is that a particular cosmic order is preserved. A great chain of being with the plebs located somewhere above the oyster and the Very Serious Investors somewhere up near the seraphim. 

Yet how often does the Very Serious Investor take to CNBC when his long positions become badly divorced from fundamentals?

How often does the Very Serious Investor bemoan the ways in which explicit government policies of rock-bottom interest rates and permanent liquidity support distort his portfolio’s value?

Where was the Very Serious Investor’s shame when she beseeched the Fed to reverse course on rates in December 2018 after blaming the Fed for the prior four years’ underperformance in every quarterly investor letter?

Where were the Very Serious Investor’s anxieties about the integrity of corporate finance when his airline holdings levered up their balance sheets to engage in reckless and unsustainable returns of capital? Where were her high-minded ideals when she tweeted in favor of an airline bailout?

Of course, to pose these questions is beside the point.

The Very Serious Investor does not care about any of these things. What the Very Serious Investor cares about is money. He can hardly abide when others are making more of it than him. Least of all when those people are his inferiors.


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The Invulnerable Hero*

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Die Nibelungen: Siegfried (1924) : Hollywood Metal
Siegfried bathes in dragon’s blood, from Fritz Lang’s Die Nibelungen (1924)

The Invulnerable Hero* is among our most treasured and recurring tropes.

It is the core feature of the great German epic, the Nibelungenlied. You probably know it better as the story of Siegfried from Wagner’s treatment of the story in his famed Ring Cycle. Siegfried slays a dragon and bathes in its blood, that is, everywhere except for the spot on his back covered by a drifting linden leaf. He thus becomes invulnerable to harm except in this very spot.

To those of you more familiar with the Greek epics, you will no doubt see the parallels with the story of Achilles. Thetis takes an infant Achilles to the River Styx and dips him into its waters. He thus becomes invulnerable at every spot but the one covered by the fingers by which his mother held him beneath the Styx: his ankle.

For the more cultured among us, we have our Superman story. Our invulnerable hero with practically every possible advantage and a weakness to one substance that, like the Achilles heel, is so iconic an expression of the trope that it is now a euphemism for a singular weakness or point of failure. Kryptonite. And no, nerds and/or Ben, please do not email me your pedantic notes on red sun radiation, etc.

Still, there’s a funny thing about Invulnerable Hero* stories. Though we know the hero is all but invulnerable, and though we know that the only real conflict in our story is one which might threaten their single point of vulnerability, the stories are rarely about the vulnerability itself. The stories are about their great battles, their great triumphs and the roles they play in the other stories of their time. Stories which pose them practically no threat.

And even though those stories aren’t the real story, they still matter.


I know that we all want to believe that the story of GameStop is really about regular people sticking it to institutions that have done the same thing to others for years. That a revolution has taken place.

I could give you my suspicions that most of the volume and capital that have driven the short squeezes have come not from Reddit or other retail investors but from institutions (read: other hedge funds) who quickly devised strategies to predict where the energy produced by these groups would be directed next. But they would be only suspicions. Pretty strong ones, mind, but still suspicions all the same.

I also think there’s a certain misguidedness to so much of what has taken place, driven by the belief that it’s short-sellers who are the ones who most aggressively manipulate the system and do harm to the average investor. I can think of many cases where this is specifically true, and I can think of many cases where this is categorically false, cases in which this group of investors have been among the only truth-tellers left, opposed by the same financial media that patronizes retail investors today. Lazy fund-of-fund diligence analysts, hubris-and-implicit-debt-laden macro funds and 2-and-20 long/short funds minting decamillionaires by delivering 30% net exposure to the S&P and the occasional branded Patagonia vest have each extracted far more real value from the average investor and citizen.

But leave both of those things aside. Because it’s still a good story. It’s a story I think people will remember. It’s a story that still matters, even if it isn’t 100% true and even if its target was maybe a bit off-the-mark.

But it also isn’t the real story. It isn’t the Invulnerable Hero* story.

The real story is the one that lies underneath: it is the story of the source of cascading events in markets, of short squeezes and events in which those squeezes lead to large de-grossing events in which funds rapidly reduce their exposure and cause the kind of broader market events that do have real-world effects. It is the story of the heel of Achilles, the shoulder of Siegfried, the kryptonite of Superman.

It is the story of leverage.

It is the story of the gross exposure which we have collectively decided is the birthright of these institutions.

