The PPP Narrative for Asset Managers


The vast majority of ET Pro subscribers are in the business of managing other people’s money in one form or another, and many of you are key decisionmakers at asset management firms that qualify for forgivable loans from the US government under the SBA Paycheck Protection Program (PPP). So I wanted to use this week’s note to highlight a narrative backlash that I see developing against RIAs and other asset managers that took PPP money.

To be clear, I don’t have a strong view one way or another on the ethics of asset managers taking PPP loans. I get the criticism (legislative intent was to bridge payroll expense for public-facing companies in extreme duress from mandatory lockdowns), but I also believe the language describing program qualification was intentionally broad enough to allow asset managers and law firms and accounting firms and other similarly situated companies to apply for a forgivable PPP loan in good faith. Clearly there is nothing illegal about a qualifying asset manager accepting PPP money. But it IS a bad look if the narrative spotlight focuses on “Wall Street rich guys” taking PPP money, and I think that’s exactly what is starting to happen.

I first noticed this narrative backlash in the social media reaction to a self-congratulatory blog post last week by Josh Brown of Ritholtz Wealth Management, an RIA with about $1.3b AUM and 35 employees, where Josh thanks his JP Morgan bankers profusely for getting them a PPP loan in round 1 after learning that Q1 billings were down by … wait for it … 12%. You can read the post here in all its glory – – it’s a masterclass in tone deafness, all the more odd because Josh is usually pretty adept at this stuff (1.1 million Twitter followers and a fixture on CNBC).

Given Josh’s celebrity status on Fintwit and the blogosphere, his post was picked up by various media outlets, like CityWire ( It didn’t help that Josh’s partner, Barry Ritholtz, wrote a decently popular book titled “Bailout Nation”, railing at this type of stuff.

Since then, I’ve seen a social media resurfacing of older articles and opinion pieces, like this WSJ piece from April 20 (PPP Loan Terms Amount to Legalized Fraud: Healthy companies can easily exploit aid meant for those that had to shut down), as well as more recent articles about larger RIAs taking PPP money, such as Carson Group ($12b), Sanctuary Wealth ($9b), Sequoia Financial Group ($4.6b), Crestone ($3b), and IPG Investment Advisors ($2b).

Does this early-stage narrative have legs? Time will tell, but I think it probably does. As you can imagine, these articles are red meat for the always simmering anti-Wall Street sentiment, particularly in an election season and particularly as the stock market goes up even as the real economy suffers. I think there will be a lot more articles like this … no matter how unfair this treatment might be, it’s just too juicy for any political entrepreneur or media voice to pass up.

Like many of you, this is an issue that hits home for Rusty and me. Second Foundation Partners did not accept PPP funds … not because we thought it was unethical (particularly after the program was reloaded with additional capital in round 2), and not because our small business couldn’t use the money to support payroll as it was intended, but because we thought it could compromise our long-term business and brand if the narrative turned in this direction. If your asset management firm has a similar sensitivity to this narrative, it’s worth paying close attention to these developments.


Children of Men


[first lines]

Newsreader:    Day 1,000 of the Siege of Seattle.

Newsreader:    The Muslim community demands an end to the Army’s occupation of mosques.

Newsreader:    The Homeland Security bill is ratified. After eight years, British borders will remain closed. The deportation of illegal immigrants will continue. Good morning.

— Children of Men (2006)

After the global flu pandemic of 2008, mankind loses its ability to conceive children, and the world begins a long, gradual descent into anarchy and despair. By 2027, Britain is the one civilized nation remaining, although it has transformed itself into a brutal police state to manage not just a fin de siècle, but a fin to … humanity.

That’s the premise of Children of Men, a great book by PD James and an even better movie by Alfonso Cuaron. It’s a premise that’s ringing pretty loud in my ears right now.

Here’s the problem. We are in an incredibly path-dependent world right now.

What does that mean? It means that our world can go in two totally different directions depending on a roll of the dice. It’s like the Democratic primary … if Elizabeth Warren drops out of the race before Super Tuesday and Amy Klobuchar stays in, then Bernie Sanders is on the ballot against Donald Trump this fall, not Joe Biden. But that’s not what happened.

Do we get a vaccine in 6 months or 16 months? Or never?

If we get a vaccine in 6 months, then I think that all of the “stimulus”, all of the extraordinary monetary and fiscal policy, can be – not reversed – but survived. The narrative that the trillions provided to support financial asset prices amount to a “bridge loan” works in this scenario, as actual economic activity starts chugging back to “normal”.

But if the answer is never, or even if the answer is 16 months from now … then the “bridge loan” narrative fails. Then the truly hard choices begin. How does a government support financial asset prices through direct fiscal expenditures permanently? Under these circumstances, I think our political and economic systems alike fall into national socialism. Into fascism. It’s the Children of Men scenario.

The vaccine question is a derivative of a more fundamental question, one that I’ve been wrestling with for a couple of months now.

Can a free world survive an endemic COVID-19, a disease that is a chronic affliction, killing 500 to 1,000 Americans every day (many more in countries like Brazil or India) but never collapsing a major metro hospital system?

I used to think yes. Now I think no.

I think no because I don’t believe we have legitimate governments in the four countries that matter for global security: the United States, China, Russia and India. I don’t believe we have governments in these countries based on the consent of the governed and committed to the interests of its citizenry over institutional self-interest. This isn’t a Trump thing (although he makes it much worse), any more than it’s a Modi thing or a Xi thing or a Putin thing. This isn’t something that gets fixed with an election or a putsch. This is a structural thing. It’s a regime thing. And it’s not that the governing regimes in Berlin or London or Paris are paragons of virtue, it’s that they just don’t matter for what I’m about to say.

In the same way that highly efficient economic supply chains are wrecked under the stress of COVID-19, so are highly efficient political supply chains.

And that’s what modern governing regimes are: highly efficient political supply chains. This is the machinery of what I call The Long Now, where the threat of the economic future is removed by fiat and narrative, replaced by constructed political threats like who can use what bathroom, such that citizens “spend” their votes to purchase a political experience that tastes delicious (mmm, dopamine), but has zero lasting or fundamental economic consequence. It’s pure political theater, finely-tuned to serve the institutional self-interest of every faction in the Nudging State.

But when there’s an actual real-world threat to that real-world economic future, a threat that really doesn’t care about your narratives but just marches ahead according to its biology … well, that’s what breaks the Long Now equilibrium. Like all well-managed supply chains, the Long Now is perfectly robust on its own terms. It IS an equilibrium in its own system. But COVID-19 comes from outside that system, and it’s a wrecking ball. Sure, every faction will try to politicize COVID-19, to turn it into more of the same political theater (A Truth That’s Told With Bad Intent), and that can work if there’s a vaccine in six months take the threat away for real. But it doesn’t work if COVID-19 becomes a permanent part of our public health landscape.

Without a vaccine against COVID-19, I don’t believe the governments of the Big 4 Global Security powers – the US, China, Russia and India – can survive without participating in a major power war to mobilize domestic public support against a foreign Other.

So they will.

This is the next systemic shoe to drop – major power war – and I think it’s entirely path-dependent on whether or not we get a truly effective vaccine into initial deployment by the end of the year. Otherwise it’s not just our economic supply chains that will breakdown irretrievably, but our political supply chains, too.


Everything You Always Wanted to Know About CDS … But Were Afraid to Ask


I know it’s forbidden to say this, but I like Woody Allen movies. If you’ve never seen Everything You Always Wanted to Know About Sex* … But Were Afraid to Ask, it’s worth your time just for the Gene Wilder scenes. And yes, credit default swaps are the sheep in this story.

Here’s the replay for the CDS trading primer we held via conference call and screenshare for ET Pro subscribers:

I’ve also attached the slide deck I used in the presentation here: ET Pro CDS Primer deck.


The Bear Stearns Bounce


In all my time running a hedge fund, I only felt one trade “in my bones”, as they say. That was in Q4 of 2007, when I became convinced that there was a good chance of a nationwide decline in home prices, which would in turn unwind the entire $10 trillion asset class of RMBS. We took our net exposure down close to market neutral in Q4 2007, and stayed that way through Q1 2009. That trade made my career.

And then I tweeted this on Feb. 26.

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I thought it might be useful to review the hard times in that looong short of Q4-07 through Q1-09, meaning the times that shook my confidence (and my partners’ and my investors’), because I think there are some key similarities in the trades. Big differences, too, of course.

The hardest period in that Long Short was from March 15 to May 31, 2008 – a 10-week period I’ll call the Bear Stearns Bounce. Here’s the chart in all its gruesome glory, with Bear Stearns in red and the S&P 500 in green.

You can see how Bear was highly correlated with the S&P 500 from May 31, 2007 onwards, which makes sense given Bear’s poster child status for that market on the way up … and the way down. At the top in October 2007, Bear was trading north of $150/share. By March 15, 2008, when Bear was taken out in the street and shot in the head by regulators, it was trading at $2. The carcass was ultimately sold to Jamie Dimon and JP Morgan for just under $10/share, although the effective price (long story) for most Bear investors who hung on to the bitter end (employees mostly) was $5/share.

Everyone who has been in markets long enough has their Bear stories, and I’m no exception. I liked Bear Stearns the company and I loved Bear Stearns the people! Bear was one of my two prime brokers (Morgan Stanley was the other), and we had a wonderful business relationship. Didn’t stop me from shorting them from $145 down to the bottom (with a borrow from MS, natch), and it didn’t stop me from moving our prime business over to JPM in January 2008, but as Hyman Roth said, this is the business we have chosen. Nothing personal.

Anyhoo … while Bear Stearns was enduring an old-fashioned run on the bank in March of 2008 (it was guys like me taking their money out of the prime brokerage that killed the company), the overall market was in a severe correction. Not a bear market, mind you (no pun intended), but a severe correction. When Bear went out, the S&P 500 was down 18% from the October highs and down 12% from the Jan. 1 year start. Painful for most, but not crushing. Nice for me, being single digit net long and shorting financials like Bear with abandon, but not bliss.

And then we had the Bear Stearns Bounce.

The overall market came roaring back over the next 8 weeks, so that by May 19 the S&P was only off 1% for the year. Still down 8% or something like that from the highs of 2007, but who cares about that? Like any right-thinking hedge fund, those gains had been crystalized at 2007 year-end. 2008 was a brand new story, for good or for ill, and on May 19 I was about a million miles away from feeling good!

But I stuck with the short. Why? Because narrative. Because the overwhelming market narrative after May 19 was that Bear had been a bad apple, that by liquidating Bear the crisis was over, that – and I’ll never forget this phrase, because it was used over and over – “systemic risk was off the table.” Oh sure, there were still problems here and there in MBS portfolios, and sure we were probably in a recession, but there was no longer a risk of the system falling down. So long as I was sure this narrative was a lie – and I was – my conviction in the short remained. And starting in late May, the trade worked. Man, did it work.

And so here we are in 2020.

