Figaro

The dancers on stage are flopping around, dancing awkwardly in the absence of any music. They look uncomfortable as the Emperor Joseph II enters the rehearsal for the first performance of Mozart’s The Marriage of Figaro.

Emperor Joseph II: What is this? I don’t understand. Is it modern?

Kappelmeister Bonno: Majesty, the Herr Director, he has removed a balleto that would have occurred at this place.

Joseph: Why?

Count Orsini-Rosenberg: It is your regulation, Sire. No ballet in your opera.

Joseph:  Do you like this, Salieri?

Antonio Salieri: It is not a question of liking, Your Majesty. Your own law decrees it, I’m afraid.

Joseph:  Well, LOOK at them! No, no, no! This is nonsense. Let me hear the scene with the music.

Amadeus (1984)

Of all the investment strategies that force investors to hold their noses and take their medicine, we are most uncomfortable with those based on historical price movements. We know that they work, up to a point. And so we balance in our heads the ideas of participating in trends with some vague notion that we will make enough money doing so to compensate us for it all blowing up in our face one day. Alternatively we hope that we will be able to buck the trend before it reverses, whether through a contrarian analysis of price movements or some statistical model of investor behavior. Even when the models work, it can feel unsettling, like dancing a ballet without music.


Music’s exclusive function is to structure the flow of time and keep order in it.

Igor Stravinsky, as quoted by Geza Szamosi in The Twin Dimensions: Inventing Time and Space

In a Three-Body Market, narratives are the music. Understanding how they influence the structure and flow of price-trending behaviors is not a cure-all. But it can be a useful tool.


If you would dance, my pretty Count, I’ll play the tune on my little guitar. If you will come to my dancing school I’ll gladly teach you the capriole. I’ll know how; but soft, every dark secret I’ll discover better by pretending. Sharpening my skill, and using it, pricking with this one, playing with that one, all of your schemes I’ll turn inside out.   Se vuol ballare, signor contino, il chitarrino le suonerò, sì, se vuol venire nella mia scuola, la capriola le insegnerò, sì. Saprò, saprò, ma piano, meglio ogni arcano dissimulando scoprir potrò. L’arte schermendo, l’arte adoprando, di qua pungendo, di là scherzando, tutte le macchine rovescerò.
  • The Marriage of Figaro, by Wolfgang Amadeus Mozart from a libretto by Lorenzo da Ponte (1796)

If narratives are the music, we must be conscious of the musicians.


This is Part 4 of the multi-part Three-Body Alpha series, introduced in the Investing with Icarus note. The Series seeks to explore how the increasing transformation of fundamental and economic data into abstractions may influence strategies for investing – and how it should influence investors accessing them. 

  Economic Models Behavioral Models Idiosyncratic Models
Systematic Security Screening Econometric GTAATrend-Following
Momentum
Value Factor Investing
Mean-Reversion
Statistical Arbitrage
High Frequency  
Discretionary DCF / DDM / Price Target
Quality-Based
Credit Work
Growth Equity
Relative Value
Asset Value
Sentiment Value + Catalyst Discretionary Macro
Other Trading Strategies
Activism Distress

Trend-following is an odd little corner of the market.

Well, not little, I suppose. When taken in the aggregate, trend-following strategies – by which I include all strategies which use historical price behavior as a primary component in determining current positioning – account for at least $400 billion, and some multiple of that in exposure. If we included all the momentum-inclusive quant equity strategies and related factor portfolios, too, we’re easily wandering into the trillions.

And yet it still has an uneven reputation.

It wasn’t long ago that the most reputationally aware institutional money (i.e. endowments and foundations) wouldn’t touch anything that looked like it was trading based on price movements. Some still don’t. It was considered this sort of uncouth thing, a place for daytraders and charlatans. The real adults were investors! Value investors, business buyers, participants in the process of setting the proper price of capital! It didn’t help, of course, that many of the go-go momentum shops of the late 90’s were pretty sloppy, or that many so-called trend-following strategies were just some guy drawing dumb lines on a Bloomberg chart. And then later getting a computer to draw dumb lines for him.

Now, the empirical premises of the most basic trend-following strategies are not really all that much in question. They work. The data are pretty clear that they work. Of course, don’t tell that to the professor at Wharton who taught me 18 years ago that technical analysis was only so much superstitious hogwash. And yes, as much as we might protest that the reversal pattern of long-term underperformers that DeBondt and Thaler identified in 1985 or the short-term trend continuation pegged by Jegadeesh and Titman in 1996 are different, it is still technical analysis, y’all.