As they have many times before, regulators, financial media and financial institutions are responding to make sure that this Achilles heel doesn’t lead to the kind of wildfire event that it very well could. As they have many times before, they are doing so not by addressing the Achilles Heel of leverage and excessive gross exposure, but by seeking to prevent whatever proximate cause threatens to expose that weakness. Last year it meant our government providing a bid for assets that had none. In this case, that means our government and institutions doing what they can to prevent the establishment of new positions by retail investors.

When the dust settles in the next couple days, you’ll get the usual laughing “This time it’s different…not!” thinkpieces from Very Respectable Investors, and they’ll be mostly right. Short squeezes aren’t new. De-grossing events aren’t new. Goofy run-ups happen all the time. But there is a new common knowledge that applies to a much broader audience.

The place where Achilles was held when he was dipped into the River Styx is now common knowledge. The spot covered by the linden leaf on Siegfried’s back is now common knowledge. Superman’s home planet is now common knowledge.

Soon, the fact that hedge funds have long been and are now even more actively scraping, watching, predicting and pouncing on public, pseudo-private and private social networks will become common knowledge. Their realization that they can free-ride on asymmetric, illiquidity-driven trades that don’t create the same regulatory risk as their own public agitation and collusion might will become common knowledge.

That an entire industry is vulnerable to and will itself join in cannibalistically with this kind of coordinated attack will soon become common knowledge.

I suspect that the gatekeepers and regulators will have to face the choice: do they want free and fair markets for the pricing of capital in which everyone plays by the same rules, or do they want to protect the birthright of the hedge fund industry to run high levels of gross exposure and substantial explicit and implicit leverage that will continue to necessitate these impartial emergency restrictions and rescue packages?

We know what they’ve chosen before.

Maybe this isn’t the revolution some were hoping it would be. But it might be a policy inflection point. There might be an opportunity to build a movement around fairness, truly free markets and the rule of law.

Let’s tell those stories.

32+

The Zimbabwe Event

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Covid funeral in Harare

Over the past two weeks, three senior Cabinet officials in Zimbabwe (including the Foreign Minister and the Infrastructure Minister) have died from Covid. Not gotten sick. Died. More broadly, reported Covid cases and deaths have exploded in this country of 15 million just in the month of January. The unreported numbers are certainly much higher, as about 90% of Zimbabwe’s population works outside of the formal economy, and the majority of Zimbabweans have little to no access to the healthcare facilities that report these official case and death numbers.

through Jan. 21 (source: worldometers.info)
through Jan. 21 (source: worldometers.info)

The societal unraveling that is taking place in Zimbabwe – a desperately poor country where per capita GDP is less than $1,500 and declining – is staggering.

Two days ago, the government’s Information Minister tweeted that his fellow Cabinet members had been “eliminated” and called the nation’s doctors “medical assassins”. He deleted the tweets yesterday and apologized “if anyone was offended”. Nurses at a major hospital in the capital city of Harare are on strike because they are provided a single cloth mask and bakery aprons as PPE. The Defense Minister has accused China of “botched experiments” that brought Covid to Zimbabwe, and has said that she will only accept a vaccine if it is manufactured locally. Today, the government announced that it “plans to buy” cheapo Chinese and Russian vaccines, but can only afford to cover two-thirds of the country’s population. The Harare elite have taken to hoarding – not food, but oxygen– to the point where hospitals are placing newspaper ads promising to pay top dollar for any remaining supply.

This is the ‘Zimbabwe Event’, and I believe it has significant real-world and market-world consequences.

Like the ‘Ireland Event’ I’ve been writing about recently, what is happening in Zimbabwe (and every country in Southern Africa) is driven by a combination of relaxed social mitigation policies AND the introduction of a more infectious SARS-CoV-2 virus variant.

What is different is that Zimbabwe is a “weak state”, not a strong, stable state like Ireland.

What is different is that Zimbabwe is being hit by the South African-variant (501.V2), not the UK-variant virus (B117). 


The “Weak State” Difference

The stress of the Covid pandemic is enormous in ALL countries, and it is stress at EVERY stratum of society. The poor are dying. The middle class is dying and getting poorer. The elite are not dying quite as much, but they’re not getting richer and the difference in outcomes between some elites and other elites is enormous.

This broad societal stress results in popular discontent and elite conflict in every country on Earth.

Rich country or poor country, weak state or strong state, big nation or small nation … doesn’t matter. ALL nations are experiencing much higher levels of popular discontent and elite conflict today, which means that ALL governments are experiencing much higher pressure for regime change and leadership transitions.

In a strong state – meaning a nation that has the institutions, traditions, narrative legitimacy and state-supporting common knowledge to accommodate a peaceful leadership transition even under times of intense stress – you can survive a Covid Event without violent regime change.