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We have flattened the curve. Not just in New York, but in San Francisco and Kansas City and Nashville. Not just in the United States, but in most countries around the world. We’re going to start reopening economies – too soon IMO – but because of the biology of this virus and the nature of exponential functions, I think we’re going to have a solid month of mostly “good news” from states like Georgia and Ohio in regards to their re-opening “data” before the clusters begin again. I think we will hear a solid month’s worth of the 2020 version of “systemic risk is off the table”, where the Bear Stearns equivalent is the surge we experienced in New York/New Jersey but nowhere else. I think we are already inured to the prospects of 2,000+ Americans dying every freakin’ day from this disease, so that “improvement” to only 1,000+ Americans dying every freakin’ day becomes a wall of worry for the market to climb.

The question you will have to ask yourself over the next four weeks is this: do you think there is still a risk of the system falling down?

But before you answer that question, let’s review the big difference between today and 2008 – the gravitational mass of $20 trillion going on $30 trillion in central bank balance sheets. Let’s review the punch line of The Three-Body Problem, a core note in the Epsilon Theory canon, that there is no closed-form solution, no model or prediction that can tell us whether or not there is a repetitive pattern here. Even though our human brains are desperate to find just that. I’m not bringing this up to chicken out from giving you my opinion on the question of persistent systemic risk, but to point out that we may not be talking about the same system (or the same meaning of the system) here in 2020!

So here’s my opinion.

Yes, I think there is still significant risk of the real-world socio-economic system falling down from COVID-19, and I think that will be reflected in market-world prices. Yes, I would stay short.

AND, I think that if the Fed starts buying equities – something literally unthinkable in 2008 but a pretty commonplace conversation in 2020 – then the meaning of the market-world system will be existentially different and its divorce from the real-world socio-economic system will be finally complete. And you’d be crazy to be short.

Yes, I feel this trade in my bones. But does that matter – does ANY trade matter – for market-world anymore? I dunno. That I do NOT feel in my bones.

Man, it was so much easier to run a hedge fund in 2008. And it wasn’t easy then.


Pandemic Playbook Notes – 4/7


If our 3/23 update seemed slightly asymmetrically rosy in characterizing the near-term balance of narrative structural elements, you will probably spot a similar bent toward negative asymmetry here. Most of that is due to what we see as the emergence of a complacent narrative structure around the flattening of the curve in the US.

This is a network graph of high-circulation US financial markets-related news from April 1 through the morning of April 7. The highlighted nodes relate to articles mentioning flattening or slowing of the curve. It immediately circulated through nearly every part of the network, and was related to nearly every COVID-19 related topic within financial news.

TopicNarrative StructureNarrative Structure Changes Since 3/23
Current General Spread / Fear of Covid-19:Complacent (Changed from Mixed)Our assessment of this narrative structure has changed from “Mixed” to “Complacent”

We think there continues to be both upside risk and downside risk relating to facts about the spread of COVID-19; however, in the past week we have seen the rapid emergence of a “the curve is flattening!” narrative across traditional and financial news media. We are likewise hesitant to ever attribute market action to one factor, but it is hard to ignore how this news corresponded to a meaningful shift in risk posture for many investors on 4/6 and 4/7 (the latter based on pre-open futures). We now think the risk from this factor is asymmetrically skewed toward the downside.

If we were attempting to trade directionally, we would be very focused on two prospective catalysts:

1. We have long felt the major downside risk lies in changes to the reality and narrative of the length of the recession caused by the pandemic response. Flattening is wonderful news! AND it does not necessarily have very much to do with the potential for long-term knock-on effects of the shutdown. We’d be looking for unexpected stay-at-home extensions, announcements of potential delays of major events, and late summer / early fall popups of the disease as early catalysts that might cause concern for some investors.

2. We believed that investors would focus unduly on New York (for obvious reasons). That has proven true, but not in the way we anticipated. The US doesn’t have one curve. It has multiple, each at different stages. Hot spots will emerge, and if they are in economically significant locations, they could constitute meaningfully negative surprises.
Political SeriousnessComplacent (Changed from Mixed)Our assessment of this narrative structure has changed from “Mixed” to “Complacent”

What we observe in narrative structure is an expectation that some normal economic activity will resume at the end of April. We have zero insight into the accuracy of that. We also aren’t certain how the market will treat it. We think that would be greeted as good news initially, and we also think that pressure to cancel stay-at-home orders could have consequences for the length of COVID-19.

This one is too complicated to be read as directionally bullish or bearish. We think you should expect meaningful volatility about how a return to normalcy takes place, and we think that volatility is probably being understated.
Depth of Economic OutcomesConsensus (N.C.)Minor change.

We have continued to assert that an extremely deep recession was largely part of a consensus narrative structure. Big negative payrolls? Yawn. Bank comes out with new apocalyptic Q2 GDP print? Yawn.

We think that’s still true, and we still think that ‘better-than-feared’ prints from individual companies are an interesting opportunity to mine.

However, we also think that the “flattening narrative” is changing this somewhat. Investors may permit themselves to start dreaming a bit about Q2.
Length of Economic OutcomesComplacent (N.C.)No changes.

The potential transition of common knowledge from “short and deep” to “long and brutal” remains our biggest concern. We think the tail of this issue is almost entirely in one direction. Given its attachment to the Unknown Unknowns, it also keeps our posture for most short-horizon investors as underweight risky assets.
Cases of Economic RuinComplacent
(with Exceptions)

No changes.

On 3/23 we repeated our caution against taking risk on first-order ruin trades (airlines, hotels, etc.). We repeat that caution here. Fiscal and monetary intervention remain immense risks to any go-to-zero trade.

For investors in individual securities, time searching for credit-sensitive pockets in industries unlikely to meet the attention of congress could be time well spent.
Emotional / Visceral ResponseCompleteWe are removing this from our list of Known Unknowns, as we think the major dynamic here is no longer relevant to the narrative structure.

In our last update we wrote, “We think there is probably short-run risk associated with this that doesn’t yet seem present in the narrative structure we have observed. It is very hard to quantify these effects.”

We were right on the timing, right on the difficulty to quantify, but wrong on whether there would be much response. That probably adds up to a wrong. This one was a temporary narrative structure item and will be removed.
Fiscal Policy ResponseConsensus (Change from Mixed)Our assessment of this narrative structure has changed from “Mixed” to “Consensus

In our last update, we noted the following, neither of which were earth-shattering predictions.

if you are outright short risky assets over anything other than a trading horizon, your bet is at least in part a bet against coordinated, coherent government messaging about the exit strategy from distancing and lockdowns


as noted above on a separate issue, know that your short run bets are probably also bets on the timing of, discussion of roadblocks for, and ultimate sticker size of the senate’s fiscal plan

We are observing a consensus narrative structure that the “big fiscal bullets have been fired”. We have no edge on whether the newest $1 trillion proposed next step being floated is useful or high confidence. Or whether the $2 trillion Infrastructure concept Trump threw out has a chance in hell of moving forward.

However, we DO think that big additional fiscal stimulus is absent from any narrative structure we can detect. We also don’t see any evidence that the actual efficacy of fiscal intervention is being treated as all that important (e.g. the PPP fiasco, which has largely been shrugged off). Big Bills with Big Headlines are still likely to be treated as Big News.
Monetary Policy ResponseConsensus (Change from Mixed)Our assessment of this narrative structure has changed from “Mixed” to “Consensus

As we have observed previously, we see common knowledge that the Fed is “out of ammo”, which we believed created some upside asymmetry in the market’s likely response to new information about fiscal intervention. We think that is more true than it was in the past weeks.

We are also observing early missionary behavior (in literally the past week) that appears to be preparing the way for a “the Fed should be able to buy equities” narrative. It is early, but we think investors should be very cautious betting on the depth of drawdowns that will be permitted.

Markets being treated as a utility remains a thing.

But Barry Sternlicht Says …


I was an investor in one of Barry Sternlicht’s public vehicles back in the day, for a short period of time. As I recall, it was some mule-like offspring of a REIT and a SPAC. The thesis, of course, is that we were “on the same side of the table as Barry” in these transactions, which was, of course, nonsense. You’re never on the same side as guys like Sternlicht or Icahn or Barrack or Peltz or whatever robber baron you want to toss out there. Even if you win a hand tagging along on a particular deal, you know two things … a) they’re taking a huge rake from your winnings, and b) they’re just setting up for the next play, of which you are definitely not a part.

So it always amazes me when ordinarily sensible people take what guys like Sternlicht say on CNBC or Bloomberg at face value, as if their statements are anything other than a purely self-serving collection of words. That when Sternlicht goes on the tube to say that we need to suspend mark-to-market on CMBS, or Barrack says we need to suspend margin calls on levered CMBS portfolios, they are not lying through their teeth when they also say they have no dog in the fight. These guys don’t get out of bed if there’s not something in it for them. Or as my favorite market saying of old goes, they’d sell their mother for an eighth. That’s at least three mixed metaphors, but you get my drift.

Rusty wrote a great little note on this the other week: The Miracle Max of MBS.

But it did get me to thinking … what the hell is happening in MBS-world that both Tom Barrack and Barry Sternlicht feel compelled to slick back their hair, put on their best TV make-up, and go do their song and dance routine on CNBC? How bad does it have to be wake these two krakens? Well, pretty damn bad, as it turns out, both in market-world and real-world.

I’m sure that Barrack and Sternlicht are primarily concerned with market-world, and the problem here is familiar to anyone who survived 2008. If your business as a lender makes you naturally long mortgages (either commercial or residential), and so you maintain a hedge by shorting mortgage-backed securities (MBS) … that hedge has killed you recently and your long position hasn’t really caught up. On the other hand, if your business as an investor involves you being levered long MBS (either commercial or residential) … well, you’ve been killed on that position, too. Basically, whatever your business model is in the MBS world these days, you’re getting killed, and whatever cleverness you were employing not to get killed has been too clever by half, as the Brits would say.

I say that this problem is familiar to anyone who survived 2008, because hedges similarly failed throughout that market crisis, for both naturals and speculators. It’s tempting, right? You’re a Master of the Universe, so why should you draw down your book, why should you take down your gross exposure and your leverage here in an era of free money, when you can just lever up a little bit more and put on some clever hedges to your core positions? It’s what too clever by half coyotes always do … they reduce their net exposure and maintain their leverage rather than reduce their gross exposure and reduce their leverage. I can’t tell you how many people I saw blow themselves up in 2008 doing this, because hedges go perverse when tectonic plates shift in real-world.

And that IS what’s happening in real-world. It’s not just the tectonic plate of globalization that has now reversed course … it’s the tectonic plate of lease obligations that now seems like it could be rent asunder. What do I mean? I mean that companies with massive lease obligations like Cheesecake Factory (CAKE) have told their landlords that they’re not going to pay any more rent on their VERY long-term lease obligations. Not because they can’t pay. But because they’ve decided they won’t pay. I mean … wow.

And I get it. There’s a non-trivial chance that the physical world of commerce … the world that gives meaning to Commercial. Real. Estate. … will be permanently scarred and structurally altered by the COVID-19 pandemic. Will we EVER go back to cramming ourselves into little booths at Cheesecake Factory and ordering something from page 23 of the menu? It’s hard to believe I’m saying this, because no one loves a starter of loaded potatoes followed by a main of spicy tuna wrapped in lettuce leaves more than me, but maybe not.

