Brave New World


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.


  • Perception versus reality. Facts do not cease to exist simply because they are ignored (Aldous Huxley). Performance dispersion within and amongst equity indices tells the ‘true’ story about U.S. equity performance. Unlike the S&P 500 and Nasdaq Composite, many broad indices and non-technology sectors remain well below previous highs, some of which were marked in mid-2018.[1] Since then, it’s been a bear market for the Russell 2000 and NYSE Composite.
  • Overvaluation. Even when considering that many stocks have performed negatively for the year (or even since mid-2018), equities generally remain expensive relative to where they sit in the business credit cycle. Large cap technology companies, which are benefiting from the pandemic (almost as if they were countercyclical), are now excessively overvalued and poised to drag down other sectors on a correlation event, which could be related to a number of risks.[2]
  • Risk-Reward. As I’ve suggested for some time, risk-reward remains generally unfavorable to U.S. equity ownership as equity markets are underappreciating risks to the following:
    • Valuation – Molodovsky misapplied: the business cycle’s credit contraction isn’t over. It’s just starting. This context for growth and inflation make forward multiples excessive for many sectors.
    • Fiscal policy – The DC gridlock around Heros and HEALs will continue as the election approaches. More importantly, because of massive deficits, higher taxes are coming, especially if a Democratic President takes office;
      • Election outcome – The risk to a less business friendly Biden Presidency (perceived or real) is far higher than corporate credit and equity valuations suggest;
      • Trade – the trade war with China is back in full swing again, and it’s a bipartisan problem. It will weigh on global economic activity.
    • Monetary policy – For the Fed, there’s basically no policy space left but a move to negative rates across the curve; they are inefficacious at best and harmful at worst.
    • Growth – At the end of 2019, the U.S. economy was already fragile. The risk of a double dip is far greater than risk-asset markets (temporarily propped up by fiscal and monetary policy) are suggesting.
      • The virus – Vaccine efficacy and distribution are unpredictable at best… making the pace of the economic reopening equally as uncertain.
  • Conclusion. It may be a brave new world, but it’s not enough to convince yours truly to drink the soma. To me, markets feel as if they are on the cusp of yet another significant risk-off correlation event.


Facts do not cease to exist simply because they are ignored. –Aldous Huxley

Huxley’s most famous work was A Brave New World, which was written during the Great Depression. This quote comes from his complete essays and predates the novel, which is set in the futuristic, dystopic ‘World State.” (Now that I’m on my own time, I’ve been able to revisit some of the classics.)[3] The State’s citizens are genetically and socially engineered in hatcheries and conditioning centers, respectively, for placement within an intelligence-based social hierarchy. The protagonist, Bernard, studies sleep-learning, which is one of the conditioning techniques used to influence the moral choices and behaviors of its citizenry. In addition, the Alpha controlling caste both uses and administers a mind numbing drug called soma to suppress whatever base, natural instincts might still remain. It is especially useful for control of the working class “Gammas.”

The Brave New World’s existential condition seems uncomfortably familiar. Consider some of Huxley’s descriptions:

“The mind that judges and desires and decides [is] made up of these suggestions. But all these suggestions are our suggestions… suggestions from the State.”

Don’t fight the Fed. Use the Fed Model.

“The Nine Years’ War, the great Economic Collapse. There was a choice between World Control and destruction. Between stability and…”

Must I explain?

Soma had raised a quite impenetrable wall between the actual universe and their minds.”

The Fed’s SOMA (System Open Market Account) is now, too, an integral part of how it controls the markets’ gammas.[4] What was extraordinary has become ordinary. The unthinkable is being slowly accepted as necessary to the preservation of order and stability. Unfortunately, the gammas have become somewhat tolerant of the SOMA, and it has forced the State to act directly with massive fiscal stimulus. Stability achieved at the expense of democratic capitalism? It ends up being a societal choice. We are making it… one crisis, one ‘extraordinary circumstance’ at a time.

While philosophy can be useful, this comment ought to bring to light more pragmatic truths that might lead one to conclude the following: 1) equities as an asset class (excluding its largest technology constituents) have broadly been in a bear market since 2018, and 2) risk-reward to equities is awful because market breadth is unhealthy, valuations are extreme, and risks to fiscal policy are elevated into the election.

Ignorance Is Bliss

On August 17th, I wrote:

“While I’m on the wrong side of history [relative to the most-widely followed indices] at the moment, I continue to believe [my skepticism] will prove justified in the context of what’s to come. The expansion of breadth into small caps is likely to pan out as a short-lived rotation that continued weakness in earnings and higher levels of defaults will derail.”

Indeed, the rotation into small caps has so far failed to endure. While a touch above the June 8th local high, around which I wrote The Portnoy Top, I continue to believe upside is extremely limited. The true condition of U.S. stocks has been masked by the construction of the most widely followed indices, but that construction will not ultimately save them… unless a vaccine is found and distributed far faster than appears possible.


When one drops the veil, it becomes clear that stocks have not performed well overall. While Huxley was correct – ignorance of facts does not deny their existence – it can lend itself to an impenetrable wall between people’s minds and the reality of the world around them. As I wrote in The Narrative Matrix, perception becomes reality, but the truth ultimately prevails. I haven’t conducted a formal survey, but I’d guess the average investor perceives that ‘stocks’ are doing well. My doorman certainly seems to think so. In fact, since 2018, the majority of stocks have been in a bear market. Performance dispersion within and amongst equity indices tells the ‘true’ story about U.S. equity performance.

Unlike the S&P 500 and Nasdaq Composite, many broad indices and non-technology sectors remain below or well below previous highs, some of which were marked in mid-2018. It’s essentially been a bear market for the Russell 2000 and NYSE Composite since then. The NYSE Composite is down 7.5% YTD (down 4.6% from its 2018 high) and Russell 2000 is down 9.6% YTD (down ~11.5% from 2018 high). The S&P Equal Weighted Index, which is roughly 6.5% below its January high, shows the importance of large cap technology company performance to the capitalization weighted S&P 500. Only a handful of stocks have driven returns for the broader tech-heavy indices like the S&P and the Nasdaq. This is not a unique insight, but it bears emphasis because narrow breadth typically means markets are fragile.

Sector dispersion and breadth indicators within the NYSE and S&P 500 further tell the story. Financials tend to be important to the sustainability of market moves. Large cap banks (XLF ETF) are still roughly 20% off their 2020 high and~18% off their 2018 high; regional banks (KRE ETF) are roughly 35% off their 2020 high and 40% off their 2018 all-time high. Financials (and particularly regional banks) are struggling.[5] Not since mid-2018 has it generally paid to be overweight economically sensitive stocks.[6] The Dow Jones industrial average still remains down almost 5% from its 2020 high, despite the very recent addition of a wholly un-industrial company: Salesforce. Whoever said the benchmark indices weren’t actively managed?

Index breadth has been narrowing. According to Bloomberg data, the percentage of NYSE stocks above their 200-day moving average has certainly rebounded, but it has failed to rebound quickly above the 60% level that typically characterizes the beginning of a new bull market advance. See Exhibit 1 of the Appendix. The NYSE cumulative advance-decline line tells the same story. It looks quite a bit like it did in mid-2015 just prior to the significant hiccup in energy and industrials. See Exhibit 2 of the Appendix. Like 2015, when healthcare and retail drove the entirety of the S&P’s advance, now there is even narrower leadership from technology. New highs minus new lows on the NYSE now hovers around zero and has been quite weak as market bounces typically go. See Exhibit 3 of the Appendix. The media narrative, which tends to focus on tech, masks this reality.

Telling a story and creating a feeling around what it means to day trade has certainly help change the nature of market participation. The Robinhood app has brought the promiscuity of Bumble to investing.[7] Sexy is as sexy does. From numerous anecdotes, it would appear that little thought is given before getting in or getting out. [8] (For those who’ve read Brave, we can agree I’m really stretching the analogy here, but why not try to have some fun with it?) Market participants are part of society, so this behavior should come as no surprise. With the numbing effects of SOMA at work, and with the continued assurances that The State will provide prophylaxis for its citizenry’s misjudgments, it’s no surprise that there’s little fear. No morals. No moral hazard. Pretty simple.


Because of performance dispersion within the S&P and negative earnings within the Russell 2000, talking about valuation is far more difficult than it’s ever been. While it does not tell the story for most stocks, or even for most stocks in the S&P, it does help inform how much risk there is to the narrow band of S&P leaders. Technology companies within the S&P 500 trade on a capitalization weighted basis at ~31x year-end estimates; the remainder of the index trades around 20x. There is so little visibility around Russell 2000 earnings, and so many companies have negative earnings, that the P/E based on the 2020 estimate for earnings is 93x. The estimate for companies with positive earnings is 17.4x. It’s a laughable disparity. Nearly 1/3 of small caps lost money over the last twelve months (according to FactSet) and, based on my rough estimates, at least 25% will lose money over the coming twelve months. Index valuation has always been tricky, but it is now even more so for both large cap and small cap indices.

Of late, I’ve seen every manner of justification for a year-end 2020 forward S&P 500 P/E of almost 26x. One obvious justification is an expectation for a rapid recovery in earnings. Even a recovery in S&P earnings to $150 by this time next year would make the forward twelve month P/E a still eye-popping 21x. I’ve recently seen some good analysts try to make a case that a fair value forward multiple for the S&P 500 is just that (21x). This ludicrous assertion is typically reliant on some variation of the Fed model (i.e. – equity yields are favorable relative to Treasury yields). It also routinely points to tight corporate spreads and equity risk premium relative to those spreads. The latter, at least, is more sensible. The Fed model justification is just rubbish. It does not take into account the normal equity risk premium required above a risk-free asset. It also doesn’t it take into account inflation or the reason rates are so low in the first place!

Rates began falling in 2019 for a reason – there was a global slowdown that began in 2018. In 2019, earnings for U.S. large caps were flat year-over-year, and for corporate America (more broadly), they were down over 5%, despite the tax cuts. Russell 2000 earnings were down over 15%! Few seem to recall this fact. The 2019 curve inversion caused lower loan volume growth, which eventually turned negative in December 2109.[9]   This probably would have aggravated the already weak earnings picture in 2020, but we’ll never know.  The earnings slowdown was followed by an unprecedented pandemic shock. In sum, corporate cash flows were already challenged and then collapsed on the pandemic’s impact. This resulted in unprecedented and unsustainable stimulus from both monetary and fiscal policy makers. Given this backdrop, why should we expect cash flows to rebound quickly above 2019 levels? Soma anyone?

This is likely a distorted and prolonged cycle downturn. The already fragile backdrop for corporate earnings makes a quick recovery unlikely, so the Molodovsky effect does not yet apply. Molodovsky’s 1953 article “A Theory of Price Earnings Ratios” observed that at the bottom of the business cycle, earnings were depressed to the point that P/E ratios were often much higher than when earnings were strong at the top of the cycle – even though share prices were higher. First, this is actually not always the case, as additional empirical observation since then have revealed. Second, if one is to make the case that valuations are ‘distorted’ by the recession, then one must believe the recession has ended and that earnings will bounce back as they would after the end of other cycle downturns. It is a flawed and tautological argument to assume that valuations are elevated because of the earnings downturn. If the downturn hasn’t ended, then price rather than earnings could just as easily correct for the overvaluation.

Alongside and related to poor cash flow growth, inflation has been well below target for some time. Inflation is a key variable when assessing earnings risk premium (ERP) and P/E. Central banks have failed to produce it for over a decade.[10] Last month, PPI excluding food and energy printed at 60bps, up from just above zero the prior month. The proprietary ERP model I’ve previously presented in detail uses a forward inflation rate of 1.5%; it suggests that the ‘fair value’ forward P/E multiple for the S&P 500 is closer to 17.5x twelve-month forward earnings. Even if one assumed an EPS recovery to $150 by this time next year, using this fair value multiple, the S&P should be closer to 2,625. The traditional Fed model is rubbish, but the State has programmed many to believe it.

At current valuations, it’s almost a ‘no win’ for large cap tech here. If the economy improves, enthusiasm for many of the tech giants should wane. If the economy double-dips, which is likely, even these tech giants are likely to suffer. The growth in cash flow and earnings just isn’t there to justify the valuations of these mature, large cap tech companies. The reversion will come as these go-go names suffer a mean reversion to the rest of the market and as market participants realize they are impacted by the same risks as the rest of the market. Moreover, relative value assessments to corporate spreads are misplaced; the default cycle is just getting started and pandemic policy response won’t prevent it for lower-rated borrowers. High yield credit spreads implying 3% to 4% default rates with defaults already on pace to rise above 5% makes little sense. Investment grade (IG) spreads may not budge, but the risk premium of equities over IG should widen instead. In sum, valuation risk is extreme.

Policy and Growth

Except after the Great Depression, U.S. markets have never been so reliant on policy – especially fiscal policy. Despite Treasury-funded Fed lending, the most recent loan officer survey (released on July 31st), shows that standards have tightened across the board. This will have a feedback effect on growth. Importantly, and as I’ve written ad nauseam of late, fiscal policy is now far more important that monetary policy. Without a coordinated effort between the Treasury and the Fed, the Fed would not be able to lend under Section 13(3) to buy corporate debt. Companies would not have received the (Paycheck Protection Program) PPP loans, which have prevented even deeper layoffs.[11] PPP expired on August 8th, and the pace of the recovery has not been quick enough that PPP borrowers will be able to afford keeping on workers. These layoffs will keep PPP loans on company books and, unfortunately, the pace of improvement in unemployment may slow.

We’ve already seen the beginnings of those postponed layoffs with airlines, big banks and automakers making announcements. What will small businesses do? It appears that many of the beneficiaries of PPP or other companies that took more of a ‘wait-and-see’ approach, began to read the writing on the wall in mid-September. According to news reports, on September 14th, Citigroup continued laying off roughly 1% of its global workforce. The cuts end a previous commitment to pause layoffs amid the pandemic. United Airlines announced on September 2 that it will furlough 16,370 employees once federal aid expires on October 1. On August 25, American Airlines, which previously announced cutting 20% of the company’s workforce, said that it would cut 19,000 employees in October when federal aid ends. In late August, Delta Airlines announced it plans to furlough 1,941 pilots in October following the expiration of federal aid.  In April, Boeing announced plans to cut its staff of roughly 160,000 by 10%. In an August 17 memo, Boeing told employees it was starting a second round of buyout offers that would extend beyond the original expected numbers.

It’s not just airlines and aerospace, which are clearly industries most impacted by Covid-19’s progression. Ford is offering buyouts to 1,400 workers eligible for retirement this year in the US. The September 2 cuts make up just under 5% of the company’s US workforce. MGM Resorts is laying off 18,000 previously furloughed employees, and that began August 28. Coca-Cola said it plans to offer voluntary-separation packages to 4,000 employees in North America beginning on August 28. It did not specify the total number of employees it plans to lay off. Salesforce started to lay off 1,000 of 54,000 employees on August 26In March, CEO Marc Benioff pledged a 90-day freeze on layoffs. These layoffs demonstrate that corporate America is being forced to respond to a slower-than-expected emergence from the pandemic. Balance sheets were already levered, with leverage ratios at all-time highs and even with coverage ratios beginning to start to deteriorate – even with ultra-low rates.

While extraordinary fiscal policy action has been effective, once the initial stimulus ends, credit to businesses and consumers is still generally transmitted through banks. Given 1) high corporate leverage levels, 2) anecdotal evidence that large firms will begin to lay off workers in October, and 3) initial claims still hovering just below a million (with continuing claims falling to just over 13 million), it’s unlikely banks will become more excited to lend in the near future. The higher frequency payrolls data seems to confirm what ISM’s payroll component reflected on September 1st when it printed at 46.4. It also seems to confirm the deceleration in private payrolls growth to just over 1 million. Figure 1 shows that standards tightened considerably in the second quarter despite stabilization in credit and equity markets due to implementation of a plethora of policy responses. With credit this tight, it will be difficult for growth to immediately rebound in the way markets seem to be expecting.


The truth of the matter is that, since 2018, most U.S. equities have had a rough time of it. Most seem blissfully unaware of this condition, as the headline indices are dominated by what have turned out to be somewhat countercyclical (at least relative to the pandemic) technology stocks. While these stocks are wildly overvalued and subject to correction, even the more ‘reasonably’ valued remainder of the S&P 500 is still too expensive. Yes, this is true even when taking into account rates and the so-called Molodovsky effect. I believe it’s almost impossible to argue that high yield credit and U.S. equities (and I’ll throw a blanket around all of them) are priced at fair value. The kind of recovery in corporate cash flows that’s needed just isn’t in the cards. The backdrop coming into the pandemic was just too fragile and the foundation simply too weak.

