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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.

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The Portnoy Top

I’m coining the name … The Portnoy Top … here and now unless somebody else already has. Anybody who does not know what the Portnoy Top is, take a look. It’s self-explanatory. The Barstool Sports founder is a new, more extreme (and in his case wealthier) version of the day traders of the late 1990s or the house-flippers of the mid-2000s. His attention-getting, wild style is emblematic of just how emotional and extreme equity markets are now. Even more important is the fact that this emotion can be translated to action with a click anytime and anywhere. It’s both impulsive and compulsive. His behavior really just explains everything. It doesn’t even matter if he’s serious or not. His behavior ‘represents.’

Clearly, small caps (Russell 2000) will be most impacted by the defaults I expect in the high yield market. It would seem that at 83x 2020 earnings, there’s little room for this level of defaults. Market participants appear to be betting aggressively on what amounts to continued corporate bailouts vis-à-vis the Fed and Treasuries combined corporate lending facilities. (Please see the Fed discussion below.) S&P valuation is just as bad. At 3,100, on 2020 consensus estimates of $130 in EPS, the S&P is trading just under 24x. There’s absolutely no reason to own U.S. equities right now – unless one likes low to negative future returns.

I wrote last year with my team at Cantor in Robinhood Rally that fundamentals were out the window and that a speculative rotation had commenced – mostly driven by dopamine-fueled, retail access to markets through online trading apps. (Most importantly, that piece debunked the notion that low rates necessarily justified high equity market valuations (P/Es)). Since the pandemic began, this dynamic oddly became even more important. Work-from-home speculation using ‘found money’ in the form of government relief checks is a never-before-seen dynamic that I certainly underestimated. Never before have citizens received this kind of direct bailout. Current fiscal stimulus, including incredibly outsized unemployment benefits – funded by massive deficits facilitated by the Fed’s bond-buying – have encouraged ludicrous risk-taking behavior. The prospect that Congress and the administration will continue to buy votes with the extension of such policies has emboldened market participants. When combined with easy access to markets through platforms like Robinhood, it’s an unholy speculative mix.^[1]

The Powell Presser

The seminal moment in the press conference yesterday occurred when Bloomberg’s Mike McKee asked a few pointed questions, but I’ll discuss that momentarily. First, I would point out that the Chairman appears to suffer from a delusion of sorts. Alternatively, perhaps he’s not deluded – just deceptive. He was careful to emphasize:

“I would stress that these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad based eligibility to make loans to solve entities with the expectation that the loans will be repaid. Many borrowers will benefit from these programs, as will the overall economy. But for many others, getting a loan that may be difficult to repay may not be the answer. In these cases, direct fiscal support may be needed. Elected officials have the power to tax and spend and to make decisions about where we as a society should direct our collective resources.”

Baloney. The Fed is directly enabling the massive deficits that are funding veiled bailouts of… everything. Its actions are now fully complicit and inseparable from fiscal policy actions. A pig wearing lipstick is still a pig. Without the Fed’s massive buying, Treasury yields would be much higher than they are now – and corporate bond spreads would be far wider. Moreover, the lending facilities the Fed is offering with Treasury are clearly benefitting particular beneficiaries. After all, when you facilitate the fiscal bailout bail out of everybody, you also facilitate the bail out ‘particular beneficiaries.’ It’s a distinction without a difference!

Without the Fed’s action, both bill and coupon markets would be a mess. We witnessed dislocations in the Treasury market on two different occasions over the past nine months. Both occurred – at least in part – because of the massive bill and coupon issuance needed to fund deficits. The first such dislocation came last September when the repo market dislocated, in part due to excessive bill supply and coupled with the Fed’s failed attempt to normalize the balance sheet (and a collapse in system reserves). This occurred well before the pandemic. Only balance sheet expansion could fix that problem and bring reserves up enough to meet the supply of collateral (bills).

Now, the pandemic as led to annual deficits of at least $3 trillion. That prospect alongside a frenzy for liquidity led to a move in 10-year yields above 1% (from ~35bps earlier in the week) on March 13^th at the same time the equity market was collapsing. Yields should fall rather than rise in such risk-offs on a flight to safety. Instead, everything was for sale. This led to the Fed’s March 15^th emergency meeting. Make no mistake, without the Fed monetizing Treasury issuance, the Treasury could not act to fund deficits. Without Treasury-funded SPVs, the Fed could not act to bailout companies. The Fed’s current corporate credit lending facilities are TARP in disguise. (Please see my piece Exigent Circumstances).

And what of the positive returns of each and every stock in the S&P 500 since the March meeting? Mike McKee asked whether there might be capital misallocation facilitated by Fed policy that leaves us worse off than before the pandemic. Chairman Powell’s response was wholly unsatisfying. Mike’s question was THE question that needed to be asked, and he had the courage to ask it. My only disagreement with it is the premise that the Fed remains capable of stimulating the economy and juicing equity markets standing alone. It no longer has that power. Only with the help of fiscal policy can the Fed help stimulate. Alone, the Fed is now helpless. We are currently in an unbreakable cycle of addiction to not only monetary policy but also fiscal policy. Fiscal and monetary policy are now one. This may be the reason why David Portnoy just thinks stocks go up and up… can he really be serious? Maybe.

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[1] https://www.cnbc.com/2020/05/12/young-investors-pile-into-stocks-seeing-generational-buying-moment-instead-of-risk.html

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Both Ben and I have struggled somewhat with how to write about the murder of George Floyd last week.

The most important reason we haven’t written much should be pretty obvious. In short, there are a lot of voices telling you how they feel about his death and the protests that have followed it. There are plenty trying to tell you how you should think and feel about it, too. In both cases, most of those voices are more worth listening to than those of two middle-aged, upper middle class white guys in Connecticut.

But if you are like either of us, you have probably also noticed something else. As you learned more about George’s death at the hands of a Minneapolis police officer, maybe you felt and thought a lot of different things at once. About the rule of law. About police and whose interests they serve and protect. About racism and where it still exists. About righteous protest and civil disobedience. About the moral obligations that go along with that disobedience. And then maybe you felt like you were being told that you couldn’t feel all of those things, that they were somehow in conflict with one another. Maybe you felt like you were being offered a set of two diametrically opposed and arbitrarily limited perspectives that didn’t allow for the depths of everything you felt. Maybe you felt channeled into one of the two archetypes which just so happened to align with the messaging of the two major political parties.

We won’t add to that chorus.

Instead, what we can do is try to shed some light on that chorus. What we can do is show you how media-driven narratives began to define and shape how all of us talked about this issue over the last week. And we can tell you where we think those narratives go from here.

If we would remember George Floyd with full hearts, we must first see with clear eyes what we are being told by a politicized media his death represents.

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Phase 1: Just the Facts

On Memorial Day – May 25th – Officer Derek Chauvin kneeled on George Floyd’s neck until he died of some combination of mechanical asphyxiation or cardiopulmonary arrest triggered by the pressure applied, depending on the report you rely on. For the first two days – Tuesday and Wednesday – news reporting was generally focused on the facts and circumstances of his death, discussions of potential racial motivations and recounting of similar events in the recent past.

If you aren’t familiar with our framework, a short refresher. We leverage NLP-based clustering of language across a broad universe of English-language news to identify what we call the structure of narrative. We define that structure across multiple dimensions, namely: cohesion, attention, volume, engagement and sentiment. In this case, the attention of linguistic clusters – their mathematical similarity to the overall collection of news about the same topic – was highest for language describing procedural details, facts, and what we would describe as primary related topics. During these first two days of coverage – what we are calling Phase 1 – it was lowest for language relating to abstractions of “what his death was about” or coverage of knock-on effects.

In addition to observing the attention of linguistic clusters, we can also observe the aggregate similarity of language about a topic like the death of George Floyd. In this case, the cohesion of language used was initially very slightly below what we would typically expect for a similar number of news stories about a single topic. As you will see below, however, that cohesion increased dramatically over the subsequent periods, which we will discuss in greater detail in the following sections. What does this mean? It means that at first, media outlets reported what they knew and saw on the ground, without much consideration possible for what everyone else was writing and thinking. Yet within two days, the language used by those same outlets had been channeled and constrained into archetypal language. By Phase 2 (Thursday and Friday of last week), off-narrative language was almost non-existent. As we will see, however, that does not mean that there was a single narrative to which that language was forced to conform.

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Phase 2: Enter the Missionaries

By the Thursday and Friday following Mr. Floyd’s murder, coverage had changed. So had events. In the latter case, what we mean is that the early emerging protests themselves became a newsworthy topic. In terms of coverage, we mean that the framing of the entire topic began to shift dramatically from the facts and circumstances of the event to discussions of what it was really about. In the game theoretic terms which underlie our framework, this represents the emergence of Missionaries, the people who tell us how to think about events in our world. And on Thursday and Friday, two clear and different missionary-driven narratives emerged.

The first was that Floyd’s death was not so much about Floyd, racism or the social role of police so much as it was about Donald Trump and the rise of white nationalism and white supremacist movements in the United States.

The second was that Floyd’s death was not so much about Floyd, racism or the social role of police so much as it was about the desire of the political left for destructive, anarchic riots to damage the presidency of Donald Trump.

In both cases, it is worth bearing in mind that these were not coverage of specific events. By Thursday, there was very little in the way of what might be described by anyone as a ‘riot’, and no evidence had emerged of any attachment of the involved officers to white nationalist movements. In our view, both represented frames that were voluntarily inserted into the coverage at this time. We make no judgment on whether either represented appropriate context to the events, simply that they reflected decisions to make the events about a particular external framing. The efforts were successful, and the two topics dominated the narrative structure on both Thursday and Friday.