I honestly have no idea what the world is going to look like in six months! I’m sure I’m not alone. And if you honestly have no idea what the world is going to look like in six months, are you going to live up to your commercial obligations (like a lease) over the next six months as if the world is still spinning as always on its axis? I am. I know that Rusty is. Cheesecake Factory, though … not so much. And there are a lot Cheesecake Factorys out there.

There’s a war of all against all brewing today. Or at least a war of the dealbreakers against the dealbreakers. It’s as important in business as it is in our personal lives. Find your partner. Find your pack.


Pandemic Playbook Notes – 3/23


This is a running set of observations of changes in the structures of narratives relative to our initial document published on March 17th. You can read it here for context.

We don’t see any material change in the Known Knowns or Unknown Unknowns as described in the prior document, and have not updated them here. That means that we continue to believe the right broad playbook relies on reduced use of leverage, reduced reliance on correlation and diversification assumptions, reduced position-level and risk-level concentration.

However, with the week’s news and unprecedented action by the Federal Reserve, we update our assessment of the narrative structure of what we previously coined the Known Unknowns: risks that it may be possible to model probabilistically. The two with material changes? Both in policy response land: the narratives surrounding Fiscal and Monetary Policy response.

TopicNarrative StructureNarrative Structure Changes Since 3/17
Current General Spread / Fear of Covid-19:Mixed (N.C.)No material changes.

We continue to think that means there is risk in both directions on bets on the speed / expansion of spread. 

That said, we do think, despite the fact that #DontTestDontTell is still rampant in many areas, the ramp this week in testing is real and probably underdiscounted. Numbers in the US are becoming less fictional and the reality of the situation is becoming more widely acknowledged. As we communicated in an early Pro note, testing steadily removes one source of uncertainty from the system.

Similarly, as argued here, we think it is entirely possible to change course from the overwhelmingly bearish transition from “short and deep” to a “long and brutal” narrative. Testing and screening is a fundamental part of how that would take place.

If you are outright short risky assets over anything other than a trading horizon, your bet is at least in part a bet against coordinated, coherent government messaging about the exit strategy from distancing and lockdowns. Not saying that’s a bad bet, but now more than ever, know what edge you are counting on to make you right.
Political SeriousnessConsensus (N.C.)No material changes.

Separating this from the slowness of fiscal response (covered below), the general sense of seriousness conveyed in media reports, especially about local and state governments, remains high. We are somewhat concerned about emerging language relating to agitation for a “date certain” that could change the narrative structure. (As one subscriber pointed out to us, this appeared to accelerate over the weekend, with more commentators expressing concern about the looming economic impact of distancing. We agree.) Either way, we think this remains mostly a one-way risk to the downside for the near term.
Depth of Economic OutcomesConsensus (N.C.)No material changes.

The common knowledge about GPS / Earnings / Unemployment outcomes for Q1 and Q2 continued to deepen – each of the banks came out with progressively more aggressive drops for these periods. Consistent with our expectations, this didn’t seem to cause much concern or consternation. We continue to think this strong common knowledge structure will create idiosyncratic opportunities (to the upside) in the coming weeks/months for companies who buck that common knowledge.
Length of Economic OutcomesComplacent (N.C.)No material changes.

The potential transition of common knowledge from “short and deep” to “long and brutal” remains our biggest concern. We think the tail of this issue is almost entirely in one direction. Given its attachment to the Unknown Unknowns, it also keeps our posture for most short-horizon investors as underweight risky assets.
Cases of Economic RuinComplacent
(with Exceptions)

No material changes.

We still think markets remain focused on the obvious first-order ruin risks (airlines, hotels, etc.).
Emotional / Visceral ResponseComplacent (N.C.)No material changes.

This week through, say, April 10th will be the ones with the first images coming from crowded NYC hospitals with empty NYC streets. We think there is probably short-run risk associated with this that doesn’t yet seem present in the narrative structure we have observed. It is very hard to quantify these effects.
Fiscal Policy ResponseMixed (N.C.)Some change.

We still see this structure as mixed, with risk of creating volatility in both directions. But with bickering in the Senate, the focus of the narrative seems to be shifting from how large to how long is it going to take. We think this makes it a likely (and increasing) source of volatility this week if unresolved. As noted above on a separate issue, know that your short run bets are probably also bets on the timing of, discussion of roadblocks for, and ultimate sticker size of the senate’s fiscal plan.
Monetary Policy ResponseMixed (N.C.)Some change.

We observed in our initial assessment that the common knowledge that the Fed was “out of ammo” created some upside asymmetry in the market’s likely response to new information. This morning proved that to be the case, although truth be told, the perking up from limit down futures was still pretty limited given the remarkable expansiveness of the steps taken. We STILL think this narrative structure exists, and that the common knowledge that the Fed is out of bullets continues to support asymmetrically positive market response to rabbits they may pull out of hats from time to time. But probably less, barring a relaxing of restrictions on buying equity securities outright.

Pandemic Playbook – 3/17


Epsilon Theory PDF Download (paid subscription required): The Pandemic Playbook – 3/17

Beyond what we have published about Covid-19 itself since early February, we have also published a range of more explicit observations about Covid-19 from the perspective of a risk manager or asset owner over the past several weeks.

On February 27th we argued that the narrative of Covid-19 continued to be complacent. We argued that most investors should pursue the universal shrinking of active risk and gross exposure. We argued for a circumstances-based analysis to consider risk asset exposure reduction (i.e. net exposure). We also wrote what we thought would trigger a reevaluation of circumstances:

It means we’d be doing all of the above until the cargo cult of Covid-19 analysis turns back into science. In short, we’d be doing the above until we felt that the measurements being provided about the state of Covid-19 infections reflected some underlying reality.

Covid-19 Cargo Cults

Following the speech given by Donald Trump yesterday (3/16) and the change in strategy adopted by the United Kingdom that same day, we believe this is now the case. The two components of this change are the capacity and willingness/recognition to make testing the single highest priority. The former quality is identifiable. Covid-19 testing across (most of) the United States ramped up substantially over the weekend. Individual states like New York are now performing more than 1,000 tests per day. The latter is subjective. Watch both speeches for yourself.

What do we think that means?

It means we think that the narrative of market complacency about Covid-19 is officially over.

It means that data demonstrating the importance of asymptomatic transmission in earlier infected countries has supported a rapid sea-change in the seriousness with which countries have embraced social distancing measures that explicitly reduce tail outcomes (for the disease).

It means we think the uncertainty overhang related to non-testing and the lack of institutional inertia within business and government to act on testing and mitigation has been relaxed.

This is NOT an all clear, folks. But it does mean a change in the game being played and in our ability to play that game. We’d like to walk through our updated framework for thinking about the governing narratives and events we see for the Covid-19 pandemic (a term which you should understand we always mean in context of the medical, economic AND quarantine effects unless otherwise stated).

We recommend that institutions and asset owners construct their response framework from what we have referred to previously as the Koan of Donald Rumsfeld.

Decision-making under certainty – the known knowns. This is the sure thing, like betting on the sun coming up tomorrow, and it is a trivial sub-set of decision-making under risk where probabilities collapse to zero or 1.

Decision-making under risk – the known unknowns, where we are reasonably confident that we know the potential future states of the world and the rough probability distributions associated with those outcomes. This is the logical foundation of Expected Utility, the formal language of microeconomic behavior, and mainstream economic theory is predicated on the prevalence of decision-making under risk in our everyday lives.

Decision-making under uncertainty – the unknown unknowns, where we have little sense of either the potential future states of the world or, obviously, the probability distributions associated with those unknown outcomes. This is the decision-making environment faced by a Stranger in a Strange Land, where traditional cause-and-effect is topsy-turvy and personal or institutional experience counts for little, where good news is really bad news and vice versa. Sound familiar?

The Koan of Donald Rumsfeld

To that end, below we outline for each of the three categories the facts, narratives and events which we think will frame how information that matters to markets is conveyed. To the extent we can, we will identify the type of narrative structure which we believe exists and how we think new information will be processed.

Importantly, you should know that this will necessarily evolve. We will not always be in a position to update the state of each item. What we are recommending is incorporating aspects of this into your own framework in ways that suit your objectives, process and ability to take in rapidly evolving new information.

The Known Knowns

Other than “the sky is not falling” and “the sun will rise”, practically nothing falls into this category today.

I don’t mean this flippantly. It matters that this set is empty for all practical purposes, because it would usually include things like “markets will be open” and “you’ll be able to short” and “daily variation margin on centrally cleared derivatives is de facto riskless.”

That means that your framework must assume a non-zero probability that your hedges will not work. That means that your framework must assume that series of small trades structured to exploit asymmetry / volatility have a non-zero chance of not paying out.

We think that continues to argue for a smaller gross exposure or (for long-oriented investors) smaller active risk position than your perceived edge would otherwise lead you to establish.

We think that furthermore argues for some caution in thinking that options-based view expressions are a “workaround” for gross exposure aversion. If this were part of our strategy and we weren’t explicit about this in our risk management to begin with, we’d explicitly cap our negative carry from premium.

The Known Unknowns

We refer to the below as known unknowns because we think they are appropriately thought of as decisions that can be made under risk rather than uncertainty. But make no mistake: the level of risk attached to any predictions you might make on any of these categories is substantial.

