The meat really starts to kick in the section ‘There Are No Shortcuts’ and reaches peak lucidity in the section ‘Organizational Structure’. Excellent work by Leigh Drogan, Founder and CEO at Estimize, laying out what I really do believe is the blueprint for success with ‘next gen’ strategies that are foundationally systematic and substantially software-encoded:
Portfolio Manager — Of all the roles this is where I think things really need to change in terms of who sits in this seat. It can no longer be hedge fund bros, they simply won’t survive here. Nor will the pure gunslingers and tape readers, gone. And you certainly don’t want the pure quants sitting in this seat. PMs of the future are going to be far more interpersonal and process driven…. This is a cross functional role, and one that needs to be based on the behavioral attributes of the person more than anything else. An MBA may be useful here, but I would even say that having experience working at the early stages of a startup as a CEO can add a lot. I’m waiting for someone to develop a firm to leverage psychometric testing for different investment strategies so that we can identify people tuned for momentum vs value. You’re talking about a completely different psychology between those two people and it’s imperative you choose the person correctly … PMs should have some training in statistical and quantitative methods in order for them to talk intelligently with the quants and trust the factor models. Without that trust, there’s simply no point in having them and you’ll only gain that by understanding how they are built. Should a PM know how to code, no. Should they understand what the code does and why, absolutely. Basic data science classes can provide this knowledge. Quantitative research methods 101 in college is a requirement … I believe that compensation structures for the PM need to change. This is no longer “his book”. He is another player on the team, who has a specific role, to coordinate the dance. But in many ways, he will have less impact on the alpha generated by the book than the analysts or the quants who create the factor models. The PM is now the offensive coordination calling the plays, not the quarterback on the field scrambling around and throwing touchdowns. We can now compensate analysts accurately for the efficacy of their calls, and the PM for how much alpha she adds above them. The rest of the team should be bonused out based on the performance of the book.
Our basic idea with our DeepMoji project is that if the model is able to predict which emoji was included with a given sentence, then it has an understanding of the emotional content of that sentence. We are training our model to predict emojis on a dataset of 1.2B tweets (filtered from 55B tweets). We can then transfer this knowledge to a target task by doing just a little bit of additional training on top with the target dataset. With this approach, we beat the state-of-the-art across benchmarks for sentiment, emotion, and sarcasm detection.
Check out the online demo here, more detailed write-up here, and full technical paper here.
Useful skills like VR, NLP and… econometrics?
This list of fastest-growing freelancer skills compiled by Upwork, a job site that matches freelancers with employers, is just so odd I feel there is either some deep pattern coded in there that explains everything, or else some intern at Upwork is having a laugh.
Growth in VR and NLP makes total sense given the relative lack of experienced talent vs growth in demand, especially for VR developers. Neural network and Docker development for the same reasons. Adobe Photoshop freelancers — sure, I guess Photoshop is still operated by a priesthood although it’s unclear why the journeyman priesthood is growing rapidly.
But then Econometrics, really??!!? — never, ever, in my life have I thought “what I really need to do is to hire a random econometrician over the internet”, and for sure that thought has not been exponentially increasing of late.
And Asana work tracking, which had only around 20,000 paying customers a year ago?!!? — that’s like having ’Tesla car polisher’ on the list.
Anyway, I leave you to ponder. It certainly is an intriguing list — perhaps what we need is an econometric hireling to make sense of it for us…
And finally and frivolously, we have this article which is pretty much a total waste of storage space as it is a 700-word, not-very-good takedown of a new not-very-good mushroom-identifying mobile app with sub-par mushroom image recognition. However, it warrants inclusion in this week’s Rabbit Hole for the one immortal line:
There’s a saying in the mushroom-picking community that all mushrooms are edible but some mushrooms are only edible once.
Johnny Ola told me about this place. He brought me here. I didn’t believe it, but seeing’s believing, huh? Old man Roth would never come here, but Johnny knows these places like the back of his hand.
– “The Godfather, Part II” (1974)
C’mon, Frankie… my father did business with Hyman Roth, he respected Hyman Roth.
Your father did business with Hyman Roth, he respected Hyman Roth… but he never *trusted* Hyman Roth!