Perhaps I’m just plain wrong. Maybe the new breed of market Bumblers has changed markets from price discounting and discovery mechanisms to a new form of entertainment. But I’m just not willing to concede that ‘truth’ is no longer relevant. Future corporate and personal taxation increases are an almost inevitable consequence of the current fiscal policy response, which the Fed has (for now) been monetizing. In my view, the risk that these tax increases come in January 2021 is now far greater than it was prior to the pandemic. Given the perceived effectiveness of the Trump administration’s pandemic response, a Biden victory is not out of the question. All in all, the risks are severely skewed the wrong way for equity investors given current valuations. It may be a brave new world, but it’s not enough to convince yours truly to start drinking the soma. Markets feel as if they are on the cusp of yet another significant risk off correlation event. Maybe I can fix that feeling with a half hour on the heavy bag. Whatever floats your boat, I guess.


[1] The NYSE Composite is down 7.5% YTD and Russell 2000 down 9.6% YTD. The S&P Equal Weighted Index, which is roughly 6.5% below its January high, shows the importance of large cap tech’s outperformance to the S&P 500.

[2] Large cap technology companies within the S&P 500 now trade at about 31x 2020 forward earnings. These are mature technology companies whose earnings growth does not justify this elevated multiple.

[3] I’m also in the midst of rereading James Fenimore Cooper’s Last of the Mohicans. It would be a stretch to try to draw market analogies from that masterwork, but I may yet try!

[4] SOMA is the acronym for the Fed’s System Open Market Account, where it houses securities it now buys with Treasury’s able assistance under Section 13(3) of the Federal Reserve Act. Gamma just so happens to be the option Greek that that describes the ‘leverage’ an option gives the underlying asset. The higher the gamma, the greater the change on the rate of change and ultimately the more pronounced and option’s price move will be. Take out the gamma and stability returns… or something like that!

[5] Despite this underperformance, at an average of 1.2x price to tangible book, large regional banks are far from cheap. I have been particularly bearish of small cap banks since 2018, as they tend to be sensitive to the slowdown in loan growth that began then.

[6] Transports, for example, are down just under 2% since mid-2018 at their most recent peak. REITs are down slightly from their mid-2018 peak and down over 17% from their early 2020 high. Energy (XOP ETF) is down almost 58% from its mid-2018 peak. Metals and mining companies have suffered an almost 37% decline (XME ETF). Consumer discretionary (XRT ETF) is down about 4% form mid-2018. Discretionary stands in stark contrast to staples, which are up considerably because many of those companies benefit from stay-at-home trends along the homebuilders, which are also at new highs.

[7] Please see Exhibit 4 of the Appendix.

[8] As the WSJ authors of Everyone’s a Day Trader Now wrote: “it appears even bigger—and broader—this time around, amplified by digital communities on Twitter and Discord, a popular online chat hangout. Investors have transformed those social-media platforms into virtual trading desks, a place to swap tips, hype stocks and talk trash as they attempt to trade their way to a quick fortune.” My favorite quote from the story is a woman who proclaims that her trading style is aggressive because ‘scared money makes no money.’ According to the Journal, “she read ‘Trading for Dummies,’ watched YouTube videos, opened an E*Trade account and dove in.” That sounds about right.

[9] As global growth slowed, U.S. long rates continued to rise – until they hit just over 3%. The economy, as well as equity and rates markets, all had hissy fits. The yield curve inversion and equity markets selloff forced the Fed to cut and to stop balance sheet normalization.

[10] Intuitively, when inflation is low, nominal earnings growth will also be lower; thus, P/Es should be lower all else equal. Importantly, capital costs have little room to move lower, as rates/loneger-yields been so close to zero for some time and spreads have been so tight. That is the ‘all else equal.’

[11] “To bolster the effectiveness of the Small Business Administration’s Paycheck Protection Program (PPP), the Federal Reserve is supplying liquidity to participating financial institutions through term financing backed by PPP loans to small businesses. The PPP provides loans to small businesses so that they can keep their workers on the payroll. The Paycheck Protection Program Liquidity Facility (PPPLF) will extend credit to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value.” – The Fed


Invisible Threads: Matrix Edition


Editor’s Note: On August 24th, 2015 – almost exactly five years ago – we had a flash crash in the S&P 500 when the VIX didn’t price correctly one morning and the invisible thread of option gamma that holds the market together was snipped. And so everyone got gamma-squeezed whether they knew what gamma was or not.

In August 2020 we were all gamma-squeezed again, just in the opposite direction … a bubble rather than a crash. And again, whether we knew what gamma was or not.

I wrote this note about six weeks after that 2015 flash crash. My focus then was on systematic options trading and how the meaning of the options market has changed over the past 10-20 years. Today we’ve got a flood of decidedly non-systematic puppets retail options traders who have zero idea about any of this, together with large pools of capital (like SoftBank) who know how to pull these invisible threads to their advantage.

If you’re in public markets at all, you can’t disentangle yourself completely from these invisible threads.

But you can stop being a puppet.

Start by paying attention to the S&P 500 volatility term structure, and understand what it means …

PDF Download (Paid Membership Required): Invisible Threads – Matrix Edition

Originally published October 13, 2015


These are both aerial photographs of Old Hickory Lake in Tennessee. On the left is a visible light photo in cloudy/hazy weather conditions, and on the right is an infrared light photo taken at the same time.

Almost all equity investors look at the stock market through a visible light camera.

Morpheus:Do you believe in fate, Neo?
Morpheus:Why not?
Neo:Because I don’t like the idea that I’m not in control of my life.
Morpheus:I know *exactly* what you mean. Let me tell you why you’re here. You’re here because you know something. What you know you can’t explain, but you feel it. You’ve felt it your entire life, that there’s something wrong with the world. You don’t know what it is, but it’s there, like a splinter in your mind, driving you mad.
Cypher:I know this steak doesn’t exist. I know that when I put it in my mouth, the Matrix is telling my brain that it is juicy and delicious. After nine years, you know what I realize? [Takes a bite of steak]
Cypher:Ignorance is bliss.
Agent Smith:Never send a human to do a machine’s job.

A right-hand glove could be put on the left hand if it could be turned round in four-dimensional space.
Ludwig Wittgenstein, “Tractatus Logico-Philosophicus” (1921)

I remember that I’m invisible and walk softly so as not awake the sleeping ones. Sometimes it is best not to awaken them; there are few things in the world as dangerous as sleepwalkers.
Ralph Ellison, “Invisible Man” (1952)

Tell people there’s an invisible man in the sky who created the universe, and the vast majority will believe you. Tell them the paint is wet, and they have to touch it to be sure.
George Carlin (1937 – 2008)

Invisible threads are the strongest ties.
Friedrich Nietzsche (1844 – 1900)

This is the concluding Epsilon Theory note of a trilogy on coping with the Golden Age of the Central Banker, where a policy-driven bull market has combined with a machine-driven market structure to play you false. The first installment – “One MILLION Dollars” – took a trader’s perspective. The second – “Rounders” – was geared for investors. Today’s note digs into the dynamics of the machine-driven market structure, which gets far less attention than Fed monetary policy but is no less important, to identify what I think is an unrecognized structural risk facing both traders and investors here in the Brave New World of modern markets.

To understand that risk, we have to wrestle with the investment strategies that few of us see but all of us feel … strategies that traffic in the invisible threads of the market, like volatility and correlation and other derivative dimensions. A few weeks ago (“Season of the Glitch”) I wrote that “If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily ‘news’.” Actually, the problem is worse than that. Just as dark matter (which as the name implies can’t be seen with visible light or any other electromagnetic radiation, but is perceived only through its gravitational effects) makes up some enormous portion of the universe, so do “dark strategies”, invisible to the vast majority of investors, make up some enormous portion of modern markets. Perceiving these dark strategies isn’t just a nice-to-have ability for short-term or tactical portfolio adjustments, it’s a must-have perspective for understanding the basic structure of markets today. Regardless of what the Fed does or doesn’t do, regardless of how, when, or if a “lift-off” in rates occurs, answering questions like “does active portfolio management work today?” or “is now a good time or a bad time for discretionary portfolio managers?” is impossible if you ignore derivative market dimensions and the vast sums of capital that flow along these dimensions.

How vast? No one knows for sure. Like dark matter in astrophysics, we “see” these dark strategies primarily through their gravitational pull on obviously visible securities like stocks and bonds and their more commonly visible dimensions like price and volume. But three massive structural shifts over the past decade – the concentration of investable capital within mega-allocators, the development of powerful machine intelligences, and the explosion in derivative trading activity – provide enough circumstantial evidence to convince me that well more than half of daily trading activity in global capital markets originates within derivative dimension strategies, and that a significant percentage (if you held a gun to my head I’d say 10%) of global capital allocated to public markets finds its way into these strategies.

Let me stick with that last structural change – the explosive growth in derivative trading activity – as it provides the best connection to a specific dark strategy that we can use as a “teachable moment” in how these invisible market dimensions exert such a powerful force over every portfolio, like it or not. The chart on the right, courtesy of Nanex’s Eric Scott Hunsader, shows the daily volume of US equity and index option quotes (not trades, but quotes) since mid-2003. The red dots are daily observations and the blue line is a moving average. In 2004 we would consistently see 100,000 options quotes posted on US exchanges on any given day. In 2015 we can see as many as 18 billion quotes in a single day. Now obviously this options activity isn’t being generated by humans. There aren’t millions of fundamental analysts saying, “Gee, I think there’s an interesting catalyst for company XYZ that might happen in the next 30 days. Think I’ll buy myself a Dec. call option and see what happens.” These are machine-generated quotes from machine-driven strategies, almost all of which see the world on the human-invisible wavelength of volatility rather than the human-visible wavelength of price.


There’s one and only one reason why machine-driven options strategies have exploded in popularity over the past decade: they work. They satisfy the portfolio preference functions of mega-allocators with trillions of dollars in capital, and those allocators in turn pay lots of money to the quant managers and market makers who deliver the goods. But volatility, like love if you believe The Four Aces, is a many splendored thing. That is, there’s no single meaning that humans ascribe to the concept of volatility, so not only is the direct relationship between volatility and price variable, but so is the function that describes that relationship. The definition of gamma hasn’t changed, but its meaning has. And that’s a threat, both to guys who have been trading options for 20 years and to guys who wouldn’t know a straddle from a hole in the head.

Okay, Ben, you lost me. English, please?

The basic price relationship between a stock and its option is called delta. If the stock moves up in price by $2.00 and the option moves up in price by $1.00, then we say that the option has a delta of 0.5. All else being equal, the more in-the-money the option’s strike price, the higher the delta, and vice versa for out-of-the-money options. But that delta measurement only exists for a single point in time. As soon as the underlying stock price change is translated into an option price change via delta, a new delta needs to be calculated for any subsequent underlying stock price change. That change in delta – the delta of delta, if you will – is defined as gamma.

One basic options trading strategy is to be long gamma in order to delta hedge a market neutral portfolio. Let’s say you own 100 shares of the S&P 500 ETF, and let’s assume that an at-the-money put has a delta of 0.5 (pretty common for at-the-money options). So you could buy two at-the-money put contracts (each contract controlling 100 shares) to balance out your 100 share long position. At this point you are neutral on your overall market price exposure; so if the S&P 500 goes up by $1 your ETF is +$100 in value, but your puts are -$100, resulting in no profit and no loss. But the delta of your puts declined as your S&P ETF went up in price (the options are now slightly out-of-the-money), which means that you are no longer market neutral in your portfolio but are slightly long. To bring the portfolio back into a market neutral position you need to sell some of your ETF. Now let’s say that the S&P goes down by $2. You’ve rebalanced the portfolio to be market neutral, so you don’t lose any money on this market decline, but now the delta of your puts has gone up, so you need to buy some S&P ETF to bring it back into market neutral condition. Here’s the point: as the market goes back and forth, oscillating around that starting point, you are constantly buying the ETF low and selling it high without taking on market risk, pocketing cash all the way along.

There are a thousand variations on this basic delta hedging strategy, but what most of them have in common is that they eliminate the market risk that most of us live with on a daily basis in favor of isolating an invisible thread like gamma. It feels like free money while it works, which attracts a lot of smart guys (and even smarter machines) into the fray. And it can work for a long time, particularly so long as the majority of market participants and their capital are looking at the big hazy market rather than a thread that only you and your fellow cognoscenti can “see”.

But what we’re experiencing in these dark strategies today is the same structural evolution we saw in commodity market trading 20 or 30 years ago. In the beginning you have traders working their little delta hedging strategies and skinning dimes day after day. It’s a good life for the traders plucking their invisible thread, it’s their sole focus, and the peak rate of return from the strategy comes in this period. As more and larger participants get involved – first little hedge funds, then big multistrat hedge funds, then allocators directly – the preference function shifts from maximizing the rate of return in this solo pursuit and playing the Kelly criterion edge/odds game (read “Fortune’s Formula” by William Poundstone if you don’t know what this means) in favor of incorporating derivative dimension strategies as non-correlated return streams to achieve an overall portfolio target rate of return while hewing to a targeted volatility path. This is a VERY different animal than return growth rate maximization. To make matters even muddier, the natural masters of this turf – the bank prop desks – have been regulated out of existence.

It’s like poker in Las Vegas today versus poker in Las Vegas 20 years ago. The rules and the cards and the in-game behaviors haven’t changed a bit, but the players and the institutions are totally different, both in quantity and (more importantly) what they’re trying to get out of the game. Everyone involved in Las Vegas poker today – from the casinos to the pros to the whales to the dentist in town for a weekend convention – is playing a larger game. The casino is trying to maximize the overall resort take; the pro is trying to create a marketable brand; the whale is looking for a rush; the dentist is looking for a story to take home. There’s still real money to be won at every table every night, but the meaning of that money and that gameplay isn’t what it used to be back when it was eight off-duty blackjack dealers playing poker for blood night after night. And so it is with dark investment strategies. The meaning of gamma trading has changed over the past decade in exactly the same way that the meaning of Las Vegas poker has changed. And these things never go back to the way they were.

So why does this matter?

For traders managing these derivative strategies (and the multistrats and allocators who hire them), I think this structural evolution in market participant preference functions is a big part of why these strategies aren’t working as well for you as you thought they would. It’s not quite the same classic methodological problem as (over)fitting a model to a historical data set and then inevitably suffering disappointment when you take that model outside of the sample, but it’s close. My intuition (and right now it’s only intuition) is that the changing preference functions and, to a lesser extent, the larger sums at work are confounding the expectations you’d reasonably derive from an econometric analysis of historical data. Every econometric tool in the kit has at its foundation a bedrock assumption: hold preferences constant. Once you weaken that assumption, all of your confidence measures are shot.

For everyone, trader and investor and allocator alike, the explosive growth in both the number and purpose of dark strategy implementations creates the potential for highly crowded trades that most market participants will never see developing, and even those who are immersed in this sort of thing will often miss. The mini-Flash Crash of Monday, August 24th is a great example of this, as the prior Friday saw a record imbalance of short gamma exposure in the S&P 500 versus long gamma exposure. Why did this imbalance exist? I have no idea. It’s not like there’s a fundamental “reason” for creating exposure on one of these invisible threads that you’re going to read about in Barron’s. It’s probably the random aggregation of portfolio overlays by the biggest and best institutional investors in the world. But when that imbalance doesn’t get worked off on Friday, and when you have more bad news over the weekend, and when the VIX doesn’t price on Monday morning … you get the earthquake we all felt 6 weeks ago. For about 15 minutes the invisible gamma thread was cut, and everyone who was on the wrong side of that imbalance did what you always do when you’re suddenly adrift. You derisk. In this case, that means selling the underlying equities.

I can already hear the response of traditional investors: “Somebody should do something about those darn quants. Always breaking windows and making too much noise. Bunch of market hooligans, if you ask me. Fortunately I’m sitting here in my comfortable long-term perspective, and while the quants are annoying in the short-term they really don’t impact me.”


I think this sort of Statler and Waldorf attitude is a mistake for two reasons.