TopicNarrative StructureNarrative Observations
Current General Spread / Fear of Covid-19:MixedAs noted above, we would no longer classify this as an Unknown Unknown, or as complacent. This may be too clever by half, as there is a non-zero chance that we allowed ourselves to get far enough out on the exponential curve that the downside risk of reality revealing itself exceeds any feasible prediction. But in general, we think the pandemic’s spread in this cycle is being transformed by effective policy back into a risk. However, we don’t see a single narrative here, but multiple narratives in competition. We think that means there is bi-directional risk on bets on the speed / expansion of spread. 
Political SeriousnessConsensusWe think that there is now common knowledge that there is political awareness, willingness and capacity to act on Covid-19-related policies. Everybody knows that everybody knows that policies proposed in one state are quickly manifested across the country. We think that means there is short-run one-way risk owing to any events giving the impression of politicization, lack of focus or excessive focus on short-term financial market responses.
Depth of Economic OutcomesConsensusThe potential economic effects of Covid-19 are both vast and vastly variable. Difficult to predict as they will be, we think they generally qualify as risks rather than uncertainties at this time, however. We think that there IS an expectation of very bad GDP and EPS prints. We aren’t saying they won’t have negative effects on asset prices when reported as news, but we do think in GENERAL that bad Q1 / Q2 prints will be tuned and framed and generally excused within that existing narrative. Not unreasonable to expect the odd less-nightmarish than expected Q1 prints to produce an asymmetrically positive response.
Length of Economic OutcomesComplacentWe saw flashes of this in what appeared to be the market’s response to”July or August” comments from the president on March 16th; however, in our judgment, the narrative of economic effects is that they will be short-lived. “One to two quarters” is common shared language among nearly ALL reports and research pieces. Given this complacency, we think there is mostly one-way risk (i.e. negative) on information relating to the length of EPS / GDP effects at this time. We would be very concerned about the emergence of the narrative – and obviously about the actual existence of – an extended global depression. We think this is a really significant long-term risk to markets that is being almost completely ignored in current narratives. We would take it very seriously.
Cases of Economic RuinComplacent
(with Exceptions)
Related somewhat to the “Bailout” unknown unknown in the following table, the narratives of industries at risk remains confined to first-degree effects: hospitality, leisure and transportation. There we think the narrative is consensus, subject to the binary risk of bailout policy posture. Outside of that and dalliances in feature coverage considering small restaurant businesses, there appears to be zero narrative about knock-on effects in adjacent / dependent / broader industries and sectors. We think there is significant, targeted one-way (i.e. negative) risk for some of these non-hospitality, leisure and transportation industries for contrarians. 
Emotional / Visceral ResponseComplacentEven though it has been predicted and seems almost statistically inevitable, there is practically no recognition or discussion of a prospective news cycle of overwhelmed New York City hospitals and ICUs. We think there remains complacency about the unique short-horizon impact of two weeks of news focused exclusively on the region where so much of the financial industry AND Covid-19 outbreaks are located: New York, Westchester County and Fairfield County, CT. We think this is largely a one-way risk, but over a short horizon that probably has potential to manifest in the last two weeks of March. 
Fiscal Policy ResponseMixedThere are enough policy proposal drafts and stalking horses in the wild at this point to treat this usually binary kind of event as a Known Unknown. It is difficult to pin down a narrative here, as there are clusters of commentary and missionary behaviors around multiple suggested strategies. There isn’t a global expectation of what the policy package will look like that has become common knowledge. If anything, we think the narrative tilts toward cynicism that households, families and small businesses will be helped quickly enough relative to industry backstops/bailouts. Accordingly, we mostly view this as two-way risk based on the size of the package, but our opinion (not really present in the data – purely subjective) is that there is some asymmetric upside sensitivity to a quicker or larger-than-expected package. 
Monetary Policy ResponseMixedWhile the data set is limited in scope, since Sunday (3/15) we think that a strong narrative with two dimensions – “out of ammunition” and “focused on liquidity and orderliness” – has emerged about central banks, and the Fed in particular. We think the former is a consensus narrative with more upside asymmetry in certain extreme cases (ie – everybody believes that everybody believes the Fed can’t take actions that will support asset price). We think the latter is supportive of framing most illiquidity-related news, data or research in a positive way, but also creates downside asymmetry if they aren’t as rapid dealing with issues in CP markets or other sources of market illiquidity.

The Unknown Unknowns

Part of the concept of unknown unknowns is, of course, that they are unknown, so the first allowance here that must be made is a general one: there are paths here that are not identifiable in advance. They all yield the same answers: Avoid leverage. Avoid reliance on ex-post measurements of cross-asset correlations. Avoid position-level and risk-level concentration. We’d add our previously communicated “avoid illiquidity” but it’s probably too late for that at this point.

But the Koan of Rumsfeld as we have it slots in the idea of unknown unknowns as uncertainty. In addition to the many paths which cannot be identified in advance, we think there are three other major categories of uncertainty which investors must take into account.

TopicNarrative StructureNarrative Observations
Seasonality Effects and Resurgence?We have some data now about the R0 influences of heat and humidity, and that data is positive. Positive but not enough for prediction. The parameters are still insufficient to tell us what life with an endemic Covid-19 looks like. Will its resurgence mirror 1918? How effective will vaccinations be from making Covid-20 just as bad? We think investors should expect that information which rapidly shifts this critical topic’s substance and importance into the Known Unknown range could still emerge at ANY time and in either direction. This alone should keep gross exposures and active risk budgets at very subdued levels. 
Industry Bailout Response?While we think there is a general focus on risks to certain obvious industries (as described in the known unknowns above) that should govern some forms of risk-taking, specific company outcomes are subject to a veil of binary uncertainty. This is obvious counsel, but still must be part of the framework: go-to-zero bets on airlines, cruise companies, aerospace companies and hospitality companies are not risky but uncertain. We would warn investors away from spending active risk on such positions based on a fundamental thesis unless they are explicitly cordoned and risk-managed behavioral bets on other investors (e.g. in vol markets). 
Election and Unrest?We are witnesses to what we think will probably be the single biggest sociopolitical event of our lives (so far, anyway). We are shutting off entire economies. For months. Soldiers are being deployed in free, democratic countries. A base rate of a return to normalcy is probably still correct! It’s our mean case, too. But these kinds of events create branching paths with no visibility beyond them. Unrest and political upheaval in many markets throughout the world are absolutely unquantifiable possibilities. We would continue to be apply deep skepticism to the diversifying properties of sovereign debt both against risky assets and against other debt assets in our portfolio construction.

Again, we will continue to update the general framework based on events that warrant it, but the rapidity of changes in narrative structure will likely exceed that frequency. We think any of these would be additive to whatever framework your institution or team is using to monitor and manage through this situation, and will benefit from your incorporation of monitoring and judgment of news flow and research relating to each narrative and event. If you have specific questions, of course, please feel free to reach out to either Ben or Rusty via email.

Epsilon Theory PDF Download (paid subscription required):  The Pandemic Playbook – 3/17


First-Level Foolishness


PDF Download (paid subscription required): First-Level Foolishness

“I’d like to first repeat what I said last week, and that is that over 90% of the value of a stock is due to its profits more than one year into the future. So as bad as this year can be…we could really have a short quick recession, the long-term value is not significantly impaired…let’s face it, this is mostly going to be a demand-induced slowdown.”

Dr. Jeremy Siegel to CNBC (March 2, 2020)

In a severe pandemic, infrastructure can be disrupted at a national level, such as healthcare, transportation, commerce, and utilities. This is due partly to risk mitigation measures but also potentially higher rates of patients on sick leave, employees taking care of children or other family members, or general population anxiety about gathering in public places.

The direct and indirect U.S. healthcare costs of a moderate pandemic, like those in the 1950s and 1960s, were estimated at roughly $180 billion in 2005 by the U.S. Department of Health and Human Services, assuming no intervention, but this does not include potential for commerce disruption. According to the Congressional Budget Office, a pandemic could cost the U.S. more than 4% of GDP in a severe situation (similar to the Spanish flu of 1918) or 1% of GDP (if the pandemic is more mild, similar to 1957 and 1968 pandemics).

Overall, we think the costs of coronavirus will mirror those of a milder pandemic. As we assume a lower death rate that primarily focuses on patients over the age of 65, we think there could be a significant short-term hit (1.5% of 2020 GDP) but minimal hits beyond, as the economy should be in position to rebound quickly.

Morningstar’s View: The Impact of Coronavirus on the Economy (March 10, 2020)

It is an uncertain time, but I’m willing to bet on a couple things: I know what your personal email inbox looks like. I know what your professional email inbox looks like.

And I bet yesterday – March 11th – felt like a dam breaking for both.

There wasn’t any real change in the facts on the ground about Covid-19 in that time. Nothing fundamental. China continued to report few new cases. Korea continued to report improvement, with a little new concern in Seoul, perhaps. Italy continued to be grim. Germany and France had pockets of growing concern. America looked to be somewhat closer to the path of southern Europe than East Asia. The fact pattern on the morning of March 11th was consistent with the day before and the week before.

What changed was common knowledge. What changed was what everybody knew everybody knew.

It changed because powerful missionaries who had been in the grip of “just the flu” and “panic would be worse than the disease” memes – memes promoted in financial media beginning in January, as we highlighted previously here – threw in the towel. The WHO, which for weeks pretended it could be agnostic about the “p” word, relented. Harvard sent students home, and a raft of schools followed within hours.

That change in common knowledge is why yesterday you received a dozen or two “Here’s what we’re doing” emails from your kids’ schools, your local fast food chain, the airline you have frequent flier miles with, and the hotel flag you used to be loyal to until they merged and made your points worth half as much. A long-time friend and reader informed us of a Covid-19 CYA Communication from a…<checks notes>…food truck. Apparently they got his email through Square.

It’s also why (along with a little bit of feisty market action) your professional inbox filled up with new sell side reports, buy side update letters and – unless you were lucky – one or two “can we talk after the close?” emails from a fund manager or two this morning.

Will you permit me one more wager? I will also bet more than a few of THOSE emails probably looked like the lukewarm garbage that produced the two quotes above.

Both the Siegel appearances and the pseudo-scientific “scenario analyses” Morningstar and others are pumping into your inboxes are emblematic of the same thing: first level thinking, the mistaken assumption that markets function by assessing the first order effects of events. But it is far worse than that. They are also emblematic of ergodic thinking, which is a ten dollar way of saying that someone is using their estimate of the potential range of current outcomes as a proxy for the potential range of how outcomes may unfold in sequence over time.

Just one problem with that:

The path that events follow matters.

Path-dependence is why a disease that is only moderately more deadly than the seasonal flu becomes a Big Deal when its characteristics give it the potential to overwhelm hospital capacity. Path-dependence is why every college, school, sports team and corporation made their decisions in unison once missionaries finally created common knowledge. Path-dependence is why uncertainty in markets should inform your portfolio risk management.

The first-level thinkers miss this, and they miss it in three big ways.

1. They treat the market as if it were a clockwork machine, constantly repricing everything about issuers and securities. In reality, the market is a bonfire, unevenly assessing investors’ expectations of other investors’ responses to information at the margin.

The Siegel style of analysis is perhaps the most emblematic of this idiotic framework. That shouldn’t be surprising – the notion that market participants wake up every day and reassess everything in their portfolio and what it ought to be worth is a foundational abstraction of academics in finance, even today. To be true, it IS useful for teaching DCF-based thinking on a bottom-up basis. But it is utterly nonsensical for explaining asset prices changes at a top-down level.

At any given time, millions of people setting prices at the margin treat the prior day’s price as a Thing In-Itself. In other words, the prior day’s price becomes the thing that matters, completely independent of whatever information was being considered by the participants who participated in the prior day’s price setting activities. Take that back a week or a month and you start to realize something very important about markets: at any given time, simple inertia is a very important part of why people believe the price of a thing is correct.

When prices move after an event, first-level thinkers say, “Well, only X has changed, so the price should only change by the effects of X.” The problem, of course, is that when prices change by a sufficient amount, investors who AREN’T first level thinkers don’t just question how much Event X ought to have changed the price; they begin to question the inertia that led to YESTERDAY’S price.

One financial markets commentator observed the following today (March 12th):

All the permabears are coming out now and saying, “I told you so.” It’s just too bad that not a single one of their theories is the reason why we are in the current sell off. But don’t worry, they will congratulate themselves anyways.


Thinking that the sell-off we are observing can be completely divorced from all of the assumptions that led to the prices yesterday that are being subjected to closer scrutiny TODAY is first-level thinking. All those things the “perma-bears” straw men theorized cannot be ignored. The expectations of undue central bank asset price support and profligacy that led to those prices is going to be questioned. The appropriateness of multiples that led to previous prices is going to be questioned. The behavioral expectations investors had for other investors that led to previous prices is going to be questioned.

In short, any event of sufficient size is capable of influencing asset prices BEYOND the scale of the event itself, and that influence must NOT be considered an inherent overreaction. It is a fundamental part of the long-cycle process whereby markets periodically reevaluate endemic assumptions that exist on the basis of inertia alone!