– “The Godfather, Part II” (1974)
There’s no more dramatic moment in all of movies than the Havana club scene in Godfather, Part II, where Michael overhears Fredo blurting out that he’s partied with Johnny Ola, Hyman Roth’s lieutenant, and lied to Michael about knowing him. The look on Michael’s face as he realizes that Fredo has betrayed the family is, for my money, Al Pacino’s finest scene as an actor, and it helped him gain a 1975 Oscar nomination for Best Leading Actor. Unfortunately for Pacino, it was a good year for strong leading man performances, as Jack Nicholson was also nominated that year for his role in “Chinatown”. The winner, of course, was Art Carney from the immortal film “Harry and Tonto”. Thank you, Academy.
But this isn’t going to be a note focused on Michael or Fredo, or even my favorite Godfather character of all time, Hyman Roth. No, this is a note focused on the polite and respected henchman, Johnny Ola. Johnny Ola is the transmission mechanism, the disease vector, the crucial connection between the schemes of Hyman Roth and the survival of the Corleone family. Without Johnny Ola there is no Fredo betrayal, no path for a misplaced trust in Hyman Roth to infect the Corleone family. Without Johnny Ola there is no movie.
Now bear with me for a moment. There is a Fredo inside all of us. We are, each and every one of us, often betrayed in our actions and decision making by aspects of our own psyches, and our investment actions and decision making are no exception. The Epsilon Theory Fredo is the little voice inside our heads that convinces us to act in what we think is our own self-interest when actually we are acting in the interests of others. The internal Fredo that we all must seek to identify and root out is, like the movie Fredo, not an inherently bad or evil sort, but weak-willed and easily misled by the Johnny Olas of the world.
The Johnny Olas of the world are not so much flesh and blood people as they are idea or concepts. They are the transmission mechanism by which powerful institutions and even more powerful ideas and concepts – the Hyman Roths of the world – wield their most potent influence: the internalized influence of trust. It’s necessary and smart to do business with the Hyman Roths of the world. It’s necessary and smart to respect the Hyman Roths of the world. But as Frankie Pentangeli reminds Michael, you can never trust the Hyman Roths of the world, and that’s what Johnny Ola does … he convinces our internal Fredo to trust Roth and betray our self-interest.
I could write a long note about how the Fed is Hyman Roth and “communication policy” is Johnny Ola. Too easy. Too true, but too easy.
No, this note is about the Hyman Roth that works above even the Fed. It’s a note about the Johnny Ola that sweet talks all of our internal Fredos, even the Fredo inside Janet Yellen.
The Epsilon Theory Hyman Roth is Econometric Modeling.
The Epsilon Theory Johnny Ola is The Central Tendency.
It’s important to respect the power of econometric models. It’s important to work with econometric models. But I don’t care who you are … whether you’re the leader of the world’s largest central bank or you’re the CIO of an enormous pension fund or you’re the world’s most successful financial advisor … it’s a terrible mistake to trust econometric models. But we all do, because we’ve been convinced by modeling’s henchman, The Central Tendency.
What is the The Central Tendency? It’s the overwhelmingly widespread and enticing idea that there’s a single-peaked probability distribution associated with everything in life, and that more often than not it looks just like this:
It’s our acceptance of The Central Tendency as The Way The World Works that transforms our healthy respect for econometric modeling into an unhealthy trust in econometric modeling. It’s what creates our unhealthy trust in projections of asset price returns. It’s what creates our unhealthy trust in projections of monetary policy impact.
It also creates an unhealthy trust in the mainstream tools we use to project risk and reward in our investment portfolios.
I’m not saying that The Central Tendency is wrong. I’m saying that it is (much) less useful in a world that is polarized by massive debt and the political efforts required to maintain that debt. I’m saying that it is (much) less useful in a market system where exchanges have been transformed into for-profit data centers and liquidity is provided by machines programmed to turn off when profit margins are uncertain.
These are the two big Epsilon Theory topics of the past year – polarized politics and structurally hollow markets – and I’ll give a few paragraphs on each. Then I’ll tell you what I think you should do about it.