First, you can bet that whenever an earthquake like this happens, especially when it’s triggered by two invisible tectonic plates like put gamma and call gamma and then cascades through arcane geologies like options expiration dates and ETF pricing software, both the media and self-interested parties will begin a mad rush to find someone or something a tad bit more obvious to blame. This has to be presented in soundbite fashion, and there’s no need for a rifle when a shotgun will make more noise and scatters over more potential villains. So you end up getting every investment process that uses a computer – from high frequency trading to risk parity allocations to derivative hedges – all lumped together in one big shotgun blast. Never mind that HFT shops, for which I have no love, kept their machines running and provided liquidity into this mess throughout (and enjoyed their most profitable day in years as a result). Never mind that risk parity allocation strategies are at the complete opposite end of the fast-trading spectrum than HFTs, accounting for a few percent (at most!) of average daily trading in the afflicted securities. No, no … you use computers and math, so you must be part of the problem. This may be entertaining to the Statler and Waldorf crowd and help the CNBC ratings, but it’s the sort of easy prejudice and casual accusation that makes my skin crawl. It’s like saying that “the bankers” caused the Great Recession or that “the [insert political party here]” are evil. Give me a break.

Second, there’s absolutely a long-term impact on traditional buy-and-hold strategies from these dark strategies, because they largely determine the shape of the implied volatility curves for major indices, and those curves have never been more influential. Here’s an example of what I’m talking about showing the term structure for S&P 500 volatility prior to the October jobs report (“Last Week”), the following Monday (“Now”), and prior years as marked.


Three observations:

  • The inverted curve of S&P 500 volatility prior to the jobs report is a tremendous signal of a potential reversal, which is exactly what we got on Friday. I don’t care what your investment time horizon is, that’s valuable information. Solid gold.

  • Today’s volatility term structure indicates to me that mega-allocators are slightly less confident in the ability of the Powers That Be to hold things together in the long run than they were in October 2013 or 2014, but not dramatically less confident. The faith in central banks to save the day seems largely undiminished, despite all the Fed dithering and despite the breaking of the China growth story. What’s dramatic is the flatness of the curve the Monday after the jobs report, which suggests a generic expectation of more short-term shocks. Of course, that also provides lots of room (and profits) to sell the front end of the volatility curve and drive the S&P 500 up, which is exactly what’s happened over the past week. Why is this important for long-term investors? Because if you were wondering if the market rally since the October jobs report indicated that anything had changed on a fundamental level, here’s your answer. No.  

  • In exactly the same way that no US Treasury investor or allocator makes any sort of decision without taking a look at the UST term structure, I don’t think any major equity allocator is unaware of this SPX term structure. Yes, it’s something of a self-fulfilling prophecy or a house of mirrors or a feedback loop (choose your own analogy), as it’s these same mega-allocators that are establishing the volatility term structure in the first place, but that doesn’t make its influence any less real. If you’re considering any sort of adjustment to your traditional stock portfolio (and I don’t care how long you say your long-term perspective is … if you’re invested in public markets you’re always thinking about making a change), you should be looking at these volatility term structures, too. At the very least you should understand what these curves mean.

I suppose that’s the big message in this note, that you’re doing yourself a disservice if you don’t have a basic working knowledge of what, say, a volatility surface means. I’m not saying that we all have to become volatility traders to survive in the market jungle today, any more than we all have to become game theorists to avoid being the sucker at the Fed’s communication policy table. And if you want to remove yourself as much as possible from the machines, then find a niche in the public markets where dark strategies have little sway. Muni bonds, say, or MLPs. The machines will find you eventually, but for now you’re safe. But if you’re a traditional investor whose sandbox includes big markets like the S&P 500, then you’re only disadvantaging yourself by ignoring this stuff.

Ignorance is not bliss, and I say that with great empathy for Cypher’s exhaustion after 9 years on the Matrix battlefield. After all, we’ve now endured more than 9 years on the ZIRP battlefield. Nor am I suggesting that anyone fight the Fed, much less fight the machine intelligences that dominate market structure and its invisible threads. Not only will you lose both fights, but neither is an adversary that deserves “fighting”. At the same time, though, I also think it’s crazy to ignore or blindly trust the Fed and the machine intelligences. The only way I know to maintain that independence of thought, to reject the Cypher that lives in all of us … is to identify the invisible threads that enmesh us, some woven by machines and some by politicians, and start disentangling ourselves. That’s what Epsilon Theory is all about, and I hope you find it useful.

PDF Download (Paid Membership Required): Invisible Threads – Matrix Edition


A Society of Tinkerers


Editor’s note: We’re pleased to publish a note today by Luis Perez-Breva, author of Innovating: A Doer’s Manifesto (MIT Press: 2017), and MIT Faculty Director of Innovation Teams Enterprise. Luis holds a Ph.D. in artificial intelligence from MIT, as well as degrees in chemical engineering, physics and business. He is an inventor and entrepreneur. He is also, as of a few weeks ago, a brand new American citizen. If you’d like to connect with Luis, you can find him on Twitter at @lpbreva or via email at

As with all articles we publish from our guest authors, this note 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.

We may have perfected the wrong economy; we’ve got one that struggles to protect the long-term survival of the species. But we can fix that.

We can move past Speculate-ship, allow ourselves to do well and good at the same time, and put energy into building a Society of Tinkerers … with just enough good ol’ American ingenuity to invent our way to an economy in which greed is once again aligned with survival.

Ok. There are some new terms in there. To explain, let me start at the beginning.

Whether it’s this pandemic, or inequality, or the opioid crisis, or climate change, or whatever comes next, the most important crises hit us when we’re almost ready to handle them. And it’s almost always the same big, invisible enemy: humans — who are (unknowingly?) laying waste to our own species.

As is often the case in these almost-ready moments, everyone’s in denial—just like we’re now talking about getting back to some “normal.” Sigh. Fast forward. I propose we seize the moment to make it harder, less fun, and definitely less rewarding for humans to bring the species down and with it the economy every time someone sneezes the wrong way.

There’s got to be a way to help humans help humans that’s compatible with making money, or we’re doomed.

Herein lies our chance to establish a different enterprising mindset.

  • We need new ways to explore problems that matter.
  • We need to share hands-on knowledge with society so that anyone who wants to tinker with problems can tinker with problems.
  • We need an alternative to the zero-sum speculation that poses as celebration of entrepreneurship.

Letting go of speculate-ship and daring to create a Society of Tinkerers is not for the faint of heart. It’s about appreciating how true wealth, the idea of wealth itself, ought to be sustainable (you could ask Marie Antoinette what will happen to your wealth if we reach a point at which no one can afford anything).

But to thrive in this new mindset we may need to accept that we face a tremendous deficit of authenticity in investment, entrepreneurship, leadership, and generally education that has resulted in a genuine surplus of frivolity and waste.

These crises are so moronically “elitist” (epidemiology, climatology, socioeconomics) that it seems as if you need some kind of advanced degree just to read through the gobbledygook, let alone have any real understanding about what’s truly going on. We need to stop creating opportunities for any random idiot to call everything “fake news” and appear more believable than current events only because his/her stupidities can be understood and current events can’t.

We all hope entrepreneurs will get us out of this. After all, “Entrepreneurship” has been touted as the greatest invention of the late twentieth century. Along with the culture of “startups” it spawned, it was supposed to help us continually reinvent our economy for the better. Instead, beginning in the 1980s, we fell into a pattern of chasing after “solutions” to whatever next big emergency, bubble, or crisis comes along — and getting nowhere.

So here we are. The distraction of seemingly easy money got in the way of doing things that matter. It made us complacent. Bad slogans emerged in the entrepreneurship world: “Fail fast!” and “Pay it forward!” We accepted as just fine that 9 of 10 startups fail: “It’s okay! Here’s your participation trophy!”

That’s right: every year in the United States, we expend about $75 billion to back new venture formation, with odds of success hovering around 1 in 10. That’s quite a “death rate.”

By the way, every year nearly five times as much goes to philanthropy.

Hence, frivolous and wasteful. We grew content with mediocrity, inclined to rush the next “great” idea out the door — lately, that’s likely to be some app that spies on you. Not surprisingly, from the need to track a virus everyone came up with a “solution” to lapse into spying on people’s interactions—as the New York Times has reported.

The fact that so many thought this — the very essence of speculate-ship — could ever work reveals far too many of the defects in our thinking. Just as the “Spanish Inquisition” became the theme of the late Middle Ages’ resistance to any kind of science, the theme for our era’s resistance to addressing problems that truly matter could be: “Everything can be solved by ‘spying’ and ‘running ads’.” And so, the past two-plus decades may be remembered for crashes, deepening inequality, and putting humans on the verge of extinction.

Does anyone really believe that this kind of “entrepreneurship” can get us out of our current crisis? What good is the next “killer spy app” when a virus can close entire countries, climate can force refugee crises, and inequality drives opioid epidemics? At the other end of this pandemic may lie a veritable wasteland full of newly dead companies that will join the already huge pile of bad startup ideas, wasted “innovations,” and failed venture funds. What if this were salvageable?

Given the dismal success rate of venture investing and an obvious desire in America to put money into worthy causes, I can’t help but wonder why we separate the two. The short answer is “the tax code.” But the longer answer may be more telling, as the well-known investment advisor David Salem once pointed out to me: It’s the “cheap capital.” When capital is cheap, wasting money is less expensive than thinking through a long-term way out of a mess.

That’s why I wonder whether we perfected the wrong economy. What if we could resolve these contradictions and unite these forces — do good and do well — in a new way? What if we could reinvigorate American ingenuity while creating breathing room for a kind of entrepreneurship intent on solving problems that matter and building great companies rather than just selling startups?

About a year-and-a-half ago, I gave a talk to the Harvard Business School Entrepreneurship Club. I was asked: “How do I find an idea, even ONE to invest in?”. At the time, with daily articles about the opioid epidemic, weekly climate protests, and monthly articles detailing the rise of income inequality I sought to inspire these wannabe entrepreneurs to do something that truly matters.

That seems especially relevant today — and perhaps even easier to explain. There are now at least three ways to play “entrepreneur,” but not all lead to the economic progress we now need. I call them: industrialist or businessperson (let’s call it Entrepreneur 1.0); Speculate-ship, as I mentioned at the beginning; and Tinkerer—the newest one and the basis for the society of tinkerers. Tinkerer is only now emerging. It longs for entrepreneurship with meaning. It fulfills our ambition for wealth that is sustainable. It is the one I’m set to help prosper. But for me to explain why, I need to make sure we are all on the same page about the other options.

The likes of Henry Ford, Nikola Tesla, Thomas Edison, and other industrialists inspired an Entrepreneur 1.0 culture that includes today nearly everyone who dares launch a business—a technology company, restaurant, consulting firm, law firm, or whatever—or who evolves a work of art, movie, or book into a business.

The key characteristic these Entrepreneur 1.0 people share is that they are driven to work on something they are curious about, care about doing, or think they are good at. Extreme Entrepreneur 1.0 people are further defined by a problem they have an itch to solve — typically a problem that looks intractable to others. Even just working on the problem seems preposterous. Those who solve such problems are judged along the way by their idiosyncrasies and later revered for their successes. The Elon Musk who set out to ship a greenhouse to Mars and who ultimately founded a private company, SpaceX, that managed to take astronauts to the space station in the middle of the 2020 pandemic, falls in that category.

Entrepreneur 1.0-built organizations were built to last. Alnylam, Square, the Bill and Melinda Gates Foundation, as well as older examples such as Bloomberg, Hewlett-Packard, Intel, Apple, Oracle, Microsoft, Amazon, Berkshire Hathaway are all examples of the Entrepreneur 1.0 way—that is, starting a business without one of the trendy recipes, and keeping at it.

Today there are still great examples of individuals set on the ways of Entrepreneur 1.0: Leila Phirajhi of Revivemed; Mariana Matus of BioBot analytics; Harry Schechter of the IoT company TempAlert; Ferran Adrià, the Spanish chef; Alexandra Wright-Gladstein of Ayar Labs; David Brewster and Tim Healy of EnerNOC; the investment strategist and founder of Epsilon Theory Ben Hunt; and many others. Investors that go beyond simply speculating with startups and put their money and savvy at the service of problems worth solving fit the profile, too: Khosla Ventures’ Vinod Khosla; Noubar Afeyan of Flagship Pioneering; and DFJ’s John Fischer. They can all be Googled.

If you accept that the business of Entrepreneur 1.0 can truly be anything, it becomes possible to view the Star Wars or Harry Potter franchises, too, as examples, and find inspiration in the work of George Lucas, J.K. Rowling, of the Black Eyed Peas, and countless others that started with a passion and grew a successful business out of it.

If you’re wondering why I had to say any of this at Harvard, then you may not be aware that elite universities have taken to popularizing another form of “entrepreneurship” over the last two decades. Because of that, the stories of Entrepreneur 1.0 rarely make it to entrepreneurship classes these days; they just don’t fit well with Speculate-ship—that is, the “pitch a minimum viable product” formulation and run with it that is all the rage.

Most prevalent in the past few decades has been doing a startup — or more accurately Speculate-ship.

The goal: found a startup born to be sold — and exit before it exits you.

Speculate-ship is fueled by Lean Startup, Design Thinking, the 24 steps of Disciplined Entrepreneurship, and the Startup Owner’s Manual. It’s driven by evocative buzzwords (shown here in italics): have a product or service idea; talk to lots of relevant people to validate it; give the high growth speech; do some inexpensive experimentation about the features of a single would-be product of a single-product startup; and measure success by number of users, not dollars. If it doesn’t work out, start again with a new idea for a new product. A 2019 series of articles in the Economist magazine provided a litany of reasons for why the unicorn craze that follows Speculate-ship looks more like a scam than anything entrepreneurs should pursue.

Sure, Speculate-ship has worked well for some. But here we are, immersed in at least three deep crises, without any of these “ready-made” solutions to pitch as consumer products.

Back to the question Harvard students asked: “How do I find an idea?” It’s not really about “wealth” or “speed” — all approaches could lead to wealth, and speed is tremendously variable. Snap and Tesla Motors both went public about seven years after they were founded — the software startup required five times more investment than the car manufacturer.

The way to choose is to determine how you want to play it out. And that needs serious thinking today. Entrepreneur 1.0 is about building an organization; it means you have to play the game of scale, which means you need to use and invent technology (that’s what technology is actually for: to achieve more). Speculate-ship is about fundraising for a product, about getting investors; the game you play is one of perception, and for that you’ll need messaging.

But what about the crises we face today? What about the doing good and doing well option? That’s the path I’ve called Tinkerer. It’s only just beginning to reveal itself fully as a possibility now that frivolity and waste can no longer be an option. It can take us out of this vicious cycle of crises. It’s our future.

The people along this path are industrious and learn by doing. Tinkerers learn to home in on problems with intense practical experience, wielding technologies and knowledge of any kind —engineering, sciences, but also liberal arts, finance, whatever — to gain true insight. It is not about following recipes or doing startups, but solving true problems — the kind we don’t yet know how to solve. This talent grew in an economy that’s no longer defined by lifestyle jobs, as Sarah Kessler explains in her book Gigged, but could be defined by problems solved. These tinkerers seem able to hold on to the belief they can do well and good even after being told otherwise throughout their schooling. This new talent redefines what it can mean to be one’s own boss.

Tinkering comes first, before an idea gels. That’s how Thomas Edison worked. Tinkering precedes without expending even one iota of energy on developing the perfect pitch for investors or even deciding to start a company. It keeps one from rushing before an idea is really sound.

The tinkering I’m talking about is often predicated on simple yet seemingly incongruous premises. For example: What if there was a way to align greed with the saving the environment — the greedier you get, the more habitable the planet? Or: What if we brought back manufacturing, with new, good jobs, by decentralizing factories to outperform the ones that went overseas? Or: What if we could recycle all the innovation waste and put technologies that were left on the shelf in the hands of anyone who wants to tinker with them?

In fact, these are some of the hunches for new problem-solving organizations we’ve already begun to work on. So many of the enterprises we celebrate today began with touches of lunacy just like these. You can find some stories of these kinds of ideas in my book Innovating and Safi Bahcall’s Loonshots.

I’ve spent the better part of a decade training and guiding people who wanted to be involved in innovating and learning to use any technology (not just apps) to tackle real problems. I’ve witnessed the emergence of a growing number of talented industrious people who long for means to solve —sustainably, and at a profit — the most-challenging real-world problems that matter but that are going largely unaddressed. These are the new Tinkerers. To tackle the problems traditional approaches to venture finance or philanthropy have put out of reach, these new professionals are in need of a community, instruments, a method, and jobs in which to deploy their talents for problem solving.

This moment calls for exceptional talent and capital ready to embrace a simple principle: there’s more good and money to be made investing in organizations engaged in continually solving problems that matter than there is in splitting hairs over 9 in 10 odds of failure and scheming about who might be left that can be persuaded unicorns exist.

We don’t need more minimally viable products.