As noted above, this was accompanied by a spike in the cohesion of all coverage of Mr. Floyd’s death to levels more than 30% higher than what we have historically observed for an average single-topic story of this magnitude. The only topic we have covered with a similar spike in the past year was, of all things, the coverage of the investigation and punishment of the Houston Astros cheating scandal, which drove almost uniform linguistic patterns across media outlets.

Perhaps more strikingly, the engagement of articles dominated by the two highest attention language patterns was dramatically higher than other topics. For example, articles defined by their use of language describing the early protests as riots garnered 118% more social shares, on average, than articles we judged as defined by their use of language about racism. Articles we identified as characterized by “white nationalist” language yielded nearly 50% more social shares.

In other words, during Phase 2 of this narrative, missionaries promoted two ideas about what the death of Mr. Floyd was about. And they succeeded. They quickly influenced and permeated the zeitgeist.

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Phase 3: A War of Narrative

By Saturday and up to the present, both coverage patterns and events had changed again. In terms of events, the protests had grown dramatically and, in some cases across the country, become violent and destructive. Likewise, governments had responded with curfew policies, police and national guard to curtail the violence. Yet coverage changed as well with the expansion of the dominance of the two diametrically opposed political narratives. They remained atop our measures of attention during this phase as well.

What changed, however, is that this dominance (and the associated rise in cohesion as outlets began to get on-narrative for their particular political brand) manifested in stark differences in the language used by major US media outlets to discuss all events related to the death of George Floyd. Fox News coverage was more than twice as likely as that of the New York Times, Washington Post and CNN to be driven by riot-related language. Breitbart coverage was 60% more likely. In contrast, New York Times coverage was about 40% more likely to reference white nationalism and Trump’s culpability than Fox News and Breitbart. Washington Post coverage was more than 50% more likely to do so.

This is no accident.

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I suspect you may have sympathies for one or more of these frames. I do, too. Our response to the above may be to say, “Yeah, I get it. The other side’s outlets are hopelessly biased and under/over covered the real story here.” And we can do that, and maybe we’re right.

But it doesn’t matter.

I’m willing to bet some – no, most – of the people reading this have a point of view on this. I’ll bet a lot of you are heartbroken over what happened in Minneapolis. I’ll bet a lot of you want the offending officer to be tried for first-degree murder. I’ll bet a lot of you are sick of feeling like certain institutions – like police forces in some cities – never seem to be held accountable for these errors. I’ll bet a lot of you believe police are an obviously necessary institution. I’ll bet a lot of you think that finding a way to let the full-hearted majority of officers emerge to take control of their institutions is a big part of the way forward. I’ll bet a lot of you think that a majority of full-hearted officers doesn’t mean that there isn’t institutionally embedded racism present, especially against our black neighbors. I’ll bet a lot of you think protests – real, disruptive and angry protests – are an important part of civil society and driving long-term social change. And I’ll bet a lot of you think that destroying businesses and public resources in already hurting communities is a bad act worthy of punishment. And I’ll bet a lot of you still get why there’s anger. I’ll bet a lot of you feel powerless to describe a better way to demonstrate the supremacy of the people over the state that doesn’t require betting on an uncertain, decades-long process of changing hearts and minds.

And I’ll bet a lot of you think that the death of any human should be, first and foremost, above anything else, about his or her life itself and the devastation we feel at it being taken away in our name. Well before we try to make it about anything else.

I don’t know how much of America those paragraphs describe, but I’m guessing it’s a lot. Maybe not a majority, but a LOT.

And our political narratives leave no room for you.

The games being played out in our politics make sure of that. It’s something we’ve written out before.

Virtue Signaling, or … Why Clinton is in Trouble

Ours is a system with a constitution already geared toward the inevitable dominance of two political parties. Yet since the game has been transformed from a coordination game to a competitive game, maintaining the status quo of two-party hegemony also becomes a dominant strategy – the only strategy – for BOTH parties. The combination of these two factors means that the influence of each party’s governing narratives will continue to permeate all facets of our political and social worlds. Why? Because the only strategy that keeps your party at the table is the strategy which seeks to constantly limit the gains of the Other. Whatever they say out loud, make no mistake: The divisions that make so many of us so unhappy are politically desirable to BOTH of our political parties.

George Floyd’s murder was no accident. Neither are these channeling narratives.

Our political narratives coalesce into two archetypes because our politics coalesce into two archetypes. It is a feature of our two-party system. There are political ramifications to this, and all are worthy of discussion. We have done a lot of that and plan to continue.

Yet it is equally important, as we do in this case, to recognize that there are social and personal implications of two-party dominance and its influence on the bi-modality of political narratives. Even if you believe that one of those narratives is a bit more right than the other. Especially if you believe that. These narratives channel your opinions into archetypes that don’t represent you. These narratives channel your grief into archetypes that don’t represent you. These narratives channel your anger into archetypes that don’t represent you. These narratives channel your humanity into archetypes that don’t represent you.

The answer to all this, if there is one, is complicated. And it’s going to be hard. Change will require action. Still, for you and me, knowing that we are being channeled again is still important. That awareness is what permits us to express opinions, grief, anger and humanity that is wholly our own.

And if there were a time to be capable of doing each of these, it is now. This, too, can be #ourfinesthour.

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“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” 

Winston Churchill

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I have not written much since the coronavirus outbreak blew up. Not because I’m not thinking about things. But I simply haven’t had much to say. I have no unique perspective to add regarding epidemiology or public health policy. Sometimes the best thing to do is simply hang back and reflect. This post contains some thoughts on where we’ve been, and where we might be headed.

One indisputable consequence of this pandemic is that we have quickly transitioned from a disinflationary or even (I would argue) mildly stagflationary regime to a deflationary economic regime. The duration of this new regime is an open question. Policymakers, particularly on the monetary side, have reacted as expected. They did MOAR. And they will continue to do MOAR to backstop financial markets, so long as they deem it necessary. Unsurprisingly, this has done wonders for financial assets. Particularly duration sensitive assets such as long bonds and growth equities.

Some dominant themes/narratives I think we will grapple with as this evolves:

The transformation of financial markets into political utilities is complete. It has always been a mistake to assume markets are a perfect reflection of the real economy. Now, markets are probably less a reflection of the real economy than ever before. A consequence of MOAR is that markets (or at least pockets of them) have seemingly become completely untethered from the real economy. There are sensible reasons for this, of course: ultra-low discount rates; the fact that solvent businesses with liquidity to draw on should not see long-term impairment of value as a result of the virus, etc. But as with the financial crisis, policy geared toward owners of financial assets has been implemented quickly and decisively. Much more decisively than policy geared toward vulnerable small businesses and their employees. This will have social and political consequences.

We are all MMTers now. Government deficits will never matter again. Well, at least not unless/until an inflationary bill is acknowledged as having coming due. Central Banks are explicitly engaged in debt monetization. This is mainstream. It is accepted. Yes, there are a different flavors of it. There is the progressive flavor, with its Green New Deals and job guarantees. Then there is the “fiscally conservative” flavor, with its tax cuts and its endless promises of shrinking government (of course, government is never actually shrunk in a material way). I’m not interested in arguing over whether this dynamic is right or wrong at this point. All I care about is acknowledging is that it IS. Because it matters. It matters a lot.

Politics is going to get nastier. The United States government is now explicitly in the business of choosing winners and losers in the economy. As usual, owners of financial assets have been selected as winners. As usual, those who do not own financial assets are losers. I expect the long-simmering political conflict between Capital and Labor to further intensify as a result. Political rhetoric will become more extreme. Politicians will become more ridiculous. Congress will become even less effective (difficult to imagine such a thing is possible, I know). Fun times.

Investment-wise, it’s going to be MOAR of the same. Beyond the obligatory post-recession bounce, there will not be significant mean reversion in value versus growth factor performance. Long duration growth bets will continue to perform well, because there is no opportunity cost to making them. I suspect long duration bonds will also continue to perform well in the short-term, against all odds. Because despite what Jerome Powell says in his pressers, I believe we will test negative interest rates here in the US before we test higher interest rates. And convexity is a thing people seem determined to refuse to understand.

Now, this idea of long duration growth bets merits some additional comment. It’s something that doesn’t get enough pixels, in my opinion. Certainly not relative to its importance. 

Most investors are familiar with the concept of a fixed income security’s duration. It’s a (linear) approximation of a bond’s price sensitivity to interest rates. The longer a bond’s duration, the more sensitive it will be to changes in interest rates. But at the end of the day, a bond is just a bunch of cash flows. From a discounted cash flow perspective, all cash flows are sensitive to changes in the cost of capital.

The archetypical example of a long duration equity is probably development stage biotech. These companies have no free cash flow in the present. They burn cash on R&D and regulatory approval processes. Their free cash flows lie far out in the future. But, if a biotech succeeds in developing and commercializing a therapy with a large addressable market, the future cash flows can be enormous. In the meantime, these equities are kind of like the world’s craziest zero coupon bonds.

In this sense, any breakeven or cash burning growth equity can be seen as a duration play. Much of the small cap enterprise SaaS space fits this profile, for example.

Ultimately, interest rates are financial gravity. When rates are high, and gravity is strong, valuation multiples collapse. When rates are low, and gravity is weak, everything floats. And the longest duration stuff either falls or floats the most.

But how does it all end? I see a few very different endings to this story. The first, of course, is some kind of inflationary or stagflationary regime triggered, in part, by relentless monetary easing. But people like me have been worried about this for a long time. And it’s never shown up. Another possibility is that some kind of transformational technological innovation, similar to the internet, allows us to return to much higher trend growth rates. This would be ideal. Perhaps the darkest scenario is that the political conflict described above spirals completely out of control, and we get to live through a reprise of the 1930s and 1940s.

This is not a very hopeful post. It is not hopeful because I do not have a very positive outlook on the macroeconomic and political trends of the day.