In a weak state – meaning a nation that does NOT have the institutions, traditions, narrative legitimacy and state-supporting common knowledge to accommodate a peaceful leadership transition under times of intense stress – you cannot.

Weak states do not have an effective political steam valve for popular discontent and elite conflict, resulting in war and violent regime change when a Covid Event hits.

The United States is a strong state. It is, arguably, the strongest state in the world, with an institutional legitimacy and broad-based popular loyalty to those core institutions that has few peers. The United States has many political steam valves for the expression of popular discontent and elite conflict.

If the events of January 6th and the storming of the Capitol can happen in the United States, can you imagine what’s possible in Harare? In Tehran? In Moscow?

In a desperately poor country like Zimbabwe – and there are a lot of Zimbabwes in the world – the violence of popular discontent and elite conflict is obvious enough. When the core functions of a domestic government effectively collapse, civilian life in these circumstances quickly becomes, as Hobbes would say, nasty, brutish and short. The outcome of these circumstances is ALWAYS war. First a war of all against all, then a war of organized factions, then (often) a war of nations. Some of these wars in the Zimbabwes of the world will be entirely internal to existing borders. Some of these wars will cross those borders. Some of these wars will include major powers. 

I think 2021 will be a Year of Civil War in weak states that are desperately poor.

The market couldn’t care less about that, of course, whatever the human enormity of this violence might be.

But the dynamics I’m describing are not only true for an insanely poor weak state like Zimbabwe, but are also true for a relatively wealthy weak state like South Africa. Or Iran. Or Russia.

If you don’t see that the Navalny protests and the growing popular discontent with Putin and his billion dollar palace and all that is both made possible and accelerated by the enormous stress that Covid has placed on the Russian economy and public health … well, I think you’re missing the larger picture here. By the same token, I also think it’s clear that there is real and significant elite conflict behind the protests you see on TV, similarly stemming from that stress on the Russian economy. Clausewitz famously said that war is the continuation of politics by other means. In weak states, though, the reverse is also true: politics is the continuation of war by other means. Right now, Russia is a political war of all against all. Can Putin survive this political war? Sure. But if he does, it won’t be pretty. My bet is that he “retires for health reasons”.

I could absolutely see the same thing happening with Khamenei in Iran. Or MBS in Saudi Arabia.

I think 2021 will be a Year of Unexpected Regime Change in weak states that are relatively wealthy.

The market will care about this a great deal.


The S. African-Variant (501.V2) Difference

My notes about the Ireland Event focused on two questions:

1) how likely is a rolling series of B117-driven Ireland Events in the United States? (very, in my opinion)

2) where are we in the timeline for the first of these US-based Ireland Events? (2 to 3 weeks from today, in my opinion)

There was a third question embedded in all this, of course, which is what the market response might be to an Ireland Event here in the United States. Again imo, I don’t see this as a similar risk as last March. I really don’t see this as an epic major market smackdown, provided that the Fed and the White House say all the right things about unlimited liquidity support for S&P 500 companies … which they will. But I DO see this as a sharp punch in the nose to all of the dominant investment themes and narratives today: “dollar debasement”, “reflation”, “number go up” (Bitcoin), “commodity supercycle”, “cyclical recovery”, “earnings recovery”, “pent-up consumer spending”, etc. etc.

Is it just one good punch to all risk assets before we return to our regularly scheduled market entertainment of looking through previously unthinkable numbers of deaths and cases to some happy day of fully vaccinated business as usual?

Probably. But more and more I’m thinking it’s a very solid punch. More and more I’m thinking that this is a tradable punch. I say this for four reasons:

1) There is a sharp difference in general media coverage of the risk of viral variant spread versus financial media coverage of the risk of viral variant spread. 

While there’s an almost willful ignoring of the virus variants in major financial media, this is not the case with major non-financial media, where coverage of the news and risks of viral variant spread shows both “coherence” and “strength”, to use our narrative structure terms. Notably, however, even in non-financial media, the sentiment associated with articles about viral variant spread is oddly … positive. Like it’s really not a big deal and with Team Biden at the helm we got this covered! Yay, Team Biden! I think this is a classic example of narrative complacency, particularly in financial media, where all of the narrative risks right now are to the downside.

2) There are now four independent medical studies showing that the B117 variant is both more infectious AND more lethal than the baseline virus, versus zero medical studies showing only the same lethality (you can download a PDF copy of the most recent NERVTAG paper here). 

While the mathematical truth is that increased lethality is not nearly as “dangerous” from a public health perspective as increased infectiousness, from a popular perspective just the reverse is true. Stories of increased lethality carry a lot more narrative punch than stories of increased infectiousness. When there’s a confirmation of the lethality data (and I think it’s a when, not an if), that’s a hard hit to the “variants aren’t a big deal” narrative.