The world is awash in debt, with debt/GDP levels back to 1930 levels and far higher than 2007 levels prior to the Great Recession. What’s different today in 2015 as compared to the beginning of the Great Recession, however, is that governments rather than banks are now the largest owners (and creators!) of that debt. Governments have more tools and time than corporations, households, or financial institutions when it comes to managing debt loads, but the tools they use to kick the can down the road always result in a more polarized electorate. Why? Because the tools of status quo debt maintenance, particularly as they inflate financial asset prices and perpetuate financial leverage, always exacerbate income and wealth inequality. I’m not saying that’s a good thing or a bad thing. I’m not saying that some alternative debt resolution path like austerity or loss assignment would be more or less injurious to income and wealth equality. I’m just observing that whether you’re talking about the 1930s or the 2010s, whether you’re talking about the US, Europe, or China, greater income and wealth inequality driven by government debt maintenance policy simply IS.
Greater income and wealth inequality reverberates throughout a society in every possible way, but most obviously in polarization of electorate preferences and party structure. Below is a visual representation of increased polarization in the US electorate, courtesy of the Pew Research Center. Other Western nations are worse, many much worse, and no nation is immune.
There’s one inevitable consequence of significant political polarization: the center does not hold. Our expectation that The Central Tendency carries the day will fail, and this failure will occur at all levels of political organization, from your local school board to a congressional caucus to a national political party to the overall electorate. Political outcomes will always surprise in a polarized world, either surprisingly to the left or surprisingly to the right. And all too often, I might add, it’s a surprising outcome pushed by the illiberal left or the illiberal right.
The failure of The Central Tendency occurs in markets, as well. Below is a chart of 3-month forward VIX expectations in December 2012, as the Fiscal Cliff crisis reared its ugly head, as calculated by Credit Suisse based on open option positions. If you calculated the average expectations of the market (the go-to move of all econometric models based on The Central Tendency), you’d predict a future VIX price of 19 or so. But that’s actually the least likely price outcome! The Fiscal Cliff outcome might be a policy surprise of government shutdown, resulting in a market bearish equilibrium (high VIX). Or it might be a policy surprise of government cooperation, resulting in a market bullish equilibrium (low VIX). But I can promise you that there was no possible outcome of the political game of Chicken between the White House and the Republican congressional caucus that would have resulted in a market “meh” equilibrium and a VIX of 19.
Whatever shocks emanate from polarized politics, their market impact today is significantly greater than even 10 years ago. That’s because we have evolved a profoundly non-robust liquidity provision system, where trading volumes look fine on the surface and appear to function perfectly well in ordinary times, but collapse utterly under duress. Even in the ordinary times, healthy trading volumes are more appearance than reality, as once you strip out all of the faux trades (HFT machines trading with other HFT machines for rebates, ETF arbitrage, etc.) and positioning trades (algo-driven rebalancing of systematic strategies and portfolio overlays), there’s precious little investment happening today.
Here’s how I think we got into this difficult state of affairs.
First, Dodd-Frank regulation makes it prohibitively expensive for bulge bracket bank trading desks to maintain a trading “inventory” of stocks and bonds and directional exposures of any sort for any length of time. Just as Amazon measures itself on the basis of how little inventory it has to maintain for how little a span of time, so do modern trading desks. There is soooo little risk-taking or prop desk trading at the big banks these days, which of course was an explicit goal of Dodd-Frank, but the unintended consequence is that a major trading counterparty and liquidity provider when markets get squirrelly has been taken out into the street and shot.
Second, the deregulation and privatization of market exchanges, combined with modern networking technologies, has created an opportunity for technology companies to provide trading liquidity on a purely voluntary basis. To be clear, I’m not suggesting that liquidity was provided on an involuntary basis in the past or that the old-fashioned humans manning the old-fashioned order book at the old-fashioned exchanges were motivated by anything other than greed. As Don Barzini would say, “after all, we are not Communists”. But there is a massive and systemically vital difference between the business model and liquidity provision regime (to use a good political science word) of humans operating within a narrowly defined, publicly repeatable game with forced participation and of machines operating within a broadly defined, privately unrepeatable game with unforced participation.
Whatever the root causes, modern market liquidity (like beauty) is only skin deep. And because liquidity is only skin deep, whenever a policy shock hits (say, the Swiss National Bank unpegs the Swiss franc from the euro) or whenever there’s a technology “glitch” (say, when a new Sungard program misfires and the VIX can’t be priced for 10 minutes) everything falls apart, particularly the models that we commonly use to calculate portfolio risk.