That said, this is also not an argument for bearish positioning in a portfolio. If you follow me on the Twitter, you may recall my exhortation to “dare to be smart enough to be dumb.” Flexibility is key here. I can forgive people (myself included) for not grasping how monetary policy would impact financial market behavior post-2008. That mistake is less forgivable today. In my opinion, it is nigh on impossible to invest today without accounting for the gravity of monetary and fiscal policy.

To be perfectly explicit, as things stand today:

Quantitative deep value (“owning really cheap things because they are really cheap”) is at best a tactical trade.

Economic policy will hamper mean reversion.

As investors, trends are our friends for the foreseeable future.

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The Heroes Act appears to contain classic pork barrel-like provisions in a Congressional election year. Even by its name, it seems to exalt the federal government (Congress) – forget about party – as a savior in a ‘bold response to the coronavirus pandemic and economic collapse.’ Yes, the states and local governments need support, and the bill provides for $500 billion and $375 billion, respectively. This makes sense, but throwing in the kitchen sink does not. Does the Fish and Wildlife Service need to be included alongside the USGS for a cool $90 million? The connection to the coronavirus is tenuous.

Setting aside arguments for or against specific provisions in the bill, we bring this up because the almost $3 trillion bill cuts to the heart of (at least) one thing that equity market participants are missing.

All of this stimulus will come at a staggering cost to growth and potentially at a cost that threatens the functioning of markets and our capitalist democracy.

While risk-asset markets and the economy are sometimes disconnected, they often suddenly and dramatically reconnect when emotion exits and reality enters. We maintain that the recent rally is a bear market bounce and that the correction over the past couple of days is the start of a more sustained selloff. We believe market participants will eventually catch on to the fact that THERE ARE NO FREE LUNCHES OVER THE LONG-TERM.

The consequences of such aggressive fiscal policy may have initially been perceived as unequivocally positive by risk-asset markets. Over time, however, unintended consequences now hidden and unknowable, will likely manifest. Aside from the unknowable, there are unintended consequences that market participants might come to appreciate in the near future. First, massive fiscal deficits kneecap monetary authorities and make them simply knaves of fiscal policy actors. Monetary policy loses its efficacy as a stimulative tool and becomes only a palliative one. This is why deficits DO matter. Deficits may not matter when myopically considering they can be monetized, but monetization does not happen in a vacuum. Monetization occurs at a cost to the monetary authority in the form of opportunity cost. Next, in recent history, fiscal policy has been notoriously slow and inefficient at stimulating GDP growth.^[1] Lastly, monetization of deficits without taxation as a source of funds for spending presents potentially existential problems for a capitalist democracy.

Recent experience demonstrates that, in the absence of Fed action, U.S. rates may rise radically in the face of massive T-bill or coupon issuance. Recently, long-thought-dead bond vigilantes jumped out of their graves in the face of Treasury issuance need to fund deficits. Figure 1 shows the dislocations in March 2020 when the Treasury market began to absorb the fact that long-dated coupon issues would explode to fund the deficits needed to combat the pandemic. [Ed. note: the overnight gaps are interesting to me, too.] In September 2019, repo rates went to about 7% intraday when bill issuance exploded in the face of insufficient system reserves. This occurred well in advance of the pandemic. In the latter case, it was not until the Fed acted by expanding its balance sheet quickly by almost $1 trillion through term repo operations that the repo market stabilized. In the former, it was not until the Fed announced unlimited quantitative easing (QE) that coupons stabilized after several days of incredibly sloppy and illiquid trading. These periods were the catalysts for a shift in the role of Fed policy from a stimulative to palliative one.^[2]

Said differently, it’s not a question of whether the Fed has tools, it’s a question of efficacy of the tools employed. Do the tools available actually work as intended? Both traditional monetary policy (through open market operations that manage to Fed fund target rates) and extraordinary policies like quantitative easing (that suppress the term premium of interest rates) work through a rates mechanism. By first order effect, buying USTs (either long or short dated) lowers targeted interest rates. By second order effect, those lower rates may help suppress risk premium (credit spreads). They may also suppress spreads by first order effect if a central bank is buying risk assets directly. When rates are near or below zero, these policies maintain the status quo – at best. They lose marginal benefit. In fact, they may even do more harm than good because they encourage ‘malinvestment’ and create overcapacity (as in U.S. E&P). This oversupply leads to price disinflation and even deflation. This lack of efficacy (at best) or harmful side-effects (at worst) are what ultimately pushes the Fed to focus on ‘wealth effect’ or ‘confidence’ channels. This is what led it to buy corporate bonds. It had nothing left. It can’t afford defaults to shake confidence in equities or destroy the wealth that it has helped create for corporations and individuals through low rates.

Even if one rejects the notion that monetary policy has lost its efficacy or believes that fiscal policy has immediate and multiplicative benefit to an economy, then there’s an entirely different question that ought not be ignored. Importantly, if debt monetization is a panacea, then what of taxation as the source of funds for government spending? If one argues no taxation is needed, the entire system of taxation and spending comes into question. Why even bother to tax? Taxation, authorization and appropriation are some of Congress’ most important roles. If there’s no need to tax to fund spending, then what does that mean for a legislative system based upon that basic equality? Are we as Americans once again (as during the reign of the English monarchy) ceding authority to undemocratic institutions (i.e. – the Fed)? What incentives does such a system create to spend without limitation on any pet project that a Congressman or Congresswoman deems suitable for their district – as long as the Fed chooses to monetize it? It seems clear that it creates a world rife with economic inefficiency, corruption and moral hazard.

What about the rest of the world’s take on such a U.S. system? Do other nations simply sit by and watch the U.S. and Japan monetize their debts without trying to do the same?^[3]

Of course not. They will certainly try and have already started. There is now talk of emerging market central banks ‘joining the QE party,’ as this Economist article points out. This will likely not end well as it risks destroying the creditworthiness of already challenged EM economies. Their growth is essential to the world. We are the leader in global monetary policy and one size simply does not fit all. Yet, that lesson seems already lost on those central bankers outside the U.S. that do not appreciate the benefits of our reserve currency (and the worlds’ continued structural need for the U.S. dollar).

This discussion goes well beyond esoteric considerations of monetary policy and Modern Monetary theory (MMT). It ultimately cuts to the heart of sustaining our democracy and the checks and balances that make it work. U.S. democracy works because of these checks and balances, which exist in a fragile equilibrium that the Fed’s willingness to monetize deficits will now upset – unless it is checked by a newly created system of checks and balances. Our powerful democracy has far less cronyism and corruption than many others. The flow of funds from taxpayers to a government for the people and by the people is the foundation of it all. Wholesale debt monetization without appropriate taxation threatens this balance and concentrates power with the monetary authority. Perhaps most scary, is it allows legislators to act without worry about where their self-interested spending eventually goes. As in many countries, a good deal of that could end up in their own pockets. That’s the end game if we are not vigilant.

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[1] https://econweb.ucsd.edu/~vramey/research/RZUS.pdf. Using Jordà’s (2005) local projection method we find no evidence that government spending multipliers are high during high unemployment states. Most estimates of the multiplier are between 0.3 and 0.8.

[2] We’d been concerned that the Fed would be backed into this corner, and it was at the heart of our 2020 Outlook, in which we argued that limited policy space would be a challenge to U.S. equity markets.

[3] By the way, Japan’s equity purchases – an attempt to juice equity valuations – have not been particularly successful, as Figure 2 shows. P/Es are actually lower there than in the U.S.

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Epsilon Theory PDF Download (paid subscription required): Too Connected to Fail

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If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.

Attributed to J. Paul Getty in The Five Rules for Successful Stock Investing

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I don’t know how much life wisdom it is possible to extract from the life of J. Paul Getty.

On the one hand, Getty became fabulously wealthy by taking actual risk and doing things (like, say, learning Arabic) that no one else was willing to do at the time. On the other hand, he famously bartered for the life of his abducted grandson, seeking to whittle down the ransom demands to an amount that would be fully tax-deductible. Gee thanks, Gramps.

The Ridley Scott film chronicling this affair is a pretty fascinating story in its own right. Filmed and nearly ready for distribution right before the revelation of sexual assault allegations against Kevin Spacey, Ridley’s picture leaned on the great Christopher Plummer to step in and reshoot every scene featuring the, um, protagonist. It is an underrated film too overshadowed by the attendant real-life drama, and Plummer positively owned the Getty role.

Whether or not the notoriously miserly bastard – Getty, not Plummer – had much wisdom to commend him in other areas, however, his famous and possibly apocryphal description of the relationship between exposure and co-dependency remains powerful. It is the staple concept of the Too Big To Fail genre of global financial crisis thinkpieces, since it at once describes the nature of interdependence between banks and other banks, between banks and large institutional clients (e.g. hedge funds, some corporate hedgers, some asset owners), and between banks and the financial system at large.

But like Getty’s expression, TBTF is fundamentally an expression of the ability of scale to create systemic co-dependencies. It is accordingly, and appropriately, the rallying cry for those who seek to decentralize how reliant we are on any social or political institution, industry, business or individual by reducing and limiting the scale of our reliance on them. For those more inclined to ignore the extent to which government institutions are not organs of the people but petty powers to themselves, that usually means regulation. For those more inclined toward skepticism about state solutions to concentrated power but naivete toward the Ponzi-like self-dealing that has typified most good-sounding efforts to decentralize power, that usually means buying into the vision of this or that tech oligarch.

Yet there is a similar class of systemic risks which exist independent of scale. That is, they exist because everybody knows that everybody knows that an institution affects too many other issues or areas of society to be left ‘unmanaged’. They are often fulcrums on which some other policy or important issue rests, or otherwise carry external political implications.

In short, they are too connected to fail.

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Yes, there is a financial markets observation coming, but a couple examples first.

Like, say, corn.