3) We now have multiple examples of a B117-driven Ireland Event, not just in Ireland and the UK, but also now in Portugal, Spain and Israel, and coming soon to the rest of continental Europe. 

The ‘Israel Event’ is particularly chastening, as the explosion in Covid cases occurred despite the most advanced vaccination program in the world, with close to 40% of the population vaccinated even as the Event occurred. As I wrote last week, one of the major consequences of a more infectious viral strain is that the percentage of the population that must be vaccinated before herd immunity brings down the R-number is significantly higher than with a less infectious viral strain, so that even 40% is only a modest help in limiting new infections. Also, and this is even more problematic news, Israel reports that a single dose of the vaccines that originally contemplated a two-dose regimen is notably less effective than was suggested in clinical trials. Whether this reduced efficacy for one dose of a two-dose vaccine is because of something particular to the B117 variant is unknown. Either way, that gets us to the last and more important point.

4) The potential for reduced vaccine efficacy is at the heart of why I think the 501.V2 variant is so important, both in real-world and in market-world. 

On Monday, we got the first hard evidence on vaccine efficacy versus 501.V2 (you can read the full Moderna press release here), largely duplicating the findings of South African studies earlier this month of antibody protection from prior baseline Covid infections. These are in vitro tests (lab tests) on the sera (blood) of vaccinated (Moderna analysis) or previously Covid-infected (S. African analysis) patients to measure how much “neutralizing” the antibodies in this vaccinated or previously Covid-infected sera gives you against the new virus variant. There will always be some degradation in neutralizing efficacy, but it’s a matter of degree as for whether you can keep going with the existing vaccine or whether you need a booster shot or whether you need to develop a new vaccine or what. The results from both studies, showing a “six-fold reduction in neutralizing titers” (vaccine protection) and an “eight-fold reduction in neutralizing titers” (prior Covid-infection protection) are on the okay side of “meh” but are still pretty “meh”. These are “yes, but” results.

YES, the current Moderna vaccine appears to be technically effective against 501.V2, meaning that it should provide a greater than 50% chance of protection against serious illness from contracting Covid. My interpretation of a “six-fold reduction in neutralizing titers” is that it’s roughly as effective as last year’s flu vaccine would be for this year’s flu (happy to be corrected on this by anyone who knows better). That’s not nothing! It’s a lot, in fact. BUT it’s a far cry from the efficacy we’ve seen in clinical trials against the non-variant virus, which is really outstanding.

In market-world, I think it is impossible to overstate the destabilizing impact of a Covid variant that is vaccine-resistant.

And to be clear, 501.V2 is probably not that variant. If it were, then I’d be worried about a lot more than just a transitory punch to the market’s nose. Also to be clear, I don’t think 501.V2 in the United States is even in the case, case, case phase of the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! cycle of exponential virus spread. B117 is the immediate threat here, not 501.V2.

But what we DO have with 501.V2 is the start of a vaccine-resistant Covid variant narrative.

I hope that’s all it ever is … the start of a vaccine-resistance story that never develops into a vaccine-resistance reality! But for market-world, the mere existence of a narrative like this, even in an embryonic state, is enough to drive tradeable market events.

Put this together with recent developments with B117 … put the imminent impact of a US-based Ireland Event together with the long-term and geopolitical impact of Zimbabwe Events … and yeah, I think you’ve got a tradeable punch coming to markets.


25+

Off Wall Street and Off-Off Wall Street

33+

Rusty and I are thrilled to announce that Brent Donnelly will be joining us as a guest contributor to Epsilon Theory.

Brent is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021. Brent writes a daily email focused on FX markets that is my go-to source for understanding that enormous corner of the market, but in truth his writing is applicable to every aspect of investing. You’ll see what I mean when you read his latest post below!

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.



What is off-Wall-Street and off-off-Wall-Street?

In New York City, there is Broadway, where the lights are bright and the famous plays like Hamilton, Rent and The Lion King run. Then, there is Off Broadway, venues with seating capacity from 100 to 499 that show some fairly well-known but obviously less epic productions. Third, there is Off-off-Broadway, which began as a “complete rejection of commercial theatre”. These are the sub-100 seat venues that show experimental drama and theatre.

Similar, but different, is the information ecosystem for trading and investing. While we tend to focus on the highbrow outlets like FT, Reuters, The Economist and others, there are other less highbrow outlets that carry useful information and market-moving clout.

The point of this note is to do a medium-deep dive into a few off and off-off Wall Street joints that you may not know about and may find useful.