So yes, it works. But investing because of how the price has moved doesn’t FEEL like investing, and this feeling is a hump that a lot of investors still can’t get over. It’s too simple. As it happens, a lot of professional investors are really uncomfortable telling their clients and boards that they buy things just because they’re going up and sell them just because they’re going down. This is a predictable outcome, given that many of those professional investors have sold themselves to their clients and boards on the basis of, y’know, not being the kind of poor sap who just does what everyone else has been doing.

And so it is that there are all sorts of stories about why trend-following and momentum strategies work that are meant to lend them credibility. Maybe it’s because dispersion of fundamental information takes time. Maybe it’s because we overextrapolate earnings growth. Maybe it’s because price trends are really just a proxy for intangible business momentum.  I’m sure there are many very bright people who earnestly believe these stories. Hell, they may even be right. But for my money, the simpler explanation – and to be fair, it’s one that is usually recognized by those proposing the other explanations – is the easier one. Things that go up feel better and safer, a natural emotion that we have institutionalized through Morningstar ratings, consultant buy lists, ‘approved lists’ and hyper-frequent portfolio reviews designed under the auspices of weeding out ‘bad investments’, by which we mean ‘investments that have done poorly over the last 12-24 months.’

The problem is that while most of us can get our heads around why price and performance trends ought to continue, we also know that they can’t and don’t continue indefinitely. We also know that, if value investing works, too – and it does – there’s a point at which our view probably ought to shift to an expectation of a contrary relationship between future returns and stocks with strong historical performance. As you might imagine, there are a lot of implementation choices here. In fact, I’m not sure there is a space that provides the potential for as much diversity in signal design as trend-following.

Lest you get too frightened (or excited), no. This isn’t going to be a survey piece. There are great primers available on trend-following, and I’m not going to write a better one. If you’re in the market for a survey course in investment strategies, AQR’s Antti Ilmanen wrote the Bible. I’d also add that if you aren’t following the work by Corey Hoffstein at Newfound Research, you may find it even more useful. He researches implementation questions in the open, and since doing is invariably the best way to learn, I suspect you will gain immeasurably from following along. I have.

If you do want to understand the smorgasbord of strategies which incorporate price as an input, I do have a small number of suggestions, none of which is groundbreaking, and all of which would be a standard part of the arsenal of questions to ask any trend, CTA, managed futures or systematic macro fund manager:

  1. Understand the difference between time-series momentum and cross-sectional momentum, and know which your managers are relying on. They perform more differently than you would expect.
  2. Understand time horizon diversity among the signals being used, and how you might expect those signals to work differently.
  3. Understand how non-price data is being used in models, as primary signals or conditioners.
  4. Understand how positions are sized, and how gross and net exposures are managed.

I’m not making recommendations here, but at their very likely great distress, I’ll also share the names of a few people who, in my experience, are preternaturally good at discussing the hows and whys of these strategies. And this is me suggesting, not them offering, y’all:

  • Ewan Kirk at Cantab Capital, to explain anything trend-following or managed futures.
  • Rob Croce at BNY Mellon (and in full disclosure, a former colleague), to sell you on the religion of pure trend.
  • Jason Beverage at Two Sigma, to explain shockingly complicated quant portfolio construction concepts in ways you will understand.
  • On anything on the shorter end of the time-horizon spectrum (where a lot of mean reversion strategies live), you will never go very wrong by asking your AQR rep for a chat with Michael Mendelson.

But again, the intent behind this piece – as with the rest of the series – isn’t to tell you how and why these strategies work. It is to discuss whether we think a more abstracted market with greater always-on awareness of what other investors are thinking and doing ought to change the way these strategies work. The short answer? Yes. It should also change the way some of the strategies are designed and incorporated into portfolios.

What we are NOT talking about is parsing the news for sentiment. Sure, tone and sentiment are a component of any narrative. But a lot of money has been spent by hedge funds and others over the last decade and a half to mine news for sentiment, first by building huge manual research teams in India, and later by assigning those tasks to computers. Most of those efforts have been huge flops. The relationship between narrative and price trends is different, and I want to show you why.

This foray will necessarily cover the relationship between narrative and trend-following more generally, and not with individual strategies. After all, if we’re going to tell stories about how prices dance to the music of the stories that Wall Street tells, we must hold some things constant. So let me tell you a story about just three companies. They existed over the last 3 years. Conveniently, all of them are called Tesla Motors.

A Ballet in Three Acts, Act I: Resilient Tesla

Since calling them all the same thing will be confusing, let’s call the first of our companies “Resilient Tesla.” Resilient Tesla existed between for six months, from November 2016 to May 2017. In what will be familiar to regular readers, we rely on natural language processing technology from Quid to relate and graph news articles from a very broad universe of sources based on content, context, phrasing and sentiment. We provide some of our own characterizations of the clustered content to aid interpretation.