We need more maximally viable organizations attacking big problems with a tinkerer’s mindset and a capitalist’s goals.

In the face of the coronavirus pandemic and the changed world we will confront when it’s over, I’m feeling an intense urgency to help build that community in which Tinkerer 1.0 people and a new kind of forward-thinking investor can thrive.

I envision a new kind of investment and development firm set on exploring problems that matter, building bold organizations that fail to fail, recycling insights and technologies to arrest the innovation waste, and making instruments for problem-solving broadly available to propel a Society of Tinkerers committed to addressing problems that matter.

That’s the reimagination of development we need to get past this era of setting off crises and venture into the uncharted land of doing good and doing well that traditional venture and philanthropic thinking have so often put out of reach. These seem like the right next steps to make innovation “grassroots” again, super-powered by the American ingenuity still out there and waiting to be tapped, and thus restore the connection between work and economic progress for individuals and for the nation as a whole.




Source: My Family Room

That is a photo from my actual family room, where for some reason my wife has permitted me to display my collection of video games. These are my physical copies of Electronic Arts’s Madden NFL series of games. I stopped buying physical copies in 2015, when I started downloading them directly to my gaming consoles with each year’s release. I didn’t buy Madden 13 because I was transitioning jobs and moving at the time. I won’t buy Madden 21, which will be formally released this Friday, because the trial version has been released, and it is terrible. It will be the first such game that I could play that I won’t since I graduated from college.

We could build an entire Epsilon Theory grifters series around the monopoly-fueled shenanigans at Electronic Arts alone. You’ll note the last game in my picture that doesn’t have the “EA Sports” logo is pretty far to the left – that’s ESPN 2K5. Since then, EA has had an exclusive license to develop video games based on a property (i.e. the NFL) that has been given special anti-trust and anti-collusion dispensations from US regulators and special funding from taxpayers, hotel guests and rental car customers. With that license, EA has functionally transformed the extraordinary American football simulation that existed when there was competition in the market into a game that is built around a gambling engine.

Like many other sports games – especially EA-developed games like the FIFA series – the Madden revenue model has transitioned rapidly away from game sales to the sale of “packs” of player cards and boosters that can be used to build custom teams to use in online games in the “Madden Ultimate Team” mode. These packs may reward the player with a lousy bunch of roster-filling players…or if you’re lucky (read: if you’ve bought enough packs), Hall of Fame-caliber superstars. It is all ephemeral, all electronic, and all about giving players the ability to win by spending the most money.

If it sounds like a terrible way to structure something like a video game that should be inherently competitive, well, yeah. But even before Ultimate Team and Ultra Booster Packs were a gleam in the eye of an accountant whose first response to the word “nickelback” would be to remember that amazing concert he went to with his buddies in college, Madden had a rich tradition of competitive distortions. Things that made the game-in-practice deviate wildly from the game-as-we-imagine-it. So rich is this tradition that there is a word for it:


The idea behind cheesing is to take advantage of the inability of something like a coded American football simulation to handle extreme use cases. As you might imagine, the mechanics of such games are designed and tested to look and feel realistic when they are played in the expected way. That means that mechanics which make complete sense when players run a normal mix of plays with a normal range of strategies and a normal set of behaviors can often produce bizarre and anti-competitive outcomes when players adopt bizarre and anti-competitive strategies.

The most classic and well-known example of cheesing from Madden’s history is the extreme use of Michael Vick, the once disgraced and later rehabilitated former star quarterback of the Atlanta Falcons and Philadelphia Eagles. In Madden 04, developers wanted to make using Vick in a game feel different in the way that watching real-life Vick showed you that his style was different from that of other NFL quarterbacks at the time. And so his in-game character was given remarkable speed and agility that permitted him to produce gains in normal plays that were more or less consistent with Vick’s sometimes remarkable on-the-field rushing achievements. The problem, however, was that players figured out that these same traits, when applied to unrealistic strategies, like running slower defenders ragged for extended periods behind the line of scrimmage, constantly rolling out into QB draws, etc. were nearly indefensible.

Not quite Bo Jackson in Tecmo Bowl, but not that far off, either.

If you weren’t cheesing with the Vick-led Falcons in a head-to-head game of Madden 04, you probably lost.

Even when Vick faded from Madden, cheesing didn’t. In future editions it might not have meant playing with a dominant player, but instead repeatedly and unrealistically calling two or three plays and formations to which that year’s AI was especially vulnerable. In some years, that might mean constant QB draws and rollouts. In some years, that might mean some trick play like a play-action end-around, which was nearly unstoppable with the right personnel. In some years, that might mean seam routes or lobbed streaks when the game introduced different throw trajectory types. In some years, that might mean a ridiculously short punt that confused the AI into muffing it nearly every time. To a greater or lesser extent there may have been unpredictable (and equally unrealistic) defensive counters to those repetitive and disproportionately effective plays, but competitive and online play has often been typified by play-styles that executed extreme strategies to exploit the weaknesses of the simulation engine.

There have also always been extreme gameplay behaviors that sat just outside the periphery of cheesing, too. These are behaviors in which the exploitation took some measure of skill, but still represented a winning in-game strategy with no real-life corollary. For example, certain animations for players (especially linemen) made them perfectly, predictably vulnerable to a particular pass rush move or positioning of a defensive player. If you were skillful enough to put your player in the right positioning vis-a-vis that animation and execute a particular pass rush move, you would always win. Micro adjustments to the positioning of defensive players to best match up with the way the AI processes contact between them and blockers is an almost indispensable skill for competitive players of the game. Most players don’t consider it cheesing – because you’ve got to be able to execute it – but these tactics still represent extremes at odds with the real-life game and the intent for randomness on the part of the game’s developers.

Even in modes in which players manage franchises over full seasons, there have always been ways to exploit the game’s sensitivity to extreme and unexpected behaviors. For example, because the logic which made AI-controlled teams evaluate trades has never been consistent with the logic concerning free agency signings and roster cuts, it has nearly always been possible to sign a quality older player from the street and immediately turn him around to an AI-controlled team for draft picks. Likewise, because EA’s focus on developing the casino-for-teenagers it calls Madden Ultimate Team has meant the abandonment of any development on the traditional franchise mode, it has been possible to force AI teams to do things like cut the best player on their team by trading them mediocre players at the same position for several editions now.

If there is a lesson here, it is this:

There is a certain class of games for which winning the game largely becomes a function of how good you are at exploiting the inability of the game’s mechanics to properly model edge cases and extreme behaviors, and how quickly you realize that other players are executing this strategy.

Sound familiar? It should.

In the 2020 edition of our political, financial and social games, it is not the most expertly executed strategies which are richly rewarded. It is strategies which most brazenly identify how to exploit the newly vulnerable mechanics of the Widening Gyre. Have you said or heard any of these things in the past three years? This isn’t how capitalism is supposed to work! This isn’t how elections are supposed to work! This isn’t how politics is supposed to work! This isn’t how free speech is supposed to work! This isn’t how the Fed is supposed to work (they’re out of bullets)!

Good! You’re familiar with the idea.

And yes, it is political markets which provide the most obvious examples of these more extreme strategies designed to fit a particular set of mechanics.

As Twitter itself recognized through one of its classic discourse-suppressive overreaches, this is not normal. Similarly, one of our readers made a very reasonable observation to this tweet in the comment section of one of our recently published briefs.

Am I the only one who sees the desperation in a tweet like the one this morning “They are not Covid sanitized?” I’ve said often lately, that this election has some scary outcomes, but it also feels like DT is getting more and more desperate, which can’t be good for “ratings”. Not sure what the October surprise will be, but if we have a president who believes he needs a “Hail Mary” to keep his title…

User Comment to The Fujiwhara Effect

And yes, in a normal environment I would have agreed wholeheartedly. But a strategy which lobs various terrifying theories of dubious provenance is one for which a polarized political environment has very little answer. In the rules we thought we understood, it doesn’t work. In the way we understand the world, it doesn’t work. But we live in an age of cheesing. This isn’t a sign of desperation. It’s much worse than that.

It is the new dominant strategy. It is a sign of the new normal.

Yet even if political markets provide the most obvious examples, our other social markets are just as prone to the advantage of seeking out edge strategies for the absurd current environment against expertly executed strategies designed for the way those markets are supposed to work.

Cheesing of those edge strategies is how Kodak happens.

Cheesing of those edge strategies is also how Tesla creates a hundred billion dollars in paper gains (and, presumably, many more in shareholder value-extractive non-paper gains for executives paid on incentives), not through execution of a true value additive strategy but through a tautologically value-neutral stock split. All this has happened before, and all this will happen again.

Don’t Be Fooled By Stock-Split Mania LOOK FOR EARNINGS, NOT HYPE [Fortune, February 1999]

The challenge, as always, is considering how the investor-citizen or executive-citizen who is not a sociopath responds to a game in which everyone else is cheesing and winning. Here’s what I think.

Clear eyes:

If you’re running a company and you’re not thinking about the low hanging fruit edge strategies in which you do non-value-additive things that add value to the stock price, you are nuts.

If you’re running an investment strategy and you’re pretending that the world is NOT one in which management cheesing by paying homage to administration officials or announcing a stock split to “allow young investors to participate” is rewarded with return, you are nuts.

If you’re running an election campaign and you think that you can win on being nothing more than a straight-shooter without recognizing the way in which meme and narrative interact with the mechanics of the Widening Gyre, you are nuts.

Full hearts:

Just because you recognize the world as it is does not mean that you must extract value from the edge cases for your own benefit. If bailout money is being thrown at you, you don’t have to turn it down. But you also don’t have to accept it to benefit your share grants, RSUs and options before you write some saccharine letter describing dumping tens of thousands of middle- and lower-income employees as a shared sacrifice. If you’re building narratives to argue for your election, make them Holy Theatre. Don’t justify lies on the basis of the Widening Gyre’s permanent fixture of manufactured existential threats, and don’t justify deadly theater built on a basis of deception just because you think its heart is in the right place.

Alternatively: Neither left guy nor right guy be.

Money Printer Go Brrr | Know Your Meme

In world awash with cheesing, being lawful good doesn’t mean being lawful stupid.

But for God’s sake, don’t lose your soul in the process.


The Fujiwhara Effect


Source: NBC 15 Mobile

Early next week, two tropical systems are expected to be present in the Gulf of Mexico at the same time. Both are currently projected to strengthen to at least Category 1 hurricanes at some point before making landfall. The current plots have moved a bit from my screengrab above, such that the lovely people of Lafayette and Lake Charles now sit within the official National Hurricane Center forecast cones for both tropical systems.

I won’t insult you by making the obligatory 2020 remark.

Now, as I’ve written before, the tropical weather community is a funny thing. Especially the online tropical weather community. They are practitioners of the most cringeworthy, obvious kind of Kabuki Theater imaginable. Everyone – everyone – performs exaggerated, tortuous expressions of genuine hope that the storms will not harm life or property as preamble to what they really feel. And what they really feel is an unquenchable desire for something magnificent and historically destructive to take place. It is the natural reaction when you love storms, want to see a monster storm and don’t know anybody down in Beaumont anyway…but still feel a little bit ashamed about it.

Sansa Stark: They respect you, they really do, but you have to… Why are you laughing?

Jon Snow: What did father used to say? Everything before the word “but” is horse shit.

Game of Thrones, Season 7 Episode 1: “Dragonstone”

Still, when you’ve got two almost overlapping tropical systems abrewin’, it’s hard to keep the disaster-porn aficionados from wishcasting a superstorm on the central gulf coast. And so there are two kinds of stories you’ll see this weekend. The first will be stories that try to suck you in with dramatic descriptions of the two hurricanes combining into a single frankenhurricane. The second will be stories that highlight how interesting it is to have the storms in such proximity, describe that yes, they will influence each other’s path and growth, and reinforce that they will probably have the net effect of impeding their respective development. At a very minimum, that they make predictions about what both will do somewhat more difficult.

The effect describing the fascinating mutual interactions of complex cyclonic weather systems is called the Fujiwhara Effect, and you’ll be hearing a lot about it over the next week or so.

And then probably never again.

In narrative world, we have got two complex systems on a similar collision course. They are already interacting, already creating new common knowledge and already trying to shape our language. They both reflect the best efforts of missionaries to guide how we are thinking about both issues. And unlike Marco and Laura, by all appearances they are combining into a single storm. The real Fujiwhara Effect of 2020 sits at the intersection of the narratives of COVID-19 and the 2020 US Presidential Election.

So how influential are the narratives of COVID-19 on the US Presidential elections right now?

Using the updated methodology from our ET Professional narrative monitors, we examined the relative influence of various topics on the language used so far in the month of August to discuss US elections. The narrative strength measure is our composite of the (1) volume of and (2) similarity of language used by media outlets, blogs and press releases to discuss those topics in context of elections. The scores are normalized against our typical expectations for an election topic’s narrative strength. A score of 1 means we think that topic exerts influence that is higher than only 10% of comparable topics. A score of 10 means the topic exerts influence that is higher than just about any we have observed.

Source: Epsilon Theory, Quid

While economy narratives are important to this election, they are nearly always important. While narratives about the likely right to nominate at least one Supreme Court justice are important, they are nearly always important. Race and identity play more of a role as electoral issues than they have in the past, as does wealth inequality. As we’ve noted previously, both of those were dominant topics for the DNC primary process. But at least in narrative space, 2020 is now a COVID election.

You probably have a picture in your head of what that means. That picture probably isn’t complete.

To some Americans, the dominant COVID narrative is that the government utterly failed to take the steps that other countries took to reduce the impact of the virus on human lives and the economy alike. To others, the dominant COVID narrative is that opportunists in the government saw a pandemic as the opportunity to push policies and government mandates that they long desired, shutting down entire sectors of the economy without any kind of cost/benefit analysis to doing so.

But here’s the thing: COVID’s relationship to the election in narrative world isn’t about either of those things. Not really. Not any more. It isn’t about the human toll. It isn’t about freedoms taken. It isn’t about unnecessary shutdowns. It isn’t about simple steps that weren’t taken on masks and testing. The perfect storm forming out of the intersection of COVID and US elections is circulating around the narratives of the need for mail-in voting and the risk of widespread fraud.

Source: Epsilon Theory, Quid

Yes, of course this topic ranks higher in August because there have been news events worthy of reporting that referenced it. But it is the overwhelming similarity of the language being used that should concern every citizen. Narrative missionaries on both sides are weaponizing this topic. They are all on the same page. They are sticking to the talking points.

The visualization below should give you a picture of just what I mean. It is a network of all COVID-related election news during the month of August, constructed through natural language processing-based analysis that compares the words and phrases of meaning in each article to those in each other article. Each node represents a single article. The bold-faced nodes and connectors relate to articles demanding broad mail-in voting and articles asserting the risk of fraud, delays and errors in such voting. Nodes that are closer together and have more connecting lines are more similar in language. Those that are further apart are less similar. North-south and east-west have no meaning. Distance and concentration are the only dimensions that matter here.

The nodes defined by language associated with the narratives of mail-in voting fraud (in bold) dominate the network and are far more tightly clustered and connected than other clusters and language. What you see here is what we measured above. It is what we mean when we say that everyone with an opinion on this is staying very on-message.

Network Graph of COVID-Related Election News – “Fraud” Language in Bold

Source: Epsilon Theory, Quid

When we write about the widening gyre, what we mean is a political environment in which two randomly selected Americans of differing political alignments are increasingly living in two completely different worlds. They see the same events with the same facts and understand them through two separate lenses.

I think this issue has great potential to accelerate that widening process.

We would be far from the first to note the inherent divisiveness of assertions by President Trump that mail-in voting will certainly result in widespread fraud, ballot destruction and delays. Selectively neutering the USPS to prevent its use by the several states to manage their election processes as delegated to them under the law was about as transparently political a use of the office as possible. The implication of fraud at in-person voting has made its appearance again, too, with the chilling indication that police will be present at polling locations to prevent it. Yet two things can be true at once: that there doesn’t seem to be a lot of evidence that this has happened in the recent past AND that mass mail-in voting is a whole other beast from anything we’ve tried to-date.

And yet the political left have not ignored every lesson from Donald Trump. They are good at the common knowledge game, too. The time it took for the self-evident need for widespread mail-in voting because of COVID-19 to become common knowledge was immeasurably short, despite in-person voting with accommodations for certain vulnerable populations being perfectly feasible in nearly every region in the US. The narrative that there is no risk of fraud also took root in left-leaning media outlets almost immediately. Nearly identical language popped up almost simultaneously across hundreds of outlets claiming that the risk of fraud, ballot losses and delays has been fact-checked as “false”, despite there being no existing study that matches the potential scale of what is being contemplated in the 2020 election that could justify that kind of statement.