Here’s a diagram that shows my best effort to classify the major investment and trading information outlets according to the year they were founded and whether they are highbrow or lowbrow. This classification is subjective and was not as easy as I thought it would be. For example, which is more highbrow … The Economist, or The Wall Street Journal ?

I hope no one is insulted by my choices and just to be 100% clear: lowbrow is not synonymous with bad! Some of my favorite things are lowbrow. To me, lowbrow just means something that is not highly intellectual; something that appeals to the median  person on the street. For me, that can be good (movies like Old School, music by Post Malone, and quality chicken wings) or bad (American Pie sequels, music by Pitbull and boiled peanuts). The matrix is inspired by those New York Magazine matrixes from the 2000s. Here it is:

The curvature of the chart over time is interesting. The only publications that survive in the long run are highbrow. This makes sense to me intuitively as parody and lowbrow tend to be more faddish and fashionable while intellectual rigor is timeless.

But before we get into the discussion of FinTwit, Reddit and TikTok, you may wonder: Why does any of this matter? There are four reasons:


1. There is interesting and unique analysis on Twitter and Reddit that you won’t see anywhere else.

This is true whether you trade macro (best stuff is on Twitter) or single names (craziest stuff is on Reddit).


2. Retail opening new accounts and gambling with stimulus checks is the rocket fuel driving bubblicious, crazy moves in single names.

You cannot fully understand this until you witness the amount of overconfidence, indiscriminate buying, straight up silliness and outright gambling going on. In 1999, I belonged to a bulletin board called The Underground Trader. When a stock started to trend on there, it might rally 3%-5% in a few hours. Now, when a stock starts to trend on r/wallstreetbets, it can go up >100%. See GameStop (GME) in recent weeks, for example.

The chart at right shows the rocket ship formation in GME as the massive short interest ran head on into the r/wallstreetbets hype machine. There are other factors behind the rise in GME but even Jim Cramer has been talking about the subreddit’s influence on this particular single name.

These next charts from Bloomberg and FinTwit give you another indication of the explosion of interest from retail. Note that retail investors tend to prefer things that are cheap and things that have significant leverage.

This stuff matters hugely at the penny stock level as retail interest can completely overwhelm supply. There was a day last week where 20% of all US equity volume was made up by five microcaps and 6 of the top 10 most active stocks were priced under $1. Obviously it’s easier for cheaper shares to trade higher volumes but this sort of activity in microcaps is highly unusual. To quote from this Bloomberg article:

“I thought it was pretty odd,” said Saluzzi, co-head of equity trading at Themis Trading. “I’ve been around for a long time, I’ve seen people in chat rooms and retail investors saying ‘we can make some money – it’s easy.’ There’s a risk it may not end well.”


3. Retail is an important driver of the bull market / bubble in financial assets.

While retail is the dominant player in many single names now, there is most likely an impact at the index level as well with TSLA, AAPL and other index members attracting much of the new long-only money. You cannot go short in a Robinhood account and very few people seem to buy puts so the money is either long or levered long with some multiplier above 1. Every stimulus announcement sees a massive inflow into crypto and retail equities and there is no reason to expect that to change.

Poorly-targeted stimulus (See Scott Galloway here, for example) and ultra-loose monetary policy are driving assets higher. The more you understand the retail story, the more you will be prepared to take the other side of the bubble when it comes crashing down. As I have said many times, but would like to say again: It’s easier to make money long a bubble, not short. The two recent USA bubbles (internet 1999 and housing 2005) both popped well after the Fed’s first rate hike. Even if you think this bubble is crazier and that markets learn from the past, the bursting of the current bubble is still somewhere way, wayyyy down the road. Here’s a Bloomberg story:

Stock froth boiled after $600 checks. Now $1,400 may be coming.

Here’s what happened in the market around the time the government sent people $600 earlier this month. Penny share volume mushroomed. A company that sounds like a word Elon Musk tweeted rose 1,100%. Tesla added $130 billion, IPOs doubled and options trading exploded.

Coincidence? Maybe — though a lot of people doubt it. They can’t help notice how tiny traders with money to spend keep turning up in the vicinity of almost every market spectacle these days. Now, more federal aid may be on the way, and Wall Street pros are bracing for what comes next.

“If the additional $1,400 goes to the same income levels it did before, we are highly likely to see additional speculation in stocks, which could continue to inflate an already-existing bubble,” Peter Cecchini, founder and chief strategist of AlphaOmega Advisors LLC, said in an interview.