What did media reports have to say about Resilient Tesla? Well, they didn’t ignore bad things that were going on. Media reported on issues with autopilot, and on reported safety issues. It reported on issues with dealership access in states. But those stories were curiously isolated. With few exceptions, they shared no language or other similarities with the core of the conversations taking place about Tesla.

The center of gravity around which the Resilient Tesla narrative orbitted was management guidance, in particular around Tesla’s desire to raise capital to grow. The stories about management guidance and capital raising were usually also stories about the Model 3 launch. They were also about Tesla taking over as the most valuable carmaker in the US. Importantly, they were also stories about Wall Street positioning, and what big investors and sell side analysts thought about the company. And – for the most part – the tone and sentiment of all of these categories were good and positive. What is more, all of these linked positive topics were things where Tesla was the only game in town. That lent stability to the overall narrative, and that narrative was growth. We need capital, but we need it to launch our exciting new product, to grow our factory production, to expand into exciting Semi and Solar brands. Sure, there were threats, but always on the periphery.

Source: Quid, Epsilon Theory

Resilient Tesla was a positive trending stock. Over all but short bursts over this period, it would have been a long position for most long-, medium- and short-term models. Sure, models and strategies incorporating liquidity, volume, daily price action, large block trade activity or other esoteric anomalies may have had different exposure, but Resilient Tesla was a classic long for most.


Source: Bloomberg, Epsilon Theory. Note: This is not a recommendation to buy or sell any security, or to take any portfolio action. Past performance is not indicative of future results. You cannot invest directly in an index, and we do not invest directly in any individual securities.

A Ballet in Three Acts, Act II: Transitioning Tesla

The stories started changing in summer 2017. Act II tells the story of Transitioning Tesla, a company which existed for three months, from May 2017 through August 2017.


Source: Quid, Epsilon Theory

The overall sentiment and the language used in stories about Transitioning Tesla were still positive. In fact, they were actually slightly more positive than they were for Resilient Tesla. But gone was the center of gravity around management guidance and growth capital. In its place, the cluster of topics permeating most stories about Tesla was now about vehicle deliveries. Articles about Tesla used to be Management says this AND Model 3 is coming AND did you know that Tesla is now the most valuable US carmaker AND here’s Wall Street’s updated buy/sell recommendation stories. For Transitioning Tesla they were The Model 3 launch is exciting AND the performance of these cars is amazing, BUT Tesla is having delivery problems AND can they actually make them AND what does Wall Street think about all this? The narrative was still positive, but it was no longer stable.

In other words, two things happened here:

  • Transitioning Tesla lost control over the narrative. It failed to control its cartoon.
  • The main connectivity among the stories people tell about Tesla became concern about deliveries and production.

We’ve previously described narrative as providing meta-stability to an overall market: the ability to shrug off contrary new facts that are inconsistent with the narrative, and to incorporate new facts that were previously considered tangential. Instead, the excitement about non-Model 3 opportunities like Solar, Gigafactory and Semi moved further to the periphery, less linked to most content about the company. Debt concerns, competition and partnership issues, previously easily shrugged off, were now being mentioned in articles that were ostensibly about something else. This is what it looks like when meta-stability fails. This is what it looks like when the narrative breaks.

You wouldn’t necessarily have sensed a difference in how the Tesla story was being told. It was still positive in tone, still almost universally optimistic. Investors and the public alike were still excited about the vehicles’ uniqueness. They still saw value in the periphery businesses. You probably wouldn’t have thought much of the price performance over these four months, either. Long-term cross-sectional momentum models would have shrugged off the addition of four choppy months of ultimately in-line performance. Time-series models would have scored a still-rising stock.

But it was already broken.


Source: Bloomberg, Epsilon Theory. Note: This is not a recommendation to buy or sell any security, or to take any portfolio action. Past performance is not indicative of future results. You cannot invest directly in an index, and we do not invest directly in any individual securities.

A Ballet in Three Acts, Act III: Broken Tesla

The third Tesla – Broken Tesla – existed between August 2017 and the present.

The growing concern about production and vehicle deliveries entered the nucleus of the narrative about Tesla Motors in late summer 2017 and propagated. The stories about production shortfalls now began to mention canceled reservations. The efforts to increase production also resulted in some quality control issues and employee complaints, all of which started to make their way into those same articles. When stories about suppliers not getting paid were coupled with a failed MBO, writers all too easily related these concepts with the management and oversight of the company. Once writers connect these items, then the previously peripheral issues of autopilot crashes, recalls and union disputes start finding their way in as well.

