The Martingale Market

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Before I jump into a discussion of this month’s Narrative Monitors, I want to give you a brief update on our research efforts, which I’ll present around a specific example – our publication of In Praise of Bitcoin last week.

In Praise of Bitcoin

What made Bitcoin special is nearly lost, and what remains is a false and constructed narrative that exists in service to Wall Street and Washington rather than in resistance.

The Bitcoin narrative must be renewed. And that will change everything.

The note itself is really good, I think! And the response has been … crazy. For example, the tweet that I used to publicize the note has generated 1.6 million impressions so far, which is far more than any note-specific tweet to date. So yes, the note is good and popular, and yes, you should read it, but that’s not where I want to call your attention.

The note mentions our intention to examine the archetypes and structural characteristics of Bitcoin narratives. To quote:

In exactly the same way that there are only, say, a dozen archetypal scripts for every TV sitcom episode ever filmed, or in exactly the same way that there are three acts to every modern movie screenplay, so is there an underlying structure and a finite number of underlying archetypes to the media coverage of every market entity.

We believe that we can measure these narrative structures and archetypes as they apply to Bitcoin! TM, and map those structural dynamics to market behaviors.

What we’re describing here is our belief that we can now go beyond the identification of entity-specific narrative archetypes – the five Fed narrative archetypes in the CB Monitor, for example, or the three “language of Wall Street” archetypes in the SAM Narrative Monitor – and also identify underlying entity-generic narrative structures like “Bear Case” or “Bull Case” or “This is Expensive” or “This is Cheap”. We think that combining entity-generic narrative structures with entity-specific narrative archetypes creates a MUCH more powerful lens for understanding market behavior than either analysis on its own, and over the next 6-8 weeks we will find ways to roll out this new analytical lens within ET Pro.

Honestly, we’re building this airplane and testing new wing designs while we are flying it, so I don’t want to commit to any results-oriented outcomes. But I did want to give you a heads-up on our new process for understanding narratives and their impact on markets, and we are looking forward to the launch of a third Narrative Monitor over the next few months focused on … Bitcoin.

So now on to this month’s Narrative Monitors.

On the surface, very little has changed from the past several months. The dominant Central Bank narrative regime is still Hawkish, which is a moderately market-negative signal, but it’s still just barely the tallest blade of grass in a closely-mowed patch of grass. The dominant Security Analysis Methods narrative regime is still Multiples, which is a moderately market-positive signal, although it is still tightly wound-up with the hawkish/reflation narrative regime we see over in the Central Bank analysis.

As we’ve been noting for several months now, the narrative takeaway here is NOT that everyone knows that everyone knows that we have a hawkish Fed today and we’re in a value-outperformance environment today. We do NOT see common knowledge that the Fed today presents a headwind for markets in general, and growthy tech stocks, infinite PE stocks, and long-duration securities in particular. What we do see, though, is growing narrative stability around the idea that it is a matter of when, not if, that we get a hawkish Fed and a value-outperformance market environment. No Wall Street Missionary is asking for this – at least not the hawkish Fed part – but the main narrative stream is increasingly resigned to it!

This growing narrative resignation to a future hawkish Fed and a future tough road for high-flying, high-multiple stocks has two major implications, I think. First, it prevents exuberant market rallies. Good macro news becomes bad market news, because it hastens that evil day when the Fed is forced to start tapering. Sure, value stocks will outperform a bit, and that will make a certain group of long-suffering discretionary managers happy, but given the market-cap dominance of the high-flyers in every core index and every core portfolio, that’s going to be small comfort. On the flip side, though, this growing narrative resignation makes it much harder for the Fed and its Missionaries to shock the market into a really bad stretch. Narrative resignation like this acts like a repeated dose of Moderna vaccine … you get brief spells of malaise and aches and pains, and you feel pretty terrible for a while, but you’re not going to end up in the hospital. That’s a tortured metaphor to make the point, but I think you get the idea.

Here’s a better metaphor. The growing narrative resignation to a future hawkish Fed and a future tough road for high-flying, high-multiple stocks is a martingale. It’s a couple of leather straps that keep a horse from lifting its head too high and getting too spirited, and the overall effect is to keep the horse under control. I think that’s what we’re looking at with capital markets until further notice … a narrative martingale that makes market exuberance impossible, but also keeps the market from getting totally spooked.


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Building a Short Book

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Last week I closed the ET Pro note with this semi-cryptic comment: CDS spreads in both IG and HY are as tight as they’ve been since 2007. Just sayin’.

I want to dig into that comment this week with some specific analysis on credit default swaps, as I try to identify a target list of individual companies where I want to do further research in developing a dedicated short or long-vol portfolio with highly asymmetric risk/reward qualities.

First off, if you’re unfamiliar with the history and trading mechanics of CDS, last year we put together both a PDF primer and a webcast video to help Professional subscribers understand them better.

Credit default swaps are like chef knives. They are precision instruments and a necessary tool for so many tasks in the professional kitchen, but they are also sharp as hell and will give you a nasty cut if you don’t know what you’re doing. Still, the truth in the kitchen and the market is that a sharp knife is actually safer than a dull knife. If you spend any time in a kitchen you’ll want to own a sharp knife, and if you spend any time in the market you’ll want to know the mechanics and rationale of a CDS trade!

So assuming that we’ve got that intro out of the way, let me jump right into the meat of this analysis.

Here’s an example of what I mean when I say that credit spreads are historically low. These are the 1-year, 5-year, and max-year charts for the US High Yield credit default swap index (Markit CDX HY):


CDX HY 1-yr

CDX HY 5-yr

CDX HY max time series

The reference spread for high yield is 500 basis points, meaning that if you’re buying protection on $100 million worth of HY corporate credit it costs you $5 million per year for that “insurance policy”. But the market is telling you that the real price of that protection today is less than 300 basis points. That’s amazingly cheap, historically speaking!

This amazing cheapness of current credit protection can be found in every CDS index in markets today. Here, for example, is my fave trading instrument for questions of systemic risk, the iTrax CDS index of senior debt issued by European banks and insurance cos. Again, the 1-year, 5-year and max-year charts:


iTrax SNRFIN 1-yr

iTrax SNRFIN 5-yr

iTrax SNRFIN max time series

At 58 basis points wide, it’s not quite at all-time lows, but close enough for our purposes.

Now one of the reasons this index of CDS on European senior financial debt is not at all-time lows is that Credit Suisse is part of that index. Credit Suisse has had some … errr … difficulties of late, difficulties which we’ve written a lot about here on Epsilon Theory. Here are the 1-year and 5-year CDS charts on Credit Suisse:


Credit Suisse CDS 1-yr

Credit Suisse CDS 5-yr

Oh, haha! Did I say that Credit Suisse was problematic for the overall CDS index? Nah, JK. The cost of insuring your senior debt issued by Credit Suisse, after all of the bungling and mismanagement and equity raises and billions of dollars lost, is still … less than 60 basis points. LOL.

BUT … there IS a touch more market risk being priced into Credit Suisse CDS than its peers. There IS an idiosyncratic difference being priced into Credit Suisse. It’s not much of an idiosyncratic difference, and for good reason: Credit Suisse is the definition of Too Big To Fail. I mean, along with UBS it’s basically enshrined in the Swiss Federal Constitution as a permanent part of the European political/economic landscape. Does that mean that it is impossible for Credit Suisse to default on its senior debt? No. But basically the world as we know it would have to end for that to happen. Credit Suisse CDS spreads may widen and narrow idiosyncratically versus its peers by a limited amount, and that’s perfectly tradable! But Credit Suisse credit spreads are only going to really blow out wider if there’s an event (like the initial Covid pandemic) that poses systemic risk. As a charter member of the Too Big To Fail club, I don’t think it’s possible for Credit Suisse CDS to blow out wider for idiosyncratic reasons such as I’m trying to explore for building a focused, asymmetric risk/reward short book.

So that leads me to this question: are there similar signs of Credit Suisse-esque nascent idiosyncratic risk that the market is pricing into credit issuers that are NOT too big to fail, that do NOT have access to the unending largesse of the Fed or the ECB or the BOJ?

And that led me to this. Here’s the 1-year chart on the Asia ex-Japan CDS index, an equally weighted index of 40 giant Asian credit issuers that aren’t a Japanese company:


iTrax Asia ex-Japan 1-yr

Now if that looks to you like the CDS chart for Credit Suisse, you’re not wrong. Here are the two plotted on top of each other (Credit Suisse in magenta and Asia ex-Japan in white, with the Credit Suisse normalized by 1.2x to put them on the same scale).


Credit Suisse vs. Asia ex-Japan CDS 1-yr

That is … umm … a very high correlation. A much higher correlation than you get by plotting Credit Suisse CDS spreads against anything else I’ve found.

Now, of course, correlation does not imply causation, but I’m not making any causal claims here between Credit Suisse and these Asia ex-Japan credit issuers.

What I am claiming is that whatever factors are impacting Credit Suisse credit spreads in an idiosyncratic way are impacting these 40 Asia ex-Japan credit issuers in exactly the same way, and that these 40 Asia ex-Japan credit issuers do not enjoy the nuclear deterrence protection of the Big Three central banks.

Here are the 40 members of the Asia ex-Japan CDS index:

Company NameCorp Tkr
Alibaba Group Holding LtdBABA
Baidu IncBIDU
Bank of China LtdBCHINA
BOC Aviation LtdBOCAVI
China Cinda HK Holdings Co Ltd
China Construction Bank CorpCCB
China Development BankSDBC
China Huarong International Holdings LtdHRINTH
China Minmetals CorpMINMET
China National Petroleum CorpCNPCCH
China Orient Asset Management International Holding Ltd
China Petrochemical CorpSINOPE
CITIC LtdCITLTD
DBS Bank LtdDBSSP
Hutchison Whampoa LtdCKHH
Industrial & Commercial Bank of China LtdICBCAS
Kingdom of ThailandTHAI
KT CorpKOREAT
Longfor Group Holdings LtdLNGFOR
Federation of MalaysiaMALAYS
People’s Republic of ChinaCHINA
Perusahaan Perseroan Persero PT Perusahaan Listrik NegaraPLNIJ
Petroliam Nasional BhdPETMK
POSCOPOHANG
Indonesia Asahan Aluminium Persero PTIDASAL
Pertamina Persero PTPERTIJ
Reliance Industries LtdRILIN
Republic of IndonesiaINDON
Republic of KoreaKOREA
Republic of the PhilippinesPHILIP
Singapore Telecommunications LtdSTSP
State Bank of India/LondonSBIIN
State Grid Corp of ChinaCHGRID
Sun Hung Kai Properties LtdSUNHUN
Swire Pacific LtdSWIRE
Tencent Holdings LtdTENCNT
Export-Import Bank of KoreaEIBKOR
Hongkong Land Co Ltd/TheHKLSP
Vanke Real Estate Hong Kong Co LtdVNKRLE
Woori BankWOORIB

A couple of observations on this list. First, you’ll notice that it includes sovereigns, not just corporate issuers. I think that’s a feature, not a bug, for reasons I’ll review in a subsequent note. Second, you’ll also notice that it’s very China-heavy in its corporate members. Less of a feature and more of a bug, but keep in mind that this is a non-exhaustive first crack at a target list. That leads to a third observation, which is that Australia isn’t represented here at all (and India barely). Again, it’s a first crack at developing a target list for more research.