The network graph below zooms in on just those election articles referencing the assertions of mail-in voting fraud. The bold-faced nodes are those referencing those pseudo-authoritative claims of “proof” based on a non-representative historical analog.

Network Graph of Election Fraud News – “Fact Check = False” Language in Bold

Source: Epsilon Theory, Quid

Let’s be real about what’s happening here:

Donald Trump is building a bullshit narrative about fraud to keep as many marginally politically involved voters as possible from voting – and to keep open potential avenues to dispute the election on the basis of fraud.

The DNC is building a bullshit narrative about COVID to allow as many marginally politically involved voters as possible to vote – and to keep open potential avenues to dispute the election on the basis of voter suppression.

If you’re typing ‘whataboutism’, you can stop now. I am not comparing the two intents obscured by these narratives. I think one intent is worse than the other. Way, way worse. But you’re smart enough to think for yourself on that point, and don’t need my opinion to make up your mind about how to weigh that along with whatever else you think is important to determine how you will vote.

More importantly, we must realize that even if the underlying aims that gave birth to the narratives are not moral equals, it still matters that we are being manipulated. It still matters that both methods are going to contribute to a more divided America in which each half literally lives in a different reality. Both methods are narrative nuclear options which almost guarantee a disastrous civic and social outcome. If Biden loses, the approaches taken by the two parties ensure that half the country will consider it illegitimate because of voter suppression. If Trump loses, the approaches taken by the two parties ensure that half the country will consider it illegitimate because of fraud.

These are truths told with bad intent, sweeping narratives built on the shaky ground of assertions about the risks of mail-in voting on a scale not yet attempted and the feasibility of in-person voting during the COVID-19 pandemic.

Citizens who would resist the transformation of the widening gyre into a perfect storm must be capable of holding multiple ideas in our heads at once. We can make judgments about the relative merits of the underlying intents of two political powers with full hearts. AND we can make our judgments about the mutual use of manipulative, divisive narratives with clear eyes.

Neither requires us to forgo the other.


Why Publish Academic Research?


A few days ago, we read a tweet from Corey Hoffstein saying that after a six month review process, an academic journal decided not to publish an investment research paper written by Corey and two colleagues.

We reached out to Corey and team to see if they would be interested in publishing their research on Epsilon Theory, and today we’re delighted to publish Rebalance Timing Luck: The Dumb (Timing) Luck of Smart Beta, by Corey Hoffstein, Nathan Faber and Steven Braun.

We think this is an important paper. Here’s why.

Sensible-sounding abstractions, sometimes acknowledged perfunctorily and sometimes considered so self-evidently reasonable as to be passively accepted, are the bane of social science research and are at the heart of the reproducibility crisis – the frequent inability to duplicate the findings of published research.

This is especially true in financial markets.

Studies of systematic investment strategies and factors are far more sensitive to assumptions about rebalancing, time horizons, rolling windows, calculation methods, etc. than researchers are typically willing to indicate in their papers, and as a result their conclusions usually need to be taken with a substantial grain of salt.

We think this paper is an excellent illustration of how this phenomenon plays out in smart beta benchmarks, and it might have been buried forever if there were no alternative to academic journals and an inherently flawed peer-review process.

So we’re not stopping here.

Epsilon Theory is more than happy to occasionally publish academic research of merit pertaining to financial and political markets.

If you have something that you think expands our collective understanding of those markets, send it to us at

Why are we committed to publishing academic research?

Because we think the peer review process of academic journals cannot avoid embedding bias in paper selection.

We think peer review is useful, and that the vast majority of peer reviewers are serious and ethical people. But in the social sciences in particular, we also think that methodology and priors are often inextricably linked. That means that what you think the answer will be influences how you set up the problem and how you try to answer it. That also means that what you want the answer to be may affect whether you, as a reviewer or editor, think the methodology used by another to explore the question is sound. We believe that the peer review process often rejects papers on the superficial basis of methodology and rigor when the true underlying basis is dissatisfaction with its conclusion, problem framing or priors.

Because we think academic research in finance tends to be excessively backward-looking.

We think there is an emphasis in academic finance on empirical studies of asset prices, security-level fundamental characteristics and quantitative economic variables that do a magnificent job of creating an explanation for things that happened and not much else. There is a role for this sort of economic history, but it is a bit part, and not the leading role we have made it. There are reasons why financial markets research tends to not reflect live testing of hypotheses like it absolutely could, and most of that reason is “because we’d usually end up with nothing to write about.”

Because academic journals’ focus on novelty weakens collective understanding.

For commercial and philosophical reasons, academic journals in the social sciences prioritize the publishing of entirely novel research and topics. It is an understandable aim, but one that doesn’t always serve the expansion of the collective understanding of important topics. In our experience, finding new ways to illustrate a truth is every bit as important as discovering it in the first place. Ditto for trying out a hypothesis and finding that the empirical evidence does NOT support that hypothesis.

Because we think our readers are smart enough to evaluate this research on their own.

We think that journals have a legitimate challenge in determining how to accept or reject papers. There are a LOT of submissions. Some submissions are better than others. We think that good people truly do their best to publish the higher quality papers, but we also think that reputation and credentials play a role in these decisions. If, say, Harry Markowitz decides to send you a new paper, you keep your red pen in your damned desk drawer. But what’s true at that extreme is true in the in-between as well: there are reasons that a paper might be rejected or accepted, edited or taken as-is, that sometimes have nothing to do with its importance or quality. We think you’re smart enough and capable enough to decide on the usefulness of research for yourself.

A few ground rules …

We can’t commit to publishing everything. Your paper might be objectively bad. Your paper might be objectively incomprehensible. And by objectively, we mean subjectively to Rusty and Ben.

We can’t commit to giving you feedback and comments on a paper that you send us, whether we publish it or not.

We can’t commit to timing on any of this. Some weeks we’ll be really quick on this, and other weeks we’ll be swamped with other stuff.

We absolutely, positively will NOT commit to publishing your corporate white papers.

But if we don’t publish your academic research on financial or political markets, it will never be because we don’t like the conclusions, the topic, or the methodology.

It will never be because you don’t have a certain set of academic credentials or a certain set of academic connections.

And if we do publish your research paper, our commitment to you is this:

  • We won’t charge you anything, ever.
  • We won’t put it behind a pay wall.
  • We won’t edit or modify it.
  • We won’t keep you from publishing it somewhere else, and if getting it published somewhere else means you need us to take it down here, we’ll do that, too.
  • We will make it visible and searchable, and we will give it access to our network of 100,000+ investment professionals, asset owners, academics and market enthusiasts.

There are many institutional gatekeepers. There are many powerful guilds and socially embedded practices that seek to limit our voices and ideas. Are academic journals the worst of these? Not by a long shot. But they ARE one of these.

This is how we change the world. This is how we unleash our voices and ideas. Not by attacking these institutional gatekeepers from the top-down with yet another institutional gatekeeper, but by making the institutional gatekeeper irrelevant through our bottom-up, decentralized actions.

Will making academic journals irrelevant save the world? No.

But it’s a good start.


Can’t Fight This Feeling


Source: The historically bad video to REO Speedwagon’s 1985 hit power ballad “Can’t Fight This Feeling”

When I left home for college, the dot-com bubble was bursting.

The unfortunate events of March 2000 were already in the rear-view mirror, but the summer months gave at least some renewed hope to speculators and investors alike. That was the certainly the spirit on-campus at Wharton, anyway, where it seemed that just about every other undergrad was still supplementing work-study income (or draws from mommy and daddy’s trust fund) with stock speculation using the miracle of E*Trade on university-provided high speed internet.

Not me. Not really. Sure, I sold the shares of stock in the way-too-boring-for-1999 Dow Chemical Company I had gotten from them as part of a scholarship when I graduated and played around a little bit. But I was terrified of risk, didn’t really care about trading stocks and hadn’t the foggiest idea where to start. I also didn’t have any money.

But I remember how I felt.

I remember how class working groups broke down into late-night discussions of upside-maximizing options strategies. I remember upperclassmen talking about how the hardest class at Wharton to get into – by a HUGE margin – was speculative markets, the name for the options course. I remember penny stock discussions, the perfunctory nonsense that passed for “doing your DD”, which is very much the same perfunctory nonsense that passes for “doing your DD” today. I remember the elaborate hoops everyone jumped through to obscure the fact that they were just screening for excitement, sentiment and trailing price performance. I remember how clear it was that people explicitly looking for price, technical or other analogs to stocks that had been 8-baggers the year before, were wrapping their interest in made-up stories that would sound better to b-school students who would still have Graham and Dodd stuffed down their hungover gullets the next morning. I remember the validation that everyone sought from others about their particular elaborate charades, and how willing everyone was to provide that same validation to others.

I remember when discussions of strategies became discussions of tips became discussions of plays. When everything sort of shifted from figuring out how to evaluate a stock to figuring out how to identify what the smart money was doing to…well, maybe figuring out what people who had real, insider knowledge were doing. Not that anyone said that out loud, but c’mon. It was the tail end of a dying bull market, and we were grasping for whatever was left.

I remember how all of this felt as if it were yesterday, and I haven’t felt that way in a long time.

Mark Cuban, on the other hand, has felt that way. Several weeks back he joined our friends at RealVision to make a video about his experiences in the dot-com bubble, how he was able to protect the value of his position in Yahoo, and why some of what is happening today reminds him very much of the frenzy of leverage, risk-taking and asymmetric position-seeking that typified late-90s speculation in technology stocks.

I didn’t agree with Mark when he said it in June. I think our unprecedented connectedness today makes historical comparisons really difficult. It’s the same problem we all run into in our news consumption: are so many ridiculous things really happening, or are we just hearing about it more because we are so connected to news and instant-reaction social media? Are people really more sensitive, more aggressive, more divided and more hateful, or are the mechanisms through which missionaries promote that common knowledge more ubiquitous?

I don’t know. But after the past couple weeks, I can’t fight this feeling any more. I think Mark Cuban is right.

No, I don’t have any reason to think we’ve got a bubble that’s about to burst. No, I don’t think we’re looking at a crash in markets supported explicitly by a comically overzealous and inflation-indifferent Federal Reserve. But for the first time, the boundary-testing behaviors of retail speculators really do remind me of how I felt in 1999 and 2000.

The implications of these behaviors are big, even if I think they are likely to be very different this time around.

Let me share with you a post I read this morning.

This fare will be familiar to any who have perused the more casual Robinhood-inspired masses of /r/Stocks or /r/Wallstreetbets on Reddit. Let me assure you, it will be downright banal in comparison to what you’d find on the associated private Discord channels designed to avoid regulatory recordkeeping requirements and public disclosure.

If you follow financial markets much at all, the big news today for markets and for the company in question was the Trump administration’s announcement of a deal with Moderna, Inc. for 100 million doses of an experimental vaccine candidate for COVID-19. That is what the Reddit post above refers to. Moderna stock traded up more than 11% before the buy side and sell side alike did the math to realize that barely profitable vaccines were much better news for the market and economy in general than to producers that had been trading on far higher prices per dose.

The curious part, of course, is that there is a direct allusion to there being some indication of deep out-of-the-money options activity before any announcement was made. That is made less curious by the limited scale of that activity, but more curious again by the casualness with which retail participants bandy about the expectations that it might indicate insider activity.

The post, and many other posts in both subreddits, link to a service – “not advice”, naturally – that tracks unusual volume and activity in both stocks and options markets. The service itself is not novel. This has been basic stuff for traders and institutional investors since well before even I entered the industry. What is novel is that the service’s pinned tweet references early indications on a stock whose activity is now under investigation by the SEC for allegations of insider trading.

What is novel is that the very next promoted post, a retweet of an earlier promo, is a celebration of indications of unusual and early insider volume on a pending split by the ur-stock of the Robinhood revolution – Tesla.

I don’t really care about these guys, this service, or what they’re doing. Truly, I don’t. It’s (probably) not illegal, it uses information available to anyone willing to pay for it, and it is far more of a crapshoot than anecdotal examples where unusual activity was beneficially predictive will ever show. If that weren’t the case, the stat arb guys and other short-horizon quants would have mined this to oblivion before you could animate Stonks! into a GIF featuring the sea-dwelling mammal of your choice. Far more importantly, whatever mild impropriety exists here would pale in comparison to the actions of the grifters at the actual issuers, their political allies and the banks who serve them who know that they can get away with just about anything right now.

No, the real implication here is far more powerful: there is a new common knowledge. Everybody knows that everybody knows that the way you make a killing is to bet that grifters are gonna’ grift, and nobody’s going to lift a finger to stop them.

For most of the late 90’s through the summer of 2000, when you heard the rumors from energy traders you knew about what was going on at Enron and saw them get away with it, when you had heard of a hundred guys who’d made a killing on a stock tip from a guy they knew at a bank, you knew that you could either play or get left behind. When the courts came for Enron and when evaporating institutional asset price support came for tip-following retail speculators, those who bet on grifters learned a powerful lesson.

But this time? This time I don’t think the lesson the world is delivering is “bet on inside info at your own peril” or “bet with leverage on aggressive, sexy new business models that are probably frauds and get burnt along with management.” This time I think the lesson is different:

That nobody gives a shit what you do.

It doesn’t sound like much of a lesson, I guess. But if you care about why we do capital markets at all, about why we designed our economy to rely on markets to funnel rewards to the most productive owners of capital, it is a far more terrifying lesson. If you care about why we believe that governments should operate for the general welfare of the people and not for the concentrated pecuniary interests of a particular privileged few, it is a far more terrifying lesson.

It doesn’t matter that retail investors are trying to figure out what shenanigans Kodak insiders are able to get up to to see if they can tag along. It doesn’t matter that retail investors might be doing the same with Owens and Minor or 3M or Honeywell. It doesn’t matter that retail investors want to detect ways to ride the coattails of grifters at Tesla or Moderna or anywhere else.

What matters is that the transformation of capital markets into political utilities also appears to be the transformation of capital markets into entertainment and gambling utilities.

What matters is that no one in any position to do anything about it seems to care.

What matters is that none of that will change until you and I DO.


The Mountain and the Molehill


The best thing about 2020 is that if you don’t know where your close friends, family and colleagues stand on something, now you do.

The worst thing about 2020 is that if you don’t know where your close friends, family and colleagues stand on something, now you do.

There isn’t any avoiding it when you’ve been stuck in tight quarters with some of those people every day of the week for four months. It probably doesn’t help that being distanced from everyone else leads to spurts of collective oversharing on social media, either. Or that more than a few of y’all have become a bit too comfortable with day-drinking on a Tuesday. I know, I know, it’s very European.

But if you came into this hellscape of a year yearning to know just what your vaguely-gesturing-in-the-direction-of-racism high school classmate or your aggressively anti-everything-in-society-that-actually-works niece thought about every damned thing that might happen, well, then 2020 is coming up roses for you, my friend.

Less so for the rest of us, I fear.

For my part? Most of my friends and nearly all of my extended family are conservative. My uncle is a minor conservative celebrity on Twitter and thinks he has remained mostly anonymous. I know what your dog looks like, Uncle Dave, and also your pool looks really lovely. I’m conservative, too, or at least I was when that term was still defined by a desire to defend institutions that have survived hundreds or thousands of years from the majority’s occasional flights of passion. I’ve heard a lot from people who think about the world like I do this year, and I’m charitable enough to presume that only a portion of what I’ve heard was motivated by the now-ubiquitous 11:30 AM take-out frozen margarita.

Fellow conservatives, I suspect we don’t agree on as much as we usually do right now. For instance, I think that the militarization of police goes beyond a race-related problem to an issue for all freedom-loving peoples who would see the government fear them and not the reverse. I think that racism is absolutely embedded in some of our institutions, even if I cringe as much as you every time I hear it described in the postmodern terms invented on university campuses to create further division. I think protests are energizing and fiercely American, and that would-be anarchists trying to take over their agenda doesn’t make the authentic expressions of resistance less valuable or important. And yes, I think missionary-promoted narratives are working hard to skew your takes on these issues, and I’m pretty sure they’re trying to do the same thing to me.

AND I know why most of you are uncomfortable expressing support for Black Lives Matter and some of the ongoing protests. For most of you (alas, not all), I know it has literally nothing to do with the narrative that national media desperately want to promote about you. I understand.

I know that you struggle signing on to protests that in too many cases have devolved into or been accompanied by violence and vandalism. I know why the “defund police” message sits very badly with you, and turns you off completely to anything else that person has to say.