Now, almost all of these things were obviously very real, very tangible problems. That’s not the point. The point is that there was already broad private knowledge that there were issues with Tesla’s manufacturing process. There was already broad private knowledge that senior finance executives had been leaving the company. There was already broad private knowledge that Elon was eccentric. There was already broad private knowledge about the previously peripheral problems for the company. But none of those things really mattered until they became part of the common knowledge around the stock. Once that happened, a new narrative formed: Tesla is a visionary company, sure, but one that doesn’t seem to have any idea how to (1) make cars, (2) sell cars or (3) run a real company that can make money doing either.

Source: Quid, Epsilon Theory

But that’s all the music. So what is the dance? Well, the performance of the stock in this period is probably familiar. This was a model trade for most trend-followers, especially those with more basic strategies. A long-term positive trend, followed by a flat period to roll off old signals, followed by relatively quick transition to a new trend. The funds incorporating more basic long-term cross-sectional signals only probably got hurt a little in Q3 2017, but have been in the money since then.


Source: Bloomberg, Epsilon Theory. Note: This is not a recommendation to buy or sell any security, or to take any portfolio action. Past performance is not indicative of future results. You cannot invest directly in an index, and we do not invest directly in any individual securities.

The Epilogue

If you’re reading this note on Tuesday, October 23rd, you’ll know that Tesla has moved up its earnings call to tomorrow evening. As of mid-day today, TSLA stock is up about 5.6%. As always, these things are overdetermined, but it’s hard to think that responses to chirps from management about a ‘near-profitable’ quarter and record production and deliveries don’t have something to do with it.

Tesla valuations are built on the basis of phenomenal projected future growth. The idea that anyone is going to update some model assumption after tomorrow’s results and legitimately come up with a massively different valuation is nonsense. And yet. If I were short the stock based on the supportive environment for a continued negative price trend, I’d be looking very closely at the following:

  • Can Elon and team put on a performance that starts to put distance between how media and Wall Street talk about the company in the same breath that they talk about credibility issues for management? Can they stay on-point and look like adults?
  • Will the ‘near-profitability’ story and facts dispel the swirling attachment of debt / cash flow / failed MBO concerns to the principal stories about Tesla?
  • Will they be able to bring the topics that have remained positive (e.g. China production, Panasonic’s progress, even Semi, believe it or not) into the main narrative about the stock?

Perhaps most importantly, can Elon step back into the role of Missionary? Or will he continue to let other people determine his cartoon?

The Story of the Three Acts

Let me address a couple legitimate criticisms of this way of complementing trend-following in advance.

The first is that this all seems very easy to see in retrospect. Would I have seen this in advance? Would you? Not sure. There is predictive power in this, but it is hard. It is also systemizable. It is also a new way of looking at things that requires us to build some new muscles to see clearly – and to avoid the confirmation bias that inevitably creeps into this kind of analysis.

The second criticism – and this one comes up a lot – is that professional investors and analysts don’t make judgments about companies and securities based on the content of news pieces. Assuming that this is a serious observation, I would only respond by recommending that you talk to more fund managers and read more sell side pieces. Still, there is a lot to be gained by understanding how common knowledge and broad private knowledge alike DO differ by and among different groups – from broad media, to specialized media, the sell side, long-only fund managers, hedge fund managers and macro strategists. This is something we are working on expanding as part of our research effort.

The third is skepticism that the existence of what we’re calling narrative can predict the direction of a stock. Well…yeah. I mean, I agree. I’m not at all convinced that it can, and there’s nothing I’ve written here today that should convince us that we could have used this ex ante to bet on or against TSLA. This isn’t about predicting the direction of a stock. It’s about updating our predictions about whether it is an environment more or less conductive to investing with or allocating to various types of trend-following strategies. You may not be able to predict the trend, but you may have some ability to project its stability. It’s about understanding how the music changes the dance. It’s not about the answer, it’s about the process.

What else do we take away from all this? What else do I think?