4. It’s fun!

The fourth reason to spend some time on FinTwit and Reddit is that there are a ton of smart and funny individuals posting hilarity. Recall the fun and games around Davey Day Trader in April and May. Here are a few examples from one of my favorite follows on Twitter, a parody account called Dr. Parik Patel.


So what are these things anyway?

What is FinTwit?

Let’s talk briefly about Twitter, then move on down the spectrum. I am finding more and more in recent years that FinTwit can be a source of unique and super smart information. (In case you don’t know: FinTwit sounds like a putdown but it’s just short for “Finance Twitter”). Writers like Jon Turek, Lyn Alden, and Nathan Tankus rose to prominence on FinTwit and are among the gurus that share in-depth writing on the site. Jens Nordvig publishes great stuff all the time, and you can get a view of what pre-eminent thinkers like Ben Hunt, Tim Duy, and Scott Galloway have on their minds. Hard to say if FinTwit is lowbrow or highbrow: It’s both.

It takes a while to properly curate a list of Twitter handles to follow and it’s not as simple as just cutting and pasting someone else’s list because it’s a matter of taste and preferred topics. That said, next week I will send out a survey and try to aggregate everyone’s favorite Twitter handles and see if we can come up with a nice master list.

As you drop down the highbrow axis, you eventually get to r/wallstreetbets.

What is r/wallstreetbets?

Let’s start from the top level and work down. Reddit is a community-curated message board where posts of value are upvoted and content deemed unworthy is downvoted. The result is a marketplace of ideas that is nearly impossible for marketers and corporations to infiltrate and a system where quality mostly rises to the top. The culture is smart, snarky, funny, self-referential and full of in-group lingo. Reddit is broken into over one million topic-based communities called subreddits. One of those millions of subreddits is a beautiful and amazing cesspool of intellect and degenerate financial market gambling called r/wallstreetbets.

The main screen says: “r/wallstreetbets: Like 4chan found a Bloomberg terminal”. Members of the community are called “degenerates”. The r/wallstreetbets subreddit currently has 1,888,019 members.

If you go into r/wallstreetbets (WSB for short), you will find a community of funny, rude, self-deprecating and reckless speculators riffing on various market-related activities. The focus tends to be one or two stocks and the primary investment thesis is almost always to YOLO as many calls as possible in the thing that is about to…

There is a lot of despicable and sophomoric language but mixed in there are some good ideas and some well-informed speculators. For every dumb post, there is  (for example) a quality analysis of the SEC uptick rule and how its enforcement or lack thereof can impact a stock with more than 100% of free float outstanding.

In WSB lingo, strong hands are called “diamond hands” and weak hands are called “paper hands”. Profits are called “tendies” as in chicken tenders, as in the ultimate luxury food. One sample post I just scrolled to reads as follows: “TSLA – Best $100K I’ve ever spent. When do I hop off the tendie coaster???” and then shows a screenshot of an absurd gain on super low delta calls in a Robinhood account.

A lot of the memes and posts and culture are self-effacing, self-deprecating and traders brag just as much about huge losses as they do about huge gains. It’s ridiculous but much of what is on there is clearly real and it’s serious money being wagered, much of it borrowed money or entire 401ks.

Under the fun headlines and silly posts, you will see some impressive deep dives usually under the flair: “DD” for due diligence. Every post is headed with a “flair” or heading. The most popular flairs are: Meme, gain, loss, YOLO, and DD. At right you see a DD post that then goes into some CFA type analysis that you might otherwise have read on Seeking Alpha or some similar site.

The community is heavily invested in hopes for a continuation of the GME short squeeze right now, so there are many posts like the one on the left below (turning the $1,200 stimmy check into more than $10,000) and random cheering:

Obviously some of the screenshots could be faked but overall it seems to me that many, many young traders have a majority of their net worth ($25k to $100k) invested in one or two stocks or a few OTM calls with hopes that those stocks will continue to rocket. So far so good for them!

Bull market, dude.

You can have a look for yourself, just Google r/wallstreetbets.

As you follow the y-axis lower and lower on my original “investment information ecosystem” chart on Page 2, you will notice way down in the corner, down below zero on the 0-1o lowbrow/highbrow scale is: “TikTok Finance”.

What is TikTok finance?

TikTok Finance is generally an extremely hype-heavy cringey place where inexperienced traders pump questionable strategies to an audience of inexperienced investor-trader-gamblers.

A CNBC story explained it this way:

TikTok for financial advice? Young people are turning to the video app for tips to weather the recession. Amid TikTok’s surge in popularity, a growing number of users are turning to the app for personal advice. As of mid-June, the #investing tag on TikTok had racked up 278 million views. Experts caution that accounts offering guidance may be skipping important lessons and hawking get-rich quick schemes.