It is because you cherish a belief in the rule of law.

I know why you believe that the protests are being driven by – or at the very least have been co-opted by – organizers whose goal is to subvert capitalism. It’s not hard to know given that many of them literally say as much, whether through stated policies or signs. I know why a movement that doesn’t adequately police the destruction of private property and the ruining of livelihoods by a group of its participants, no matter how small, isn’t one you feel you can sign up for.

It is because you believe that capitalism works. That without it the American Dream doesn’t work.

And I think you are right. On both counts. But I know something else, too. I know that whatever threat these divisive elements co-opting an important social movement pose to our cherished values, at a national level it is a molehill.

If it is the threat to capitalism that concerns you, let me ease your mind; its end will not be at the hands of a 24-year old ukelele-strumming Oberlin grad with a man bun and a “capitalism kills” sign.

If it is the threat to the rule of law that concerns you, let me give you peace; it will not perish from this Earth by the will of a mustachioed software engineer in a $120 t-shirt and paintball mask who busts the windows of small businesses because something something equality, then goes home to unironically post a meme comparing himself to the soldiers who stormed the beaches of Normandy on his $3,000 MacBook Pro.

If it is the threat to either of those things that concerns you – and it should – then I implore you: Pay attention to what is happening right now at the intersection of political power, financial markets and corporate power. Because this, friends, THIS is a mountain. We needn’t be hyperbolic. Capitalism will survive this. So will the rule of law. But if there is a threat to either, you won’t find it on the streets of Seattle or Portland.

You will find it here.

Trump Says U.S. Should Get Slice of TikTok Sale Price [WSJ]

Trump Says U.S. Should Get Slice of TikTok Sale Price, Wall Street Journal (8/3/2020)

If you aren’t plugged into financial markets, you probably haven’t seen that much about this story yet. A bit of background is in order.

TikTok is a social application developer. Their main product is an ultra-short-form video sharing app for mobile devices. If you have kids, they probably have it on their phones. It is owned by a Chinese company. It collects a lot of identifying information about its user base, more than 2/3 of which is between the ages of 13 and 24. It says it doesn’t share that information with the Chinese government, which you are free to believe if you want. It says it never will, which you are free to believe if you are illiterate. Whether TikTok’s parent regularly shares your kid’s keystroke data with the CCP or not today, don’t delude yourself – by Chinese law we are never more than a single phone call from a party official away from exactly that.

It is also true that TikTok has become a part of the escalating disputes conjured to serve the domestic political interests of the CCP and US government alike. Various government agencies, including the US Army, have banned its use. Some corporations have, too. In early July, the Trump administration began to publicly float the idea of banning TikTok in the United States. On July 31st, it announced that unless TikTok’s Chinese parent company divested 100% of TikTok, its operations in the United States could be banned by executive order. Shortly thereafter, in a conversation with the White House press pool on Air Force One, President Trump was less equivocal. TikTok would be banned and it would not be sold to a US corporation.

Source: David Cloud via Maggie Haberman

A day later, President Trump met with Microsoft CEO Satya Nadella and changed his tune. It would be OK if Microsoft bought TikTok from its Chinese parent company. If it did, however, the treasury would have to receive a payment. And then he set a deal deadline.

Let us recap.

  1. The President of the United States threatened the use of executive power to unilaterally ban a foreign company from the distribution of a product in the United States.
  2. He then met with the CEO of one of the two biggest US-based public companies to negotiate permission to acquire the company distributing that product.
  3. He then demanded a payment to the US government to facilitate the approval of such a transaction.

The rule of law we cherish hasn’t anything to do with the overaggressive enforcement and policing of laws. It means a system in which permissible activities under the law are clear and unequivocal to all. It means a system in which the adjudication of conflicts with those laws is conducted without favor or prejudice against any party. It means a nation in which citizens, investors and businesspeople need have no fear that the outcomes of their behaviors will be subject to the arbitrary determinations of a single individual. The rule of law is the answer to the rule of man.

The capitalist system we cherish is about a belief in markets, the superior power of a collection of individuals expressing their preferences to arrive at the correct prices and values of things, against, say, the beliefs of a small group of ‘experts’, or worse, ‘politicians’, or even worse than that, ‘academics’. It is about a belief that the flow of rewards to capital creates a relationship between risk and reward that produces society-supporting growth. Is it the belief that the system does the best job possible – if often imperfect – of achieving that while providing competitive incentives to reward and attract labor.

That US corporations must now consider their actions based on how they believe they will align with the person and preferences of the president in order to conduct business is a basic betrayal of the rule of law. That we have now established a precedent to enforce or not enforce regulations or orders based entirely on whether a citizen or corporation pays a financial tribute to the US treasury is a brazen betrayal of the rule of law. That the ability to pursue corporate actions and investments is now not determined by the forces of competition but by which institutions can secure an audience with the king and most afford to pay it tribute is a shameless and destructive betrayal of the capitalist system.

The Microsoft / TikTok affair is a betrayal of both the rule of law and the capitalist system on a scale that dwarfs anything being done by the cosplayers in the Pacific Northwest that dominate the conservative news cycle right now.

And yeah, when those people scream “fascism”, what they are usually referring to is “a bunch of policies I don’t really like.” Sure. But fascism IS a thing. And while fascist governments vary wildly in economic models, all share one trait: they rely on the use of arbitrary executive power to coerce or incentivize powerful corporate institutions into obedience and alignment with the aims of a political party or individual.

Fellow conservatives who care deeply about the rule of law and quality-of-life improving miracle of capitalism, now is our time to howl.

How about we focus on the mountain instead of the molehill?


It’s a Mad, Mad, Mad, Mad Market


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.

Tyler Fitzgerald (Jim Backus aka Thurston Howell III from Gilligan’s Island): Anybody can fly a plane, now here: I’ll check you out. Put your little hands on the wheel there. Now put your feet on the rudder. There. Who says this ol’ boy can’t fly this ol’ plane? Now I’m gonna make us some Old Fashioneds the old-fashioned way – the way dear old Dad used to!

Benjy Benjamin (Buddy Hackett): What if something happens?

Tyler Fitzgerald: What could happen to an Old Fashioned?  

It’s a Mad, Mad, Mad, Mad World (1963)

I’m guessing some readers won’t remember this all-star, Oscar-winning classic. Indeed, it was made well before even my time, but I remember watching it on the ‘tube’ on more than one Sunday night in the late 1970s. I’d watch it with my Dad, who’d howl with laughter. I decided to watch it once again with my son. If you’ve never seen it, it’s worth the time. They just don’t make existential comedies like this one anymore. The story begins after a reckless driver named Smiler Grogan (Jimmy Durante) roars past a handful of cars on a winding California road and ends up launching himself over a cliff. Before (literally) kicking the bucket, he cryptically tells the assembled drivers that he’s buried a fortune in stolen loot… under a mysterious ‘Big W.’ He says: “350G’s. I’m givin’ it to ya’ but watch out for the bulls. They are everywhere.” Yes, they are, albeit he had a different sense in mind. [1] With little moral reservation, the motorists set out to find what they now consider their fortune.

The characters exemplify some of human nature’s best and worst qualities. At times, they are wildly creative and improvisational. However, they work together only to the extent necessary – double-crossing each other repeatedly. They lie. They cheat. They steal without a second thought. They have a singular focus: treasure – at any cost. Their sense of entitlement is overwhelming. In the scene quoting Tyler Fitzgerald, who is a high-society alcoholic, two of the treasure seekers (played by Mickey Rooney and Buddy Hackett) convince him to fly them to Santa Rosita in a brand-new Beechcraft twin. Blinded by greed, they seem to care little that he is too drunk to stand. In the end, they all find the Big W together along with the treasure beneath – but only to be bamboozled out of it. Eventually, the money ends up being lost completely and redistributed from atop a fire escape to a crowd in ‘Santa Rosita Square.’ Helicopter money of sorts – easy come, easy go. Greed is not only their foremost motivation, but it’s their ultimate undoing.

There are more than a few similarities between the Mad, Mad, Mad, Mad World characters and today’s market participants. So far at least, myopic greed and speculation have paid well. Analysis has been a handicap. Unprecedented fiscal policy stimulus combined with the Fed’s debt monetization has thus far maintained a pretense of normalcy in markets. There will be consequences to ballooning balance sheets (both corporate and federal). Few seem to be considering that the ultimate consequence of massive deficits is at the very least potentially crushing taxation.[2] Or worse, as rates would likely rise steeply if the Fed ever stops QE in an attempt to normalize policy by shrinking its balance sheet (soon to be an anachronistic concept). The Fed is too busy bailing out the bottom of the boat to raise the sails.

Deficits are now so large that Treasury issuance monetization must occupy the vast majority of the Fed’s attention. This close to the zero bound, the Fed can no longer significantly lower rates, it simply must prevent rate market dislocations due to massive supply. Fed action is no longer stimulative; rather, it is only palliative.[3] Importantly, it’s not Fed ‘liquidity’ that is feeding market participants’ emotional impulse. While the Fed remains an enabler, it is fiscal policy that is putting money directly into gamblers’ bank accounts. This distinction is crucial to whether fiscal policy continues to provide enough liquidity for a return to the casino later this year.[4] It seems that equity markets are priced for an aggressive second round of fiscal policy action, an efficacious vaccine by year end, and a healthy corporate America – free from defaults.


  • This time, there’s no treasure under the Big W. It’s just a big ‘W.’ We remain in a bear market with highly unfavorable return characteristics for large and small cap U.S. equities alike.
  • Equity and credit market performance is no longer all about monetary policy; it’s mostly about market participant emotion, which is largely dependent upon the pandemic fiscal policy response.
    • The Fed that is now hamstrung – now ‘forced’ to monetize massive, and otherwise unsustainable, policy deficits.[5]
    • Fiscal policy stimulus has found its way directly into U.S. equity markets – particularly speculative names and technology.[6]
  • Pre-existing fragility – especially excessive leverage – will make escape velocity for markets and the economy particularly difficult to achieve.
    • Liquidity will likely evaporate when personal and business defaults eventually sop up fiscal policy liquidity. The Fed is ill-positioned to act efficaciously. It’s too busy mopping up Treasury issuance.
    • Loans create deposits and without creditworthy borrowers, even a continued, fiscal-policy driven expansion of M2 may not result in higher asset prices.[7]
      • Risk-asset markets are not correctly pricing the coming explosion in prospective personal, corporate, and commercial real estate (CRE) defaults.

Liquidity Trap

Let’s start with the oft-cited reason to be long equity markets now. As the story often goes:

“Take a look at the money supply. The Fed has printed money… so much money. Just look at the monetary base and M2. It has exploded. It’s bound to find its way into equities. Don’t fight the Fed.”

Old Fashioned, anyone? Proponents of this rationale may be right on the result (higher equities) for a time, but they’d be right for the wrong reason. This time is different. First, the Fed ‘printing money’ is an anachronistic phrase I wish strategists would stop using all together. The Fed’s creation of excess reserves (‘money printing’) and subsequent purchases of assets are no longer lowering interest rates sufficiently to stimulate real economic growth. Rates are already low. Its’s not the quantity of money that stimulates growth or increases inflation; it’s first and second order effects of lower capital costs – i.e. lower rates or yields. Today, the Fed’s reserve creation is solely for the purpose of preventing a rates market dislocation. After the GFC, the Fed lowered capital costs considerably; today, it’s simply treading water to keep them low.[8] Importantly, not only does this make it more difficult for the Fed to stimulate the economy, but it also makes it tough for the Fed to help prevent corporate loan defaults when cash flows deteriorate. Thus, the Fed’s direct impact on risk-asset markets has diminished greatly, and I’ll soon explain why it matters.

For one, it’s helpful to understand that the Fed has often implemented QE without a consequent outsized increase in M2, to which so many have pointed as supporting equities now. The connection is more complicated. First, risk assets have often rallied without any M2 increase. Contrary to popular belief, the more or less consistent growth in M2 (due to natural growth of currency in circulation as loans are made) generally sees spikes when there is aggressive fiscal policy response. As Figure 1 shows, the Fed’s balance sheet expansions (the asset side of the balance sheet identity for reserve liability creation) often do not correspond well with significant M2 increases. This is particularly clear during the $1 trillion 2013 quantitative easing program; money supply growth didn’t budge above trend.[9] In contrast, in both 2008, 2011 and most recently, M2 did increase. Those instances accompanied fiscal policy stimulus, and in each case M2 increased in line with the amount of the fiscal stimulus. For obvious reasons, the impact of recent fiscal stimulus on M2 has been outsized.

Figure 1: Top Panel – M2 (blue) and Fed Balance Sheet (orange); Lower Panel – Change in M2 (blue bars); Source – Bloomberg Data

To cut to the chase, M2 growth is supporting equities, but it’s not a monetary policy phenomenon – it’s fiscal policy one. While fiscal policy is driving both investor sentiment and the beginnings of an economic recovery, the Fed still plays a critical role. Without its current “QE to infinity” approach, the massive supply of Treasuries would have little place to go.[10] Rates would likely move considerably higher, especially on the long end of the curve as demand would most certainly fall short of supply. Why? Precisely because of the massive policy deficits – already supersized even before the pandemic – required to combat the enormity of the pandemic shock. Fiscal policy is now the key – the Fed is the enabler but no longer the main actor.

Indeed, especially near the zero bound, low rates may lose their real-world stimulative efficacy.[11] A liquidity trap typically occurs when interest rates are low yet consumers and businesses tend to save. Indeed, since last year, I have advocated for gold (in part) because of this phenomenon.[12] Such behavior renders monetary policy ineffective. First described by economist John Maynard Keynes, during a liquidity trap, investors may choose to keep their funds in cash savings because they believe interest rates could soon rise, because they need to repair balance sheets, or because they wish to prepare for upcoming financial stress. At the same time, central bank efforts to spur economic activity are hampered as they are unable to lower interest rates sufficiently to incentivize corporations and consumers to invest or to consume, respectively. This is precisely why central bankers had been advocating for a fiscal policy response long before the pandemic shock. Ironically, because market participants no longer seem to perceive equities as a risky asset, saving appears to manifest vis-a-vis equity market speculation!

Fiscal Dominance [13]

So, what is next on the fiscal policy front? Well, it seems this stimulus round is shaping up more modestly than the initial round. Over $500 billion in paycheck protection (PPP) and another almost $300 billion in direct to consumer programs (including supplementary pandemic unemployment insurance relief) accounted for the lion’s share of a ~$1 trillion increase in M2 (Figure 1).[14] According to Bloomberg, after the White House dropped the idea of including a payroll tax cut, White House and Senate Republicans now have a “fundamental agreement” on a GOP plan for another round of pandemic relief. Instead of a payroll tax cut, the GOP will now back $1,200 checks for individuals who make up to $75,000 a year, just as in the March stimulus bill. Moreover, last week, Treasury Secretary Steven Mnuchin told CNBC that the Republican coronavirus relief plan will extend enhanced unemployment insurance “based on approximately 70% wage replacement.” [15] Presumably, this will be something less that the current $600 for most Americans. In aggregate, the Republicans reportedly are looking to propose $1 trillion in relief versus over $3 trillion from Democrats. The timetable for releasing legislative text, which is key to beginning negotiations with Democrats, is uncertain. One thing seems clear: the package’s scope will be more limited than the initial round of stimulus.

While likely smaller, the second round of fiscal policy response will once again put cash into checking accounts. This will once again help increase M2 and may also help to support equities. This is what’s so different about this equity market. With an assurance that the economy will be directly supported by more consumer directed stimulus, retail market participants are driving the rally – not unlike the late 1990s. [16]

Just this weekend the WSJ put an exclamation point after the sentence. Figure 2 from the Journal shows the number of new E*Trade accounts retail investors opened in march. It dwarfs any previous month. It’s generally the same dynamic for the Robinhood platform which I began writing about in September of 2019. My favorite quote from the story is a woman who proclaims that her trading style is aggressive because ‘scared money makes no money.’ According to the Journal, “she read ‘Trading for Dummies,’ watched YouTube videos, opened an E*Trade account and dove in.” That sounds about right.

This is now the sixth month of a pandemic that has not yet significantly abated in the U.S.  In order to continue unwaveringly towards the Big W, it would seem to require market participants believe an efficacious vaccine is not only assured but that it is also distributed quickly to the population. Moreover, there remains much unknown about the immune response and evidence is growing that immunity may be short-lived. [17] Nobody even seem to recall the slowdown that was already afoot before the pandemic occurred. [18] In light of an extended first wave of virus cases and with continuing unemployment claims still above 16 million, how much longer might market participants throw caution to the wind? (Figure 3 illustrates just how enormous that unemployment statistic is.) Just how long will banks and investors continue to loan money based on a stimulus-based recovery thesis? The answer to the latter question is critical to not only asset prices but also to the main-street economy.