  • I think allocators should be more actively engaging our trend-following managers to be curious about why their signals work. Ask questions about how they try to develop economic intuition for them. They don’t have to buy into how we are conceptualizing this. But they should be constantly curious.
  • I think I’m more inclined toward simple strategies that are heavy on long-term trend. While abstractions are just as capable of creating choppy periods, I think  conducive environments for long-term trends will be more common. I think the cause will be broader awareness of these tools by CEOs and other missionaries. . That’s pure conjecture on my part. But even if I’m wrong, long-term trend’s traits in major equity market drawdowns are a very nice second prize.
  • I’m less inclined toward the managed futures / CTA behemoths. By definition, I think more adaptable strategies capable of turning off models that aren’t suited for the environment – maybe on similar grounds to what we’re arguing, and maybe on more sophisticated ones – will be the winners. The megashops in this space have created capacity and liquidity through strategy stratification that tether them to relatively more static approaches, or else would force them to significantly reduce risk budgets (which many have already done as they’ve transformed themselves into management fee shops).
  • I think, at the margin, I prefer strategies more heavily driven by absolute time-series momentum vs. cross-sectional strategies, although they are perfectly acceptable complements, as well. Both have a role. But I think the bigger abstractions and narratives will require us to capture beta effects (i.e. I want strategies more capable of making non-offsetting directional bets).
  • As an aside, I think if Elon Musk wants to get this thing back on track, he needs to control his own cartoon and embrace his role as Tesla’s missionary again. Among…uh…a few other things. I’ve never owned the stock and I never will. But unlike most people at this point, I really do want Elon to succeed. Yes, really.
  • Maybe most importantly, we have all intuitively adopted ‘trend-following’ thinking in our normal portfolio construction behaviors. After a pleasant decade for risky assets, most of us have internalized a sense of stability in the trend in something like the S&P 500. It won’t allow you to predict the future. But awareness of narrative stability may help you to understand if and when the narratives supporting the “just keep it simple and buy SPY” heuristics start to break down.

PDF Download (Paid Membership Required): http://www.epsilontheory.com/download/16949/

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 Myth of Market In-Itself: Things That Matter #3, Pt. 2

Nothing at all. No figures. Only a blank.

“What’s it mean?” Reinhart muttered, dazed.

“It’s fantastic. We didn’t think this could—”

“What’s happened?”

“The machines aren’t able to handle the item. No reading can come. It’s data they can’t integrate. They can’t use it for prediction material, and it throws off all their other figures.”

“Why?”

“It’s—it’s a variable.” Kaplan was shaking, white-lipped and pale. “Something from which no inference can be made. The man from the past. The machines can’t deal with him. The variable man!”

Philip K. Dick, The Variable Man (1953)

This science fiction classic imagines a future world where specialization and technology have made versatility, adaptability and ingenuity obsolete. The unwitting introduction of a man from the past Thomas Cole capable of solving practical (and mundane) problems of this world throws off the models they use to predict the outcomes of government and military action.

Thomas Cole breaks the models because his foreignness allows him to see problems outside the confines of specialized taxonomy. He isn’t too dumb to see the tribes and archetypes of the future. He transcends them, and can’t be controlled by them. The successful navigator of policy-controlled, narrative-driven markets must be Thomas Cole. He must be The Variable Man.

When someone shows you who they are, believe them the first time.

Maya Angelou, as told by Oprah Winfrey

I have given them Your word; and the world has hated them because they are not of the world, just as I am not of the world. I do not pray that You should take them out of the world, but that You should keep them from the evil one. They are not of the world, just as I am not of the world. Sanctify them by Your truth. Your word is truth. As You sent Me into the world, I also have sent them into the world.

The Bible, The Gospel of John 17:14-18

One of the most powerful consistent themes of many religious texts is the battle between the adherent’s role in the spiritual world and in the physical one. The approach Jesus describes here in the Gospel of John is to be in the world, but not of it. It’s a consistent message for the man who dined with gamblers and prostitutes.

We’re presented with the same challenge. Behavior exists. Tribes exist. Taxonomies exist. “Communications Policy” exists. Rejecting them doesn’t mean rejecting their existence, and it absolutely doesn’t mean that we ought not to invest and trade with awareness of how they impact markets. Being as shrewd as snakes and as innocent as doves means a willingness to know about tribal thinking even when we reject it in ourselves.

The Most Interesting Man in the World: “I have no idea what this is.”

Although, truth be told, there are some things it’s worth being content knowing nothing about.

We will live in this world, which for us has all the disquieting strangeness of the desert and of the simulacrum, with all the veracity of living phantoms, of wandering and simulating animals that capital, that the death of capital has made of us—because the desert of cities is equal to the desert of sand—the jungle of signs is equal to that of the forests—the vertigo of simulacra is equal to that of nature—only the vertiginous seduction of a dying system remains, in which work buries work, in which value buries value—leaving a virgin, sacred space without pathways.