2. They treat market events as if they were isolated from the non-market events they influence, especially in political and regulatory spheres.

Ben is going to be write about this in a great deal more detail for a note next week, so I won’t belabor it too much here. But analyzing purely market fundamental events through probabilistic analyses to estimate market outcomes is worse than useless if it abstracts from the range of potential non-market responses.

Some of those events under a cloud of uncertainty are bullish! A massive landmark fiscal package coupled with aggressive state government aid would be a seminal such event, and could dramatically change the complexion of the market event.

Some of them are not so bullish. Some of those bearish outcomes manifest in major structural changes, such as changes to the narrative of globalization Ben and I have both hinted at observing as an emerging narrative. This is a potential multi-year outcome that could become part of core market narratives much sooner than most investors expect. The effects of a forced return of manufacturing and supply chains to North American shores would go far beyond the Siegel Cartoon of a 1-year share of a stock’s present value.

Some of the more bearish potential outcomes are almost impossible to bake into prices in ANY way prior to them taking shape. Your septuagenarian president hung out for a good bit with a Covid-19 exposed (and potentially infected) Jair Bolsonaro a week ago. How much of today’s price decline would you estimate accounts for the probability that our >10% CFR bucketed administration will announce infection next week? Some? None? Lots? A little?

You have no idea. I have no idea. There are a hundred events exactly like this – both bullish and bearish (but probably more bearish, if we’re being honest) – lurking in the fog of uncertainty, of unknowable incidence and severity. The idea that some sell side guy on CNBC thinks he can tell you what S&P earnings level for 2H 2020 the market is discounting should offend your spirit. The idea that there’s a clockwork machine pricing a risk premium on this basis should produce pain deep within your capitalist soul.


3. They miss that nearly all financial assets exist in and cannot be divorced from their portfolios. When events change the interaction of those financial assets, those events can have reflexive responses in asset prices that we cannot assume are temporary or irrational!

Ben and I have both written frequently about how critical the narrative of stocks and bonds as mutual diversifiers is for the plumbing of the asset management industry, much of which has formed around that assumption during the last 35 years. If an event like the Covid-19 response produces compression of rates on US sovereign debt toward zero and an extended period of zero to positive correlations between rates and risk assets, modeling the event itself without accounting for how these assumptions would dramatically change the behaviors of institutions from pensions to insurance companies to family offices to yield-sensitive high net worth individuals is incomplete to the point of irrelevance!

And a reminder, since this is Epsilon Theory after all: to be IMPORTANT, these things don’t have to be long-term true in fundamental space so long as they are true in narrative space. If everybody knows that everybody knows that bonds don’t diversify stocks, or if everybody knows that everybody knows that you don’t buy bonds for yield but for duration bets alone, the game has changed on dimensions that go far beyond what one might model for the event.

What does all this mean?

It means that the appreciation for uncertainty that we have counseled throughout this process should remain. There are single events ahead of us which will completely change the complexion of this situation. They will shift the incidence and severity of outcomes on their head. Some may even bring probabilistically modeling outcomes back into the realm of the reasonable.

We should manage risks for an uncertain market, and monitor the signs investors’ are transitioning back to a risky market.

What do we do?

The same thing you did the last two weeks. By far the most important play in this playbook, because it responds to EACH of these three problems, is this:

Shrink your book.

Keep your use of leverage at a minimum.

Keep your reduced reliance on covariance estimates.

Keep your trimmed down gross exposure.

If you’re deciding between a selling and hedging, sell.

The most important place that path-dependence rears its head to create unexpected risks is in the breakdown in relationships among assets. A limited gross and skepticism about covariance estimates is how you reduce your exposure to THAT. And keep it down.

What do we look for?

We counsel looking for signs of an emerging narrative that uncertainty is changing back to risk.

I’ll be more explicit. I think bearish behavior subsides for some period if and when everybody knows that everybody knows that US testing is happening and is representative. There are enough analogs in Korea and Italy to frame the problem. Once this data exists, missionaries of “quantifiable risk” narratives will be more successful.

But let’s be clear on another point. We think that is a tradeable phenomenon in the short run. We also think that it doesn’t necessarily change the real, fundamental uncertainty of some long-term outcomes precipitated by Covid-19.

More on that to come next week.


Minimax Regret


This email is the foundation of a much longer ET note that I hope to publish next week, but wanted to share the basic idea with you and get your feedback.

The title of the note is going to be Minimax Regret, which is a game-playing strategy referring to minimizing your maximum regret. It’s a very different approach to playing any game, whether it’s investing or voting or living with our families, than the approach we almost always take in life, which is straightforward Utility Maximization. I don’t think I need to spend a lot of time describing what Utility Maximization is, except that it’s so embedded in our social psychology that sometimes people have a hard time imagining that there is any other way to think about their choices in a game … or in life. Certainly it’s embedded in everything we do as professional investors, from the very definition of an “efficient frontier” in economics and portfolio construction to the monomaniacal focus we have on evaluating “performance”.

One aspect of Utility Maximization that usually goes unnoticed, however, until it bites us in the ass when something like the coronavirus comes around, is that it’s based on a “normally distributed underlying stochastic process”. Now there’s a mouthful! In English, that means that when we engage in Utility Maximization (which we are always doing, whether we recognize it or not) we assume that there is some sort of a probabilistic bell curve that sits behind our guesses about the answer to a question we’re pondering. Like I say, this is so embedded in our human psychology that we don’t even recognize that we’re doing it.  

But you can see this phenomenon clearly in surveys about things which people have NO IDEA about.

A screenshot of a cell phone

Description automatically generated

This is a “snap survey” from one of those independent market research firms that you may subscribe to, and I want to call your attention to the first question: when do you believe the maximum impact from the coronavirus will be felt?

Now what I will tell you, from years and years of constructing surveys like this in a prior lifetime, is that if you give humans three dates as possible answers to a question like this, the middle date will ALWAYS get the most votes. If you give them seven dates, the middle date will get the most votes, and the dates just before and after will get the second-most votes. If you give them 15 dates (yes, you always give an odd number of possible responses in survey questions like this, for this reason), you’ll see the same pattern take shape. Doesn’t matter what the dates are (I mean, within reason) … the votes will take the form of a bell curve, aka a normal distribution.

Again, this is for questions where the respondents have no freakin’ idea what the right answer is … like asking investors when the maximum impact of the coronavirus will be felt.

The problem, of course, is that we assume there is some information to be taken from surveys like this, some sort of “wisdom of the crowd” to be gleaned from this exercise. There’s not. There’s zero information here. What we’re seeing is nothing more than the bell curve probability distribution that we human utility maximizers apply when we have no idea what the future holds.

The larger problem, of course, is that SO MUCH of market price setting and market behavior is based on “surveys” like this. For example, all of CNBC’s coverage of CV-19 has been a form of a survey like this … asking professional investors what they think about the “impact” of coronavirus on these Markets in Turmoil ™. There’s zero information here. Zero. All you are receiving is different votes for an underlying bell curve of possible outcomes. That’s it. There is literally nothing more to the entire exercise than that.

To be fair, usually this isn’t a problem at all. Usually this is nothing more than harmless entertainment, because usually the reality of something like corporate earnings or a jobs report (technically, the difference in our guesses about things like corporate earnings and the reality of things like corporate earnings) truly does fit some sort of bell curve distribution. There’s a reason we’ve been so well trained to be utility maximizers in our social lives … it usually works!

But when reality doesn’t fit a “normally distributed underlying stochastic process”, then all hell breaks loose. Like happened in 2008 with mortgage-backed securities. Like is happening now with CV-19.

All of our thinking about CV-19 is wrong and all of our decision-making about CV-19 is wrong because we believe we’re getting “information”, when actually all we’re getting is an irrelevant error distribution.

Investing (or just living for that matter) under the shadow of CV-19 is not decision-making under risk. It is decision-making under uncertainty, and for that you need Minimax Regret.

Here are four older ET notes that talk about Minimax Regret (there are others, too):

The Koan of Donald Rumsfeld

It’s Not About the Nail

Why Take a Chance

Things Fall Apart (Part 3) – Markets

My goal is to take some elements from these older notes and write a couple of notes on how I think we have to change our thinking about investing in an age of CV-19. Because I believe that CV-19 is bringing forth permanent and secular changes to our world, changes that will not show their “maximum impact” by … [[checks survey]] … April.

CV-19 is the catalyst that not only slows down globalization, but reverses it.

I’m trying to figure out the first, second and third order consequences of THAT. And I’d love your help. If you have any thoughts or ideas, I’m all ears.


Covid-19 Cargo Cults


In the South Seas there is a Cargo Cult of people.  During the war they saw airplanes land with lots of good materials, and they want the same thing to happen now.  So they’ve arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas—he’s the controller—and they wait for the airplanes to land.  They’re doing everything right.  The form is perfect.  It looks exactly the way it looked before.  But it doesn’t work.  No airplanes land.  So I call these things Cargo Cult Science, because they follow all the apparent precepts and forms of scientific investigation, but they’re missing something essential, because the planes don’t land.

Richard Feynman, The Cargo Cult Science (Speech at Caltech in 1974)

A friendly reminder: this is general commentary and IS NOT investment advice. You should act based on your own situation, because this analysis is generalized and doesn’t take it into account. We don’t have a crystal ball. If we make forward-looking statements about the markets, they will often be wrong. Because we’re discussing tail risks, it may be INHERENTLY MORE LIKELY than not that we are wrong. Clear Eyes, Full Hearts.

I tease Ben sometimes for devoting his graduate studies to political science. Not because it isn’t a worthy field of study. I tease him because the idea of politics being a science is absurd on its face. And then he usually reminds me that my economics degree is nominally referred to as a science degree, too.

I am immediately chastened.

There are a lot of scientifically minded people in the investment industry. In general, this is for the good. I mean, of course it is. Investing in risky assets constantly appeals to our baser tendencies toward fear and greed. Worse, we do not respond to those appeals in isolation. We are surrounded by others who are watching us and responding to our actions for their own benefit. Process is a gift to investors.

And yet.

When we are free to be, shall we say, uncommercial, outside of the behavioral benefits accruing to process-adherence it is very difficult to find much that we do in the investment industry that is not what Physicist Richard Feynman called cargo cult science. When he wrote and spoke about cargo cults, he usually referred to very obvious pseudosciences like phrenology, astrology or reflexology. But his fundamental analogy is much more expansive, and in classic Feynman style, works in micro, macro AND meta. It is simultaneously an illustration of the practice of pseudoscience and the philosophy underlying pseudo-scientific practice.

If you imagine the islanders trying to recreate the landing of the airplane that brought goods and supplies, you are seeing the frustration yielded in the practice of pseudoscience. They observed a pattern: runway is cleared, fires are lit, man sits in a shack with things on its head, plane with goods and supplies lands. Easy peasy. They want to reproduce the final result, so, they get to clearing and manufacturing a makeshift set of wooden headphones.

It sure looked better in the backtest.