For example, here’s a compilation of recent impossible market events across different asset classes and geographies (hat tip to the Barclays derivatives team) … impossible in the sense that, per the Central Tendency on which standard deviation risk modeling is based, these events shouldn’t occur together over a million years of market activity, much less the past 4 years.
Source: Barclays, November 2015.
So just to recap … these market dislocations DID occur, and yet we continue to use the risk models that say these dislocations cannot possibly occur. Huh? And before you say, “well, I’m a long term investor, not a trader, so these temporary market liquidity failures don’t really affect me”, ask yourself this: do you use a trader’s tools, like stop-loss orders? do you use a trader’s securities, like ETFs? If you answered yes to either question, then you can call yourself a long term investor all you like, but you’ve got more than a little trader in you. And a trader who doesn’t pay attention to the modern realities of market structure and liquidity provision is not long for this world.
Adaptive Investing and Aware Investing
Okay, now for the big finish. What does one DO about this? How does one invest in a world of bimodal uncertainty and a market of skin-deep liquidity?
Both of these investment goblins – Political Polarization and the Hollow Market – are so thoroughly problematic because our perceptions of both long-term investment outcomes and short-term trading outcomes are so thoroughly infected by The Central Tendency and a quasi-religious faith in econometric modeling. But while their problematic root cause may be the same, their Epsilon Theory solutions are different. I call the former Adaptive Investing, and I call the latter Aware Investing.
Adaptive Investing focuses on portfolio construction and the failure of The Central Tendency to predict long(ish)-term investment returns. Aware Investing focuses on portfolio trading and the failure of The Central Tendency to predict short(ish)-term investment returns. Each is a crucial concept. Each deserves its own book, much less its own Epsilon Theory note. But this note is going to focus on Adaptive Investing.
Adaptive Investing tries to construct a portfolio that does as well when The Central Tendency fails as when it succeeds. Adaptive Investing expects historical correlations to shift dramatically as a matter of course, usually in a market-jarring way. But this is NOT a tail-risk portfolio or a sky-is-falling perspective. I really, really, really don’t believe in either. What it IS – and the stronger your internal Fredo the harder this concept will be to wrap your head around – is a profoundly agnostic investing approach that treats probabilities and models and predictions as secondary considerations.
I’ll use two words to describe the Adaptive Investing perspective, one that’s a technical term and one that’s an analogy. The technical term is “convexity”. The analogy is “barbell”. In truth, both are metaphors. Both are Narratives. As such, they are applicable across almost every dimension of investing or portfolio allocation, and at almost every scale.
Everyone knows what a barbell is. Convexity, on the other hand, is a daunting term. Let’s un-daunt it.
The basic idea of convexity is that rather than have Portfolio A, where your returns go up and down with a market or a benchmark’s returns in a linear manner, you’d rather have Portfolio B, where there’s a pleasant upward curve to your returns if the market or benchmark does really well or really poorly. The convex Portfolio B performs pretty much the same as the linear Portfolio A during “meh” markets (maybe a tiny bit worse depending on how you’re funding the convexity benefits), but outperforms when markets are surprisingly good or surprisingly bad. A convex portfolio is essentially long some sort of optionality, such that a market surprising event pays off unusually well, which is why convexity is typically injected into a portfolio through the use of out-of-the-money options and other derivative securities. Another way of saying that you’re long optionality is to say that you’re long gamma. If that term is unfamiliar, check out the Epsilon Theory note “Invisible Threads”.
All other things being equal, few people wouldn’t prefer Portfolio B to Portfolio A, particularly if you thought that markets are likely to be surprisingly good or surprisingly bad in the near future. But of course, all other things are never equal, and there are (at least) three big caveats you need to be aware of before you belly up to the portfolio management bar and order a big cool glass of convexity.
Caveat 1: A convex portfolio based on optionality must be an actively managed portfolio, not a buy-and-hold portfolio. There’s no such thing as a permanent option … they all have a time limit, and the longer the time limit the more expensive the option. The clock works in your favor with a buy-and-hold portfolio (or it should), but the clock always works against you with a convex portfolio constructed by purchasing options. That means it needs to be actively traded, both in rolling forward the option if you get the timing wrong, as well as in exercising the option if you get the timing right. Doing this effectively over a long period of time is exactly as impossible difficult and expensive as it sounds.
