Year In Review

We’ve had a heckuva busy year at Epsilon Theory, so to ring out 2017 I thought it might be helpful to distribute a master list of our publications over the past 12 months. We’re long essay writers trying to make our way in a TLDR world, so even the most avid follower may well need a map!

It’s also a good opportunity to give thanks where thanks are due.

First, a heartfelt thank you to my partners at Salient for contributing a ton of resources to make Epsilon Theory happen, never once asking me to sell product, and allowing me the leeway to speak my mind with a strong voice that would make a less courageous firm blanch. Epsilon Theory isn’t charity, and it’s the smart move for a firm playing the long game, but no less rare for all that.

Second, an equally heartfelt thank you to the hundreds of thousands of readers who have contributed their most precious resource – their time and attention – to the Epsilon Theory effort. We live in a world that is simultaneously shattered and connected, where we are relentlessly encouraged to mistrust our fellow citizens IRL but to engage with complete strangers on social media. It’s an atomized and polarized existence, which works really well for the Nudging State and the Nudging Oligarchy, less well for everyone else. The lasting impact of Epsilon Theory won’t be in what we publish, but in how we’re able to bring together truth-seekers of all stripes and persuasions, because it’s your engagement with the ideas presented here that will change the world. I know that sounds corny, but it’s happening.

Now on to the 2017 publishing map.

Our big initiative for this year was to publish two coherent sets of long-form notes, one by yours truly and one by my partner Rusty Guinn.

My series of essays is called Notes From the Field. As many long-time readers know, I’m originally from Alabama but now live out in the wilds of Fairfield County, Connecticut, on a “farm” of 44 acres. I put that word in quotations because although we have horses and sheep and goats and chickens and bees, my grandfather – who owned a pre-electrification, pre-refrigeration, pre-pasteurization dairy farm in the 1930s – would surely enjoy a good belly laugh at my calling this a farm. Still, I’ve learned a few things over the years from the farm and its animals, and they’ve helped me to become a better investor.

  1. Notes From the Field: The eponymous note has two essays: “Fingernail Clean”, introducing the concept of the Industrially Necessary Egg – something we take for granted as proper and “natural” when it’s anything but, and “Structure is a Cruel Master”, introducing the genius of both humans and bees – our ability to build complex societies with simple algorithms.
  2. The Goldfinch in Winter: What can a bird teach us about value investing? To everything there is a season.
  3. Horsepower: The horse and horse collar revolutionized European agriculture in the 10th and 11th centuries, a revolution that lives on in words like “horsepower” and changed the course of human civilization. Today we are struggling with a productivity devolution, not revolution, and there is nothing more important for our investments and our politics and our future than understanding its causes and remedies.
  4. The Arborist: We are overrun with Oriental Bittersweet, privet, and kudzu — or as I like to call them, monetary policy, the regulatory state, and fiat news — invasive species that crowd out the small-l liberal virtues of free markets and free elections. What to do about it? Well, that’s citizenship, and I’ve got some ideas.
  5. Always Go To the Funeral: Going to the funeral is part of the personal obligation that we have to others, obligation that doesn’t fit neatly or at all into our bizarro world of crystalized self-interest, where scale and mass distribution are ends in themselves, where the supercilious State knows what’s best for you and your family, where communication policy and fiat news shout down authenticity, where rapacious, know-nothing narcissism is celebrated as leadership even as civility, expertise, and service are mocked as cuckery. Going to the funeral is at the heart of playing the meta-game – the game behind the game – of social systems like markets and elections, and it’s something we all need to understand so that we’re not played for fools.
  6. Sheep Logic: We think we are wolves, living by the logic of the pack. In truth we are sheep, living by the logic of the flock. In both markets and politics, our human intelligences are being trained to be sheep intelligences. Why? Because that’s how you transform capital markets into a political utility, which is just about the greatest gift status quo political institutions can imagine.
  7. Clever Hans: You don’t break a wild horse by crushing its spirit. You nudge it into willingly surrendering its autonomy. Because once you’re trained to welcome the saddle, you’re going to take the bit. We are Clever Hans, dutifully hanging on every word or signal from the Nudging Fed and the Nudging Street as we stomp out our investment behavior.
  8. Pecking Order: The pecking order is a social system designed to preserve economic inequality: inequality of food for chickens, inequality of wealth for humans. We are trained and told by Team Elite that the pecking order is not a real and brutal thing in the human species, but this is a lie. It is an intentional lie, formed by two powerful Narratives: trickle-down monetary policy and massive consumer debt financing.