I grew up three houses down from a cornfield in Illinois. I used to get lost in that cornfield. I saw a tornado rip up that cornfield. I consider wrong opinions about cornbread fighting words under the precedent of Chaplinsky v. New Hampshire. I maintain a bottle of corn oil for the sole purpose of use in my green chile pork stew. Sometimes I think about corn.

You should, too.

Leave aside the decades of silliness of ethanol or the years in which low fat, high sugar diets rich in high fructose corn syrupy goodness were pushed by nutritionists and American food safety and health officials on American families. Instead, think about what you say when you talk about corn with friends and neighbors. What, you don’t talk about corn?

OK, fine, for the sake of argument let’s pretend that you are the normal one here. Still, I’m willing to wager that you, like I, have opinions on “farmers” and the US as the “Breadbasket of the World.” I’ll bet you know at least a little about ethanol’s ability to make us “energy independent” and something-something environment, something-something Chevy commercial mumbled under the breath of a lobbyist stinking of an artificially maple-flavored bourbon with a mash bill that runs awful heavy on the corn. Maybe you even know a bit about how corn was going to be how we built a diplomatic rapport with Brazil?

You and I know those things because there was a concerted missionary effort over decades to make the narrative of this particular agricultural commodity connected to things that do matter to us. Our country. Blue collar families. Health. Safety. In turn, those efforts manifested in rhetorically powerful policies which have become third rails in states with arbitrarily disproportionate influence on national primaries and senate composition.

Corn is not too big to fail. In both real-world and narrative-world, corn is too connected to fail.

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Or, say, public education.

I went to public school and it worked out great for me. Still, my wife and I homeschool our boys, and not just in the way all of us are sort of having to do that right now. It is a life and lifestyle we have chosen. I still think about education and public school a lot.

You should, too. And you probably do.

When you discuss educational outcomes with friends, family and neighbors, what is the framing for your discussion? Do you talk about pedagogy? Singapore math vs. common core vs. the point-counting system and carry-the-one stuff we used to do when we grew up? Do you talk about the specific educational outcomes you want for your child, their predispositions and where they might be best-suited to focus efforts? Or do you, like the rest of us, mostly talk about “what we can do to improve our schools?” About how you can best support the teachers and staff at the local school?

Those aren’t necessarily bad things to discuss. The point isn’t that you or I are thinking and talking about the wrong things. It is simply worthwhile to know that we have accepted a dialogue which presupposes both the incumbent institution and the framing of the issue in terms of the producer of something we need.

Why do we do that?

We may certainly do it in part because of earnest conviction by many that compulsory public education is the best, fairest and most socially cohesive way to organize childhood learning. We may also do it in part because of decades of missionary-promoted narratives arguing that “support for public schools”, “opposition to non-public education” and “support for teachers” are rhetorically identical to “belief in education.” As many American families have discovered over the recent months, we may do it because our lives are (and for many of us, must be!) designed completely around subsidized supervision of our kids between the hours of 8AM and 3PM every day. And yes, we may do it because the tax-advantaged credentialing and real estate acquisition business we call the American university system actively penalizes thinking about childhood education in any other context. In the end, it is these entrenched connections that force the framing of our conversations about the topic.

Our current public education system is not too big to fail. In both real-world and narrative-world, it is too connected to fail.

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You may well be fine with that. And that’s fine!

After all, calling something ‘too connected to fail’ is not a pejorative expression. It is a descriptive expression. Maybe you even read the above and said to yourself, “Well, what you’re describing sounds kind of like a description of public utilities.” No. What I described isn’t kind of like public utilities. I literally described what we treat as public utilities – entities which everybody knows everybody knows deliver a necessary public good.

But that is the fundamental risk of things that are too connected to fail. They expand the definition of “necessary” from “things we die from or suffer greatly if we don’t get” to “things which would upset the political balance” or “things which would shed light on a structural problem elsewhere in society if they broke” or “things which would be really, really inconvenient for someone in a place of political power if things went wrong.”

In other words, public utilities are not only what we call public utilities. Public utilities are also the industries and institutions whose narratives have connected them inextricably to other social and political objectives and needs. Everybody knows that everybody knows a failure in these things would have ripple effects on a variety of other institutions and issues of one kind or another. Effects we often aren’t willing to contemplate. And in the wake of the COVID-19 pandemic, we can officially add one more to the list:

Capital markets.

Don’t get me wrong. Capital markets have been deeply connected to other American institutions and concerns for just about our entire history. And they very obviously have a scale issue too, if it is even appropriate to think about them as a monolithic institution. It depends on the context.

However, I think the connections today are different in both kind and magnitude. In light of recent policy responses from the Federal Reserve in particular, they are worthy of consideration. To wit:

• State and municipal pension systems are today both vastly underfunded and utterly reliant on the returns of US equity markets. In some cases that reliance can no longer be qualified by “over the long term”. Short- and medium-term stock market returns are now “necessary” to ensure a functioning pension system for tens of millions of American households.
• With the exception of legacy systems, corporate defined benefit programs have gone away, replaced with defined contribution systems which eliminate the obligation for any party to fund a retirement benefit, replaced by the “necessity” of positive short- and medium-term stock market returns. This is especially true for the concentrated cohort of oft-referenced Boomers approaching or at retirement age.
• Memes of “Yay, Alignment!” have shifted executive and board compensation programs toward equity-linked incentives from cash compensation, creating “necessity” on the part of many institutions to ensure share price stability and appreciation over short horizons.
• Politicians such as Donald Trump have become increasingly explicit about messaging that stock market returns be used as the measuring stick for their presidency.
• Media outlets have, in turn and where appropriate for their editorial aims, selectively done the same as part of a broader abstraction of the economy into “the stock market.” There is very little economic or business news in 2020. There is only market news.

What’s more, these connections in both real-world and narrative-world have become common knowledge. They are things we all know that we all know, beliefs about the true purpose of capital markets that are now being said out loud. Political strategists openly discuss and social media promotes data on the stock market’s impact on election outcomes. The St. Louis Fed openly celebrates the impact of nominally liquidity-focused intervention policies on short-term equity market returns. White House officials call the personal mobile phones of stock market-covering morning show hosts live and on-the-air.

The common knowledge about what markets are for is no longer “to direct capital to its most productive ends”.

The common knowledge about what markets are for is now “to give us the returns we need.”

Sure, markets have always directed capital and provided some return in exchange. This isn’t new. It’s kind of the point of the whole thing, after all. But capital markets that are for directing capital where it should go even if that doesn’t give us the returns we need right now will tend to do that. And capital markets that are for giving us the returns we need right now even if that doesn’t direct capital to the most productive places will tend to do that. This isn’t complicated.

Any time we change through word and deed what we all agree something “is for”, it is a Big Deal.

It is a Big Deal because once you accept the common knowledge primary purpose of capital markets as a “return-generating machine”, and once you implement policies which are designed to ensure that returns keep being generated at whatever cost (remember, it’s “necessary”), it is extremely difficult to walk those policies back.

It is a Big Deal because it fosters and promotes blind acceptance of policies that are designed to ensure equity prices and credit spreads hold within certain acceptable boundaries under the laughably thin veneer of “maintaining liquidity” by huge swaths of market participants who are among those who “need the returns”.

It is a Big Deal because it will permit and encourage the allocation of capital based on the expectations of policy intervention rather than on the expectations of turning that capital into future cash flow. That will reduce the value of everything we create together as a society over our lifetimes.

It is a Big Deal because it will make our children poorer and the world they inherit less vibrant, less dynamic and less prosperous.

Clear Eyes: In the coming weeks and months, if you hear anyone dismissing concerns about moral hazards of or the impact on long-term returns and cash flow generation of policies intervening in the prices of risky assets, know that you are speaking to someone who at best doesn’t believe in the basic function of markets and more likely doesn’t have a foundational belief in why markets work in the first place. They believe in returns, not markets. That is because they need market returns (e.g. someone with a large, AUM-based management fee business) more than they want long-term prosperity for all of us. Don’t waste time arguing with them. They are too entangled in the too connected to fail problem.

Full Hearts: If trying to build a pack here has taught us anything, it is that there are people in every corner of this industry – asset owners, fund managers, individual investors, strategists – who are interested in creating an environment where it is still possible to continue investing. You know, things like evaluating value, cash flow, growth prospects and the capital stewardship traits of management? Lawful good doesn’t mean lawful stupid, and there is no need to needlessly fight the Fed or the broad treatment of markets as public utilities. But there ARE ways to add value as investors that don’t require becoming entangled with what makes capital markets too connected to fail.

Embracing some of those methods will be hard. Really hard.

Can full-hearted board members overseeing large asset pools grapple with the risk of killing off consensus-driven models based on Wilshire TUCS universes and asset consultants that keep investors entangled with the too connected to fail problems of capital markets?

Can full-hearted corporate executives and boards move on from the Yay, Alignment! memes that permit stock- and option-based compensation models that favor an emphasis on short-time price appreciation?

Can full-hearted asset managers begin to consider moving away from AUM-based compensation models that drive behaviors, methods and positioning toward industry norms to protect the management fee franchise?

If change must come from the top down, the answer is no. But from the bottom up? From a group of people who recognize that the net social good of financial markets is the proper direction of capital to its most productive ends? From people who are committed enough to that idea that they are willing to take career and business risk?

Maybe.

With the COVID-19 pandemic putting a damper on our in-person ET Forum plans for later this year, we are planning something else. We want to use this unique time in history to help build regional networks of asset owners, business leaders and asset managers who think capital markets still matter. Networks that are too connected to fail – but in the right way.

Look for more from us on this effort over the coming weeks.

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Epsilon Theory PDF Download (paid subscription required): Too Connected to Fail

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Last week, when Ben and I published our assessment and response to the institutional failures revealed by the COVID-19 pandemic, it didn’t take long for some other suggestions to roll in. I have been thinking about one of the first one someone suggested to me ever since.