Caveat 2: A convex portfolio fights the Fed, at least on the left-hand part of the curve where you’re making money (or losing less money) as the market gets scorched. Yes, there are going to be more and more political shocks hitting markets over the next few years, and yes, those shocks are going to be exacerbated by the hollow market and its structurally non-robust liquidity provision. But in reaction to each of these market-wrenching policy and liquidity shocks, you can bet your bottom dollar that every central bank in the world will stop at nothing to support asset price levels and reduce market volatility. Make no mistake – if you’re long down-side protection optionality in your portfolio, you’re also long volatility. That puts you on the other side of the trade from the Fed and the ECB and the PBOC and every other central bank, and that’s not a particularly comfortable place to be. Certainly it’s not a comfortable (or profitable) place to be without a keen sense of timing, which is why, again, a convex portfolio expressed through options and derivatives needs to be actively managed and can’t be a passive buy-and-hold strategy.
Caveat 3: Top-down portfolio risk adjustments like convexity injection through index options or risk premia derivatives are *always* going to disappoint bottom-up stock-picking investors. I’ve written a lot about this phenomenon, from one of the first Epsilon Theory notes, “The Tao of Portfolio Management”, to the more recent “Season of the Glitch”, so I won’t repeat all that here. The basic idea is that it’s a classic logical fallacy to infer characteristics of the whole (in this case the portfolio) from characteristics of the component pieces (in this case the individual securities selected via a bottom-up process), and vice versa. What that means in more or less plain English is that risk-managing individual positions in an effort to achieve a risk-managed overall portfolio is inherently an exercise in frustration and almost always ends in unanticipated underperformance for stock pickers.
Okay, Ben, those are three big problems with implementing convexity in a portfolio. I thought you said this was a good thing.
You’ll notice that each of these three caveats pertain most directly to the largest population of investors in the world – non-institutional investors who create an equity-heavy buy-and-hold portfolio by applying a bottom-up, fundamental, stock-picking perspective. The caveats don’t apply nearly so much to institutional allocators who apply a systematic, top-down perspective to a portfolio that’s typically too large to engage in anything so time-consuming as direct stock-picking. They have no problem employing a staff to manage these portfolio overlays (or hiring external managers who do), and they’re not terrified by the mere notion of negative carry, derivatives, and leverage. These institutional allocators may not be large in numbers, but they are enormous in terms of AUM. I spend a lot of time meeting with these allocators, and I can tell you this – implementing convexity into a portfolio in one way or another is the single most common topic of conversation I’ve had over the past year. Every single one of these allocators is thinking in terms of portfolio convexity, even if most are still in the exploration phase, and you’re going to be hearing more and more about this concept in the coming months.
So that’s all well and good for the CIO of a forward thinking multi-billion dollar pension fund, but what if it’s a non-starter to have a conversation about the pros and cons of a long gamma portfolio overlay with your client or your investment committee? What if you’re a stock picker at heart and you’d have to change your investment stripes (something no one should ever do!) and reconceive your entire portfolio to adopt a top-down convexity approach using derivatives and risk premia and the like?
This is where the barbell comes in.
The basic concepts of Adaptive Investing can be described as placing modest portfolio “weights” or exposures on either side of an investment dimension. This is in sharp contrast to what Johnny Ola has convinced most of us to do, which is to place lots and lots of portfolio weight right in the middle of the bar, with normally distributed tails on either end of the massive weight in the center (i.e., a whopping 5% allocation to “alternatives”). What are these investment dimensions? They are the Big Questions of investing in a world of massive debt maintenace (and are actually very similar to the Big Questions of the 1930s), questions like … will central banks succeed in preventing a global deflationary equilibrium? … is there still a viable growth story in China and in Emerging Markets more broadly, or was it all just a mirage built on post-war US monetary policy? … is there a self-sustaining economic recovery in the US?
Here’s an example of what I’m talking about, a barbell portfolio around the Biggest of the Big Questions in the Golden Age of the Central Banker: will extraordinarily accommodative monetary policy everywhere in the world spur inflationary expectations and growth-supporting economic behaviors? Like all barbell dimensions, there’s really no middle ground on this. In 2016, either the market will be surprised by resurgent global growth / inflation, or the market will be surprised by anemic growth / deflation despite extraordinary monetary policy accommodation. I want to “be there” in my portfolio with modest exposures positioned to succeed in each potential outcome, as opposed to having a big exposure somewhere in the middle that I have to drag in one direction or another when I end up being “surprised” just like the rest of the market.