But I really love this first crack at a target set. For example, here are the long-term CDS spread charts for Swire Pacific (Hong Kong) and Reliance Industries (India):


Swire Holdings CDS max time series

Reliance Industries CDS max time series

I am sure that there are wonderful bull cases to be made for both Swire and Reliance.

I am NOT saying to go out and short these puppies on Monday.

But I AM saying that there is an extremely asymmetric risk/reward profile here in these mega-cap, highly liquid companies that are highly levered to globalization and a benign geopolitical environment AND reside outside the protective walls of the Fed, ECB and BOJ.

And that gets me all tingly inside. More to come …


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The Missing Wall of Worry

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Last week we published a great note from Rusty titled “What Do We Need To Be True”, which is (among other things) about the difference between the surface narratives that provide the talking points on CNBC and the much deeper, much bigger narratives (what we call “common knowledge”) that are never talked about on CNBC but are SO much more important in determining long-term market outcomes. Narratives like “we live in an interconnected, deflationary world” or “the Fed has got your back”.

What we’re trying to do with the Narrative Machine is track both types of narratives – the surface narratives that change week to week and month to month AND the common knowledge narratives that change over decades. They require different technologies to measure (my metaphor is using a regular telescope for the ordinary light of surface narratives versus using a giant radio-array dish for the background radiation of common knowledge narratives), but the underlying theory – Information Theory – is the same. That’s really important because it gives us a framework for marrying the week-to-week narratives based on Wall Street and Washington “news” with the decade-to-decade narratives based on the common knowledge foundations of our lives as citizens and investors, and to marry them in a way that (we hope!) allows us to trade around the former and invest alongside the latter. That is, the week-to-week narratives are always changing. They are always zigging and zagging, and there’s money to be made by trading around that. But the decade-to-decade narratives are almost never changing. Until they do. And then all the zigging and zagging doesn’t matter very much at all.

So, I think that we’re at one of those points in history when the decade-to-decade narratives are changing. Or at least I think that one of the primary common knowledge narratives – “we live in an interconnected, deflationary world” – is changing. I think that globalization has reversed course. I think that the “unipolar moment” where the United States is the world’s only superpower is over. I think that Covid is going to spark violent regime change and armed conflict between nations in Africa, Latin America, South Asia and East Asia. I think that inflationary expectations have taken root in the two pillars of the US real economy – housing and autos – and that they will only grow from here.

I ALSO think that the week-to-week narratives of Wall Street are almost all good news, positive sentiment stories of reopening and reflation (but not inflation!). I am really hard pressed to find a pervasive negative story vis-à-vis markets, really hard pressed to find a narrative that talks predictively about any Number Go Down scenario. Look at any of the good news / bad news diffusion charts that all the big bank research groups put out – they’re all at max good news. Look at the AAII Bull-Bear investor sentiment index – it’s at multi-year highs of optimism and good feelings. It’s not just crypto (although most obviously there) … virtually every story around investing today is a Number Go Up story.

Using an Information Theory framework, this makes me bearish on a short-term zigging and zagging perspective AND a long-term investing alongside common knowledge perspective.

The hallmark of Information Theory is this: information is neither true nor false; it is only more or less powerful, with power defined by how much it changes your mind from what you believed before.

Which leads inexorably to this investment corollary: more good news doesn’t have much of an effect on someone who already drank the kool-aid. The marginal buyer is always found in the ranks of former sellers, in the ranks of converts to the cause, not from the true-believers who have already gone all-in.

For stocks to go up on good news, there must be a negative story of woe and doubt that the good news “overcomes”.

This is the source of the old Wall Street saw, that stocks “climb a wall of worry”. It is the smartest and truest thing I know about behavioral economics, and of course there’s an Epsilon Theory note about this. From “Mailbag: Wall of Worry”, back in August 2018:


“Climbing a wall of worry is the least understood and most powerful crowd behavior of a bull market. The phrase refers to investors bidding up stocks when news comes out that some worrisome issue for markets has – huzzah! – been successfully overcome. Then tomorrow there’s another worrisome issue that all the talking heads are buzzing about, but soon enough – huzzah! – there’s a resolution to that problem, too, and markets take another leg up. Wash, rinse, repeat. If you haven’t noticed this time and time and time again over the course of the past few years in this long-in-the-tooth-but-still-chugging-along bull market, then you’re just not paying attention.

But there’s nothing fake or imagined about the problems for the market. They’re all quite real. But they’re also manageable. They’re imminently solvable, if not in fact then in narrative. Meaning that there are darn few cans than can’t be kicked down the road with a pleasantly framed press release. For example, is tearing up NAFTA a real problem for markets? Yes. Is today’s “much better than NAFTA” agreement between the US and Mexico a solution for that problem? Please. In classic DJT style, it’s like trading in the family minivan for a motorcycle and telling your wife what a great deal you got and how this is really the perfect way to take the kids to school. But that doesn’t mean the announcement isn’t good for another leg up in markets and another record close. I mean, you could’ve traded the minivan in for three magic beans. At least we have a vehicle here. Huzzah!

More generally, climbing a wall of worry is – like all market behaviors – a great example of Information Theory in action, which is why I started this note with a picture of Claude Shannon, the Bell Labs scientist who invented the field, or at least the modern version of it.

Here’s the central insight of Shannon’s work: information is measured by how much it changes your mind. That’s it. There is no Truth with a capital T to information. Information is neither true nor false. It’s just more or less influential. If a signal doesn’t make you see the world differently, then it has zero information. As a corollary, the more confident you are in a certain view of the world, the more new information is required to make you have a different view of the world and the less new information is required to confirm your initial view. As a result, the informational strength of any signal is relative. In fact, the same signal may make a big difference in my view of the world but a tiny difference in yours, in which case the exact same message has a lot of information to me and very little to you.

The hallmark of a market climbing a wall of worry is that the “worries” are not widely held. They’re not Common Knowledge. They’re stories that are presented to us as worries, as in “here’s what experts think might derail this market.” As a result, it takes very little informational strength to change your opinion about the worry and decide that it’s actually not a worry at all. In more technical terms, the informational hurdle for a new and higher equilibrium view of markets is relatively low. Repeat this a couple of times, and you have a market that is “climbing a wall of worry.”

I wrote a lot about Information Theory in the early days of Epsilon Theory, including ways to represent its dynamics graphically, and it’s going to be a focus going forward. If you’d like to read more, and you’re curious what diagrams like shown below have to say about lots of investing behaviors, but especially technical analysis, take a look at “Through the Looking Glass” and “Sometimes a Cigar Is Just a Cigar“. Oldies but goodies!”


Right now here’s what I see: there is no wall of worry for stocks. There is no week-to-week collection of narratives of gloom and doom about stocks, which means that there is nothing for more good news to “overcome”. Which means that stocks won’t continue to go up on continued good news.

On the other hand …

The reverse is true for market reaction to bad news, whether it’s on a macro scale or an individual company scale. For stocks to go down on bad news, there must be a positive story of success and joy that the bad news “overcomes”. I see LOTS of pervasive Number Go Up stories in the market today, and given my macro views about inflationary expectations, supply chain stress, and a rolling series of emerging market crises … I think there’s LOTS of bad news in the offing.

Two final points …

First, the old (8 years ago!) Epsilon Theory notes where I developed this application of Information Theory to markets are pretty good, I think. Some of my best work! That’s “Through the Looking Glass” and “Sometimes a Cigar Is Just a Cigar“.

Second, CDS spreads in both IG and HY are as tight as they’ve been since 2007. Just sayin’.


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Drawing the Narrative Battle Lines

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There was a notable change in our narrative Monitors coming into April (available here and here), both in Central Banks and Security Analysis Methods. The dominant regime (also called an archetype; I use the terms interchangeably) remains the same in both – Hawkish for the Central Bank narrative archetype and Multiples-focused for the Security Analysis Methods narrative archetype. Similarly, there’s no change in the weak “dominance” of both … Hawkish and Multiples-focused are the strongest among the archetypes, but only the strongest within a weak bunch.

What has changed is the cohesion of these dominant narrative regimes – their internal narrative consistency – lifting from a Very Weak cohesion reading over the past several months to a Very Strong reading today. Interestingly, it’s not only the dominant narratives – Hawkish and Multiples-focused – that have seen a sharp increase in their internal consistency, but pretty much all of the contending narrative regimes show the same strengthening of cohesion.

This is the necessary next step in the creation of market common knowledge and (I suspect) a longer-term investable trade/direction for markets.

We’re not there yet. We still don’t have a clear narrative “winner”, marked by high strength and high cohesion. But now that the internal confusion within each of the different narrative archetypes has diminished and solidified into a focused argument, I expect the archetypes to duke it out in narrative-space over the next few months for supremacy.

What is the focused argument within the now-cohesive Hawkish narrative? It’s a set of trades for responding to reflation and inflation. Ditto for the focused argument within the now-cohesive Dovish-forever narrative. It’s also a set of trades for responding to reflation and inflation, just in pretty much the opposite direction! If you feel like you are currently besieged by Wall Street selling you “products”, both of the-world-is-totally-changed-now type AND of the what’s-worked-before-still-works type … well, that’s exactly what’s happening. Which will prevail? The market-negative Hawkish narrative is in the lead right now, but it’s early in the race.