— Jean Baudrillard, Simulacra and Simulations (1981)

If anything describes the feeling I get about the market, it is disquieting strangeness. Sound familiar to you? As Baudrillard pointed out, this is the vertigo we get from a world of things that are not things in-themselves, but socially constructed amalgams of symbols and proxies for those things. With every Narrative, every bit of fiat news, the vertigo for those who seek after the truth of something increases. There is no cure, but the only treatment is to try to really, truly understand the simulacra of reality for what they are.


We live in a world awash with archetypes.

A personality test once told me that I’m an INTJ. When I play(ed) Dungeons and Dragons my alignment was Chaotic Good, and I usually roleplayed a Half-Elf Bard. I’m a #NeverTrumper on the libertarian wing of the Republican Party. I attend a Presbyterian Church, but I’ve always identified as Non-Denominational, which is, of course, a denomination that takes its denominational identity from not belonging to a denomination. I’ve been a WASP all my life, and a non-POC cishet who was coercively assigned the male gender at birth for about 2 ½ years since society decided that the sentence I just wrote is not at all horrifying and makes any kind of sense. I am of Scots-Irish extraction, a Libra or a Virgo depending on the calendar, and Buzzfeed tells me I would be Faramir[1] in the Lord of the Rings Universe, Jon Snow in Game of Thrones and Miranda in Sex and the City. Apparently, if I were admitted to Hogwarts the sorting hat would put me in Ravenclaw.

Over the last few months Ben and I have written a lot about archetypes like this, along with tribes and symbols, and the way that they are used. In Gandalf, GZA and Granovetter I argued that when symbols are used as allegories as tools to divide and dominate they have the effect of either (1) causing people to shift their beliefs and actions to match up with the symbol or tribe they identify with or (2) causing people to treat others as if their beliefs and values align with the symbol. Or, in Ben’s terminology, the (1) obedience collar and the (2) dog whistle. In that note, I took particular issue with the latter, with the idea that anyone gets to determine our intent as citizens or investors.

Here, as we continue the exploration of why investor behavior is one of the Things that Matter in our Code, I want to expand on the first: the tendency for the temperament and behaviors of investors to coalesce around archetypes. Because while we believe we ought to fight to ensure that we are all treated like principals, we also believe that when someone shows us who they are, we ought to believe them. And investors show us an awful lot about who they are. Archetypes are everywhere in markets, and if you have the patience to understand and observe them, you will understand what we think is one of the Things That Matter for all investors.

Notes from a Much More Boring Field

I grew up running through corn fields in Minooka, Illinois, but I don’t have it in me to be a gentleman farmer like Ben.

No, my notes from the field are much more dull as regular readers will know, my prior field was an institutional allocator. And people who were and are in my position bear a lot of responsibility for the archetypes in markets. You see, picking fund managers is hard, usually a waste of time, and basically everybody sucks at it. Fund evaluators have very little visibility into what causes a manager to generate returns that produce outperformance or a higher-than-expected risk-adjusted return. And so, instead of focusing on a few “things that matter” to identifying strategies and approaches that could even conceivably have an edge, the emphasis of nearly every fund allocator is exclusively on process.

Here’s the problem with that: process is a necessary but insufficient condition for consistently beating the market.

The fund allocator’s toolkit is full of ways to tell if a manager is following his process. He looks at tracking error. Rolling correlations to all sorts of indices. Cash positions over time. Factor exposures over time. Risk contributions from factor exposures, country bets, all sorts of things. These are the things that fund managers are expected to discuss, and they are often the right things to discuss. But if you have no justifiable idea whether the process itself should or will lead to outperformance, what the hell are you actually measuring? We have built an entire industry on accurately measuring whether someone followed the recipe, without knowing if the recipe tastes like hot garbage.

As a consequence, the conventions of our industry are exactly the same as the conventions of our political reality: we evaluate participants’ consistency with an archetype that is vapor, a construct, a simulacrum. In so doing, we create strong forces to drive them toward consistently behaving in that very particular way, toward incentives and responses to stimuli that are repeatable mostly because we reward them for being repeatable! It’s not really even a Pavlovian response, because the reward is usually crappy performance.

Managers of institutional pools of capital are one of the largest influences on markets, and so it is critical to understand the languages that coalesce around these archetypes. Others form around the conventions of retail gatekeepers (Howdy, Morningstar… or Lipper for the mutual fund managers who didn’t like their Morningstar rating), around sell-side research providers, around the styles of well-respected investors (e.g. Buffett) or around insufferable gasbaskets (e.g. Cramer). Others form around the self-reinforcing conventions of esoteric worlds like FinTwitter, which end up driving far more of something like USD/BTC than anything fundamental about cryptocurrency.