But Feynman’s analogy is not just an illustration of what cargo cults do. It’s also an illustration of why they do it. Instead of thinking about the airplane as an illustration of some feature of the world a scientist might be trying to research, think about the airplane as science itself. People who earnestly want to be more scientific see what scientists do. They do experiments. They measure data. They write it down. They perform calculations based on the data their experiments yielded. They build things based on those experiments. Alas, adhering to the cartoon of sciencey-looking process is not science. Neither is the closely-related meme of Yay, Science!

I don’t mean to be unkind. I’m also not condemning inductive reasoning in full, since in sciences where it can be combined with observation in ways that aren’t available to us in financial markets it has been responsible for some of our great discoveries.

But if your adviser or consultant does a lot of slicing and dicing of quintiles and quartiles on some good-sounding fundamental dimension and showing you the returns over the last 20 years if you’d bought this one and sold that one, you’re probably paying a cargo cultist to clear you a runway. Many quantitative managers do a lot better than this, of course. Some are, I think, doing something that is close enough to science to warrant the name. But even then, the airplane landing is dependent on some actual transmission mechanism to make it land. And the actual transmission mechanism in markets after removing abstraction layers is always – ALWAYS – another human making a decision for whatever reason they make decisions. This thwarts a lot of good theories. Ours included.

The right question to ask, both in science and in the maybe-science variant we perform in financial markets, is always this:

Why do you believe the measurements you are producing and the actions you are taking based on those measurements are related to the actual mechanic in the real world which produces the thing being measured?

It’s the right question if you’re thinking about what Covid-19 means for your portfolio, too.

The biggest concern I have as a risk manager is related to this question. It isn’t that I am concerned (as an investor) about how many people are infected with Covid-19 in the United States today. It isn’t even that I don’t know how many people are infected.

It’s that it isn’t knowable.

It isn’t knowable because we completely botched testing on initial suspected cases, and we have continued to permit that error to compound. To be clear, I don’t mean “unknowable” in the sense that we will always be inexact in our predictions. I mean unknowable in the sense of uncertainty: that you could produce a dozen different estimates of where we are at today in the development of Covid-19, and any attempt to assign probabilities to each of those estimates would be no better than an arbitrary guess. If your epistemic uncertainty about the predictive power of any of your models is not keeping you up at night, I think you’re making a mistake.

I think that has two implications for investors and asset owners.

The first is that we must be extremely cautious of anyone peddling quantitative, predictive or scenario analysis of what this means for your portfolios. Anyone who is acting positively on the belief that they know something is a cargo cultist. Anyone showing you charts of prior contagions and pandemics and showed you what happened next – whether they intend to frighten you or calm you – is a cargo cultist. Ignore it. And for God’s sake, don’t act on it.

Not until measurement has meaning again.

The second is somewhat related to the first. Acting positively because you think you know something is not the same as responding to the fact that you don’t. Every position in our portfolio is an implicit bet on a variety of things. Your active security positions – overweights and underweights – are bets that other investors will recognize or change how much they care about certain traits that exist today or that you are predicting will exist in the future. How confident are you that the kind of bets you are making will not be swamped by bets and responses other investors will inevitably make about Covid-19?

Your exposure to risky assets in general represents an implicit bet, too.

It’s a bet on functioning economies and trade. It’s a bet on available credit and liquidity. It’s a bet on productivity and the way capital marshals that into equity value. And, uh, I’d be going a bit off-brand if I didn’t mention that it’s a bet on a friendly and accommodative institutional apparatus that includes both central banks and the cadre of MMTers who occupy both political parties. Most importantly, it’s a bet that investors still care about those things. I still think they’re good bets in the long run. I actually still think they’re good bets in the short run, by which I mean that if your central case is that the world will largely continue to spin in 2020, history tells us that you are more likely than not to be correct.

But distributions get a bit funny in the face of the unknowable, folks. While the chest-pounding prediction game practiced by the media, banks and asset managers coerced by their head of sales to go on CNBC IS about acting on what’s more likely than not to be true, investing is not.

In short, if your confidence that the models leading you to active positions will matter in the near term is high, or if your confidence that the aforementioned uncertainty is already being discounted is high, we think you are wrong.

Part of the reason is epistemological. Uncertainty alone may be enough. But that isn’t all. We’re concerned about where we are on the Covid-19 narrative, too.

Our analysis of narrative structure shows that Covid-19 is dominating the last two weeks of markets coverage in a way that no topic has since we begin tracking macronarratives. Here’s the activity in traditional media:

And here’s the activity in social media.

But here’s the thing: our attention measure for Covid-19 over the same period is LOWER than each of Trade War AND Central Banks. It’s lower than the AVERAGE of all financial markets news. What does that mean? It means that authors reference the Fed when they’re talking about banks, when they’re talking about consumer borrowing activities and mortgages, when they’re talking about fears of Covid-19 and other market risks, when they’re jawboning for more easing, and when they’re talking about President Trump. It means that authors reference the Trade War when they talk about Boeing, and Tesla, and farmers, and consumer prices, and Trump’s reelection, and factory shutdowns, and supply chains.

But Covid-19 news? Right now, it’s mostly just about Covid-19 and the initial investor response. There’s a smattering of supply chain linkages, and a couple of companies reporting and warning about its impacts. But generally speaking, we haven’t yet seen the deluge of linking-everything-to-Covid-19 that we expect is coming. Even at a high volume of coverage, it’s its own beat. A sideshow.

As of February 27, even after a 10% drawdown, we believe the narrative about Covid-19 is complacent.

What would we be doing if we were an asset owner or adviser? Most importantly, we’d be ignoring the cargo cultists. We’d avoid actions predicated on predictions, and respond instead to the fact that we don’t know. What does that mean?

  1. It means we’d be actively trimming the risks of ruin. That means leverage, concentration and illiquidity. The last one’s definitionally tougher to trim, so focus would be on the first two.
  2. It means we’d put off hiring new active managers in search of idiosyncratic alpha, and we’d avoid paying for existing active strategy exposure if frictional costs were low (e.g. anything on swap, accessed through platforms like DB Direct, etc.)
  3. It means we’d be thinking long and hard about our dependence on backward-looking covariance estimates. If I was a steward for investors with a short investment horizon or a low risk tolerance that was based on some conversation I had with them about a remote probability of a major loss, I’d be inclined to pull back exposure to risk assets.
  4. It means we’d be couching our investment committee conversations for the near future in terms of insurance. In short, are you an institution whose objectives are better served by paying a 10% premium on your equity book by locking in this drawdown and avoiding potential tails? Or does your agency structure, investment policy and institutional temperament permit you to self-insure and avoid the uncertainty of foregone gains from the brutal difficulty of timing re-entry?
  5. It means we’d be doing all of the above until the cargo cult of Covid-19 analysis turns back into science. In short, we’d be doing the above until we felt that the measurements being provided about the state of Covid-19 infections reflected some underlying reality.

A friendly reminder: this is general commentary and IS NOT investment advice. You should act based on your own situation, because this analysis is generalized and doesn’t take it into account. We don’t have a crystal ball. If we make forward-looking statements about the markets, they will often be wrong. Because we’re discussing tail risks, it may be INHERENTLY MORE LIKELY than not that we are wrong. Clear Eyes, Full Hearts.


Not Gonna Lie


Not gonna lie … the more I dig into the statistical analysis of the Wuhan coronavirus outbreak (I used to call it nCov2019, but going forward I’ll call it COVID-19 to follow the latest World Health Organization naming convention), the more I believe that the virus has not been contained in China and that we are far more likely than not to have a major outbreak of the disease outside of China.

This statistical analysis is principally based on two research papers (both attached here as PDFs), one written by WHO-sponsored doctors based in Hong Kong and published in The Lancet, and the other written by DARPA-sponsored researchers based at Los Alamos National Labs. The skinny from these notes is that COVID-19 is ridiculously infectious. Yes, it’s airborne. Yes, it’s waterborne. If it’s anywhere near you, odds are you’re going to catch it. I mean, when China is sterilizing and quarantining paper money from Hubei province, that should give you an idea that no one has any idea whatsoever how to contain the disease once it’s in a population center.

So when I read that there were more new cases of COVID-19 infection identified yesterday on that cruise ship in Yokohama than were identified in all of Africa and the Southeast Asian sub-continent, you can forgive me for believing that we *already* have a cluster of COVID-19 cases in cities like Djakarta … it’s just not being measured. How long will it take for this cluster to reach a noticeable mass given COVID-19’s high reproduction baseline? Using Wuhan as an example, I figure three or four weeks.

We also have a front-line doctor’s report coming in from Wuhan, also published in The Lancet, and real-time feedback from doctors in Singapore and Beijing on what they are observing in patients-under-investigation (PUI). The skinny here is that Wuhan fell because the healthcare system in that city collapsed. Doctors and nurses themselves contracted the virus in vast numbers, and once hospitals became a source of infection rather than treatment, the Chinese authorities made the decision to shut off the city and effectively let the disease run its course.

This is what we must avoid when/if there is an outbreak outside of China.

I believe we must stop playing the “Confirmed Cases” game, which is just that … a public relations game … and start doing three things:

  1. PROTECT healthcare professionals with pre-positioned gear NOW (esp. in cities like Jakarta);
  2. INFORM healthcare professionals with better diagnostic criteria NOW (Singapore is doing strong work here);
  3. INSULATE healthcare professionals with (much) bigger isolation wards that should be built NOW (esp. in cities like Jakarta).

Unfortunately, I don’t believe any of this is going to happen, in large part because senior leadership of the World Health Organization is primarily concerned with maintaining the favor of their Chinese patrons and toeing the (literal) party line. The way that WHO leadership has handled COVID-19 thus far is not just a disgrace, not just a humiliation for the thousands of people doing good and important work under WHO auspices … it’s a betrayal of the entire world.

Yep, strong words. And here’s my latest note to back it up – The Industrially Necessary Doctor Tedros.

When WHO Director General Tedros recommended on Feb. 4 that there should be NO systematic limitation on air travel and visa issuance in and out China, he KNEW that the CCP-provided “evidence” for that recommendation was a crock. How did he know? Because independent WHO-sponsored doctors had published their paper on Jan. 31 showing that the CCP-provided evidence was a crock.


Is there good news? Yes. If you’re young and female, you have an excellent chance of surviving an infection, and perhaps being asymptomatic entirely. On the other hand, if you’re an older male with a pre-existing cardiovascular condition or high cortisol levels … well, that’s a problem.

The critical thing is that we can’t let another city fall like Wuhan did.

Not gonna lie … they got us in the first half. But I think if we prepare and strengthen our healthcare systems NOW, we can still win the game.


That Escalated Quickly


I published this note today on the website, and it’s making a bi of a splash. We’ll publicize it more actively tomorrow, but wanted to give you a headstart, including a copy of the PDF.

From a narrative perspective, China is fighting this war against nCov2019 exactly like the US fought its war against North Vietnam.

It’s what the Best and the Brightest always do … they convince themselves that the people can’t handle the truth, particularly if the truth ain’t such good news. They convince themselves that they can buy enough time to win the real-world war by designing and employing a carefully constructed “communication strategy” to win the narrative-world war.

That strategy proved to be a social and political disaster for the United States, as the cartoon tail (gotta get more NV casualties for Cronkite to report) ended up wagging the policy dog (send out more counterproductive search-and-destroy missions).