The Three-Body Problem: What if I told you that the dominant strategies for human investing are, without exception, algorithms and derivatives? I don’t mean computer-driven investing, I mean good old-fashioned human investing … stock-picking and the like. And what if I told you that these algorithms and derivatives might all be broken today?

Rusty’s series of essays, Things that Matter (and Things that Don’t), connects to mine with his just published The Three-Body Portfolio. It’s a wonderful piece on its own (I can’t believe I didn’t think of the Soylent Green reference – Epsilon is people!) and is a great segue to his 2017 serial opus. In chronological order:

  1. With A Man Must Have a Code, Rusty begins the conversation about why we think that all investors ought to have a consistent way of approaching their major investment decisions.
  2. In I am Spartacus, Rusty writes that the passive-active debate doesn’t matter, and that the premise itself is fraudulent.
  3. In What a Good-Looking Question, Rusty writes that trying to pick stocks doesn’t matter, and is largely a waste of time for the majority of investors.
  4. In Break the Wheel, Rusty argues that fund picking doesn’t matter either, and he takes on the cyclical, mean-reverting patterns by which we evaluate fund managers.
  5. In And they Did Live by Watchfires, Rusty highlights how whatever skill we think we have in timing and trading (which is probably none) doesn’t matter anyway.
  6. In Chili P is My Signature, Rusty writes that the typical half-hearted tilts, even to legitimate factors like value and momentum, don’t matter either.
  7. In Whom Fortune Favors (Part 2 here), Rusty writes that quantity of risk matters more than anything else (and that most investors probably aren’t taking enough).
  8. In You Still Have Made a Choice, Rusty writes that maximizing the benefits of diversification matters more than the vast majority of views we may have on one market over another.
  9. In The Myth of Market In-Itself (Part 2 here), Rusty writes that investor behavior matters, and he spends a lot of electrons on the idea that returns are always a reflection of human behavior and emotion.
  10. In Wall Street’s Merry Pranks, Rusty acknowledges that costs matter, but he emphasizes that trading costs, taxes and indirect costs from bad buy/sell behaviors nearly always matter more than the far more frequently maligned advisory and fund management expenses.

But wait, there’s more!

You’ve got two more essays from Rusty:

  1. Before and After the Storm
  2. Gandalf, GZA and Granovetter

You’ve got 10 more essays from me:

  1. Harvey Weinstein and the Common Knowledge Game
  2. Mailbag! Fall 2017 Edition
  3. Mailbag! Midsummer 2017 Edition
  4. Gradually and Then Suddenly
  5. Tell My Horse
  6. Westworld
  7. The Horse in Motion
  8. Mailbag! Life in Trumpland
  9. The Evolution of Competition
  10. Fiat Money, Fiat News

Oh yeah, and you’ve got eleven 2017 podcasts here.

So there’s your 2017 Epsilon Theory map. 2018 will be even better.

The Goldfinch in Winter

I’ve learned that people will forget what you said, people will forget what you did, but people will never forget how you made them feel.

Maya Angelou (1928 – 2014), author of I Know Why the Caged Bird Sings

And in our business, people will forget what price targets you set, people will forget what funds you managed, but people will never forget how you impacted their personal account.

Longer summer means longer winter.

traditional Westerosi saying

We’ve got a five acre field that I brush hog once a year if I’m feeling particularly industrious, and one day I suppose we may do something with it.

In late summer this fallow field of thistle and hay is one of my favorite spots, particularly in the early morning and late afternoon, because of the flocks of goldfinches that swoop in and around the field. The goldfinch is exactly as the name implies — a small bird with a bright yellow, almost tropical, plumage — and it looks out of place in the Northeast, like maybe it’s an escapee from a gilded cage in Greenwich. But they love these Connecticut summers, and it’s not uncommon for me to count 30 or more flying around in a swarm that at times seems to be the animal itself.