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Tiger King

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I assume that by now you’ve read one of the WSJ or Bloomberg articles on Bill Hwang and the collapse of Archegos Capital, a hedge fund with an estimated $10-15 billion in AUM that was levered up more than 5x across multiple prime brokers, and came tumbling down in a “margin call” last Friday. And yes, I’ll explain why I used the quote marks in a second. There are so many touchpoints between these events and what we’ve been focused on here at Epsilon Theory that I hardly know where to start, but let’s see where this goes …

Like many other hedge fund luminaries (Chase Coleman, Lee Ainslie, Steve Mandel, Andreas Halvorsen, John Griffin, etc. etc.), Hwang is a Tiger Cub, meaning that he used to work for Julian Robertson’s OG hedge fund, Tiger Management. As the story goes, Hwang was an equity sales guy for Hyundai Securities, where he won an annual cash prize “for charity” that Robertson used to give to the “person outside the firm who contributed the most to the firm’s success”, which led to a job … LOL. This, of course, was in the heady pre-Reg FD days for golden age hedge funds like Tiger and SAC and Quantum, when the line between legal and illegal inside information was, shall we say, a bit more blurry than it is today, and guys like Hwang thrived.

Julian famously broke up the band as the Nasdaq bubble burst in early 2000, and the Cubs went their separate ways, seeded by Julian and his LPs. Hwang set up Tiger Asia, where he had great returns by following the playbook that had worked so well for him in the mothership, and Hwang became a billionaire in his own right. That playbook, however, which was probably a hot steaming mess of collusion and insider trading even before Reg-FD, was certainly a hot steaming mess after Reg-FD, and once the SEC really started to enforce all this in 2009 with the establishment of a Big Data program to review suspicious hedge fund trades (yes, there are Epsilon Theory notes on Reg-FD enforcement and its impact on alpha generation: here and here), it was only a matter of time before the feds nailed Hwang to the wall. That happened in 2012, when the SEC brought criminal charges for insider trading against Tiger Asia and Hwang personally, charges that Hwang et al pleaded guilty to and paid a $60 million fine to resolve. Hwang was sentenced to one year probation. Again … LOL. Tiger Asia had to be wound down, and like Stevie Cohen did with his similarly implicated (but never criminally convicted) SAC Capital, Hwang turned his hedge fund into a “family office” – Archegos Capital. And like Stevie did with his “family office” (Point 72), within a few years Hwang started taking outside investors and was back in full swing as a hedge fund master of the universe.

Did Hwang learn his lesson and change his tiger stripes? Again … LOL. What Hwang learned was how to avoid getting caught. With the establishment of Archegos Capital, Hwang stopped shorting stocks or taking long positions directly. Instead, he took his positions in the form of total return swaps and similar instruments with Wall Street banks. A total return swap is a contract with a broker/dealer counterparty where you agree to be on the opposite sides of the economic outcomes of a referenced security (or any referenced data flow that can be mapped against a time series of prices, really). In other words, you don’t buy shares of stock in a company directly. You buy a contract with, say, Goldman Sachs that they will owe you money if the stock goes up (or if the company pays out a dividend or makes some other cash distribution, hence the “total return” moniker here) and you will owe them money if the stock goes down. Or vice versa if you’re short. A total return swap is a pure derivative, a distilled bet on something else going up or down in price, a zero sum game played between Big Boys who know the risks and take them with eyes wide open.

In the days and weeks to come, you’ll hear the usual suspects say that swaps and derivatives are the “problem” here. Pfft. The problem is doing business with convicted felons like Bill Hwang. A tiger cub? I prefer the Epsilon Theory lingo. The guy’s a raccoon, pure and simple, and once a raccoon, always a raccoon. They can’t change their stripes, either.

So here’s how it worked. An investment portfolio based on total return swaps had one wonderful quality for the prime brokerage operations of the banks involved here, and two wonderful qualities for a raccoon like Hwang.

For the prime brokers, that wonderful quality was fee and spread income. Under almost any conceivable conditions (hold that thought!), market risk on the swap could be hedged more cheaply than the trading fees, structuring fees and net interest margin that they charged Archegos, yielding a “risk-less” income stream of millions of dollars per year.

For Hwang, the two wonderful qualities were:

  • massive embedded leverage, as these swaps are bought on margin, not cash, meaning that Hwang could receive the full economic outcome of a dollar’s worth of stock for posting, say, 15 cents in cash as collateral, and
  • zero reporting requirements with regulatory authorities, as the only thing that Archegos “owns” are these private derivative contracts with TBTF banks, leaving Hwang free to run the old Tiger Asia playbook without having that pesky SEC tracking his trades.

Again … LOL.

So how did this fraud fall apart?

Well, here’s what did NOT go wrong for Hwang. I don’t think Hwang blew up because positions like Viacom and Discovery went south on him. I don’t think he blew up because he got a margin call, as you and I understand the term. Look at all of the positions that are getting liquidated … this portfolio wasn’t down before it got sold out beneath him. To be sure, the last month or two hasn’t been great for the what-me-worry, infinite-duration stocks that Archegos loved to press. But even if he was doubling down on losses in true degen-style, this isn’t a portfolio that has obviously crapped out. This is a portfolio that needs the sails trimmed, not blown out. No, I think something else triggered the decision by Goldman Sachs et al to exercise whatever liquidation provisions they had in their ISDA (the contract governing their swaps, derivatives and prime brokering) with Archegos. This was a “margin call”, not a margin call.

What can trigger a “margin call”, by which I mean a forced liquidation of positions held at your prime broker even if you’re not in violation of net capital requirements? I can think of two possibilities:

  • Goldman Sachs got wind of Archegos borrowing with other prime brokers by pledging the same collateral they pledged to GS (let’s call it The Producers con), or
  • the general counsel’s office at Goldman and Morgan Stanley both got a letter from the Justice Dept. with some … ummm … pointed questions about the trades they were executing on behalf of or in connection with Archegos.

If I were a betting man (and I am), I’d be prepared to wager a not insubstantial amount of money that both of these for-cause reasons to tear up the ISDA and liquidate the Archegos positions came into play, with the DOJ letter being the spur to the general counsels at GS and MS et al having a phone call and enjoying a “wait, you have how much exposure to Bill?” moment. See, that’s the thing with running The Producers con … you can never let your investors (or lenders) compare notes.

A few minutes later, the head trader at Archegos gets a phone call from Goldman. “It seems that you are in violation of section (18b), subsection (iv) of your ISDA, so we’re going to need $15 billion in cash in the next thirty seconds, otherwise we will begin liquidating your positions with massive, multi-billion dollar block trades. Yes, we’re going to do this just as sloppily as we can. Also, as per section (27), subsection (i) it is our responsibility to notify you that we have received inquiries from statutory regulatory authorities of appropriate jurisdiction in regards to your trading accounts. Have a nice day!” While he’s listening to this, the head trader’s assistant informs him that Morgan Stanley is on hold.

I have no idea if this is how any of the events on Thursday and Friday actually went down. But that’s how I’d write the screenplay.

Who gets left holding the bag here? Well, it sure ain’t Goldman Sachs and whatever other prime brokers did the liquidation on Friday. They got their cash by getting out first. Same as it ever was. The bag-holders are the prime brokers who saw their screens and telephones blowing up unexpectedly on Friday afternoon NYC-time, banks like Nomura and Credit Suisse. Man, I bet that was a miserable weekend in Geneva and Tokyo. Same as it ever was.

But that’s just the first wave of bag-holders. The second wave of bag-holders … well, that’s us.

What do you get when you give a raccoon like Bill Hwang tens of billions of dollars AND invisibility from regulators so that he can run his collusion and insider trading schemes to his heart’s content? You get a rolling series of squeezes and corners. You get a market that is completely disconnected from reality. You get ridiculous Chinese companies pumped and dumped through US listings. You get a Tesla that’s valued at a trillion dollars. You get Gamestop.

I’m not saying that Hwang is responsible for all of this. I think he’s responsible for some of this. And I think there are a lot more Bill Hwangs out there.

Three weeks ago, I wrote this to ET Pro subscribers:

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

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

Two weeks ago, I wrote this to ET Pro subscribers:

No, the thing that has my spidey-sense tingling is that I think there are lots of other Greensill specialty lenders out there, lots of other Tokio Marine insurance wrappers out there, lots of other Softbank shadow banking facilities out there, lots of other Credit Suisse absolute return funds out there, all geared and levered to global trade and supply chains at precisely the moment when globalization is reversing after three decades-plus of a one-way trade.

Last week, I wrote this to ET Pro subscribers:

Specifically, I think THIS can work: a long/short go-anywhere investment program based on the Narrative Machine IP and a macroeconomic thesis of deglobalization and multipolar geopolitical conflict, supply chain and trade finance stress, and push-inflation pressures within a highly levered global economic system.

There is a tide that is flowing out today, and it’s revealing Lex Greensill and Bill Hwang just as surely as it revealed Jeff Skilling in 2001 and Bernie Madoff in 2008. The big trade around Skilling and Madoff wasn’t directly on their specific scams and frauds, but on what their specific scams and frauds showed us about systemic rot in the financial system. It’s exactly the same with Greensill and Hwang today. The big trade isn’t on some company that Greensill was propping up through “supply-chain lending” or on some company that Hwang was short-squeezing or pumping. The big trade isn’t even on some common denominator sponsor for both Greensill and Hwang like Credit Suisse (although … wow). No, those are one-off, idiosyncratic trades. Interesting prop trades, sure, but limited.

The big trade is figuring out what happens if Credit Suisse is taken out in the street and shot in the head like Bear Stearns.

The big trade is figuring out how deeply the Japanese financial system has been corrupted (Softbank, Tokio Marine, Nomura).

The big trade is figuring out what happens when the squeezes and corners from insane hedge fund and shadow banking leverage come undone.

Sounds like fun!