Bloomberg’s Eric Schatzker covered it first, I think, or at least it was the first article sent to me. Leanna Orr at Institutional Investor published a good follow-up the next day. The issue was this: CalPERS, the largest pension fund in the United States, had a tail risk portfolio that was meant to defend some portion of its massive portfolio against, well, really bad market events. Among other things, no doubt, they had hired two external managers to construct portfolios of instruments that would be sensitive to those events and convex in its sensitivity. In other words, this is a portfolio that is designed to do better when things get worse – and in a non-linear way.

And then CalPERS took it off. Right before the COVID-19 pandemic’s market impact went into full swing.

So is this an institutional failure of the type we discussed in First the People? An indictment of the narrative of prudence that governs so many large assets owners’ actions? Was it just a garden variety mistake? Or was it a mistake at all?

I have absolutely no idea.

One of the things I can tell you from experience is that nearly every decision made by a large asset owner cannot be considered in isolation from a handful of related, often consequent decisions. But from the outside? Considering those decisions in isolation is nearly always all that we can do.

In reality, big asset owners maintain a roster of defenses against terrible events. Yes, they sometimes hire external managers to implement tail risk portfolios like this. Sometimes they also implement those portfolios themselves, or in collaboration with some of their bank partners. They maintain strategic (and tactical) allocations to investments likely to do well – or better said, which have historically done well – in certain types of shock events to risky assets. Sovereign debt duration exposure for deflationary events. Precious metals for “We are all gonna die, aren’t we” types of events. Trend-following for markets where fear compounds over time. And at times, they judge that their investment horizon is better served by self-insuring, by structurally acting as a collector of insurance premiums paid by investors with shorter horizons rather than a payer.

I don’t know whether taking off the hedge was a judgment based on the belief that the specific structures provided sub-optimal protection, or the belief that they could implement them more cheaply themselves, or the belief that they would be better served by simply taking down risk exposure, or the belief that increasing tactical allocations to assets like treasurys and trend-following strategies was better, or a shift in philosophy to that of an insurance premium collector. There are a lot of reasons a decision like this gets made. Usually more than one. And yeah, one of those reasons is sometimes that they were just tired of the constant drag from paying premiums.

I don’t know what the mix of reasons was here.

But I do know this:

In the pre-pandemic world, it was nearly impossible for a professional entrusted with capital to justify paying explicit or implicit premiums for anything that didn’t show results in fewer than five years. Certainly over ten years or longer. Between 2009 and 2020, there was no sin greater than a ‘constant drag on returns’. Yay, efficiency!

The explicit premiums that create a ‘constant drag on returns’ are more obvious. That’s what CalPERS paid. That’s what Wimbledon paid. But implicit premiums that didn’t serve the meme of Yay, Efficiency! were under constant threat as well. They were far more common, too. Financial advisers who kept investors at appropriate levels of risk and appropriate levels of diversification were at risk of being fired every single quarter simply because anything which ‘diversified’ from US Large Cap stocks ended up being ‘wrong.’ Asset owners who maintained deflation hedges or who didn’t rotate from hedge funds (meaning, er, the ones that actually diversify sources of risk) to long-only public equity or private equity exposure were getting slammed in every board meeting, or by alumni suggesting in open letters that they just invest in an S&P 500 ETF.

This isn’t just an investment industry thing. Across the entire American economy, no idea has held anything approaching the power and influence of Yay, Efficiency! over the last several decades. It is the core curriculum in every business school program. It is the ‘value proposition’ of management consultants. It is the money slide of every deal being pitched to achieve scale of one kind or another by an investment banker. It is the entire complex of (non-permanent capital) private equity and private debt investments. It is THE governing meme of The Long Now. Yet if we can learn anything from, say, the millions of gallons of milk being dumped into ditches right now, it is this:

The meme of Yay, Efficiency! is not the same as the truth of long-term value creation.

I don’t have the Answer.

If you need someone to blame, throw a rock in the air – you’ll hit someone guilty. Like me, for instance. I’ve spent a lot of years believing in and working on efficiency. On optimizing. On religiously shunning ‘constant drags on returns.’ Hiring and firing advisers, fund managers and strategists based on my assessments of the pseudo-empirical efficiency of their decisions.

I think I know that there will be institutions who should absolutely still self-insure, who should be structural collectors of premium. I think I know that there will be plenty of closing-the-barn-door-after-the-cows-have-gone pandemic policies written and bought that are more likely than not to benefit the writers and not the sellers. Not everything is going to change.

Still, Ben has written that we have the opportunity now to write new songs of reciprocity and empathy. If so, let us consider rejecting the song that defines our jobs as rooting out everything that might be a ‘drag on returns’ over a 1-5 year-horizon. Let our new song be this: to create things of lasting value.

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Last week, the Fed added new programs and upsized many of the loan and bond buying programs it had already announced over the past several weeks. It is now traveling on a road without an exit in sight. It’s almost certain that withdrawal of this new support will be slow. In the near-term, it has already significantly dislocated (tightened) both investment grade and (to a lesser extent) high yield (HY) prices relative to their fundamental cash flow profiles.

Let’s call out these new “liquidity programs” for what they really are. The PMCCF and SMCCF (Primary and Secondary Corporate Credit Facilities) are targeted to help large, low-investment grade companies like Ford, whose bonds popped from 70 to 83 on the news of an upsize to the facility. The program extends support without the political fallout a new TARP (Troubled Asset relief Program) might cause.

PMCCF and SMCCF are TARP in disguise.

While extensive, I believe these varied programs will not prevent the default cycle that is coming in the BB+ and below universe. Default rates will be lower than without these programs, but not low enough to support current risk-asset values. The “exigent circumstances” to which the Fed is responding are unlikely to be short-lived, especially because corporate leverage was already so high before the pandemic began and earnings were already so weak. After today’s tightening in high yield spreads (CDX to ~500bps and HYG YAS ~600bps), we continue to believe there is little upside to ownership of U.S. high yield – even after the announcement of these expanded programs (likely to expand even more).

We believe risk-reward to U.S. equities in particular is still skewed massively to the downside, and for the Fed to take the action it took today, it must see circumstances as being dire indeed.

We wrote on March 29^th that a rally to 2700 to 2,800 could occur and that it would be a fade. We expected short squeezes in credit and equities on program announcements – those program announcements came faster than expected. We maintain that view.^[1] For the S&P to trade at 2,800, it requires a 19.5x forward earnings-per-share multiple on $145 in EPS (down a mere 10% YoY). That EPS estimate is probably far too conservative and earnings could easily fall 20% (with average recession EPS down between 20% to 30%). At S&P EPS down 20% ($130), 2,800 on the S&P requires a 21.5x forward multiple. Can large cap equities really sustain that multiple given the risks to cash flows? Can small cap stocks (Russell 2000) sustain a forward multiple of almost 40x given the inevitable defaults that will occur in BB+ credits and below? We don’t think so. Recall that equity is the residual in every capital structure and is first loss.^[2]

While the buying is currently occurring across the universe of high yield bonds, we believe worsening fundamentals will drive dispersion amongst high yield credits over time. The sub-BB+ universe will become an orphan… at least until the Fed buys it, too. Moreover, the speculative grade loan market was already strained before the pandemic began; loan volumes are likely to continue to fall – albeit even faster now. Fed programs will prevent disaster, but they won’t continue to support current equity and credit valuations as fundamentals deteriorate. HY spreads have fallen from just under 900 (CDX HY) to 530bps (as low as 475bps) on Fed euphoria.^[3] So, lets query something. Even with Fed support, do HY spreads at 500bps make sense on the cusp of the most severe recession since 1929? We think not.

Overview

Since 2008, in order to justify extraordinary policy actions (including company bailouts), the Fed has been using the Section 13(3)’s exigent circumstances exception to the specific direction provided for open market operations under Section 14 of the Federal Reserve Act (FRA). The Fed began again on March 15^th by establishing numerous Treasury-funded SPVs (Special Purpose Vehicles) that it will lever to provide financing under TALF, two investment grade buying programs, and CPFF amongst others, which we summarize below. Today, it upsized many of those programs. These corporate bond buying programs will be extended through September of 2020. There are nine programs in total.

For years, the conversation around the prospect for “Japanification” of U.S. monetary policy was almost universally met with extreme skepticism. The use of Section 13(3) now places the U.S. almost side-by-side with Japanese policymakers, and it is incumbent upon us to understand the implications of this progression. Where will it eventually lead U.S. monetary policy? Certainly, there is no policy space left. Monetary policy has been come completely palliative rather than stimulative. Will continued intervention destroy the very free market system it is attempting to save? We would argue that now is precisely the right time to ask this question. Japan serves as a vision of one possible future self for the US.

We investigate both the Fed’s authority  to implement BoJ-style policy as well as the practical near and long-term implications. We’ll review each of the policies the Fed has undertaken or is likely to undertake (alongside and in coordination with fiscal policy). On March 20^th and just prior its re-implementation, we had already suggested that the 2008 playbook would reemerge.^[4] Next, we’ll touch on the next stop on the slippery slope – the Fed buying equities and a broader swath of high yield corporate bonds. It can presumably continue to justify such actions as the next extension of its Section 13(3) powers.

We conclude that, while monetization of deficits serves a legitimate purpose of helps prevent unintended consequences in rates markets, buying equities would do little but further distort asset prices. This already extant distortion (due largely to quantitative easing) helped to create the fragility and lack of policy space that makes the current Covid-19 Tsunami so hard to combat. At this point, monetary policy alone can’t combat the 100-year disaster. It must work as the mechanism to monetize the debt required to fund the fiscal policy response. Importantly, this means Fed action should receive additional checks and balances from the legislature. In our view, Treasury-only supervision just doesn’t cut it. Our system is one of checks and balances… yet, there are none in this instance. Should there not be?