I think exactly the same thing is happening in China, and I think the social and political repercussions will be exactly as disastrous.

I believe that the Chinese government is massively under-reporting infection data in the pandemic regions of Hubei and Zhejiang provinces. Worse, I also believe that Chinese epidemic-fighting policy – just like American war-fighting policy in the Vietnam War – is now being driven by the narrative requirement to find and count the “right number” of coronavirus casualties. And I think I’ve got pretty strong evidence this is the case.

It’s a good note. I think you’ll like it (and I’m all ears to how anyone thinks this plays out in markets).

Also …

I’ll have more from our narrative Monitors in next week’s email, but I think we’ve got a really important finding in regards to the Inflation narrative. Last month I highlighted an inflection point in the structural Attention measure for Inflation (how much financial media drumbeating exists for Inflation relative to other big macro narratives).

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So here’s the Attention data for Inflation this month.

Wow! Now to be clear, the narrative *substance* of all this narrative attention is NOT “oh, my god, inflation is starting to get out of hand.” On the contrary, the biggest cluster in the inflation narrative (and the source of a lot of the attention increase) is the equivalent of a prayer to the Fed in the wake of the coronavirus outbreak in China. It’s a wail about global growth and a hope that the Fed will ease in response (and with “inflation being so low”, why not?). So I don’t want to get too worked up about the spike here. In the absence of the coronavirus growth scare, I think the narrative attention score would be up this month – and “for the right reasons” – but not at these highly elevated levels. Which is a good thing. If narrative attention were this high because of an “inflation out of control” cluster, then it would be too late to position yourself effectively for a trade. As it stands, I think you’ve got time.

Also of note (and also supportive of the gradual development of this trade), it’s very notable that for the first time in a loooong time, the gold / precious metals cluster is now near the center of the overall narrative map (it’s usually way off to itself on the periphery of the map) and is directly connected to the other central clusters. This is quite bullish for gold.


The Deflation to Inflation Playbook


First things first, we published what I think is an important note last Friday, “A New Road to Serfdom,” which I’ve included as a PDF attachment, as well.  

Here’s the skinny: Today there is a global political effort to convey vast new powers to central banks in order to “fight” climate change. In truth, however, this effort is not about climate change, any more than it could be about any number of significant dangers. This effort is about narrative. This effort is about power. It is an effort that must be resisted, especially if you believe (as I do) in the reality of anthropogenic climate change and the severe threat it poses to human society.

Second, and relatedly, I think that the use of central banks to monetize vast new fiscal spending programs in every developed nation on Earth – under the guise of CB-financed Green Bonds for left-leaning governments and CB-financed Infrastructure Bonds for right-leaning governments – is the biggest economic story of, not just the next year, but the next decade. This is how the Fourth Horseman of the Investment Apocalypse – inflation – rides into town, and it will challenge everything we think we know about investing and asset allocation.

We still have time. Deflationary shocks like the Wuhan coronavirus will rear their deadly head from time to time, pushing us temporarily back into the slowing global growth narrative (and reality). More importantly, there is still no narrative missionary, no political entrepreneur, yet willing to turn the world on its head and say that inflation is here … and that it’s a good thing. But in an MMT world we’re getting close to that. Most importantly for the question of time, shifting to an inflationary regime isn’t going to feel so bad for months at a time. As the old country song goes, falling feels like flying … for a little while.

But ultimately this is the source of the next great reset, both politically and economically. It won’t take the form of a “crash” or a “great recession” … that’s the last war. This is the next war, and we’re going to need a new strategy – a new playbook – to get through it intact.

To that end, we’re revamping the ET Pro subscription service (or at least my contribution in these emails and analysis) to focus directly on that challenge. I think you’ll find ET Pro more focused as a result, more instrumental and direct in its efforts. I really intend this to be the construction of an investment playbook, with offensive and defensive plays – some general purpose, some situational – built around a coherent minimax regret asset allocation strategy for a deflationary regime in transition to an inflationary regime.

We’ll wrap up the construction of this playbook at the Epsilon Theory Forum this October in San Antonio, where we will have a full day dedicated exclusively to ET Pro subscribers. Stay tuned for details!


The Worm Turns


We published our macro narrative Monitors last week (attached here), and something really jumped out at me.

Media attention to an inflation narrative turned dramatically in December, and I will tell you that I see signs of it continuing to accelerate to the upside here in January, particularly in sell-side analysis and reports (which are typically NOT picked up in our Monitor analysis, which pulls from publicly available media).

Does this mean that real-world inflation is off and running? No idea. I mean … my personal opinion is that real-world inflation is much more prevalent and entrenched than we are led to believe by the mandarins, but that’s just my personal opinion. I do not have a professional opinion on real-world inflation. I DO have a professional opinion on narrative-world inflation, however, and that is YES, this a classic “Emerging Narrative” set-up. We are a couple of CNBC missionary statements away from everyone knowing that everyone knows that inflation is off and running. We are one “hot” employment report from everyone knowing that everyone knows that inflation is off and running.

And that’s going to be a very squirrely day for markets.

Why? Because it’s going to bring the politicization of the Fed into sharper focus than any amount of overnight and short-term repo financing will ever achieve.

The Fed is playing a weak hand. If we get an inflation narrative now, just as the “global recession is nigh” narrative kicks the bucket, then the chatter immediately becomes whether or not the Fed has to HIKE. Not “stand pat”. Hike.

There is zero market anticipation for this, which makes this a dinner bell for the trader types reading this note, and a warning bell for the buy-and-hold types. Political risk starts to get real after the Iowa caucuses in a few weeks. Put that together with an incipient inflation narrative and you’ve got the makings of a volatility party. Be careful out there.


The Long Now


PDF Download (Paid Subscription Required): The Long Now

Every year, I try to put together a series of notes that captures where I think we are, from both a political and investment perspective. This year, that series is The Long Now. I’ve compiled the four notes in that series into a single PDF, attached here.

The kicker here is that I think both parties have embraced a profoundly destructive meaning to the fiscal powers of the State – to tax and to spend. When the tether between taxes and spending is severed – and make no mistake, both the Republicans and the Democrats have been working to this end for 20+ years – then taxes become a pure mechanism for the exercise of government power. They don’t exist to pay for government programs. They exist to satisfy the ruling regime’s conception of justice, equity and retribution for prior wrongs done by the other side. Again, this isn’t a partisan thing. This is a power thing. This is a Management thing.

Regardless of who wins the 2020 election, I believe we are going to be buffeted by punitive fiscal policies in the years to come … punitive on the tax side in the usual sense, where the rich and the old will be pitted against the non-rich and the non-old, back and forth … punitive on the spend side in the inflationary sense, where we will all feel the bite of a monster we haven’t seen in 40+ years.

You know, there was an article in the Wall Street Journal today, titled “China is Taking No Chances with Stagflation”. As if this were something that could be banished by fiat … as if soaring pork prices and declining growth would cease to exist if Chinese citizens were just TOLD that they didn’t exist.

As with every “outlook” or “analysis” article in the WSJ that talk about China, I took this as a crystal ball for what’s coming down the pike in the US in 6-12 months. Seriously. It’s uncanny how that works. (and the subject for another note another time)

So yes, that’s what I think is going to be the Big Story for the next several years … disappointing growth + alarming inflation + a government that tries harder and harder to TELL us that everything is wonderful. A United States that becomes more like China *politically* as well as economically. Smiley-face totalitarian flirtations on the political front, and old-fashioned stagflation on the economic front, all bearded by a stock market that has been transformed into a propped-up-at-all-costs political utility.

The thing is that – depending on where you stand in the pecking order – it won’t feel that BAD as the world is undone by inflation and the politics that comes with it. As the country song goes, “Funny how fallin’ feels like flyin’ … for a little while”. But this IS what undoes us.

We need to get together and talk about all this. Maybe I’m wrong about The Long Now. Maybe I’m exaggerating the issues here. Wouldn’t be the first time. But right or wrong I think we’d all be well served to connect in person and share our ideas and observations. Stay tuned for details on timing and location … probably early fall before the election. Let me know if you’d like to help.


New on ET Pro: the Debt and Credit Monitor


One of our original macro narrative Monitors attempted to analyze the US credit cycle, but we rarely got enough media articles in a given month to generate robust results, so we placed it on hiatus. Recently, however, we (and once again this is the royal we … it’s actually all Rusty) hit upon a clever way to recast our search queries so that we think we are now able to capture a decent narrative signal on debt and credit markets. Here’s the narrative map for Debt and Credit in November, first colored by cluster topics and then colored by sentiment (you can see the high resolution graphics in the Monitors document):

We’ve got three takeaways from these maps and the prior 12 months of narrative analysis with the new query formulation:

  1. After a mid-year bout of complacency in credit markets, the past few months have seen a rapid acceleration in cohesion (focused and connected narrative topics) mostly around a negative sentiment narrative of concern regarding leveraged loans, CLOs, and the liquidity of CCC loans.
  2. This is taking place as the proportion of articles we measure as Fiat News (highly opinionated/editorial articles) has risen consistently. Missionaries are increasingly promoting the idea of a ‘coming collapse’.
  3. At the same time, however, there is also an almost equally positive sentiment narrative building around technology-based lending solutions in consumer credit.

We’re going to do more with credit narratives in 2020, as we know that a lot of our Professional subscribers work in FI and credit markets. If you have questions regarding our Debt and Credit Monitor, please give us a shout!

That brings our total of ET Pro Monitors to six, covering:

  1. Inflation
  2. Central Banks
  3. Trade and Tariffs
  4. US Recession
  5. US Fiscal Policy
  6. Debt and Credit

Of the six, Trade and Tariffs remains the most dominant in terms of narrative attention. It’s also relatively coherent, as it remains dominated by US-China vocabulary. But I want to highlight two really striking (to me, at least) narrative phenomena happening here:

  1. As described in the last several emails I’ve written you (“Silly Season” and “The Sillier Season”), coherence continues to collapse across almost all macro narrative categories. What does this mean? It means this is a market waiting for a Big Narrative from a Big Missionary. Could be a positive narrative and it could be a negative narrative. But the will-they-or-won’t-they-sign-a-deal narrative regarding the US and China, what I’ve described at length as a game of Chicken where no odds are assignable, is no longer enough to move markets up or down with any sort of narrative half-life. I think that if nothing else, we’ll get a Big Narrative of some sort coming out of the Iowa caucuses in early February. Maybe that will be a market-positive narrative. Maybe that will be a market-negative narrative. Maybe we’ll get something else before then. But right now there is nothing to serve as a narrative engine – risk-on or risk-off – for this market. God help us, but fundamentals and stock-picking might actually matter for a while. I’d be long dispersion while this continues.
  2. The other really striking finding is in regards to the inflation narrative. Attention has collapsed, as has cohesion. This is the most complacent narrative structure around inflation that I’ve ever seen. If you’re looking for an asymmetric trade, where a little narrative shock could go a loooong way, this is where you need to spend some time.

And that leads to a final thought. It’s been a fantastic year of growth here at Epsilon Theory, and we truly couldn’t have achieved that without your support. We are more committed than ever to being an independent voice for original research and original thinking, and the Professional subscriber base is our most important resource for ensuring that. THANK YOU!