Returns are anywhere and everywhere a behavioral phenomenon. Dick Thaler likes to quote Herb Simon’s characterization of “behavioral economics” as a pleonasm, but talking about a behavioral approach to markets is just as redundant. It is impossible for a non-behavioral analysis of market returns to be useful. If we are ever to understand why prices move and why our investments generate returns for the portfolios we build for ourselves and our clients, we must at least develop some understanding of how and why blocs of investors form, how they buy and sell securities, how and when they change their stripes, and how that results in changes in the prices of the investments we own. We’re going to do a lot of generalizing, so caveat the below however you deem appropriate. This isn’t a precise science or at least it isn’t yet.

The Value Archetype

It’s easy enough to introduce what it is we’re talking about with a “style” that most investors are familiar with. Well, sort of, anyway.

The language of value is familiar—buy cheap things. The investor who has adopted it is rarely a news-responder. In many cases he fancies himself a bettor on things that are out-of-favor or forgotten. In the market voting machine, he casts his ballots and crosses the [actual and proverbial] spread for things with bad tape, with bad narratives, with problems. Don’t mistake the language for the style. Graham and Dodd, Buffett and their “intrinsic value” ilk are value investors in the way that everyone is a value investor – in that they want to buy something they think will be worth more in the future than it is today. They aren’t who we’re talking about here.

We are talking about the investor who believes that investors pay too much for quality, for growth, for sex appeal, and that it will harm their returns. These days, most of these value investors are quants. Some of them are financial advisors selling a package of contrarian ideas, of differentiated thinking. Many more of them are fundamental shops, folks that focus on multiples-based analysis and build fancy models after the fact to justify the things they buy on the basis of multiples, not that there’s anything wrong with that.

So how do these value investors impact prices and returns?

Visualize the order book from Part 1, and again, think about it in long-horizon terms. Members of the Value Archetype form a big part of the willingness of the market to buy things that most think are unattractive. They form the corpus of the out-of-the-money bid for any security or market, and like their counterparts in the Mean-Reversion Archetype we’ll read about shortly, that’s when they tend to participate in the marginal price-setting process. That, and on the ask side, where they tend to be the sellers of gains. When a lot of people are rallying at this banner, it can be a pretty meaningful force to constrain upward movement in prices.

When there aren’t as many, the Value Archetype plays a much smaller part in the price-setting process. Consider: who is selling a stock that goes from trading at 45x earnings to 50x earnings? It ain’t the Value guy. He sold it a long time ago, and the next guy couldn’t care less.

The Growth Archetype

We tend to think of “growth” as being the opposite of “value,” but that isn’t strictly true. For most of the indexes that track these styles, it is kinda true, although in their vernacular, “growth” is really just “anti-value.” In other words, when you see a growth index, in most cases it isn’t sorting companies by how quickly they grew or are expected to grow, but by how expensive they are. That’s not what we’re talking about.

There may be a few investors out there who are actively looking to buy things because they are expensive, I suppose, but there are plenty who don’t care all that much if it has what they are looking for. What many of them are looking for is growth, or at a minimum the narrative of growth. That narrative may be favoring one stock over a peer. It may be in favoring technology securities over the retail sector. It may be in favoring emerging markets investments over developed markets. There are some investors at certain times and under certain conditions who see valuations as temporary phenomena and growth narratives as the only relevant focus.

Some of these individuals actively choose this posture. They believe the narratives, they buy, and they cross the spread to do it. Prices rise.

Some under this banner have no choice. They have asset-liability issues that require them to seek out growth. They are pushed by falling yields in alternative asset classes precipitated by central bank action. They, too, must buy and cross the figurative spread to do it. Prices rise.

We’ll come back to this, because it’s important.

The Momentum Archetype

Quantitative investors do this. Traders do this. In a way, of course, these are people responding to the Epsilon that represents a portion of market returns. In most cases, they do it because it generally works. Winners tend to keep winning and losers tend to keep losing. Many investors who coalesce around this archetype do so very willingly (pictured right), while others would be mortified to think that they would be tarred with a “technical” investor brush. And so they are focused on consistent improvement in earnings, or in guidance from management, or in an improving story. Narrative momentum rather than price momentum, but momentum all the same.

In the end, what matters is that these individuals ‘cross the spread’ to support continued movement in the price of securities. Some can be long/short, and so this can happen in both directions. But it’s generally long, and getting longer.

The Mean-Reversion Archetype

I’m abstracting a lot from time horizons here, and I’m doing so intentionally. Part of my story is that in a non-ergodic world, the idea that the long-term can be considered fully independently from the path that begins in shorter horizons is madness. And so, while I fully recognize that there are many, many funds that pursue strategies that happily encompass each of value, momentum and mean-reversion strategies, I’m not talking about strategies. I’m talking about frameworks of thinking and talking about investments that color the decisions that investors make across the board.