Slippery Slopes

Throughout history, liberty is almost always denied when governments assert that exigent circumstances require it. Let’s look at a constitutional analogue. The Fourth Amendment to the U.S. Constitution prohibits ‘unreasonable’ searches and seizures. Said differently, the Fourth Amendment prevents the government from unreasonably taking or infringing upon an individual’s property or privacy rights. To that end, it sets requirements for issuing warrants: warrants must be issued by a judge or magistrate, justified by probable cause, supported by oath or affirmation, and must specify the place to be searched and the persons or things to be seized.^[5]

Exigent circumstances may provide an exception to the Fourth Amendment’s protections when circumstances are dangerous or obviously indicate probable cause. The application of exigent circumstances has been highly adjudicated – meaning, the courts found it necessary to rule often on its application to assure the government’s propensity to overreach was checked. One such permissible example of justifiable exigent circumstance is the Terry stop, which allows police to frisk suspects for weapons. The Court also allowed a search of arrested persons in Weeks v. United States (1914) to preserve evidence that might otherwise be destroyed and to ensure suspects were disarmed.

The health of the public and of the police officers justified the infringement on privacy. Other circumstances might justify police to enter private property without a warrant if they have plain sight evidence that a violent crime is taking place. Importantly, there are many examples of situations in which exigent circumstances were ruled insufficient to justify the infringement on personal or property rights. For example, even if a suspect was carrying a gun (an exigent circumstance), while reasonable to ‘stop and frisk,’ it would not necessarily justify the extreme action of locking him/her up indefinitely until a search of his home could be conducted.

We think this 4^th Amendment construct is an incredibly useful analogy for understanding the danger in the Fed’s actions now; there’s a reason the very same phase – exigent circumstances – is used in 4^th Amendment cases as well as in the Federal Reserve Act. We are not arguing that the present economic circumstances are not exigent, but we are arguing that there must be due process to assure that a valid justification does not lead to overreach. That overreach arguably started today as the Fed expanded its program into HY. Unlike legal challenge under the Fourth Amendment, Section 13(3) is not subject to a well-defined process by which it may be challenged and by which ‘lines may be drawn.’ Lack of due process almost invariably leads to government overreach.

The current Japanification of policy – if gone unchecked by Congress – is the beginning of the socialization and consequent destruction of free capital markets.

In our piece Monetize It – Monetize All of It, we suggested it would be necessary for the Fed to monetize all the upcoming deficits that would be needed to fund coronavirus relief programs. We were clear to suggest that the coordination should be explicit and with the appropriating authority – i.e. – Congress. Dodd Frank amendments to the Federal Reserve Act did not have the foresight to modify 13(3) checks and balances beyond Treasury approval. The Fed is now using this loophole to skirt the explicit mandate provided for in Section 14 – without due process to ascertain where the line ought to be drawn.

Japanification

In the case of Japan, we can see what we’d consider an undesirable monetary policy outcome orchestrated by a stealthy government takeover of large swaths of private industry. Last year, the Bank of Japan (BoJ) bought just over ¥6 trillion ($55 billion) of ETFs and now holds close to 80% of outstanding Japanese ETF equity assets. Total purchases to date represent around 5% of the Topix’s total market capitalization. According to  the latest Nikkei calculations, not only has the BOJ also become the top shareholder in 23 companies, including Nidec, Fanuc and Omron, through its ETF holdings, it was among the top 10 holders for 49.7% of all Tokyo-listed enterprises.^[6] In other words, the BOJ has gone from being a top-10 holder in 40% of Japanese stocks last March to 50% just one year later.

The BoJ is not an independent central bank, so it receives explicit legislative authority to act when it buys non-governmental assets. We doubt Congress would allow that here – as Congress might actually recognize the Constitutional implications. Surely, the courts would.

Monetary policy in its Japanified form has mutated into an incredibly stealthy ‘taking’ of Japanese citizens’ private property under the auspices of the public good.

Arguably, if unchecked, the BoJ could end up owning all private assets under the auspices of supporting the economy. Is this something we should tolerate here in the US, the greatest capitalist democracy the world has ever seen? We say no.

The Fed Facilities

So, thus far, what has the Fed done? We predicted much of it. On March 20^th in Monetize It – Monetize All of It, we wrote:

“To state the obvious, today’s crisis differs from 2008. Thus, the policy response should also differ. As we know, many of the Fed-provided credit facilities from 2008-era were designed to bail out banks, but the powers of section 13(3) of the Federal Reserve Act were also extended to companies. Banks remain key as that’s how all policy is transmitted (at least in part), so we’ve suggested clients expect facilities like CPFF (Commercial Paper Funding Facility – already done), TLGP (Temporary Liquidity Guarantee Program) and others. We might also expect an expansion of the PDCF (Primary Dealer Funding Facility) collateral or a modification to haircuts. Under 13(3) we might also expect a TALF-like facility (Term Asset-Backed Securities Loan Facility) and a TARP (Troubled Asset Relief Program).”

If the Fed extends it logic under Section 13(3), all high yield bonds (not just fallen angels and the HYG ETF) and equities will be next. This would be pure folly with the drastic unintended consequences that Japan has already begun to face.^[7]

Let’s get granular around what facilities the Fed has established, how much liquidity they provide, and what authority allows the. We will include a discussion of the collaboration between the Fed and Treasury through the Exchange Stabilization Fund (ESF) and how the Treasury funds the ESF through special purpose vehicles (SPVs) which it may then leverage based on collateral provided.

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Commercial Paper Funding Facility (CPFF) – March 17th.

The CPFF facility is structured as a credit facility to a SPV authorized under section 13(3) of the Federal Reserve act. The SPV serves as a funding backstop to facilitate issuance of commercial paper. The Fed will commit to lending to the SPV on a recourse basis. The US Treasury Dept., using the ESF (Exchange Stabilization Fund) will provide $10 billion of credit protection to the Federal Reserve Bank of New York in connection to the CPFF.  The SPV will purchase 3-month commercial paper through the New York Fed’s primary dealers.  The SPV will cease purchases on March 17^th, 2021 unless the facility is extended.

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Primary Dealer Credit Facility (PDCF) – March 17^th.

The PDCF offers overnight and term funding for maturities up to 90 days. Credit extended to primary dealers can be collateralized by a range of commercial paper and muni bonds, and a range of equity securities. The PDCF will remain available to primary dealers for at least six months, and longer if conditions warrant an extension.

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Money Market Mutual Fund Liquidity Facility (MMLF) – March 18^th.

The MMLF program was established to provide support and liquidity of crucial money markets. Through the program, the Federal Reserve Bank of Boston will lend to eligible financial institutions secured by high-quality assets purchased by financial institutions from money market mutual funds. Eligible borrowers include all U.S. depository institutions, U.S. bank holding companies, and U.S. branches and agencies of foreign banks.No new credit extensions will be made after September 30^th, 2020 unless the program is extended by the Fed.

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Primary Market Corporate Credit Facility (PMCCF) – March 23^rd as amended April 9th.

The PMCCF will serve as a funding backstop for corporate debt issued by eligible parties. The Federal Reserve Bank will lend to a SPV on a recourse basis. The SPV will purchase the qualifying bonds as the sole investor in a bond issuance. The Reserve Bank will be secured by all the assets of the SPV. The Treasury will make a $75 (up from $10) billion equity investment in the SPV to fund the facility and the SMCCF (below), allocated as $50 billion to the facility and $25 billion to the SMCCF. The combined size of the facility and the SMCCF will be up to $750 billion (the facility leverages the Treasury equity at 10 to 1 when acquiring corporate bonds or syndicated loans that are IG at the time of purchase. The facility leverages its equity at 7 to 1 when acquiring any other type of asset).Eligible issuers must be rated at least BBB-/Baa3 as of March 22^nd by a major NRSRO (nationally recognized statistical rating org). If it is rated by multiple organizations, the issuer must be rated BBB-/Baa3 by two or more as of March 22^nd.The program will end on September 30^th, 2020 unless there is an extension by the Fed and the Treasury.

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Secondary Market Corporate Credit Facility (SMCCF) – April 9^th.

Under SMCCF, the Fed will lend to a SPV that will purchase corporate debt in the secondary market from eligible issuers. The SPV will purchase eligible corporate bonds (must be rated BBB-/Baa3, see above for full criteria) as well as ETF’s that provide exposure to the market for U.S. investment grade corporate bonds. Today, the Fed also indicated that purchases will also be made in ETF’s whose primary investment objective is exposure to U.S. high-yield corporate bonds. The Treasury will make a $75 (up from $10) billion equity investment in the SPV to fund the facility and the PMCCF (above), initially allocated as $50 billion to the PMCCF and $25 billion to the SMCCF. The combined size of the facility will be up to $750 billion (the facility leverages the Treasury equity at 10 to 1 when acquiring corporate bonds or syndicated loans that are IG at the time of purchase. The facility leverages its equity at 7 to 1 when acquiring corporate bonds that are below IG, and in a range between 3 to 1 and 7 to 1 depending on the risk in any other type of eligible asset).The program will end on September 30^th, 2020 unless there is an extension by the Fed and the Treasury.

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Municipal Liquidity Facility (MLF) – April 9^th.

The MLF, authorized under Section 13(3) of the Federal Reserve Act will support lending to U.S. states and cities (with population over 1 million residents) and counties (with population over 2 million residents). The Federal Reserve Bank will commit to lend to a SPV on a recourse basis, and the SPV will purchase eligible notes from issuers at time of issuance. The Treasury, using funds appropriated to the ESF, will make an initial equity investment of $35 billion in the SPV in connection with the facility. The SPV will have the ability to purchase up to $500 billion of eligible notes (which include TANs, TRANs, and BANs). The SPV will stop making these purchases on September 30^th, 2020 unless the program is extended by the Federal Reserve and the Treasury.

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Paycheck Protection Program Lending Facility (PPP) – April 6^th.