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The Darnold Dilemma

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Patrick Mahomes and Sam Darnold

I think Jay Powell and the Fed have locked themselves into a two to three year commitment to treating inflationary pressures as “transitory”, just like an NFL GM and organization lock themselves into supporting a “franchise” quarterback they draft in the first round. Once selected, and so long as they believe it is possible that their draft pick is, in fact, a franchise quarterback, it is impossible for the organization to express ANY doubts about the wisdom of the pick. Why? Because once doubt is expressed, the quarterback is finished with that organization. He can’t lead the team. He’s damaged goods. He loses all trade value. The fans howl for blood. More likely than not, the GM loses his job, too. So for two to three years – the minimum time it takes to know whether or not your #1 draft pick is truly a franchise quarterback – every public statement AND every public policy (draft picks, free agent signings) that an NFL organization makes will be 100% in support of their draft pick.

This is exactly where the Fed is with their stance on inflation. Every public statement and every public policy for the next two to three years MUST be 100% in support of their inflation-is-transitory #1 draft pick. Hey, maybe they made a great pick. Maybe inflation-is-transitory is the monetary policy equivalent of Patrick Mahomes!

Or maybe it’s Sam Darnold.

The simple truth is that the Fed doesn’t know. And neither do I. Like any NFL fan, I like to pretend that I know better than the GM and … honestly … I really do think that my instincts here are better. But, hey, maybe I’m wrong and Jay Powell is right about the transitory nature of inflationary pressures over the next two to three years.

But here’s what I DO know:

I know that for the next two to three years, the Fed can’t change its forward guidance or monetary policy to reflect any doubts it might have about the “is inflation transitory?” question.

And knowing THAT … well, knowing that gives me two to three years to make investment decisions without fear that the Fed will undercut me with a policy shift.

For the past 12 years, the primary risk to all discretionary investment, from the most vanilla US equity mutual fund to the most fly-close-to-the-sun global macro hedge fund, has been Fed risk. It’s been the cold hard fact that all of our time, all of our smarts, all of our research and knowledge and edge … all of it can be swamped in the time it takes for Bernanke and Yellen and Powell and crew to announce a new dot plot or liquidity injection or support facility. Whatever it takes, right? Not anymore.

I think the Fed is boxed in from a policy and (more importantly) a communications/forward guidance perspective, over a long enough time horizon for a discretionary alpha-oriented investment program to work. And that’s pretty exciting to me, a discretionary alpha-oriented investor.

Specifically, I think THIS can work: a long/short go-anywhere investment program based on the Narrative Machine IP and a macroeconomic thesis of deglobalization and multipolar geopolitical conflict, supply chain and trade finance stress, and push-inflation pressures within a highly levered global economic system.

I really do.


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Spidey-Sense

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The more I look at this Greensill collapse (last week’s ET Pro note, A Madoff Moment, also The Best Way to Rob a Bank), the more it has my spidey-sense tingling.

Not because Greensill itself is big enough to cause a systemic shock, and not even because I expect in my heart of hearts that Lex Greensill is going to roll over on Softbank or Credit Suisse or General Atlantic or Tokio Marine, any one of which is definitely big enough to spark a systemic shock. Sure, it could happen. And I definitely think there are some bad emails at Credit Suisse that will come to light, but if anyone knows how to cover up yet another flubbed covert op, it’s Credit Suisse.

No, the thing that has my spidey-sense tingling is that I think there are lots of other Greensill specialty lenders out there, lots of other Tokio Marine insurance wrappers out there, lots of other Softbank shadow banking facilities out there, lots of other Credit Suisse absolute return funds out there, all geared and levered to global trade and supply chains at precisely the moment when globalization is reversing after three decades-plus of a one-way trade.

I mean, look at these purchasing manager survey results on both supply chain breakdowns and supply-driven inflation:

And then I pulled these charts up today. I’m going to present them pretty much without comment.

First up, from Japan, a 20-year chart of Tokio Marine’s 5-yr CDS spreads. They’ve been 22 bps wide since 2014.

Next, from Australia, a 17-year chart of Macquarie Group’s 5-yr CDS spreads, now 27 bps wide.

From the Netherlands, here’s a 20-year chart of ING’s 5-yr CDS spreads, now 21 bps wide.

And finally, from the US, here’s a 20-year stock chart of John Deere, a company wonderfully geared to steel prices and foreign sales of its farm equipment. LOL.

To be clear, I’m not saying that these companies are complicit in some Greensill-like fraud or that they are uniquely levered to a 30-year globalization trade. But not saying that is exactly my point! These were just some of my faves from my hedge fund back in the good old days of 2008, now 13 years later with charts that are just as complacent and what-me-worry as they were back then. I think there are dozens and dozens of companies out there just like this, with billions of dollars of trading liquidity in the aggregate, all of which are … ummm … REALLY interesting to me as we hit an inflection point in a thirty-year globalization trade and a forty-year deflation trade at the same time that the Lex Greensills and Masayoshi Sons of the world have had 13 years to build their scams to the breaking point.

So I’m trying to figure out what to do. Managing a series of trades like this in a set of securities like this against a backdrop of catalysts like this … this is how I am wired as an investor. This is why my spidey-sense is tingling like crazy, in ways I haven’t felt since Q4 of 2007. I can’t believe I’m saying this, but it’s making me think about getting back in the saddle as a long/short portfolio manager, marrying my spidey-sense with the advances we’re had over the past three years in building the Narrative Machine. I dunno. We’ll see.

All I know for sure is that I’ll be building out this investment thesis in real time here in ET Pro. The game is afoot!


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A Madoff Moment?

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I’ve started writing a note on this for general publication later this week, but wanted to share with you first. I think that the collapse over the past week of Greensill Capital has a lot of systemic risk embedded within it, particularly as the fraudulent deals between Greensill and its major sponsors – Softbank and Credit Suisse – come to light. And that’s not even considering Greensill’s second tier of sponsors – entities like General Atlantic and the UK government – all of whom are up to their eyeballs in really dicey arrangements.

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

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

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

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

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

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

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

Second best way is to find a really big bank to buy up all the crap loans you originate, and that’s where Credit Suisse comes in. After the GAM debacle in early 2019, there was zero question that the loans Greensill had been selling to Credit Suisse since 2017 were just as stinky as the loans they had sold to GAM. And yet Credit Suisse did … nothing. Actually, that’s not fair. They purchased MORE of the securitized loans from Greensill than ever before. They marketed their funds HARDER than ever before. I’m sure it’s just a coincidence that Softbank put $500 million into the Credit Suisse funds after their Greensill investment. I’m sure it’s just a coincidence that Credit Suisse and Greensill found a Japanese friend-of-Softbank insurer, Tokio Marine, willing to put a wrapper around the Greensill loans so that Credit Suisse could market these funds as … wait for it … safe-as-houses money-market equivalents.

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

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

Yep, imagine that. Like I say, it’s a story as old as capital markets.

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

So here we are. The ECB is now asking whether or not the situation is “contained”. Apollo is apparently going to buy the shell of the Greensill trading platform for less than $100 million (valuation was >$4 billion last year), and bury this as deep into the bowels of the Earth as it is possible to be buried. Pretty much all of the Greensill directors have resigned, including Lex’s brother (I guess Elon is not the only one who like to keep board seats in the family). And I am certain that we will hear from the ECB and other bank regulators tomorrow that the situation IS, in fact, contained.

Unless Lex Greensill flips on Masayoshi Son at Softbank or Bill Ford at General Atlantic or ex-UK Prime Minister David Cameron. Unless the beneficiary Softbank companies can’t find short-term financing. Unless there’s a bad email at Credit Suisse.

Will all this be swept under the rug? Maybe. But then again, maybe not. In any event, this is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.


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Subprime is Contained

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This is my favorite photo of Ben Bernanke. It’s his last day as Fed Chair, and he’s leaving his office at the Federal Reserve Building in DC for the last time, pressing the elevator button as the doors close smoothly shut. There’s something about his expression and quiet smile here that’s just … everything … even though this is some months before his formal announcement that it would be unseemly for him to go work with any of the banks he regulated and so he’d be joining <<checks notes>> Citadel in an exclusive engagement as a “special advisor”.

I wonder if they got this photo in one take, or if they had to take multiple shots? Anyhoo, I digress.

I was thinking about Bernanke because of what he said multiple times in 2007, that subprime mortgage delinquencies, while “troubling”, would be “largely contained”, and that the Fed “sees no serious broader spillover to banks or thrift institutions from the problems in the subprime market.” It’s a famous line, of course. Infamous, I suppose.

I think what Jay Powell is currently saying about inflation and it being “transitory” may turn out to be equally infamous, and that Powell’s failure to react to soon enough to an inflationary storm may be as damaging as Bernanke’s failure to react soon enough to a deflationary storm. But that’s just my opinion. What is not my opinion, however, is that the financial media and our dominant narratives about the Fed are similarly focused on the timing of the Fed’s first tightening move.

Let me repeat that for emphasis: the narrative around the Fed is no longer IF the Fed will tighten, but WHEN the Fed will tighten.

After flirting with a narrative regime change for a couple of months, our Central Bank Narrative Monitor has now decidedly flipped from an Inflation-Focused regime to an outright Hawkish regime.

That’s not good for markets. The narrative tailwind we have measured and written about since April 1 is now a narrative headwind.

To be clear, we don’t see this as a strong headwind … yet. All of the narrative archetypes we measure around both central banks and security analysis are very weakly expressed these days, so this Hawkish narrative is just the most muscular of a puny lot. What that means in practice is that there is no common knowledge or even rough consensus on when the Fed will tighten. There is still plenty of room for Powell and crew to jawbone this into a happy place, to “soothe the market” as the Wall Street Journal likes to say. Seriously, it’s their go-to phrase now whenever they write about Powell. Did he “soothe the market” or not? Again, I digress.

If you think that market-world fundamentally changed over the past week or two, you are absolutely correct. The market narrative has shifted significantly, as every macro event will now be judged against a backdrop of “does that increase or decrease the chances of market-negative action by the Fed” as opposed to the decade-long dominant backdrop of “does that increase or decrease the chances of market-supportive action by the Fed”.

Put in a slightly different way, the best that the market is hoping for from the Fed today is that they won’t disappoint us too badly. There’s no stimulus to be had, no liquidity program to be administered. A Hawkish narrative regime means that we’re expecting bad news from the Fed sooner or later, and a weakly expressed Hawkish regime only means that there’s no agreement on whether that bad news will come sooner or later or much later, or whether failure to deliver the bad news sooner or later or much later is a good thing or a bad thing.

There’s lots of room in narrative-space today for Powell to “soothe the market” about inflation and bond yields.