In the absence of unusual fiscal policy stimulus programs (as present) and under normal circumstances, loans create deposits. [19] Deposits, in turn, contribute to a capital base for yet more loans. Defaults and delinquencies are surely one thing that destroys the loan-deposit cycle. Defaults will slowly start to sop up liquidity – as they always do. Lending standards, which had already begun to tighten in 2019, are now tightening significantly… it’s likely just the beginning (Figure 4 above). [20] Corporate and consumer lending will continue to slow, and as the corporate sector begins to experience even more strain as leverage grows, speculative behavior should begin to dissipate. That’s when the narrative changes from ‘there’s so much liquidity out there’ to ‘what the heck happened to all the liquidity.’ Easy come, easy go.

Corporate sector leverage – particularly speculative grade loans and bonds – has been at the top of the list of concerns for at least the past twelve months. If it was a concern pre-pandemic, it is of far greater concern now – even taking into account the scope of fiscal and monetary policy action. Banks typically slow their lending and non-bank lenders typically curtail their funding when credit fundamentals begin to deteriorate. Policy action, especially fiscally funded support for performing corporate credit, has helped suspend lower-rated paper from wires above. While prices have rebounded, credit fundamentals are not improving. As Bloomberg’s Philip Brendel puts it:

“Distressed-debt supply fell by $3 billion in June to $195 billion, a 47% correction from the cycle’s March peak of $366 billion. The stock market’s rally, seemingly without a conscience, seems to be comforting credit markets as investors shrug off record Covid-19 cases and an upcoming parade of horrific 2Q earnings results. Yet sharp corrections are common in highly volatile distressed cycles, and we think the exuberance may mirror spring 2008’s similar two-month window of calm, which didn’t last.”

According to Bloomberg data and analysis, despite 26 issuers in North America already having become fallen angels as of June 30, about 47% of corporate debt carrying BBB tier ratings has either a negative outlook or is on credit watch negative. That’s about $2.6 trillion of BBB tier debt that carries a negative outlook or is on credit watch negative. This includes over $89 billion at risk of becoming high yield. Importantly, financials are the most at risk accounting for about 33% of the total (including issues from Intesa Sanpaolo, Discover Financial and Deutsche Bank).

Importantly, non-bank lenders and loan syndication vehicles are also challenged – specifically, collateralized loan obligation (CLO) and business development companies (BDCs). The CLO market is about $700 billion and supports the $1.2 trillion speculative grade loan market. BDCs account for over $200 billion of speculative grade loans outstanding. CLOs provide banks with a syndication mechanism, which helps them keep loans off their books and shifts the risk to third parties. BDCs on the other hand, originate loans and rely upon equity issuance to help fund loans. While best of breed BDC equities have rallied, second tier lenders have continued to struggle greatly. This will leave the smaller, capital constrained companies they were designed to serve without capital access. [21] As reported by Bloomberg, about 30% of CLOs are forecast to have tripped OC tests with some being able to trade their way out by selling the CCCs and buying BBs at a discount. [22] While playing defense, it’s difficult for CLO sponsors to promote new vehicles; thus, this important source of investor loan demand begins to evaporate. Credit expansion is an essential source of liquidity and M2 growth. It will be difficult for even extreme fiscal policy measures to supplant credit expansion indefinitely.


As I suggested in the Portnoy Top in early June, recklessness and bravado had become so extreme it seemed likely to have reached a crescendo that might correspond to a market top. Such extremes are indeed difficult to gauge – after all, what’s irrational can stay that way for some time. So far at least, the broader indices like the NYSE composite and the Russell 2000 appear to have topped on June 8th. Breadth has continued to narrow as a handful of large cap tech names are responsible for the advance in the S&P 500 ad Nasdaq. Technology shares have pushed even farther beyond the limits of rationality. [23] When over a third of the S&P 500’s market cap is large-cap tech, that is a bad sign for market health. Trading for Dummies should add a chapter on that. [24] Scared money may not make money today, but at least it lives to fight another day… The monetary policy guardrails upon which so many have come to rely are flimsy. Monetary policy is no longer providing the safety it once did. Why is that important? Because we must all now be focused on fiscal policy above all else when assessing near-term sentiment and market action. Even with fiscal policy support increasing money supply by direct deposit, a liquidity trap is likely. Perhaps even more ironically, for now at least, this trap is somehow supporting equities because of a new breed of reckless equity market participant, who regards the equity market as a form of saving. Ultimately, defaults and corporate distress will steamroll greedy bravado and force a reconnect of equity prices and economic reality. It’s happened once already this year. It will likely happen again. We don’t know for sure, but presumably Smiler was on his way the Big W when he went over the cliff. As he said, he spent twenty years earning every penny of that fortune, but he failed to live long enough to see it. Today, there’s no treasure under that Big W – it’s just a big ‘W.’ Live to fight another day, Smiler.

[1] Bulls is apparently a German slang for police somewhere in between pig and cop.

[2] Please see No Free Lunches.

[3] The flaccidity of Fed action is but one reason I’ve been writing about the preexisting fragility in markets since this time last year. Others include excessive corporate leverage, weak corporate earnings (throughout 2019), and a slowdown in global growth that began in 2018. Moreover, the global trade war has continued. Please see The Art of War versus the Art of the Deal.

[4] This presumes that most of the flow into equities is coming from retail investors. Please see my June 8thCheck In entitled the Portnoy Top. The evidence keeps piling up that the marginal buyer is in fact retail. Please see:

[5] Without fiscal policy action (Treasury-funded SPVs) required under Section 13(3), the Fed could not ‘lend’ to corporations or support corporate bonds.

[6] Recently, breadth has deteriorated considerably with broader indices like the Russell 2000 and the NYSE Composite failing to break above their June 8th local highs. Technology, a group particularly subject to retail sentiment, is at risk of any hiccup this earnings season with several large-cap tech names reporting at the end of July.

[7] M2 consists of broad money supply which includes deposits.

[8] Exacerbating the Fed’s predicament, with Treasury yields so close to zero across the entire Treasury curve, there’s massive convexity risk to a backup in yields.

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

[10] The Treasuries market alone could see more than $1 trillion in net bond supply in the six months through Dec. 31. According to some Treasury analysts, sales may contain fewer bills and more, longer-dated notes. While many expect a further curve steepening, it seems more likely that the Fed will remain committed to keeping some steepness while controlling the overall level of longer-dated yields.

[11] See Edward Koo’s work at

[12] About three weeks ago, in an Aura of Treasure, I advocated for long gold and silver positions. The piece was picked up in Barron’s here:

[13] Yes, it’s being used tongue in cheek here.

[14] A company that received PPP funds faces the choice of paying employees on its own dime after the funds run out, or implementing the layoffs it put off for eight weeks and thus foregoing loan forgiveness. This choice is currently upon many companies.

[15] According to Bloomberg, Republicans would cut unemployment benefits “to $200 weekly from $600 until states are able to create the system that would provide 70% of a laid-off worker’s previous pay up to the state-set cap.”

[16] As the authors write, “it appears even bigger—and broader—this time around, amplified by digital communities on Twitter and Discord, a popular online chat hangout. Investors have transformed those social-media platforms into virtual trading desks, a place to swap tips, hype stocks and talk trash as they attempt to trade their way to a quick fortune.”


[18] Excessive corporate leverage, weak corporate earnings (throughout 2019), an inverted yield curve with slowing loan growth, and weak global growth (beginning in 2018) were among the many signs.

[19] The relationships of loans to deposits is a circular one, but deposits ‘funding loans’ is a fiction of bank’s balance sheets. Without loan growth, system deposits do not grow.

[20] An inverted yield curve beginning in early 2019 had already caused loan growth to slow, and it suggested a recession might be coming within 18-months. This had been my assessment then… alongside a steepener later in the year on early action by the Fed to cut rates.

[21] The Main Street Lending program was fully launched July 6, but the Fed only started buying loans on July 15. Banks that make eligible loans to small- and mid-size businesses are able to sell 95% of each loan to the Fed. Loans can range in size from $250,000 to $300 million for an expansion of existing credit. It has done little to fill the BDC hole.

[22] Generally speaking, CLO structures with more than 7.5% (higher in recent structures) of their loans falling into a CCC have to start refilling the over-collateralization basket (OC basket).

[23] ‘Big tech’ (AMZN, AAPL, FB, GOOG, MSFT, NFLX) now comprise 38% of the S&P 500 (Bloomberg).

[24] To be clear, I’m not ‘concerned’ for reckless retail investors, I’m simply making an observation that equity markets are reflecting the irrationality of their participants.


That’s the Thing I’m Sensitive About!


Thirteen-year-olds are the meanest people in the world. They terrify me to this day. If I’m on the street on like a Friday at 3PM and I see a group of eighth graders on one side of the street, I will cross to the other side of the street. Because eighth graders will make fun of you, but in an accurate way.

They will get to the thing that you don’t like about you. They don’t even need to look at you for long. They’ll just be like, “Ha ha ha ha ha! Ha ha ha ha ha! Hey, look at that high-waisted man, he got feminine hips!”

And I’m like, “NO! That’s the thing I’m sensitive about!”

John Mulaney: New in Town (2012)

Yesterday I read a social media post from Dana Carvey, who played a version of the recently departed Regis Philbin on SNL in the early 90s. Darrell Hammond did a later version that – like many of his impressions – relied a bit more on physical resemblance. Jimmy Fallon once did a version in 2011 that – like all of his impressions – relied more on a late-Millennial audience’s willingness to see his constant breaking as endearing instead of obnoxious. For my money, Carvey’s impression is still the standard.

In later conversations between Dana and Regis, they discussed the “Regis persona” that Philbin had created. He described it as an “exaggerated version of himself.” That made Carvey’s impression an exaggerated version of an exaggerated version of Regis.

When the 2016 Disney film Moana was being cast, the composer of some of its original songs – Lin-Manuel Miranda, of Hamilton fame – sent a draft score and demo tape to the actor who would ultimately voice the senicidal giant crab Tamatoa. Jemaine Clement, that New Zealand actor, later recounted that the demo was a recording of Lin-Manuel doing an impression of Jemaine’s impression of David Bowie. If you listen to the song Shiny from the film, you are listening to Jemaine Clement doing Lin-Manuel doing Jemaine Clement doing David Bowie.

When it comes to the stories we hear and tell, this kind of thing isn’t uncommon.

Sure, sometimes the extremes of what everyone knows everyone knows about a person or thing can be unfair and counterproductive. After all, with as many pixels as we light up on your machines with warnings about narrative abstractions, you won’t find us arguing in favor of applying our exaggerations as proxies. You can’t boil down David Bowie to a singing style in which you create an abnormally large cavity in the central sound-shaping part of your mouth to lengthen every vowel and a staccato approach to every consonant and plosive. You can’t boil down Regis Philbin to going halfway on a Kermit the Frog impression.

Extremes can be misleading.

Extremes can also be revealing. You learn a lot when you learn what thing a person or institution is sensitive about.

The extremes of a global pandemic have revealed a lot about what our political and corporate leaders and institutions are sensitive about.

For months, the Federal Reserve and White House have told anyone paying even the remotest attention that they were very sensitive to the price levels of risky assets, even at the risk of a variety of other considerations that they are theoretically or statutorily required to be sensitive to. Not that any of this is new, of course, but sometimes it’s good to appreciate the small things, like not having to update your priors for the better part of a decade or so.

Today. regional and super-regional banks are telling you that they are very sensitive to changes in the commercial real estate market. So sensitive that the CARES Act – you know, the one that was designed to help families and mom and pop small businesses? – includes a provision to allow them to suspend GAAP accounting and treat troubled debt as deferred, with much more favorable capital treatment. We’ve written more about this for our ET Pro subscribers, and will have a lot more to say about it.

Regulators and policymakers have told you that they are very sensitive to permitting the loss of equity value in certain industries and utterly indifferent to it in others. Remember when certain corners of the investment community told us that it was unfair and unjust that owners of airline stocks might permanently lose value because of government-instituted lockdowns, and then when those restrictions largely relaxed we were still operating at just a little over a 20% of normal capacity?

Source: Transportation Security Administration

Even now, after most COVID-19-related fears have settled into the familiar ennui of 2020, investors are telling you that they are still very sensitive to the perception of a company’s ability to survive and thrive in an extended stay-at-home world. So sensitive, in fact, that the manifestation of beta – systematic risk – today looks more like beta exposure to that ability than to a traditionally accepted expression of market risk. It is a fascinating phenomenon that Arik Ben Dor’s quant equity research team at Barclays wrote about yesterday. We don’t have permission to post it here, but institutional investors should reach out to your Barclays rep and ask for “Betas Reshaped: The COVID-19 Effect”.

Some of the lessons have been business lessons, too. Asset managers told you they were very economically sensitive to loss in management fee revenue associated with even brief declines in risky asset prices. Hedge fund managers told you with their pricing that they are very sensitive to all of your moves to allocate away toward other alternative investment vehicles.

It has been a busy few months.

In the end, COVID-19 too, shall pass. Like all extremes, treating all of this as a proxy for the world we will live in for the rest of our lives will be misleading. Yes, some things we thought could never change will be permanently different. And some things which we thought might be permanent will be only temporary. But in the midst of that, a lot of the institutions that should matter to you as an investor and citizen told you what they were sensitive about.

As the financial world emerges from one of the strangest periods in most of our careers, we cannot forget those lessons.


Sideways: Observations on Pain and Privilege


scenes from Whiplash (2014)

No doubt you’ve seen a movie or TV show where a sudden cataclysmic t-bone car crash happens without warning. It’s a really effective way to shock the audience, kind of a horror film technique applied to regular dramatic scripts, and it’s become so common that it’s now a trope. I think it’s so effective because we’ve all experienced a situation where something hits us with a WHAM! … totally out of the blue, physically or emotionally … and our lives suddenly go sideways.

Sometimes that WHAM! hits us collectively. Covid-19 is just that sort of shock, a global car crash that has turned billions of lives sideways. Sometimes that WHAM! hits us individually.

A little more than two weeks ago I wrote this note about a personal healthcare issue I was having.

No Country For Old Men

We all know someone who is in urgent-but-not-emergency need of some medical procedure that can’t be scheduled while Covid-19 is storming the hospital ramparts. I’m one of them.   … Continue reading

My healthcare issue – varicose veins in my ass, commonly known as hemorrhoids – wasn’t life-threatening. Neither was the complication I developed three weeks ago – an anal fissure. Now there are two words you never expected to read in an Epsilon Theory note! Certainly I never expected to write them. It’s a brutal term, right? Sounds awful. I promise you, though, the reality is worse. The pain is … otherworldly. The pain is … transcendent. But again, not life-threatening. This isn’t a sideways moment.

So Friday morning a week ago, I had a hemorrhoidectomy where the internal varicose veins were removed and the anal fissure was repaired. The surgery went well. I was sent home, prepared for the long (and painful) recovery ahead.

And then that evening my bladder stopped working.

And my life went sideways.

I have two observations from that sideways Friday night, one about pain and one about privilege. Pain first.

I thought I knew pain. I thought I knew the limits of pain. But in the ER that Friday night, in the course of several … ummm … poorly executed catheterizations, I discovered that I knew nothing about the limits of pain. I discovered *chef’s kiss* pain that night, and I’ll never be the same.

So obviously I’m better now, nine days later. I can pee and poop on my own, which unless you’ve ever had the experience of NOT being able to pee or poop on your own, I don’t think you can fully appreciate. Certainly I couldn’t have. Is there still pain? Of course, but it’s an entirely different kind of pain, an understandable pain that has an established beginning, middle and end. What I experienced over the weeks before the surgery and especially in the ER visits was pain beyond understanding. And that’s what left a scar.

They say that pain is a teacher. This is a lie, at least when it comes to pain beyond understanding. I suppose understandable pain could be used as a correction, as part of a causal learning process. Pain beyond understanding, though … pain beyond understanding teaches you nothing.

They also say that pain and pleasure are opposites. This is also a lie, again when it comes to pain beyond understanding. Pain beyond understanding is its own thing, sui generis to use a ten-dollar phrase. It becomes your entire world when it hits. It is All. Pain beyond understanding is a jealous god. It is your jealous god, and you will give yourself over to It. I’ve heard people talk about religious conversions in this language, in the sense of being brought low and placing themselves in the hands of a higher power. For me it was a lower power. In the early morning hours that Saturday in the ER, I capitulated. I gave myself over to the jealous god of pain beyond understanding and whatever mercy the ER staff would bestow.