The flocks are never as big as the far more famous murmurations of starlings, which is a good thing, of course, but they generate that same sense of awe in that there is clearly some sort of order and method to the flowing chaos of all these birds moving together. Most unlike the starlings, however, is that the goldfinch flocks are absolutely beautiful. The glints of yellows and gold moving through the air like a living liquid, the morning sun piercing the flock … it’s a natural poetry that has no good reason to exist, but does all the same.

I’m as much a dilletante birdwatcher as I am a dilletante farmer, so when the beautiful yellow birds stopped making their appearances over the field every fall, I just assumed that they were like the robin, flown south for the winter. I assumed this was the case for years, And in fact some goldfinches do migrate south every year, particularly the ones who set their breeding nests up in southern Canada.

But not our goldfinches. No, our field and its thistles, together with the nearby woods and the river that runs through it, is just too good of a home base to leave even for a season (I agree!). So they don’t fly south. They don’t go anywhere at all. They stay the whole winter, there in the field and the scrub and the forest all along.

Why didn’t I see them in the winter? Because they change color, or at least the males do, exchanging their flashy yellow feathers for a quite pedestrian dull brown. Just an ordinary little bird, one you’d never give a second glance at, even if now you remember seeing so many at the bird feeders you set out when the snows come.

Yes, the goldfinches were there all along. I just didn’t know where to look.

What’s the investing lesson here?

Goldfinches are like Value investing. Or Growth investing or Momentum investing or whatever your investment style might be. They have a season where they seize the stage, blistering in their radiance. And then they recede. They don’t go away. They just fade into the background and become a pedestrian little bird, until their appointed season returns — it always does! — and they seize the stage once more, zipping around in a glorious flock with some sort of fractalish order-in-chaos.

Unfortunately for us investors, though, the seasonality of investment styles is more like Westeros on Game of Thrones than Connecticut here on Earth. “Winter is here” on Game of Thrones today, but it took a long time coming … summer lasted a good nine years this time around, and legends tell of a winter back in the day that lasted for an entire generation. The winter currently being experienced by Value investors only seems like it’s lasted for a generation.

Not surprisingly, then, investors are always asking the same question: is there a bird for all seasons? Is there an investment style or process that can be more than just a pedestrian performer come winter, spring, summer, or fall, and no matter how long or how deep those seasons might be?

The answer, I think, is yes. The answer, I think, is diversification. There’s your bird for all seasons.

But here’s the problem with diversification, and it’s a problem I’ve written about extensively in Epsilon Theory, most recently in “It’s Not About the Nail” and “It’s Still Not About the Nail”, and in an oldie but goodie titled “Don’t Fear the Reaper”.

Diversification isn’t a pretty bird. Diversification doesn’t make my heart skip a beat like a flock of goldfinches in July. Diversification, by design, is going to have winners and losers simultaneously. Diversification, by design, is never going to look pretty doing its job, because if your portfolio is all working in unison, swooping through the market in a beautiful glint of gold … well, you may be making money, but you sure aren’t diversified. Diversification is undeniably effective, but it’s effective like a rat is effective, wonderfully adapted to do pretty well in pretty much any possible environment without calling too much attention to itself. That’s actually one of the rat’s primary survival mechanisms. It’s not flashy. It’s not pretty. It’s a freakin’ rat.

Diversification doesn’t make us feel good like a winning value or growth investment makes us feel good, and as Maya Angelou so brilliantly said, how you make people feel is ALL they remember.

I don’t have an answer for the simple fact that diversification doesn’t sing. I can’t make a financial advisor’s client feel good about diversification. I wish I could, because I would be … umm … a very rich man. But what I do know is that it’s a mistake to gussie up diversification as something that it isn’t. You can’t sell diversification as a beautiful song bird. You have to be honest about what diversification can and can’t do, not just for a portfolio’s performance, but also for a portfolio’s experience. The more years I spend in this business, the more I am convinced that how one lives with a portfolio, how one experiences its ups and downs over time, is more important for business success and business staying power than that portfolio’s performance. And I’m not just talking about volatility, which is usually how we think about the path of a portfolio and its ups and downs. No, I’m talking about how a portfolio makes us feel. Most of us need those goldfinch moments of wonder and awe, even if they just last for a season, to feel good about our portfolios, and those are moments that diversification has a really hard time delivering.

To every thing there is a season, and a time to every purpose under heaven. That holds for portfolio construction, too.

PDF Download (Paid Subscription Required): http://www.epsilontheory.com/download/15986/