The PPP facility is intended to facilitate lending by all eligible borrowers to small businesses. Under the facility, Federal Reserve Banks will lend to eligible borrowers on a non-recourse basis, and take PPP loans as collateral. Eligible borrowers include all depository institutions that originate PPP Loans. The new credit extensions will be made under the facility after September 30^th, 2020.

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Term Asset-Backed Securities Loan Facility (TALF) – March 23^rd.

The TALF is a credit facility that intends to help facilitate the issuance of asset-backed securities and improve asset-backed market conditions generally. TALF will serve as a funding backstop to facilitate the issuance of eligible ABS on or after March 23^rd. Under TALF, the Federal Reserve Bank of NY will commit to lend to a SPV on a recourse basis. The Treasury will make an equity investment of $10 billion in the SPV. The SPV initially will make up to $100 billion of loans available. Eligible collateral includes ABS that have credit rating in the long-term, or in case of non-mortgage backed ABS, short-term investment grade rating category by two NRSROs.No new credit extensions will be made after September 30^th, 2020, unless there is an extension.

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The Main Street New Loan Facility (MSNLF) and Expanded Loan Facility (MSELF) – April 9^th.

The MSNLF and MSELF are intended to facilitate lending to small and medium-sized businesses by eligible lenders. Under the facilities, a Federal Reserve Bank will commit to lend to a single common SPV on a recourse basis. The SPV will buy 95% participations in the upsized tranche of eligible loans from eligible lenders. The Treasury will make a $75 billion equity investment in the single common SPV that is connected to the facilities. The combined size of the facilities will be up to $600 billion. Eligible borrowers are businesses up to 10,000 employees or up to $2.5 billion in 2019 annual revenues. The SPV will cease purchasing participations in eligible loans on September 30^th, 2020 unless there is an extension by the Fed and Treasury.

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The $2.3 trillion in loans announced this morning is made up of the Fed’s nine programs, including leverage on the Treasury’s equity contribution to SPVs under the ESF. Specifically, the Commercial Paper Funding Facility accounts for $100 billion of loans, while the Primary and Secondary Market Corporate Credit Facilities account for $500 billion and $250 billion respectively. The Municipal Liquidity Facility (MLF) adds another $500 billion, while TALF makes up another $100 billion. Finally, the Main Street New Loan Facility (MSNLF) amounts to approximately $600 billion. Together, these specified facilities account for ~$2.05 trillion of the announced $2.3 trillion. As we understand it, the remainder of the contribution flows to the Paycheck Protection Program (PPP), the Money Market Mutual Fund Facility (MMLF), and the Primary Dealer Credit Facility (PDCF).

Conclusion

The Fed is using a potentially dangerous (from a Constitutional standpoint) exception to Section 14 of the Federal Reserve Act.

Throughout history and across the world, these sorts of exigent circumstances have led to breakdowns in process and liberty. That is what we face as a country now. Make no mistake, when we look at what is happening in Japan, it is fairly clear to us that the central bank is engaged in a kind of taking that in the United States, should be considered an infringement on individual liberty. When taken to its logical extreme, the BoJ will eventually own all private assets. In the United States, the stealthy takeover of private assets by the government stands diametrically opposed to  the unfettered right of individuals to own private property and for markets to set the price they pay for such property. Japan does not have our Constitution. We should hold ours dear.

Ours is a system of checks and balances. While the Fed’s current actions up until today were reasonable responses to clearly exigent circumstances, we ask: where is the line?

For us, a reach to low-grade high-yield and equities would cross the line. It is a line for which due process must be established – Congress or another adjudicating authority ought to serve as a check and balance. The combination of fiscal and monetary policy programs being implemented will impact generations of Americans. The new New Deal won’t look like the old new deal. In fact, many may not immediately notice the ultimate consequences. That’s what’s so troubling, as the cost will be just as high with a Fed balance sheet ultimately at about $10 trillion and with persistent multi-trillion dollar deficits.

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[1] We will admit, we’d thought we’d get another push lower before seeing those levels.

[2] We’ve written extensively that a conservative fair value on the S&P 500 is 2,340. Far from being supported by the best economy ever, U.S. markets faced significant challenges before the pandemic – from a flat to inverted yield curve and no corporate loan growth, to meager real wage growth, high levels of corporate leverage (especially in the loan market), and screamingly high asset valuations – all of which made for a fragile backdrop

[3] HYG ETF’s YAS is currently ~620bps from just under 1000bps.

[4] Please see Monetize It – Monetize All of It.

[5] A like analogy can be drawn using the Fifth Amendment’s Takings Clause, which requires the government provide reasonable compensation when property is taken in the name of the public good.

[6] https://asia.nikkei.com/Business/Markets/Bank-of-Japan-to-be-top-shareholder-of-Japan-stocks

[7] Some legislative history is useful. The Glass Steagall Act of 1932 permitted Fed to authorize “advances” to member banks “in exceptional and exigent” circumstances. As 1932 progressed some deemed it too limiting and an amendment was offered to expand lending “to any person.” It passed but was vetoed by President Hoover. Section 13(3) was offered as an amendment to Emergency Relief/Construction Act which passed. The Section permits any Fed Reserve bank to “discount for any individual, partnership or corporation, notes, drafts and bills of exchange of the kind s and maturities made eligible under other provisions of this Act when such are endorsed and otherwise secured to the satisfaction of the Fed bank.” This was deemed limited to short term commercial paper and became part of Federal Reserve Act Section 13(3). Congress removed the limitation in 1991. This enabled much of the activity after 2008 and into the Financial Crisis – including JP Morgan Baer sterna purchase, AIG, TSLF,TALF,CPFF. Dodd frank narrowed the presumed authority saying cannot be used to “aid a failing financial company” or “borrowers that are insolvent” but any lending only in connection with “a program or facility with broad based eligibility”

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The oil narrative is not as it seems. We think there will be a superficial deal between Russia and the Saudis sometime this week – just as we wrote last week. However, the narrative is not as one-dimensional as president Trump has been suggesting in his press briefings. Trump’s narrative has been that low oil prices are bad for both the Saudis and Russians. Therefore, he concludes, they have incentive to do a deal. Sure they are ‘bad’ right now – but long-term gain (for them) comes from short term pain if US E&P is permanently impaired. In our opinion, the popular oil narrative is generally ill-premised, as it assumes the Saudis and Russians to be at odds. Don’t be so sure. Their interests are aligned around disabling U.S. production. Period.

The President’s recent tweet (last week) made me wince, and I’m guessing it may have made Vladimir Putin laugh – you know, one of those evil genius laughs. President Trump tweeted:

Just spoke to my friend MBS (Crown Prince) of Saudi Arabia, who spoke with President Putin of Russia, & I expect & hope that they will be cutting back approximately 10 Million Barrels, and maybe substantially more which, if it happens, will be GREAT for the oil & gas industry!

— Donald J. Trump (@realDonaldTrump) April 2, 2020

I pray that the President does not have a sincere belief in this friendship or outcome. Brinkmanship combined with narcissism make him a hard read, and that’s probably a good thing. Does he really believe he’s going to drive a deal here? It would certainly be ironic if the Saudis and Russians actually gave him an illusory win and do cut some – allowing him to think he’s actually a real ‘influencer’ in a game that is ultimately of their design. Is a cut in the amount he cites completely unprecedented? No, there were large cuts in the early to mid-1980s.^[2] But if the cuts were 10 to 15 million barrels per day, that would amount to between roughly 25% and 38% of current output for OPEC+. Interestingly, the tweet was countered by immediate denials from Russia that any conversation between MBS and Putin had yet occurred – which means it probably has occurred – but not for the purpose of easing production. A high five perhaps?

For anybody naïve enough to think that the current production ramp-up is not a coordinated effort between the Saudi’s and Russia, I have two words: wake up. This artful play will likely have may acts. Putin and MBS are ‘frenemies.’ They will at times emphasize their friendship and at other times their adversarial relationship. That dichotomy is helpful to their narrative. Feigned compromise on production cuts should make the nefarious collaboration more believable within the context of the long-game they are playing. Whatever cuts occur will make a for a great headline, but they will be short-lived. Their goal is most likely to eliminate the high-cost U.S. producers that have survived only because of access to capital markets. Few are cash flow positive below $45/bbl, so oil probably does not have to be this low anyway. A small superficial cut will make little difference at prices this low and with demand so weak.

On March 9th, my team and I wrote in our Morning Read:

“Does anyone remember the infamous high-five between Putin and MBS (pictured)? One theory is that the Saudis are playing a game of chicken with the Russians. Unfortunately for the Saudis, the Russians have positioned away from the U.S. dollar, and ruble depreciation cushions the blow of lower oil prices for Russian producers. The Russians also have an estimated $100 billion in gold reserves after dumping most of their USTs. They have little external debt. In short, Russia has staying power. Alternatively, the Saudi’s actions could be yet another high five veiled as a slap in the face. Now that Aramco IPO done, something else could be going on here.

Perhaps this is not a game of chicken at all and instead a far more coordinated effort with Russia to finally crush US E&P. Given lack of access to credit markets E&P defaults will begin to spike. Breakevens are in the low to mid 40s, so cash burn already underway (given steep decline rates and continuous capex) will accelerate. Both the Russians and MBS seem to value instability, and this could be their moment to disable debt laden U.S. E&P companies.”

OPEC+ has seized the opportunity for which they have been waiting. Oil demand by EIA estimates was already slated to fall in the first quarter even before coronavirus hit. That said, the impact on demand from the virus is unarguably severe. Like the meme that low rates justify high equity valuations, we disagree that lower oil prices will act as a tax cut to the consumer. Rates are low for a reason; oil prices are low for a reason. In fact, low rates for far too long led to massive overcapacity in U.S. E&P. Capital markets remained open to companies because of the ‘Fed put.’ This is at the root of what catalyzed the price war we now have. OPEC+ had simply had enough. Perhaps most importantly, we suggest the oil price war is between OPEC+ and the U.S. – not between Russia and the Saudis.