If you are brave, watch this clip where two TikTok influencers describe their stock market strategy. If you are easily triggered, just read my abridged excerpt below. And keep in mind as you read it, that these two TikTokkers have 115,000 followers. Here is an excerpt:

We get this question all the time and honestly the answer is very simple… How do we make money from home? So basically, we just trade stocks on Robinhood. It’s free to sign up and they actually give you a free stock to sign up … so they’re paying you to sign up.

I know trading sounds intimidating…

Here’s my strategy in a nutshell: I see a stock going up and I buy it … And I just watch ‘til it stops going up. Then I sell it and I do that over and over and that’s how we pay for our lifestyle. What I like about this is … the fact we don’t have to go to a 9-5 job. We can focus on things we actually enjoy doing.

This month I turned $400 into $14,000 (see screenshot at right)

The terminology! “You get a free stock when you sign up” makes me cringe and it comes up all the time in the TikTok, Robinhoodie world. Here it is again at 7:34 of this video from a poker vlogger looking to sign up new Robinhoodies and WeBulls via an affiliate link. Key quote: “Last time I did this, I got an Apple stock, which is ka-razyyy!?”

You get the idea, but here are a few of the comments below that TikTok influencer video:

It’s not as funny as it seems

While much of what I have posted above is comical and good clean fun (and certainly something I would have been actively engaged with in my 20s!), it also points to a less funny issue: the ongoing gamification of stocks and the lack of seriousness with which many now view financial markets.

As asset prices decouple further and further from the real economy and a rising percentage of unprofitable companies come to market, a new generation buys a stock not because they believe in the company and its products and want to share in its future profitability. They buy stocks as a substitute for sports gambling or to stifle the unending boredom of the pandemic. They bet their entire stimmy check on deep OTM options in a YOLO move to bragpost @ their online friends.

In 1999 the main overriding thesis was “internet gonna change the world”. Now the overriding thesis is “stonks only go up”. The market is turning into a meme machine, a cartoon of its former self, as Neb Tnuh might say.

Brain science shows the prefrontal cortex is not fully developed until age 25. Young men crave novelty and risk-taking as their prefrontal cortex develops and this risk-taking is a healthy part of growing up. Now the real world is shut down and does not offer much risk. There are no cliffs to jump off, or skate parks open, or places to drive way too fast to. So the risk-taking happens on a stock betting app fueled by extreme and experimental monetary policy geared toward higher asset prices. Funded with stimulus checks.

I am not claiming superiority here, I took more than my share of unnecessary and excessive personal risks from ages 18 to 25. It’s what you do at that age. But there were better things to do at that time then play the stonks game on my phone.

The orthodox view of financial markets (or “the boring Boomer view” as they would say on Reddit) is that the stock market is where companies go to raise money for investment and expansion in the real world. Now, the cynical view is the majority view: the market is a place where founders and insiders cash out and executives turbocharge stock-based compensation via buybacks. That’s not good. When capital markets are a source of ridicule, not respect, it hurts capitalism and it inevitably hurts America. It’s all fun and games until someone loses their 401k.

Anyway … As this bubble takes on more and more air and I witness most of the exact behaviors that defined the euphoria in 1999, I feel more and more like an old man yelling at clouds.

Until the Fed reacts, just keep on dancing!


Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.


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33+

UK-Variant SARS-CoV-2 Update

22+


That’s a London scene from the post-apocalyptic zombie flick 28 Days Later on the left, and a London scene from the pre-apocalyptic March Covid lockdown on the right. I say pre-apocalyptic because today’s Covid situation in London with a 70% prevalence of the B117 SARS-CoV-2 virus is a lot worse than the situation last March. No zombies yet, but 2021 is young.

Last Wednesday we published our analysis of behavioral Covid fatigue + UK-variant SARS-CoV-2 spread in the United States.

And we released a podcast on our work, also available on Spotify and iTunes

Last Friday, the CDC held a press conference and released an analysis showing that they expect this more virulent UK-variant strain (B117) to account for 50% of Covid cases in the United States by the end of February. We’ve stored a PDF of the CDC analysis on the Epsilon Theory website here, and you can read a summary of the findings in this WSJ article

Over the weekend, the two most prominent US Covid missionaries – Scott Gottlieb and Tony Fauci – both publicly reversed their stance on the trajectory of Covid spread. Gottlieb’s twitter threads on the B117 threat were particularly urgent, noting that “new variants may change everything. They’ll be 1% of all cases by end of next week, with hot spots in Florida and Southern California.” 