You know, just like Bernanke soothed the market about subprime and mortgage-backed securities.


[Next day follow-up]

My Twitter friend Jeff Macke (yes, that Jeff Macke of the infamous CNBC meltdown 10 years ago … really impressive how he’s gotten his life back on track), posted these screenshots yesterday under the heading “These aren’t confident reactions to positive news.” So right.

Neither Target nor Zoom had a bad earnings call afterhours on Monday. No, no. They had good earnings calls after the close on Monday, with both stocks moving sharply higher in afterhours trading. These were no-questions-asked, beat-and-raise earnings announcements.

And then Tuesday morning pre-open you had some ‘yes, but’ sell-side analyst reports. And then Tuesday you got this … debacle.

I’m posting this as a follow-up to Monday’s note – “Subprime is Contained” – because this is a micro version of the macro environment I was talking about in that note … when the narrative hits an inflection point, when it goes from holding water to spilling water, when it goes from expecting a market-positive future to expecting a market-negative future … then mere good news is no longer enough to make the price go up! It’s got to be dramatically and surprisingly good news. There can’t be a whiff of ‘yes, but’ in the news flow, or you get demolished.

Woof. We’ve all been there with a stock we’re long, where you listen to the earnings announcement and it’s all good and the analysts are asking their “congrats on the quarter” questions and management is upbeat about guidance and the stock is trading up after hours on some decent volume and you’re just positive you’re going to make some serious coin tomorrow and then … WHAM.

Unfortunately I think that’s what is in store for us on a portfolio level and a macro level in the weeks and months ahead.


 

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The Opposite of 2008

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In late 2007 I started counting the For Sale signs on the 20 minute drive to work through the neighborhoods of Weston and Westport, CT. I’m not exactly sure why it made my risk antenna start quivering in the first place … honestly, I just like to count things – anything – when I’m doing a repetitive task. Coming into 2008 there were a mid-teen number of For Sale signs on my regular route, up from high single-digits in 2007. By May of 2008 there were 30+ For Sale signs.

If there’s a better real-world signal of financial system distress than everyone who takes Metro North from Westport to Grand Central trying to sell their home all at the same time and finding no buyers … I don’t know what that signal is. The insane amount of housing supply in NYC/Wall Street bedroom communities in early 2008 was a crucial datapoint in my figuring out the systemic risks and market ramifications of the Great Financial Crisis.

Last week, for the first time in years, I made the old drive to count the number of For Sale signs. Know how many there were?

Zero.

And then on Friday I saw this article from the NY TimesWhere Have All the Houses Gone? – with these two graphics:

I mean … my god.

Here’s where I am right now as I try to piece together what the Opposite of 2008 means for markets and real-world.

  • Home price appreciation will not show up in official inflation stats. In fact, given that a) rents are flat to declining, and b) the Fed uses “rent equivalents” as their modeled proxy for housing inputs to cost of living calculations, it’s entirely possible that soaring home prices will end up being a negative contribution to official inflation statistics. This is, of course, absolutely insane, but it’s why we will continue to hear Jay Powell talk about “transitory” inflation that the Fed “just doesn’t see”.
  • Cash-out mortgage refis and HELOCs are going to explode. On Friday, I saw that Rocket Mortgage reported on their quarterly call that refi applications were coming in at their fastest rate ever. As the kids would say, I’m old enough to remember the tailwind that home equity withdrawals provided for … everything … in 2005-2007. This will also “surprise” the Fed.
  • Middle class (ie, home-owning) blue color labor mobility is dead. If you need to move to find a new job, you’re a renter. You’re not going to be able to buy a home in your new metro area. That really doesn’t matter for white color labor mobility, because you can work remotely. You don’t have to move to find a new job if you’re a white collar worker. Or if you want to put this in terms of demographics rather than class, this is great for boomers and awful for millennials and Gen Z’ers who want to buy a house and start a family.
  • As for markets … I think it is impossible for the Fed NOT to fall way behind the curve here. I think it is impossible for the Fed NOT to be caught flat-footed here. I think it is impossible for the Fed NOT to underreact for months and then find themselves in a position where they must overreact just to avoid a serious melt-up in real-world prices and pockets of market-world. Could a Covid variant surge tap the deflationary brakes on all this? Absolutely. But let’s hope that doesn’t happen! And even if it does happen, that’s just going to constrict housing supply still more, which is the real driver of these inflationary pressures.

Bottom line: I am increasingly thinking that both a Covid-recovery world AND a perma-Covid world are inflationary worlds, the former from a demand shock and the latter from a supply shock to the biggest and most important single asset market in the world – the US housing market.

Just as in 2008, a lot of the ramifications of an insane shift in the available housing supply will only reveal themselves over time. We won’t be able to predict all of the market and real-world shocks that emerge from a collapse in the supply of existing homes for sale in the United States, but we will be able to expect market and real-world shocks. Maintaining an openness and awareness to the fact that there WILL BE market and real-world shocks emerging from a supply shock to the US housing market made all the difference in navigating 2008 successfully. I think it will be the same in 2021.

I’m still figuring out my take on all this. I’d love to hear yours!


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We’re All Nigeria Now

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Yes, I know that this is a Ghanaian funerary troupe, not Nigerian, but the meme is too spot-on to pass up.

Last week I was invited by an ET Pack member to join a 15-person Zoom call with some of the leading lights of DNC/Wall Street establishment doubleplusgood macroeconomic thought. If you follow this crowd you will recognize a lot of the names, but I’ll just give you the one that everyone knows – Paul Krugman.

Three random observations.

First, I have no idea how or why I was invited on this call. I’ve been blocked on Twitter by at least two of the participants, and I’ve had … umm … mean things to say about most of them. Second, you’ll be relieved to know that this was not an “unfettered” call a la Clubhouse, as reporters covering the Fed and economics beat from both the NY Times and the Washington Post were on the call to keep us “accountable”. Third, and you have no idea how much it pains me to say this, but I found Paul Krugman to be absolutely delightful. He was self-effacing, humble about the entire enterprise of academic economics, and he was wearing an insanely cool tee shirt from an obscure Russell Brand movie. I mean … wow!

Two not-so random observations.

First, 95% of the conversation was exactly as stultifying and maddening and off in academic good-leftie-soldier la-la land as you might expect. I think a good hour was spent arguing earnestly about the “multiplier effect” of the Covid stimulus bill, with exactly zero time spent discussing the real-world impact of Covid. Instead, it was all the usual shibboleths all the time … why every penny of student debt should be forgiven now, why a $15 minimum wage really wasn’t enough, why the “problem” with the Biden Administration was Joe Biden and his bizarro focus on individual working people rather than Labor (“Yay, Labor!”), and  – my personal fave – why this country desperately NEEDS higher inflation, but by-golly it’s just not happening.

At which point your humble correspondent could contain himself no longer.

“Look, I have no idea what the real-world multiplier effect of the stimulus package will be, but have you looked at the markets recently? If you look at Bitcoin … at energy stocks … at industrial commodities … at transports … if you look at the narrative within financial media … inflation isn’t a maybe thing. Inflation is a sure thing. I’ve been doing this a long time, and I’ve never seen a more powerful narrative take root and consolidate more quickly. Everyone in market-world today thinks that inflation is a sure thing and they’re acting on that common knowledge NOW.”

And then an entirely pointless conversation about Bitcoin broke out. Sigh. But then a miracle happened, which leads to my second not-so-random observation.

Paul Krugman brought the Bitcoin conversation back to inflation, not (as I expected) by making some ex cathedra pronouncement of neo-Keynesian orthodoxy that inflation was impossible and the Fed can control it easily anyway, but by asking an honest question. He said (and I’m paraphrasing here, but it’s close), “you know, I’m not so sure that the things we talk about all the time in economics – like aggregate demand, for example – are really things at all. We had a model back in the day for understanding deflation and the liquidity trap in the US, and that was Japan. What’s our model for understanding what might be inflation in the US today?”

At which point a latecomer to the Zoom call piped up. Her name is Lisa Cook. You should look her up. I predict you’ll hear her name a lot over the next four years. Again, paraphrasing. Again, it’s close.

“I don’t think you’re going to like what I think, because we all WANT to think that there’s some huge difference between developed economies and emerging economies, and of course the United States is the MOST developed economy so it can only be compared to its developed economy “peers”. So that’s where we always look for our models … Europe, Japan. I don’t think that’s right.”

“I think the model for what’s happening in the US economy today is Nigeria.”

BOOM!

Yes, this. The kleptocratic state. The weak state. The regulatory capture. The powerful intersection of media and politics. A vast inequality of wealth and opportunity. A national identity engulfed in the widening gyre, deteriorating into old allegiances on a daily basis. An economy far too reliant on one industry (oil for Nigeria, finance for the US). And yet … real growth that Europe and Japan can’t imagine … real potential … real examples of humanity and ingenuity and positive change happening every day on a local level and on a massive scale.

I’ve got to do some more thinking about this to figure out just how far the model extends, but it really struck me when I heard it. Would love to hear your thoughts if it strikes you, too.


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Barking Dogs and Super Bowl Commercials

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The dog that didn’t bark is the key to “Silver Blaze”, one of Arthur Conan Doyle’s most popular Sherlock Holmes stories.

Det. Gregory: Is there any other point to which you would wish to draw my attention?

Holmes: To the curious incident of the dog in the night-time.

Det. Gregory: The dog did nothing in the night-time.

Holmes: That was the curious incident.

Similarly in narrative-world, the absence of clear common knowledge – what everyone knows that everyone knows about markets – is often just as interesting or useful as its presence. And that’s what we’re seeing right now at a surface level in both of our Narrative Monitors coming into February (links here and here).

The dominant macro narrative structures are presenting questions – “what happens when inflation returns and how do we prepare for that?” and “what happens when fundamentals and valuations matter again and how do we prepare for that?” – without providing a strong or coherent answer to those questions.

Everyone is asking these questions. No one is settled on an answer. Wall Street is launching a thousand trial balloons right now to “answer” those questions for you. Or, to use a metaphor appropriate to this weekend, Wall Street is storyboarding a thousand Super Bowl commercials right now.

Most of these “answers” will fizzle, meaning that they will fail to generate flow into the investment product created for the “answer”. A few of them will click. A few of them will generate substantial flows, at which point every bulge bracket bank and investment manager will immediately copy that “answer” and that associated product. That’s how Wall Street common knowledge happens.