And on this dimension, while mean-reversion has a specific meaning within the context of, say, CTA and statistical arbitrage strategies, what I’m really talking about is the consciously contrarian asset allocator. Only instead of looking for unloved companies, this is the falling-knife catcher. The one looking for the turn, the top, the bottom, the inflection point.

Some demonstrate this trait consciously, but far more do so passively through policies called “rebalancing,” most of which have a negative expected return. After all, momentum works. But these people are volatility reducers. They step in to provide the bid when the longs are screaming bloody murder and the ask when the shorts are getting crushed.

The Others

Look, there are all sorts of taxonomies people rally around. We could talk about some nebulous definition of “quality” guys or the nothing-land that is most “GARP” investing. We could talk about investors who are students of more arcane technical trading approaches, or about those who invest based on macroeconomic data or news. But it’s the four things above that matter.

Except that there is a rapidly growing fifth category, a sort of Nihilistic Archetype. It’s the passive investor. Except inasmuch as he adheres to another archetype in his cross-asset allocation decisions (which he frequently does), the passive investor expresses no opinion whatsoever with respect to the pricing of individual securities. He doesn’t participate in relative price-setting.

He is out of the game.

Where Does This Put Us?

Can you tell that I’m going somewhere with this? To better understand why I think it’s important for all investors to think about the behaviors of their fellow-travelers in markets, let’s walk through what I think is happening right now:

  • The Value Archetype is dead: No one is rallying around this banner. Read the sell-side language. No one is pitching value-oriented research, because they’d have no one to sell it to. Even the old stalwarts, the quants, have evolved toward either risk premia-based or Value+Momentum+Quality mandates that dampen the emphasis on value alone. Sure, you’ll get the occasional bank strategist calling for a rotation into financials (they’ve got to be early calling the new thing), but of the people setting prices, very few of them are speaking this language. I’m not saying I don’t believe in value. I do! But the market’s belief in it is nothing more than lip service right now.
  • The Mean-Reversion Archetype guys in CTA and Global Macro Land are bleeding out: Selling winners and buying losers has rarely been a more painful trade. I’ve talked to a few FAs who are sticking with long vol trades or defensive positions because, well, at this point, you might as well stick to your guns. But other than that, this is a dead language, folks. If you expect someone to bail you out of a short squeeze, you’re barking up the wrong tree.
  • Passive Investing is levitating broad markets but allowing intra-market volatility: Investors, allocators and fund managers alike have piled into the Growth train, in part because they want to, and in part because retirees and pension plans with unfunded future liabilities have no other choice. Since they are doing so through broad market instruments and are not about to sell into weaker growth prospects, there is continued upward pressure on prices. Within markets, the decline in participants who are actively participating on individual securities is allowing continued spread potential between sectors, styles, etc.

The combined effect? Everything is levitating. With value and mean-reversion as lingua non grata, the people setting prices are (1) Growth investors, (2) Momentum investors and (3) Passive investors adhering to those archetypes. There is no one left to sell, because there is no one left who cares nearly enough about valuation or is confident enough in their ability to time a top in markets to sell into strength. The result is in Information Surface terms a market that has tremendous difficulty generating any price volatility to the negative.

What Does This Mean for Investors?

We can be in the market and be long. We can be not of this market and be ready for the move to the downside. Or we can be in the market, but not of it, by incorporating the behaviors of others into our thinking about markets AND retaining our ability to think independently about possible outcomes. How?

  1. With the core of your portfolio, you don’t fight it. This is most of what being aware of investor behaviors and the complete hegemony they have over market movements means.
  2. You think more specifically about how other investors are thinking about this market. Why they’re buying. Why they’re buying what they’re buying. You think about their motivations. And you think about how a change in their motivations would change in response to various market influences. Is a shooting war in the Middle East going to materially change investors’ view of and preference for growth? (Probably not) Is a material change in language coming from all Central Banks going to shift it? (Maybe, as Ben has written)
  3. You prepare your portfolio or at least your framework for what happens when that informational bowling ball climbs the wall to the downside, because when it does, volatility can return in a big damned hurry.

Thomas Cole wasn’t a genius. He succeeded because he was capable of acknowledging the existence and influence of archetypes without succumbing to them in his own behavior and actions. If you would navigate this market, your Code should allow you to do the same.

[1]Hopefully it’s book Faramir, and not the movie Faramir that Peter Jackson made into a spineless clone of Boromir because Jackson lacks any understanding of plot or character.

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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.

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