While on the one hand it’s gratifying that the CDC is validating what we wrote, on the other hand it’s pretty scary to contemplate the consequences of the B117 UK-variant virus accounting for 50% of all US cases 40 days from now. That’s what this update note is focused on – the consequences – because they are sorely underplayed in the WSJ article summarizing the CDC report. 

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

Consequence #2: if B117 is the dominant US strain by the end of February, the daily number of new Covid cases by the end of February will be significantly higher than today. This is the point that was completely missed in the WSJ article. B117 doesn’t become the dominant strain because it “defeats” the baseline strain. This isn’t a football game. B117 becomes the dominant strain by spreading even faster than the current fast-spreading baseline virus. The math here is as inexorable as it is sobering, and it means that the rollover in Covid cases and hospitalizations we are currently seeing is a temporary reprieve in advance of an even tougher battle. 

How tough? I dunno. Depends on how much we ignore the B117 threat and take this rollover in the holiday Covid surge numbers as an all-clear sign. An ‘Ireland event’ is a combination of two things – introduction of a more infectious virus AND a relaxation of Covid mitigation behaviors like social distancing and avoidance of indoor groups. Right now, we have it within our power to move both of these necessary conditions in the right direction. But we’re not. On the contrary, we’re moving both of these necessary conditions in the wrong direction, and by the time it becomes clear that we’re risking an Ireland event … well, it’s too late to prevent it. You can only hope to control it.

How do you control it? How do you respond politically to an Ireland event in the United States, where (extrapolating current UK numbers to the US) you could have 8,000 Americans dying from Covid every day? You shut down. And I don’t mean a Covid theater shutdown. I don’t mean an LA County shutdown, with its 50+ exemptions for any politically relevant constituency. I mean a true shutdown. I mean businesses and individuals shutting themselves down.

If B117 becomes the dominant SARS-CoV-2 strain in the United States over the next few weeks, I believe it will create a chain of events that are profoundly life-killing, job-destroying, and misery-producing. 

And I don’t believe that ANY of this is priced into markets.

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

But does it matter?

Does it matter to market-world if this profoundly deflationary, risk-off, dollar higher, flight to safety chain of events occurs in real-world?

Will markets look through all this, particularly if the Fed and White House say all the right things?

LOL. Of course they will.

I have zero doubt – ZERO – that markets will ultimately look through the B117 threat, even if that threat is realized through unprecedented real-world shutdowns and trauma. 

But between today and that ultimate look-through, I also believe there is a significant chance of a narrative shockwave hitting risk assets, particularly those securities tied to a “Covid recovery” theme. You can’t jawbone the virus. You can’t declare by fiat or by narrative that B117 isn’t happening. This IS happening, and the common knowledge that this IS happening will punch our now dominant investment narratives of “earnings recovery” and “reflation” and “the worst is over” square on the nose. Maybe its just one good punch. But it’s a punch nonetheless.

What creates the B117 common knowledge that impacts markets?

I think it’s whenever we get news of the first cluster of B117 cases in the US. 

Right now we’re still in the case, case, case phase of the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! cycle of exponential spread. You can still close your eyes and pretend B117 isn’t happening in the case, case, case phase. But once that first cluster hits the news … well, you can’t ignore that. That’s when B117 becomes common knowledge. That’s when every market missionary starts talking about it, not just Covid missionaries like Gottlieb and Fauci. That’s when every investor knows that every investor knows that our glidepath to recovery is not assured. 

When do we hear about the first B117 cluster in the US? No idea. If Gottlieb is right about 1% of US Covid cases originating from B117 by this Sunday, that’s a big number that would almost surely contain clusters and significant community spread. I think that news would hit risk assets pretty hard. But if Gottlieb is wrong and it takes longer to move into the cluster, cluster, cluster phase, then there’s more time for market-supportive “we can look through B117” narratives to develop. Bottom line: the longer it takes for B117 clusters to appear, the less the impact of B117 common knowledge on markets. 

But the cluster IS coming. As the kids would say, it’s just math.


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ET Podcast #3 – The Ireland Event

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

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

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



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

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

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



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The Ireland Event

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

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

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

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

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

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

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

I’ll start with the conclusion.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Maybe.

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


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Reap the Whirlwind

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Image: Congress Holds Joint Session To Ratify 2020 Presidential Election

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

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

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

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

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

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

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

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

Or, in the words we published in August:

They are both sowing the wind.

And they will both reap the whirlwind.

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

But here’s what’s also true:

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

And no one is thinking about that.

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

The GOP is reaping the whirlwind today.

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

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

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

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

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

In the long run?

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

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

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

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

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