There’s no predicting which “answer” will click. I mean, no one thinks that their Super Bowl commercial is a dud going into the game, but only one or two will come out as the commercial that everyone knows that everyone knows was really special and witty and effective.

So we’re watching this process carefully, and you’ll be the first to know when we see signs that one of these commercials is working. Right now, and this is more my intuition than a detailed narrative machine analysis, I think the Bitcoin commercial is working pretty well (and yes, there’s an ET Pro note and an ET podcast about this).

One more thing … when I say that this is the narrative regime activity we’re observing at a surface level, it’s because we DO think that there is STRONG common knowledge in markets at a deeper level. We see two deep and strong narrative currents here:

  1. The Fed has got your back. Yes, there is definitely increased chatter about “tightening” and “tapering”, but this is chatter on top of a very strong and highly coherent narrative that the Fed will always bail out markets when push comes to shove.
  1. Fundamentals don’t matter. Yes, there is definitely increased chatter about “bubbles” and “stretched valuations”, but this is chatter on top of a very strong and highly coherent narrative that valuations and real-world catalysts simply don’t matter anymore.

Could these surface narratives of “tightening” and “bubbles” and “currency debasement” coalesce over time into something that moves deeper into the overall narrative framework? Absolutely, and that’s what we think we can track with our structural narrative measures of Strength and Cohesion. But right now neither of those measures are showing much at all. It will take one heck of a Superbowl commercial to move these needles!


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The Zimbabwe Event

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Covid funeral in Harare

Over the past week, three senior Cabinet officials in Zimbabwe (including the Foreign Minister and the Infrastructure Minister) have died from Covid. Not gotten sick. Died. More broadly, reported Covid cases and deaths (the unreported numbers are certainly much higher) have exploded in this country of 15 million just in the month of January.

Unlike the ‘Ireland Event’ I’ve been writing about recently, the engine of this human and political tragedy is not the UK-variant virus (B117), but the South African-variant virus (501.V2). This is the ‘Zimbabwe Event’, and I believe it has significant real-world and market-world consequences.

My emails to you about the Ireland Event – an explosion in Covid cases in Ireland over the last few weeks in December, driven by a combination of relaxed social mitigation policies and the introduction of a more infectious SARS-CoV-2 virus from the UK – focused on two questions:

  1. how likely is a rolling series of B117-driven Ireland Events in the United States? (very, imo)
  2. where are we in the timeline for the first of these US-based Ireland Events? (2 to 3 weeks from today, imo)

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

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

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

  1. There is a sharp difference in general media coverage of the risk of viral variant spread versus financial media coverage of the risk of viral variant spread. While there’s an almost willful ignoring of the virus variants in major financial media, this is not the case with major non-financial media, where coverage of the news and risks of viral variant spread shows both “coherence” and “strength”, to use our narrative structure terms. I consider this is to be a classic example of financial market narrative complacency, where all of the narrative risks are to the downside for markets.
  1. There are now four independent medical studies showing that the B117 variant is both more infectious AND more lethal than the baseline virus, versus zero medical studies showing only the same lethality (the original PHE study showing similar lethality has been revised upwards). While the mathematical truth is that increased lethality is not nearly as “dangerous” from a public health perspective as increased infectiousness, from a popular perspective just the reverse is true. Stories of increased lethality carry a lot more narrative punch than stories of increased infectiousness.
  1. We now have multiple examples of a B117-driven Ireland Event, not just in Ireland and the UK, but also now in Portugal, Spain and Israel, and coming soon to the rest of continental Europe. The ‘Israel Event’ is particularly chastening, as the explosion in Covid cases occurred despite the most advanced vaccination program in the world, with close to 40% of the population now vaccinated. As I mentioned in last week’s note, one of the major consequences of a more infectious viral strain is that the percentage of the population that must be vaccinated before herd immunity brings down the R-number is significantly higher than with a less infectious viral strain, so that even 40% is only a modest help in limiting new infections. Also, and this is highly problematic new news, Israel reports that a single dose of the vaccines that originally contemplated a two-dose regimen is notably less effective than was suggested in clinical trials. Whether this reduced efficacy for one dose of a two-dose vaccine is because of something particular to the B117 variant is unknown.
  1. The potential for reduced vaccine efficacy AND increased infectiousness AND increased lethality is at the heart of why I think the Zimbabwe Event is so important, both in real-world and in market-world. We don’t yet have any hard evidence on diminished vaccine efficacy for 501.V2, but what we do know is that antibody protection from prior baseline Covid infections, which has shown itself to be very effective in preventing a subsequent baseline Covid infection, is much less effective in preventing subsequent 501.V2 Covid infections. This suggests, of course, that our current vaccines, which largely duplicate the antibody protection that you would get from a prior baseline Covid infection, will be similarly less effective against 501.V2. As for increased infectiousness and increased lethality, we also don’t have as much hard evidence as we do with B117. But the observations in case numbers and deaths we have throughout Southern Africa for 501.V2, from South Africa proper all the way up to Rwanda, are at least as staggering as we see in the UK, the EU and Israel for B117.

In real-world, I think it is impossible to overstate the destabilizing impact of 501.V2 on the politics of a weak state. That’s true in a relatively wealthy weak state like South Africa, much less an insanely poor weak state like Zimbabwe. I mean, the power vacuum that currently exists in Zimbabwe, where three prominent Ministers die within a week and every function of civil government has effectively collapsed … is staggering. Civilian life in these circumstances quickly becomes, as Hobbes would say, nasty, brutish and short. The outcome of these circumstances is ALWAYS war. First a war of all against all, then a war of organized factions, then a war of nations. Some of these wars will be entirely internal to existing borders. More of these wars will cross those borders. Some of these wars will include major powers. War and regime change. That’s the real-world legacy of the spread of these SARS-CoV-2 variants like B117 and 501.V2, and not just in countries like Zimbabwe. South Africa, too. Iran, too. Russia, too.

In market-world, I think it is impossible to overstate the destabilizing impact of a Covid variant that is vaccine-resistant. To be clear, I don’t know that we have that in 501.V2. If I did, then I’d be predicting a lot more than just a transitory punch to the market’s nose. But what we DO have is the start of a vaccine-resistant Covid variant narrative. I hope that’s all it ever is … the start of a vaccine-resistance story that never develops into a vaccine-resistance reality. But for market-world, the mere existence of a narrative like this, even in an embryonic state, is enough to drive tradeable market events. Put that together with recent developments with B117 … put the Ireland Event together with the Zimbabwe Event … and yeah, I think you’ve got a tradeable punch coming to markets.


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Ireland Event Follow-up: Shockwave

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Yesterday the CDC held a press conference and released an analysis showing that they expected the more virulent UK-variant strain (B117) to account for 50% of Covid cases in the United States by the end of February. I’ve attached the CDC analysis here, and you can read a summary of the findings in this WSJ article: https://www.wsj.com/articles/u-k-covid-19-variant-likely-to-become-dominant-u-s-strain-in-march-cdc-says-11610733600?page=1.

For reference on our work on this topic, you can read the full ET note here: https://www.epsilontheory.com/the-ireland-event-2/. We’ve also released a podcast on our work, available on the ET website https://www.epsilontheory.com/et-podcast-3-the-ireland-event/ , and on Spotify and iTunes.

While on the one hand it’s gratifying that the CDC is validating what I wrote you last weekend, on the other hand it’s pretty scary to contemplate the consequences of the B117 UK-variant virus accounting for 50% of all US cases 45 days from now. That’s what this email is focused on – the consequences – because they are sorely underplayed in the WSJ article summarizing the CDC report.

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

Consequence #2: if B117 is the dominant US strain by the end of Feb, the daily number of new Covid cases by the end of Feb will be MUCH higher than today. This is the point that was completely missed in the WSJ article. B117 doesn’t become the dominant strain because it “defeats” the baseline strain. This isn’t a football game. B117 becomes the dominant strain by spreading even faster than the current fast-spreading baseline virus. The math here is as inexorable as it is sobering.

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

If B117 becomes the dominant SARS-CoV-2 strain in the United States, that is a profoundly deflationary, risk-off, dollar higher, flight to safety event.

Will markets ultimately look through that event, particularly if the Fed says all the right things (which they will) and particularly if we get the JNJ vaccine in wide distribution soon (fingers crossed)? Sure. Absolutely, markets will ultimately look through the B117 threat.

But between today and that ultimate look-through, I believe there is a significant narrative shock coming to markets. You can’t jawbone the virus. You can’t declare by fiat or by narrative that B117 isn’t happening. This IS happening, and the common knowledge that this IS happening will hit every risk asset like a ton of bricks.

When does that narrative shock occur? What creates the B117 common knowledge that hits markets like a ton of bricks? I think it’s whenever we get news of the first cluster of B117 cases in the US. Right now we’re still in the case, case, case phase of the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! cycle of exponential spread. You can still close your eyes and pretend B117 isn’t happening in the case, case, case phase. But once that first cluster hits the news … well, you can’t ignore that. That’s when B117 becomes common knowledge. That’s when every market missionary starts talking about it. That’s when everyone knows that everyone knows that our glidepath to recovery is not assured.

When do we hear about the first B117 cluster in the US? No idea. And the longer it takes, the less the impact on markets. But the cluster IS coming. As the kids would say, it’s just math.


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The Ireland Event

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

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

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

Current US gov’t policy rejects the possibility of an Ireland event, largely because of what I believe is a politically-motivated “analysis” by the CDC that models more than 100 million Americans already possessing Covid antibodies, prior to any vaccination effort. Using data from flu monitoring programs in prior years, the CDC models project that 70 million Americans have already gotten sick with symptomatic Covid, but decided to just write it off as a bad cold and never got tested! I am not making this up. Obviously enough, if >30% of Americans are already effectively immunized against Covid because they’ve already gotten sick, then it’s very difficult to hit the Re numbers of 2.4 – 3.0 that Ireland is currently experiencing. I think this is nonsense, because NO ONE brushes off Covid symptoms the way they might have brushed off flu symptoms in the past. But this CDC model is why prominent Covid missionaries (to use an Epsilon Theory term) like Gottlieb and Fauci have said that they expect daily case numbers to decline from here on out, not accelerate, and this is why I think a potential Ireland event is NOT priced into any mainstream market expectations or political expectations for 2021.