I am 56 years old. But I had never felt old. I had never thought of myself as old. I had never felt … fragile … until I experienced pain beyond understanding. And not just a physical fragility. No, the physical fragility is something that I can bring into understanding. It’s something that I can work on; something that I know how to improve on. It’s the emotional fragility that I feel far more keenly than the physical fragility, because even as the pain and the physical fragility subsides, the emotional fragility remains strong.

And I don’t know how to fix it.

Experiencing pain beyond understanding has not inured me to pain, it has sensitized me to pain. I am constantly checking in with my body for any signs of pain. I am more aware of pain and reactive to pain – no matter how slight, no matter if it’s physical or emotional – than I have ever been. I don’t like this pain-sensitized person, this Neb Tnuh. Neb is self-absorbed. Neb still hears his jealous god whispering in his ear, tickling him with an ache here and a prick there. Neb is distracted, at a time in his life and his family’s lives when concentration and focus have never been more important.

I think there are a lot of people in this world who, at one time or another, have experienced pain beyond understanding and so endure this emotional fragility that I’m describing. I think that on a collective level, we are ALL suffering from an emotional fragility brought on by the pain beyond understanding caused by Covid-19 and its physical and economic repercussions.

And we don’t know how to fix it.

I’m equally stuck on a fix for my second observation from the night when my life went sideways. This observation isn’t about pain. It’s about privilege. I know that’s a terribly overused word, and I tend to cringe whenever I hear it. But in this case it’s exactly the right word. It’s the only word.

I believe that if I were black or poor, much less black and poor, there was a non-trivial chance that I would have died last weekend. I know that sounds melodramatic. But it’s really not.

The privilege of class that I’m talking about is not that I’m able to afford a decent health insurance plan, that I don’t have to worry about whether or not I can go to the ER when my bladder stops working. That’s a very real thing and a very real privilege, but it’s not what I’m writing about here.

The privilege of race that I’m talking about is not that I got better facilities or more effective therapies from the nurses and the attending doc in the ER that night. Nope, they were entirely equal opportunity in their maddening mix of mostly nonchalance and occasional attention, in their absolute refusal to consider this a complication from that morning’s surgery (which would have pushed all sorts of liability red buttons), and in their determination to get me out of the hospital as soon as humanly possible, even if that meant returning to the ER for a new admission every four to six hours until I could see a urologist. On Monday. I’m not making this up.

No, the privilege of being a well-to-do white guy in a Connecticut hospital ER at 1 AM on a Saturday morning is that I was able to advocate for my own survival to the (mostly) white nurses and the (exclusively) white doctors, and they would actually listen to me. I was able to speak with the attending docs as their peer (or as much of a peer as an ER doc sees anyone). I was able to speak with the nurses and all the clerical representatives of the insane bureaucracy that is a modern medical facility as a person of authority. I was able to advocate successfully for an additional three hours in the ER and another set of tests, which I know doesn’t sound like much, but which I promise you was everything.

The privilege of being a well-to-do white guy in a Connecticut hospital ER at 1 AM on a Saturday morning is that everyone recognized that there would be consequences if my sideways moment got any worse. It would be annoying and possibly dangerous to their position if I had an “adverse outcome”, plus I spoke in a language and from a position of authority that was comfortable to them, that everyone was accustomed to responding to. None of that would move mountains. None of that would get me admitted to the hospital. But it was sufficient on the margin for me to get the time and the additional tests that I advocated for. And that made ALL the difference.

One of the first lessons I learned as an investor is that markets happen on the margins.

So does life.

That’s what a sideways moment IS … a point in time where your very life becomes a probabilistic exercise, where you are well and truly at the mercy of one of two merciless social institutions: hospitals or the police. Each is an insane bureaucracy designed to deny exceptions to the rule, designed to grind everyone equally beneath its wheels, designed to eliminate marginal considerations.

One day, your life or the life of someone you love will go sideways, and the outcome of that sideways moment will depend on a stranger in one of these two massive institutions – healthcare or public safety – treating you differently on the margin. In my sideways moment last Friday night, I got that marginal difference in treatment, and you’ll never convince me that my race and class weren’t the edge in winning that marginal difference. That’s privilege.

We should all have that privilege – the privilege of advocacy, the privilege of mercy, the privilege of empathy – and it’s my life’s work to see that we do.


The Anxiety Algorithm: An interview with Adam Julian Goldstein


Epsilon Theory contributor Neville Crawley is back with an interview of Adam Julian Goldstein, discussing Adam’s fascinating new work on anxiety. If, like me, you have the entrepreneurial bug (and it is a bug, not a feature), this is a must read!

I’m very pleased to be interviewing Adam Julian Goldstein for Epsilon Theory:  Adam has led the entrepreneurial dream of founding a company from his dorm room at MIT; to founding a second company, Hipmunk, that would become one of the biggest and well known brands in the travel industry and be acquired by SAP; to now to investing in other entrepreneurs.

Despite these successes, Adam has – like all of us – also suffered from anxiety and the negative performance effects that it can produce. Adam has recently been reflecting on his journey and his and others’ experiences of anxiety as entrepreneurs and risk takers to consider “Is there such a thing as the anxiety algorithm, and if so how does it work, and what might we do to optimize it?”

Could you first set out your high-level Anxiety Algorithm thesis and what led you to this concept?

As we grew at Hipmunk, I thought I should feel great because things were going our way. But I was actually more anxious. As I noticed this among other founders, I started wondering, “why are we designed this way?”

So I approached the problem like an engineer: if I were designing a system to imagine different possibilities for the future, what algorithm would I use to generate these possibilities? Which of these futures would I make it worry about? And how would I have it revise its beliefs over time?

I theorized that there would be tractable answers to these questions: simple information-processing algorithms that would provide a real survival advantage. I wondered what behavior would emerge as a result of these simple algorithms, and whether that behavior would align with my own experience and that of other people I’ve worked with. It turned out to explain a lot.

I find your ‘expanding search space’ model for anxiety highly compelling, and as an explanation of why founders are particularly prone to anxiety. Could you explain this?

It’s impossible to be certain what the future holds, so the real question is, how can you make an algorithm as good at guessing as possible? You could try hard-coding possible futures, but that’s extremely fragile if the world turns out differently than expected.

Our immune system faces a similar challenge, because viruses and bacteria are mutating far more quickly than humans are evolving. So the immune system has a clever approach: “imagining” future threats by shuffling up little snippets of possible threats at random, over and over, until it’s imagined the shape of most viruses and bacteria that could ever exist.

The first anxiety algorithm takes some little snippets of possible futures and shuffles them up at random to imagine what might happen. When the world is changing (e.g. because your company now has investors, customers, employees, etc.), the number of snippets increases, and therefore so does the space of possible futures.

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Pre-launch (left), the number of known failure modes is small. Post-traction (right), the number of known failure modes is huge.

This explains why for me, traction resulted in more anxiety. Even as success got nearer, the space of possible ways to fail expanded.

What has been the most high anxiety moment of your entrepreneurial journey? Could you walk us through it and how you reflect on it now?

I was in the middle of fundraising for our Series D round, and Yahoo called us up and said they were ending our partnership because they were shutting down their travel site. We’d worked for years to put this partnership together and it generated a significant amount of our revenue—then it just disappeared. All my fears surfaced at once.

Our fundraise was, as I’d feared, a failure. My investors were, as I’d feared, unhappy. The employees I fired were, indeed, sad to be leaving, and I was sad for them.

However, I also learned that setbacks don’t need to be deadly as long as you don’t run out of money. Because once it became clear we had to restructure the company or else go out of business, we restructured everything I’d been afraid to before—cutting product lines, marketing channels, and growth plans. We got on the path to profitability and, less than a year later, we sold to SAP. So my biggest takeaway was that it was anxiety itself that kept me from making hard decisions; once I could no longer make excuses for inaction, I made the decisions and things got better.

But so many managers never have a forcing function like this, where inaction directly leads to failure. So instead, they listen to their anxiety when it tells them that it’s too risky to pivot, cut their burn rate, or reorganize their team—and, to use a baseball analogy, they strike out looking.

Let’s talk about Optimal Paranoia and why we are systematically over-concerned.

Let me first define what I mean by over-concerned: responding to something as if it’s a threat even when you know it’s probably not.

We all do this constantly. You refill your car when it has ¼ of a tank of gas—instead of waiting until the warning light comes on—so you don’t risk the tiny chance of running out of gas before you encounter another station.

My claim is that even though we’re systematically over-concerned in terms of raw risk likelihood, we’re somewhat “appropriately concerned” as a matter of survival. Running out of gas sucks, but even though it probably won’t happen, it’s not worth cutting it close.

The second anxiety algorithm shows what happens when this tendency gets applied to imagined futures. Even if we’re pretty sure a fear won’t come true, we err on the side of treating it as more likely than it is.

Moreover, we update our guess of how dangerous uncertain things are based on new experiences. When something good happens we tend not to dwell on it, but when something bad happens we tend to fear the worst. The third anxiety algorithm shows how this asymmetry results in higher survival odds—but also a great deal of suffering.

You model suggests we are more likely to die from over reacting than under reacting. This is certainly being hotly debated right now with various COVID response reactions. What are your thoughts on leaders’ COVID responses and over / under reactions?

When we systematically react as though threats are more likely than they actually are, we do keep ourselves safer. This is important as a starting point, because it’s tempting to say, “if we tend to overreact, we should just be more rational,” but that gets you back to running out of gas on the side of the road.

But it’s also true that when we systematically overreact (under certain assumptions), the deaths that do happen will more often arise from overreacting than underreacting.

We see this in COVID-19. It’s people’s immune overreactions that appear to be the leading cause of death from the virus. That might make you wonder why we have such aggressive immune systems, but if we didn’t, we’d die at much higher rates from other pathogens.

There’s a tendency to see that few US hospitals have been overwhelmed by COVID-19 patients yet and say, “see, we overreacted by implementing lockdowns.” Of course, if we hadn’t put the lockdowns in place, there would have been many more people who got sick and died. And yet, it’s conceivable that over the coming years more people will die from second- and third-order effects of the lockdowns (e.g. people cancelling non-essential doctors’ visits that could have caught tumors early, job losses that put people under extreme stress and raise their risk of heart attacks, etc.) than from the virus itself.

What makes COVID-19 unique compared to most threats is that it tends to spread exponentially. So I think this is a rare instance where being extremely paranoid, individually and collectively, was and is appropriate. 

You also have the concept of The Attention Portfolio. It seems like we’ve had an invisible societal shift over the past decade to an Attention Portfolio that  is more weighted to ‘Others’ due to increased information availability, social media etc. Could you walk us through The Attention Portfolio and any thoughts you might have on this invisible shift.

The Attention Portfolio posits that we allocate our attention between three things: direct experience, imagination, and what other people say. Each of these has risks and rewards. For example, listening to other people can keep us from making naive mistakes (e.g. eating a poisonous mushroom), but other people can also be self-serving, which can hurt us (e.g. a CEO who lies about his company’s prospects so he can unload stock at a high price before it crashes).

Because the risks and rewards of each source of knowledge are different and have low correlation, my fourth anxiety algorithm proposes that we are designed like a sensible investor: to allocate our attention in a diversified portfolio of all three kinds of attention and rebalance the portfolio over time. For example, when we perceive the world as having become more dangerous, we spend less time experiencing the world directly (risky) and spend more time seeking information from other people (safer). 

Critically, the more we rely on other people to understand the world, the more susceptible we are to being shaped by their agendas—an emergent outcome which has dramatic society-wide consequences.

As you have transitioned from Founder/CEO to investing your own money as proprietary bets, have you found your personal anxiety to be more, less, different as an investor than an operating company entrepreneur?

My anxiety is much, much less now. When I ran a company, there were constantly new catalysts I could imagine for the company failing—partners, employees, investors, market valuations, competition, consumer behavior, marketing channels, etc. I felt like it was my responsibility to get ahead of each of those or else break trust with the people at the company who relied on me.

These days as an investor, I know exactly what the failure mode is for each investment: it goes down. But I’m single and live cheaply, and if I lose everything, I won’t be letting anyone else down. More than making money, I enjoy learning esoteric investments and meeting new companies solving interesting problems. I imagine I’ll be more risk-averse if and when I have kids.

Given that we know we need a certain amount of anxiety, and that the amount is dynamic based on the environment, what actions would you recommend to stay on the efficient frontier?

Despite all the ills of our modern world, it’s empirically a safer time to be a human than at any time in recorded history. This suggests that today’s anxiety is on average higher than it should be even as a matter of survival. (I suspect this is especially true among the readership of ET.) I talk about some techniques for reducing anxiety at the end of each essay.

More broadly, just because our algorithms are designed to find some kind of efficient survival frontier, that doesn’t mean we should blindly go along with it. There are lots of great things besides survival higher on Maslow’s hierarchy, and anxiety works against those.

For example, when we look at older doctors helping COVID-19 patients, we think of them as courageous, aspirational figures, even though their choice entails an increased risk of contracting the virus and dying.

So to answer your question, I’d suggest that the best approach is to try to reduce anxiety far beyond what feels familiar, and use the mental cycles that open up to pursue something that feels meaningful and significant.

Your thesis takes inputs from multiple disciplines as well as, it seems, an underlying point of view which is something like Yuval Harari’s “everything is an algorithm.” Are there particular thinkers or researchers that have inspired your perspective?

Definitely. In terms of research, my top 5 inspirations were:

More recently, I credit Brian Christian’s Algorithms to Live By for showing how we can view our own behavior through the lens of what we would program machines to do. And I credit ET for it’s analysis on self-reinforcing narrative machines, which influenced my model of dynamic attention and social contagion.

Thanks, Adam. You can read Adam’s trilogy of blog posts on the Anxiety Algorithms here: The Anxiety Algorithm, The Paranoia Parameter, and The Contagion of Concern.


The Portnoy Top


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.

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.’

U.S. risk-assets (large cap equities and small caps alike) remain wildly dislocated (rich) to fundamentals – except perhaps for U.S. high yield (HY). While he CDX HY index spread has tightened as equities have rallied, it remains about where it peaked after December 2018’s selloff (Figure 1). The spread reflects the deluge of defaults that’s coming. Default rates will likely peak well above 10%. If that default rate estimate is correct, then the interpolated 1-year CDX HY spread should be around 10%. Thus, even at 482bps, the high yield market remains rich – but not nearly as rich as the U.S. equity markets.

Figure 1

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 13th 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 15th 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.



No Accident

George Floyd Left a Gospel Legacy in Houston
Source: Christianity Today

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.

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.

Source: Epsilon Theory

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.

Source: Epsilon Theory

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.

Source: Epsilon Theory

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.

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.

Source: Epsilon Theory

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.

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.

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.


The End of the Beginning


“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

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.


No Free Lunches


Alesso, Heroes (We Could Be), 2014

The Heroes Act. Is it a bill or lyrics from a song by Alesso?

[Ed. note: I always knew Pete was hipper than me, but embarrassed to say I had never heard of a non-Bowie musical reference to heroes. So you can imagine my relief when I read that this Alesso guy added David Bowie and Brian Eno to the songwriting credits for Heroes (We Could Be) in 2015, telling the Daily Star, “I just didn’t want to get sued. They aren’t similar, but we needed protection in case we pissed off Bowie.”]

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.

[1] 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.


Too Connected to Fail


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

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

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.

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.

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.

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?


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.

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


One for the Road


Source: CalPERS

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.


Exigent Circumstances


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.

Squeeze Stock Photos, Pictures & Royalty-Free Images - iStock

We wrote on March 29th 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.


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 15th 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 20th 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 4th 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 4th 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.


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 20th 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.

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 17th, 2021 unless the facility is extended.

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

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.

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

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 30th, 2020 unless the program is extended by the Fed.

Primary Market Corporate Credit Facility (PMCCF) – March 23rd 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 22nd 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 22nd.The program will end on September 30th, 2020 unless there is an extension by the Fed and the Treasury.

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

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 30th, 2020 unless there is an extension by the Fed and the Treasury.

Municipal Liquidity Facility (MLF)April 9th.

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 30th, 2020 unless the program is extended by the Federal Reserve and the Treasury.

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

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 30th, 2020.

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

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 23rd. 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 30th, 2020, unless there is an extension.

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

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 30th, 2020 unless there is an extension by the Fed and Treasury.

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).


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.

[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.


[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”




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:

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.

[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.