Happy holidays (and yours in service to the Pack),



The Sillier Season


Every day we run the Narrative Machine on the past 24 hours of financial media to generate a list of the most linguistically-connected and narrative-central individual stories. We call this the “Zeitgeist” and we use it for inspiration or insight into short-form notes that we publish a couple of times a week to the website. It’s usually pretty obvious why the articles rise to the top of our natural language processing (NLP) metrics, as they tend to be about specific companies or specific market events … topics where you see the headline and think “oh yeah, I understand why this article is appearing in financial media.”

Until recently, that is.

For example, Rusty wrote a brief note today (“Our Dumb World”) about one of the highest scoring financial media articles, “Amazon Removes Auschwitz Christmas Ornaments, Bottle Openers After Outrage”. This is as horrible as it gets, but we’ve been having lots of weird or off-narrative articles scoring high for narrative relevance recently. The same weird article never stays in the Top Ten from day to day, but it’s another weird flash-in-the-pan article day after day.

I think it’s related to the observation I sent you a few weeks ago (“Silly Season”) where I mentioned the low attention and coherence scores we were seeing across all of our macro narrative Monitors. It led me to ask a Big Question, one that I didn’t have an answer for:

At what point, if ever, do political narratives about Inflation and Fiscal Policy become market narratives about Inflation and Fiscal Policy?

We won’t have this month’s macro Monitor analysis completed for another few days, but I’ll tell you what it feels like to me. It feels like the lack of coherence around our “standard” macro narratives like Inflation or Central Banks or Recession has expanded into a lack of coherence around ANY market narrative, standard or not, macro or not. It’s like anything goes in financial media over the past few months, where not only is the ground unsteady beneath our feet in the real-world of market or company fundamentals, but it’s ALSO unsteady in narrative-world.

It feels like literally anything could happen in narrative-world. I honestly can’t imagine anything that would surprise me, or anything that would make for an investable move in markets, up OR down. It’s like the narrative-world heart is just quivering without a stable rhythm or beat of any sort.

We need a defibrillator.

Can you believe that the Iowa caucus isn’t until February? I think that’s going to be the defibrillator, the first real-world electoral result that begins to focus the political competition that’s going to dominate 2020 markets. That’s when I think political narratives start to become coherent market narratives.

Until then … the silly season is going to get even sillier.


Sneak Preview


I was invited by the Financial Times to write a guest post on my recent windmill-tilting exercise of calling attention to how corporate management is using increasingly large stock buybacks to mask increasingly large stock-based comp packages issued to themselves. That post should appear in the Market Insights column online next Monday and on the back page of the paper next Tuesday (possibly this Friday), but I thought I would give you all a sneak preview today!

I think (hope) that it’s the sort of article that can create a bit of a stir on its own, so I’ve toned down some of my more incendiary language on stock buybacks that I might use on Twitter. At the bottom of the piece, I’ve also appended my notes to the FT editor so that you can see the math behind the “Lycroloft” example. MSFT 10-K available for download here.

If you’ve missed any of the notes I’ve written to date on the topic, here are the links:

Yeah, It’s Still Water (Texas Instruments)

When Was I Radicalized? (Boeing)

The Rake (JP Morgan)

OK, Boomer (FedEx … not directly on this topic, but of somewhat related interest)

As always, I’m keen to get your take on this. And if you happen to run through your favorite company’s 10-K and find something interesting to relate, I’m all ears! – Ben


In poker, the rake is the cut that the casino dealer takes out of every pot. It’s usually a couple of dollars per hand … barely noticeable, certainly not to a donkey poker player like me.

But what if the dealer started taking 10% out of every pot? Would you notice then? How about 20%? How about 70%?

That’s what many large public companies are doing today, taking a rake of anywhere between 10% and 70% from the “pot” of stock buybacks – the hundreds of billions of dollars that these corporations make as a “return of shareholder capital” every year.

And no one is noticing.

This is the agency problem, a classic conundrum of economics, where shareholders’ agents – corporate management – find ways to enrich themselves at the expense of shareholders by gaming the system.

How does this latest incarnation of the agency problem work? Through massive stock issuance programs, masked and sterilized by even more massive stock buyback programs.

When a company issues new shares to employees with one hand (at a low price) and buys back those shares on the open market with the other hand (at a higher price), that price difference multiplied by the number of wash-traded shares equals value that never reaches shareholders at all, but is entirely captured by the recipients of the new shares. Please note that this value is lost to shareholders and captured by the employees whether or not their new shares are sold back to the company in the open market buyback operation. It’s an accounting identity. As the “Yay, stock buybacks!” crew likes to say, it’s just math.

For example, let’s say a company whose name rhymes with Lycroloft trumpets a big stock buyback program in their year-end earnings call, where they “returned capital to shareholders” in the prior 12 months by spending $16.8 billion to buy back 150 million shares of common stock on the open market. Sounds great, right? Very shareholder friendly!

But let’s also say that same company issued 116 million brand new shares to employees over those same 12 months as a result of employees exercising their stock options or vesting their previously restricted stock units (RSUs). The company receives some cash from their employees as these options are exercised and RSUs are vested (about $1.1 billion in this case), but obviously these new shares are being issued to employees at a dramatically lower average price than the average price of the same year’s open market buyback activity.

As a result, more than 60% of the total buyback “pot” that we donkey investors thought was coming to us as shareholders, close to $12 billion for this one company in this one year, is actually being raked by management to distribute among themselves.

Is this rake widely distributed among corporate employees? There’s no clean data on this, as – quelle surprise! – companies provide next to zero detail on the recipients of new stock issuance in their 10-Ks. What’s clear, however, from even a cursory review of the stock holdings of “insiders” at any big public company (Form 4 in SEC-speak), is that senior managers have done particularly well in this new regime of more stock issuance sterilized by more stock buybacks.

It’s not only CEO billionaires like Jamie Dimon, who owns more than 7 million shares of JP Morgan stock, or near billionaires like Tim Cook, who sold $114 million of freshly granted Apple stock just this August. It’s not only independent directors like Al Gore, who was issued 80,000 shares of Apple stock over the past two years, worth $21 million, after selling $38 million worth of stock in 2017. It’s the centimillionaire COOs and CFOs. It’s the legion of decamillionaire vice presidents and business line managers.

I think it’s a historic wealth transfer from shareholders to the managerial class. Not to founders or entrepreneurs or risk-takers. To managers.

What’s to be done? Here are three suggestions to start changing the incentives of rake-taking dealers.

  1. Separate the CEO and Chair positions of publicly traded companies. When the Chair of JP Morgan, Jamie Dimon, says in his 60 Minutes interview that the board independently sets the salary of the CEO of JP Morgan, also Jamie Dimon, we may be forgiven our incredulity. Let’s remove this obvious vehicle for the agency problem.
  2. No stock-based compensation for independent directors. Cash only. Let’s not give guardians of the shareholder hen-house any fox-like incentives.
  3. No exercise of stock-based compensation by ANY directors, independent or not, while they serve on the board. Again, hen-house. Again, fox-like incentives.

We’re never going to eliminate the agency problem, and the dealer deserves a proper rake. But we better start making this casino fairer to shareholders and less of a wealth transfer engine to the managerial 1%. Or someone is going to burn the casino down.


Notes to FT editor …

  1. On Microsoft …  see page 72 of 157 in the PDF (pg 44 of the original doc) for the FY 2019 open-market share repurchase of 150 million shares for $16.8 billion. Note that some sources like Bloomberg show total share repurchases for FY 19 were $19.5 billion, but that includes $2.7 billion that MSFT used to repurchase stock directly from management for tax withholding purposes, NOT open-market buyback operations. The note on the $2.7 billion (as well as more info on the open-market buyback) is on page 132 of 157 in the PDF.
  2. Also on Microsoft … see page 131 of 157 in the PDF (pg 85 of the original doc) for the FY 2019 new share issuance of 116 million shares. The $1.1 billion in funds received for that issuance is on page 85 of 157 in the PDF.
  3. The math on Microsoft is as follows … $16.8 billion spent on open-market buybacks divided by 150 million shares is an average price paid of $112.00 … $1.1 billion received on 116 million shares in an average price received of $9.48 … the difference in price per share paid and price per share received ($102.52), multiplied by the number of wash-traded shares (116 million), is the value received by employees ($11.9 billion). The total buyback “pot” is $19.5 billion ($16.8 b in open-market purchases + $2.7 b in direct-to-mgmt purchases), and $11.9 billion is 61% of that.

Silly Season


There’s something weird happening in narrative-world, and I’ve been trying to figure out what it means since we published our monthly Narrative Monitors update last week (attached to this email). I still can’t figure it out, but instead of continuing to wrestle in silence, I’m going to tell you what I find odd and ask what you think it means … if anything. It’s entirely possible that I’m just too much in my head on this.

First I’ll report on what we saw in the Monitors from October’s financial media.

Inflation – “Inflation narratives faded in both cohesion and attention in October. Any inflation narrative exists almost wholly within political worldas opposed to market world.”

Central Bank Omnipotence – “the level of attention on central bank narratives has faded rapidly: common knowledge has emerged that other investors are more focused on trade, IPO market/growth issues and election politics.”

Trade and Tariffs – “the attention on Trade War narratives has ticked down from our maximum level for the first time in months.”

US Recession – “US recession commentary drifted downward in both cohesion and attention in October.”

US Fiscal Policy – “there is no Fiscal Policy, Deficit or Austerity narrative, at least as it concerns markets.”

Individually, none of these Monitor reports is that odd. Taken together, though … well, that’s the weird part. Our measures of attention (drumbeating on an issue in financial media relative to all other issues) fell in October for ALL of these market-impacting macro narratives. Yes, Trade & Tariffs is still garnering a lot of attention, clearly the most of any of these standing issues. But even there we saw a noticeable decline in both the number of articles published in financial media on the topic and – much more importantly for our research – the centrality or “gravity” of those articles relative to other topics.

What took the place of these core macro factors? Well, we saw a ton of articles about politics … both impeachment and “how a Warren Presidency would destroy markets as we know them” articles. We also saw a lot of “OMG, WeWork” articles. I doubt that the spate of WeWork articles persists, although the Street really needs a good IPO to take the stench out … so we’ll probably get just that.

But I think we’re just getting started on the dominance of political narratives in financial media.

In fact, if you look at the Monitor narratives in terms of political-world rather than market-world, both Inflation and US Fiscal Policy are pretty darn robust in their attention scores. That is, “people are talking” about prices and taxes and spending as it impacts politics. People are not talking AT ALL about prices and taxes and spending as it impacts markets.

Or market prices.

Which leads me to the big question I have … and it’s the big question I don’t have an answer for:

At what point, if ever, do political narratives about Inflation and Fiscal Policy become market narratives about Inflation and Fiscal Policy?

Because right now they’re not, so we gravitate to new market high after new market high. And it is entirely conceivable to me that they never do – become market narratives, that is – and we continue to live in this, the best of all possible worlds. But I’m trying to figure out what might make that transition happen. Is it just time and getting closer to the election? Is it something else? That’s the weirdness that I’m wrestling with. As always, I’d love to hear your thoughts.