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

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

A full-blown Ireland event is driven by both the more virulent UK-strain AND a deterioration in social distancing behaviors. Either taken alone is bad enough. It’s the combination, though, that’s catastrophic. Irish health authorities estimate that their starting point for Covid Re was something between 1.1 and 1.4 (meaning that, on average, one person infected with the SARS-CoV-2 virus would pass it along to 1.1 – 1.4 new people). They blame deteriorating masking/social distancing for the majority of their “event” (say, a 0.9 – 1.1 increase in the Re number), and the UK-variant for the balance (say, a 0.5 – 0.7 increase in Re). This is very much in line with the latest research from Public Health England, which estimates that the UK-variant Covid virus is approximately 40% more infectious than the baseline virus. Notably, the UK-variant is, relatively speaking, significantly more infectious than the baseline virus for “close contacts” (not face-to-face, up to 2 meters apart) rather than “direct contacts”, meaning that the UK-variant virus is particularly successful at bridging the air gap between strangers or short-duration contacts in an indoor space. This is … ummm … troubling. As lax as we all have gotten with our mask wearing and our social distancing outside of the home, the UK-variant dramatically reduces the margin of error we have with mask wearing and social distancing outside of the home.

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

This is the power of exponential growth.The numbers get silly … I mean, take that Re up to 3.0 (the high end of the current Ireland estimate), and a single Covid case will result in 5.2 BILLION total cases over a 100-day period, about 60% of the entire human population on the planet … and obviously our social behaviors around the disease would change dramatically well before we got to that point. But the real challenge of all this from a social behavior perspective is the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! nature of any exponential growth process. That Re of 2.0 that results in 2 million total infections from a single Covid case over 100 days? On Day 30 there are only 127 total cases. Not noticeable at all. On Day 50 there are just over 2,000 total cases. Barely noticeable. Let’s say you’re an elected political leader. Are you really going to take the steps that are necessary to stop this process – like shutting down domestic travel to and from an infected area, like physically quarantining entire cities – over a few hundred cases? Not a chance. Even if you’re right … even if you prevent a catastrophic outcome through your actions on Day 30 or Day 50 … your voters will never know that you were right. They will only experience the lockdown pain, and they will never credit you for the catastrophe averted.

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

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

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


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What Does Inflation Mean For Your Portfolio?

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We published our January Narrative Monitors earlier this week, which you can grab online here and here (also, if you need a refresher course in how to read these Monitors, don’t forget our webcasts and primers here and here). I’m going to focus on the Central Bank Monitor in this email, because we’re seeing something in this analysis that is unique in our historical dataset.

We think there are five narrative “archetypes” when it comes to central banks in general and the Fed in particular: Fed Put (signal for strongly positive market returns), Inflation (signal for moderately positive market returns), Dovish (signal for weakly positive market returns), Unemployment (signal for moderately negative market returns), and Hawkish (signal for moderately negative market returns). As has been the case for the past 9 months, the Inflation archetype is the strongest among these five. Nothing new or unique there. But …

  1. ALL of the narrative archetypes are now very weak. Inflation is only slightly stronger (meaning more central to the entire financial media conversation) than Hawkish, and all of these archetypes are near all-time lows in terms of the “gravity” they exert on our overall investment narratives.
  1. ALL of the narrative archetypes have absurdly positive sentiment. Meaning that for every possible narrative or sub-narrative scenario, the conclusion is that this is a positive for markets. Inflation about to run rampant? Bullish! Inflation concerns overblown? Bullish! Massive fiscal stimulus on the way to reduce unemployment? Bullish! Meh stimulus on the way and unemployment remains high? Bullish! Fed is on autopilot? Bullish! Fed is highly vigilant? Bullish!
  1. WITHIN these individual narrative archetypes (with the exception of Unemployment), there is almost zero narrative consensus or cohesion. For example, within the Inflation archetype, there are equally strong and extremely disparate (very little shared language) sub-narratives/memes/claims happening simultaneously, from “inflation is already here!” to “inflation is impossible!” to “the Fed won’t respond for years!” to “the Fed will respond now!”. There is no coherence to the Inflation narrative, no narrative agreement on what inflation means today, to a degree that we’ve never seen in the data.

This is what it looks like when common knowledge – what everyone knows that everyone knows – is being formed.

Here’s how it will play out in your own head.

Your first instinct will be to try to figure out on your own what inflation really and truly means for your portfolio. You will read about the history of inflation and think really hard about it. You will have some ideas and, depending on your ego, more or less confidence in those ideas. But then, on reflection, you will decide that you want to understand what everyone else thinks inflation really and truly means for your portfolio. You will do this by watching CNBC and reading Bloomberg Opinion articles and Goldman Sachs research reports and portfolio manager letters and the like. You will call this “doing your research” and “listening to smart people”. Over time you will begin to recognize a common thread running through what you hear and what you read. You will call this common thread an “investment thesis”, and you will find yourself nodding your head by the fourth or fifth time you recognize this common thread on what inflation really and truly means for your portfolio. You will begin to recognize this common thread in more and more of what you hear and read, and you will provide positive feedback in one form or another to the creators of this content. You will congratulate yourself on being smart enough to tease out this common thread from your “research” and you will begin to implement your “investment thesis” in your portfolio. Soon you will have conversations with other smart investors who have similarly identified this investment thesis from their research, and you will take great comfort in that. You will increase your position in the investment thesis.

I am not saying that your investment thesis is wrong. I am not saying that you will lose money with your investment thesis. On the contrary, if you are early with your investment thesis and that thesis evolves into common knowledge, I think you’ll make a lot of money.

I am saying that what you call an investment thesis is a narrative.

I am saying that the business of Wall Street and financial media is to create an investment thesis that makes you nod your head. I am saying that you will always find an investment thesis that makes you nod your head, and that this process of selling you an investment thesis that makes you nod your head is as predictable and as regular as the sun rising in the east and setting in the west.

Right now, Wall Street is trying to identify which inflation narrative will be an investment thesis that makes lots of people nod their heads.

Recognizing THAT – and maybe even trying to get ahead of THAT – is how you play the game of markets successfully.


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The Spice Must Flow

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A few weeks ago, we published an ET Pro note titled “The Bitcoin Metagame”, where I wrote about how Wall Street is now productizing Bitcoin as an inflation hedge, which – in order to accomplish this at scale – requires the application of a full-fledged AML and KYC regulatory structure to Bitcoin specifically and crypto more generally. Here’s the money quote:

My strong belief is that within a few years it will be illegal for an American resident or any entity subject to American law (or SWIFT) to transact in Bitcoin outside of a federally registered exchange and without a federal registered account.

To be clear, I think this is all probably a positive for the price of Bitcoin, and I am certain that this will increase liquidity and decrease volatility in Bitcoin. The entire goal here is to create “flow” in the form of a highly liquid, easily transacted financial product that Wall Street can administer. But it’s a death knell for any “revolutionary” application for Bitcoin, as it becomes just another highly regulated game in the Wall Street casino.

Also to be clear, I think it will take a couple of years for this highly regulated future to come to pass fully. But following announcements last Friday and earlier this week, it’s possible that I may be right a lot faster than I thought.

First, the Financial Crimes Enforcement Network (FinCEN, a division of the US Treasury) announced last Friday that they intend to impose new reporting requirements on private Bitcoin holders who try to move their Bitcoin outside of currently regulated entities like exchanges and bank custodians. If you want to withdraw your Bitcoin from a regulated account and send it to an unregulated private wallet, the new rule requires you to provide full KYC information to Treasury before you are allowed to make a withdrawal from your account.

Notably, the new rule now defines Bitcoin as a “monetary instrument” (not as a commodity as it has been treated by the SEC for securitization purposes), meaning that ALL of the laws and regulations that Treasury now applies to cash transfers can now be applied to Bitcoin transfers.

This is the narrative justification that Treasury will take to surveil Bitcoin activity and criminalize non-permissioned or non-declared activity between private wallets – we’re just treating it the same way we treat cash. You’re not opposed to that, are you? You’re not opposed to fighting terrorism, are you?

The new rule, now in an accelerated two-week comment period (meaning, there is zero interest in receiving actual comments on the rule), will go into effect in early January. France, the Netherlands and Switzerland have already imposed new laws with a very similar construction. This is happening.

Second, yesterday the SEC informed Ripple that the company (and the company’s founders in a personal capacity) would be sued in federal court for selling an unregistered security in the form of XRP tokens. This is not a small thing. XRP is the third largest cryptocurrency by value in the world after Bitcoin and Ethereum, about $22 billion before this news hit, and if the SEC is successful in this case it is a crippling blow for every other crypto token and the entire decentralized finance (DeFi) movement.

Again, I’m not a bear on the price of Bitcoin. If that’s your focus, then none of this is bad news. But I am absolutely a bear on the ability of Bitcoin and crypto to drive social change. If that’s your focus, then the news could not be worse.

As always when it comes to Wall Street and its partnership with regulatory agencies, the spice must flow.


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A Disturbance in the Force

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A quick announcement and then a quick observation on a nascent shift in the narrative that we’ve identified in both our Central Bank Monitor and our Security Analysis (the language of Wall Street) Monitor. Both Monitors are attached to this email.

The announcement is that we are relaunching our podcast series, placed on long hiatus since Rusty and I spun out as an independent company more than two years ago. In ET Podcast #1: Is That All There Is?, I’m joined by renowned cryptocurrency miner and trader @notsofast for a wide-ranging conversation on Bitcoin and crypto. We pick up directly on the topics I discussed in last week’s ET Pro notecan Bitcoin preserve its revolutionary potential after a Wall Street bear hug? I’m highly skeptical, but @notsofast has some ideas on how to make this work.

The observation is that we are seeing language in both the Central Bank and Security Analysis narrative regimes that would have been unthinkable even a few months ago, language that is market-negative. It’s not enough to change the market-positive narrative regimes in place today, but it’s definitely enough to make my risk antennae start to tingle.

In Central Bank narrative-world, we are seeing our first observations of “hawkish” language in a VERY long time. As Rusty puts it, maybe it doesn’t seem particularly hawkish to say that “maybe, if things get really crazy with fiscal policy, just maybe we might need to use monetary policy to correct that craziness”, but in comparison to the months and months where we are told that the Fed is not even thinking about thinking about thinking about raising rates … this is notable.