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[1] The inflation-adjusted real 2004-dollar value of oil fell from an average of $78.2 in 1981 to an average of $26.8 per barrel in 1986.

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Since last week, we have received a number of requests to amplify our views on certain provisions of the CARES Act. Rather than opine on individual public shareholder bailouts likely to be executed under this act and its likely successor bills in 2020, we determined it would be easier to provide an easy-to-follow decision chart that will tell you in advance what our opinion will be.

Thank you for your understanding.

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The pandemic narrative changed this weekend. I’m guessing you felt it.

Let me show you what you probably felt.

Pictured below is a network graph of articles published by high-circulation US media outlets about COVID-19 the weekend of March 14th and 15th. Closely clustered articles and those connected by lines are more similar in the language they use. Bold-faced nodes and connector lines are those which we judge to be about the stock market, the economy, unemployment and a prospective recession. Colors reference different language-based clusters assigned by the graphing algorithm. The lighter, faded nodes and lines are those which are about other topics.

And here is a network graph of articles published this most recent weekend (in case you’re curious, we chose parallel weekends to minimize bias relating to the tendency of weekday news to skew towards financial markets).

Even if you know nothing about what these graphs are doing or what they mean, my guess is you will notice two things. You’ll notice there are a lot more bold-faced dots this weekend than last. That just means outlets published a lot more pandemic articles that referenced the economic impact, too. That isn’t nothing, but in our opinion it isn’t the most interesting feature of the graph. Much more interesting to us is that the articles with language about economics impact and financial markets are far more well-distributed AND far more central. They don’t exist alongside other pandemic-related topics: they are explicitly integrated into EVERY pandemic-related topic.

In less than one week, the narrative shifted from “COVID-19 is a public health crisis” to “COVID-19 is a financial crisis.”

Such is the power of the narrative missionary.

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Don’t mistake me. It IS both. Obviously it is both. The economic crunch that will be felt by hourly workers, service workers, and small business owners will go beyond whatever Congress’s bill will have the ability to rectify. It is very real. There are second-order effects and frictional effects that are very real. An SBA loan facility may not be able to restart a restaurant that already closed. A relief check may not be able to pay rent on an apartment someone has already been evicted from. A world in which people are allowed to go back into public doesn’t mean people are immediately going to crowd back into theaters to watch performing artists. This is going to be bad. This is going to be unevenly felt. We cannot predict all of those effects. That’s why we should all be creative in looking for ways to provide bottom-up support for those communities. That’s why we should continue to prod targeted sacrificial giving to local communities from all Americans.

That’s also why any time and treasure spent thinking about large public equity-holders who knowingly took equity risk in for-profit enterprises is time and treasure wasted.

But even if COVID-19 IS both a public health crisis AND a financial crisis, it should still matter to us when we observe a rapid, coordinated shift in the framing of it across public figure statements and media.

As always, the most important question we can ask when consuming media is this: why am I reading this now?

I can’t tell you that there are not people who examined the situation last week and suddenly came to earnest conclusions that the economic costs to small businesses and families might be more extreme than they thought. Surely such people exist. But I can also tell you that the overlap between groups promoting this framing and those who two weeks prior called it a media-fueled panic and those who two weeks prior to that called it ‘just the flu’ is significant.

If I had been calling something a ‘hoax’ and a ‘panic’ only to find out that I was dreadfully wrong, can you imagine how seductive it would be to be handed a way to retcon a new reality? How delighted might I be to say what I was really doing all along wasn’t completely mismanaging an unfolding pandemic, but instead carefully weighing the pluses and minuses of subjecting the population to massive economic pain or a medical crisis?

I’m really not being cynical. It really is seductive. I really am empathetic. I really do think that public servants who want to do good and know they’ve messed up the response thus far are grabbing this as a lifeline. And I really do believe that many (okay, some) of them are NOT just worried about how stocks are doing, but about how families and towns and communities are doing.

But the answer is NOT the arbitrary, panicked rejection of the distancing and quarantine measures put in place across the country.

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Friends, we can carry multiple ideas in our head at the same time. We can believe that this is a public health crisis AND that this is a financial crisis AND that it’s probably possible for people to exercise responsible social distancing in parks AND that the recent emphasis by public figures to frame reopening the economy as our direst need represents an attempt to effect early exits from social distancing measures in regions that have ZERO business exiting social distancing measures.

And maybe you carry one of those ideas with a bit more weight than another. That’s fine. Because it doesn’t matter. Regardless of what it is that you or I care most about, the best path to fixing it is the same:

• We must give the health care system the time and breathing room to care for the known and as yet unknown clusters that exist in America;
• We must take the uncertainty we created through weeks of universal undertesting out of the system;
• We must give people confidence that there will be an end to quarantines by communicating how that will take place; and
• We must give markets confidence that the economy will be restarted by communicating how that will take place.

We achieve precisely ZERO of these things by making vague assurances about “reopening America!”

We achieve EACH AND EVERY ONE of these things by developing and communicating a clear plan for how we will use widespread testing to craft a workable American version of the test-and trace approaches that have successfully brought multiple economies in Asia back online.

And we do it NOW.

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Epsilon Theory PDF Download (paid subscription required): Margin Call

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There are two cartoons which lead both investors and nations to ruin.

The first kind treats a false measure as a true one.

The second kind treats a model of reality as if it were reality.

Both cartoons are perilous in the face of uncertainty. The first, the measurement cartoon, empowers actions based on a false confidence about the current state of a thing. The second, the model cartoon, empowers actions based on a false confidence about the future behavior of a thing.

Yet while both are perilous, their perils are not equal.

When we pretend our measurement cartoons tell us true things to guide our response to uncertain events, unless we are protected by a shield of time, law, arcane GAAP rules or an iron-clad, authoritarian grip on information, truth will typically out. It is difficult to hide bodies forever. Even if the true underlying reality being measured remains elusive, common knowledge about the cartoon in the face of sufficient contrary information may not. Eventually everybody knows that everybody knows that the cartoon is a fraud.

When we pretend that our model cartoons tell us true things about uncertain events, we may never realize that the predictions from our complicated models of reality weren’t necessarily so.

Often until it is too late.

The perils of measurement cartoons have been the chief focus of our essays thus far. These are stories about how various institutions acted to suppress the discovery, measurement and reporting of the true extent of infected individuals. They are also stories about how policies of governments, corporations and other institutions were designed around those constructed realities.

Stories about the CCP.

Body Count

Stories about the WHO.

The Industrially Necessary Doctor Tedros

Stories about the US federal and state governments.

Don’t Test, Don’t Tell

Fortunately, as (almost) the entire world has slowly come around to the realization of the reality underlying the measurement cartoon, policies have changed rapidly. Damage was done, but now further damage is being limited. It can be our finest hour, and we believe it will be.

Tick-Tock

True to form, however, it is the institutions who have relied on model cartoons who have not yet acted to limit damage.

In markets, that obstinacy is still coming to head today, especially for a swath of global macro, relative value and multi-strategy hedge funds. These institutions aren’t full of idiots. They no doubt saw the uncertainty associated with Covid-19 and its policy response. But they believed in their estimates of correlations among financial assets. Even so, it isn’t just that they believed in them. There is no shame in being process-oriented. It is that they continued to bet on those models of correlation with (often) significantly leveraged positions, despite everything in the world screaming at them that their models had become representations of something that looked nothing like the world that was unfolding.

Do you think only one horror story will come out of this? Do you think Sunday’s emergency Fed action had our credit availability in mind? That it was designed to make sure we could still apply for a Capital One card or refinance our mortgages and access short-term capital to keep paying our small business’s employees for a few weeks? Don’t get me wrong about this – a lot of good hedge fund managers will lose money in March. This isn’t about whether you got the trade right. It’s about whether your process empowered you – whether systematically or intuitively – to recognize when the world of risk and cross-asset relationships your models represented wasn’t the world at all, but a cartoon.

That’s why what I worry about more than anything today is the United Kingdom, which is continuing to pursue a strategy which combines vague, conflicting recommendations with targeted social distancing. It’s a strategy effectively built on a foundation of four models: (1) behavioral response models for quarantined humans, (2) seasonality models, (3) mutation properties and (4) ‘herd immunity’ models. I worry not because I have any special knowledge about whether they are correct. I worry because by knowingly permitting the spread of a pandemic of many unknown qualities on the basis of models with hugely uncertain parameters, they are effectively levering up 66 million lives to the accuracy of those models.

Only the call you get when these trades blow up isn’t a margin call.

Here, too, I have hope. The Brits are pragmatic to a fault. They don’t need the government to tell them to keep granddad at home. Many of them have been doing it for weeks. There’s a practicality to their academics, too, an army of which quickly emerged to voice their opposition to the plan unveiled by Boris Johnson’s government. There is some evidence that closures and additional recommendations are forthcoming. The claims of herd immunity aims have been softened. I believe that the UK government will get it right. Eventually. For God’s sake, I named my firstborn son after Churchill, so I’ve got to be pretty sure they’re going to get their shit together at some point.

But for our readers and friends there, please don’t wait for that to happen. As Taleb and Norman wrote correctly yesterday, our civic obligation to the whole in the situation is individual overreaction. The best time was two weeks ago, but the second best time is now.

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Epsilon Theory PDF Download (paid subscription required): Margin Call

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MARCH 17 UPDATE

Good news on this front. The UK government is taking this seriously and has moved in the right direction – knew y’all had it in you! Pressure from, er, non-behavioral science nudging experts across the pond has to be given a lot of credit for this.

https://www.thesun.co.uk/news/11184059/boris-johnson-to-step-up-coronavirus-fight-as-he-chairs-another-emergency-cobra-meeting/