In Security Analysis narrative-world, we are seeing our first observations of “multiples” language in a VERY long time. Again, maybe it doesn’t seem very challenging to say that “maybe it’s useful to think about some stocks being cheap and some stocks being … ooh, close your ears if this word offends you … expensive relative to earnings or sales or something connected to real world business activities, and maybe it’s useful to think about profitless growth being less desirable than profitable growth”, but again, it’s a very different song than what has been played in financial media for a looong time. Not a dominant song, for sure, but one worth listening for.


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The Bitcoin Metagame

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We talk a lot about the “metagame” in Epsilon Theory, which is a ten-dollar word for the idea of not missing the forest for the trees. It’s so easy to get caught up in the day-to-day “game” of price movement in markets and the day-to-day “game” of tweets and polls in politics, that it can be hard to step back and see the larger metagame that will actually end up controlling all of those day-to-day games over time. Or at least it can be hard for me! That’s why I find it so useful to force myself to step back and look for shifts or inflection points in the larger metagames of markets and politics, shifts that typically show up first in the narrative around a certain topic. We look for these shifts rigorously in our narrative monitors on Central Banks and Market Analysis (December monitors published today!), and I’ll write about what we’re seeing there in a follow-on email. But today I want to talk about what I’m seeing in an ad hoc analysis of Bitcoin, because I think we are seeing an inflection point in the overarching narrative and metagame for Bitcoin that has direct implications for professional investors.

Again, by metagame I am NOT talking about price action. Yes, the price of Bitcoin has been going up, up, up. That’s important, and it has a bearing on what I’m writing about today, but more as symptom than as cause. What I am talking about goes by different names depending on where you’re reading or hearing about Bitcoin. I’ve seen it referred to as the “institutionalization” of Bitcoin, the “integration” of Bitcoin, the “Saylorization” of Bitcoin (after Michael Saylor, the CEO of MicroStrategy tkr: MSTR, who has famously turned his company’s stock into a Bitcoin tracking stock … up >300% ytd), and many other terms. You will get some flavor of what I’m talking about in any financial media article you read about Bitcoin today, whether it’s a personality-driven article (Paul Singer/Mike Novogratz/Paul Tudor Jones/Stanley Druckenmiller is buying Bitcoin! Shouldn’t you?) or a macro-driven article (Dollar down and rates up? Hedge that with Bitcoin!) or any other sort of article, but I don’t think it will hit you (or at least it didn’t me) unless you step back and look at ALL of the financial media articles simultaneously for the language and memes that run through them as a common thread.

This common thread, and what I mean by the metagame of Bitcoin, is the productizing of Bitcoin. Not in the sense of a specific investment “product” like an ETF or a fund or a de facto tracking stock like MSTR, but in the transformation of the meaning of Bitcoin from an intentionally rogue and counter-culture network that “is a dagger striking at the heart of central banks” (that’s a quote from a leading Bitcoin community guru with hundreds of thousands of followers who yelled at me this weekend for my clear misunderstanding of the “revolutionary power” of Bitcoin) into …. just another table in the Wall Street casino.

Wall Street is redefining Bitcoin to be an Inflation Hedge™ product. You know, like gold. But cooler. More now. Did we mention it’s up a ton this year?

Why is Wall Street doing this? Because this is how you make real money in financial services. You don’t make real money in financial services by being smarter, or by having a really, really clever idea, or by HODLing this rather than HODLing that. No, you make real money by capturing flow. You make real money by selling product that directly addresses fear and greed. Fearful of inflation and fiscal profligacy and dollar decline? Bitcoin! Greedy for something that’s up a couple of hundred percent and all the smart money is grabbing? Bitcoin! There is enormous money to be made on Wall Street by creating a new inflation hedge investment product that all the cool kids are talking about, and capturing the flow around THAT.

So that’s what Wall Street is going to do. They’re going to – pardon my language – sell the shit out of Bitcoin. It will come in dozens of forms and formats, each cheaper to own and transact in than the last, and it will be sold to you morning, noon and night. You will want it for your portfolio. Maybe you already have it in your portfolio. If you do, look for cheaper ways to get it in your portfolio … this is a product, not an insight or something that requires expertise.

There’s just one barrier between Wall Street and this happy expansion of their inflation hedge casino gaming section … Bitcoin isn’t a regulated security. It’s still this outlawish thing where people can transact in a non-KYC and non-AML environment. It’s still this outlawish thing where people celebrate their ability to transact in a non-KYC and non-AML environment.

What happens when there’s an obstacle between Wall Street and a pile of money? The obstacle is removed. With extreme prejudice.

My strong belief is that within a few years it will be illegal for an American resident or any entity subject to American law (or SWIFT) to transact in Bitcoin outside of a federally registered exchange and without a federal registered account.

And that will be an interesting day for the retail owners of Bitcoin, particularly the Original Gangster retail owners of Bitcoin, the ones who celebrate their peer-to-peer, uncensored transactions, the ones who want to plunge that dagger into the heart of central banks. That will be an interesting day for the original (and still dominant) narrative of Bitcoin.

I think the Wall Street who-cares-let’s-make-mo-money narrative wins out. It always has in the past, so I really don’t know why this would be any different. I think that the end result of all this, when all the regulatory dust settles and the OG gnashing of teeth ends, is that the price of Bitcoin is higher.

But that’s not why Wall Street is productizing Bitcoin. It’s not the price that really matters when you’re trying to capture flow. It’s the liquidity that matters. It’s the volatility that matters.

I’m not going to predict the future price of Bitcoin as this Wall Street productizing effort proceeds. I think it goes up, but who knows? What I will absolutely predict, however, is that Bitcoin trading liquidity goes way up and Bitcoin price volatility goes way down. THAT is the market and political metagame that Wall Street must control around Bitcoin in order to generate flow.

So they will.


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Tyger, Tyger

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We’ve all heard the old line that investment managers, like tigers, can’t change their stripes. Or as the line has evolved over time, that investment managers shouldn’t change their stripes. It’s a line that’s been heartily embraced by consultants as it allows them to create a cottage industry in measuring “style drift”, which is a wonderful device for firing underperforming value managers (ie, all value managers) in a way that absolves the consultant’s investment board client of any responsibility. “No, no … it’s not us. It’s you.”

Is style drift a thing? Of course it’s a thing. Active management IS style drift. That’s what active managers DO. If their process and their analytical focus aren’t working, then they “adapt” and “evaluate” and “improve” and “bring in” (all words that sound much better than “drift”) change in their process and analytical focus in order to improve performance. They hope. If you look for style drift in your underperforming managers, guess what … you will ALWAYS find it. It’s like discovering that water is wet. It’s like discovering that gambling is taking place at Rick’s Place in Casablanca.

In fact, I’ll go one step further. Style drift is WHY you hire an active manager. Otherwise, just buy a factor exposure and be done with it. No style drift there!

My point here is not to defend active management. My point here is that the evolution of the old line from “managers can’t change their stripes” into “managers shouldn’t change their stripes” is a constructed, intentional change in narrative, a vital part of the primary full-employment narratives for consultants: “Yay, diversification!” and “Yay, risk management!”.

The evolved saying is wrongheaded. The old saying is Truth with a capital T.

Exactly like tigers, investment managers CAN’T change their stripes. I don’t mean they can’t change their process and analytical focus. I don’t mean they can’t change in the sense of what the consultants call “style drift”. I mean that an investment style and the learned adjustments/drifts/change to that style are not an investor’s tiger stripes!

Your tiger stripes are your immutable investment DNA. Your tiger stripes are the psychological make-up and the grammar you use to make sense of the investment world. [there’s an oldie but goodie ET note on all this, btw, “Adaptive Investing: What’s Your Market DNA?”]

You can’t change this in yourself. Your managers can’t change this in themselves. I can’t change it in myself. And we shouldn’t try. But we must KNOW this psychological make-up and investment grammar. We must know it in our managers, yes. We must know it even more so in ourselves.

I’ll go first.

My psychological make-up as an investor is to see the flaw in all things. I do not have faith easily. I see an unending sea of mendacity in mass society, and an arc towards the quiet extinguishing of small-l liberal and small-c conservative virtues. I am, in market terms, a born short-seller. That is my DNA.

Three times in my professional life as an investor, I have felt a trade in my bones, by which I mean a certainty that there is a massive disjuncture between a real world poised for sharp secular decline and a market world at buoyant narrative highs. The first time was in the summer of 2008. The second time was in February of 2020. The third time is today.

The real world poised for sharp secular decline today can be summed up in these three charts.

First, sharply declining loan demand in the real economy, particularly by small firms (this is from the quarterly Fed survey of bank lending officers):

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Second, sharply declining confidence by small businesses that they can weather the Covid storm (this is from a Goldman Sachs report, and if you account for survivorship bias in the survey, the results are even more depressing):

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Third, the fact that a second wave of endemic Covid is now raging essentially unchecked across the entire United States, as measured by cases, hospitalizations and deaths (this is from The Covid Project maintained by The Atlantic, and is a compilation of state-reported data for the US):

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We are spent. I mean that in a societal and individual sense. I mean that in a psychological sense. I mean that in an economic sense. I mean that in a physical, real world sense. But at the same time we are spent, we are now faced with the true storm of Covid-19. Everything that is happening in France and Italy today will be happening in the United States in two weeks. These are not the conditions for a recession. These are the conditions for a global depression.

I feel this in my bones. And yet.

In the summer of 2008 and February of 2020 I saw the trade to, yes, make money from those real world calamities. I do NOT see the trade here.

Why not? Because there IS good news on the horizon in the form of the Pfizer vaccine. Wonderful news! News of a vaccine that will, unfortunately, come too late for the real world damage of this plague over the next three months, but news that can drive a tremendously supportive narrative in market world.

Why not? Because capital markets are a political utility, and neither the Fed nor, ultimately, the White House or Congress will ALLOW capital markets to reflect the real world damage that I feel in my bones is coming.

I can’t change my tiger’s stripes. I see what I see, and I think what I think, and I feel what I feel. My investor DNA has never been more at odds with my knowledge of narrative and politics. The gulf between real world distress and market world resilience has never been greater in my eyes. But I don’t know what to DO with that, other than share it with you.

Please stay safe,


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