Specifically, what might those positions look like? Everyone will have a different answer, but here’s mine:
If deflation and low global growth carry the day, then I want to be in yield-oriented securities where the cash flows are tied to real economic activity in geographies with real growth prospects, and where company management is really distributing those cash flows to shareholders directly.
If inflation and resurgent growth carry the day, then I want to be in growth-oriented securities linked to commodities.
And yes, there are companies that can thrive in both environments.
Now of course you’ll get push-back to the notion of a barbell portfolio from your client or investment committee (maybe the investment committee inside your own head), most likely in the form of some variation on these three natural questions:
Q: Wouldn’t you be be better off predicting the winning side of any of these Big Questions and putting all your weight there?
A: Yes, if I had a valid econometric model that could predict whether central banks will fail or succeed at spurring inflationary expectations in the hearts and minds of global investors, then I would definitely put all my portfolio weight on that answer. But I don’t have that model, and neither do you, and neither does the Fed or anyone else. So let’s not pretend that we do.
Q: But if one side of your portfolio barbell ends up being right, that must mean that the other side is wrong. Wouldn’t we be just as well off putting all the weight somewhere in the middle like we usually do?
A: No, that’s not how these politically-polarized investment dimensions play out, with one side clearly winning and one side clearly losing. The underlying dynamics of the Big Questions in investing today are governed by the multi-year spiraling back-and-forth of multiple equilibria games like Chicken, not The Central Tendency (read “Inherent Vice” for some examples). Not only is it far more capital efficient to use a barbell approach, but both sides will do relatively better than the middle. That is, in fact, the entire point of using an allocation approach that creates optionality and effective convexity in a portfolio without forcing the top-down imposition of option and derivative overlays.
Q: But how do we know that you’ve identified the right positions to take on either side of these Big Questions?
A: Well, that’s what you hire me for: to identify the right investments to execute our portfolio strategy effectively. But if we’re not comfortable with selecting specific assets and companies, then we might consider a trend-following strategy. Trend-following is profoundly agnostic. Unlike almost any other strategy you can imagine, trend-following doesn’t embody an opinion on whether something is cheap or expensive, overlooked or underappreciated, poised to grow or doomed to failure. All it knows is whether something is working or not, and it is as happy to be short something as it is to be long something, maybe that same thing under different circumstances. As such, a pure trend-following strategy will automatically move on its own accord from weighting one end of a barbell to the other, spending as little time as possible in the middle, depending on which side is working better. That is an incredibly powerful tool for this investment perspective.
A barbell portfolio captures the essence or underlying meaning of portfolio convexity without requiring top-down portfolio overlays that are either impractical or impossible for many investors. The investments described here have a positive carry, meaning that the clock works in your favor, meaning that – unlike convex strategies that are actively trading options and volatility – these strategies fit well in a buy-and-hold, non-Fed fighting, stock-picking portfolio. I think it’s a novel way of rethinking the powerful notions of convexity and uncertainty so that they fit the real world of most investors, and whether these ideas are implemented or not I’m certain that it’s a healthy exercise for all of us to question the conceptual dominance of The Central Tendency.
You know, Michael Corleone has a great line after he wised up to Fredo’s betrayal and the true designs of Johnny Ola and Hyman Roth: “I don’t feel I have to wipe everybody out … just my enemies.” It’s the same with our portfolios. We don’t have to completely reinvent our investment process to incorporate the valuable notion of convexity into our portfolios. We don’t have to sell out of everything and start fresh in order to adopt an Adaptive Investing perspective. Our investment enemies live inside our own heads. They are the ideas and concepts that we have allowed to hold too great a sway over our internal Fredo, and they can be put in their proper place with a fresh perspective and a questioning mind. Econometric modeling and The Central Tendency don’t need to be eliminated; they need to be demoted from a position of unwarranted trust to a position of respectful but arms-length business relationship. After all, let’s remember the secret of Hyman Roth’s success: he always made money for his partners. I’m happy to be partners with modeling because I think it’s a concept that can make me a lot of money. But I’m never going to trust my portfolio to it.
Mike McDermott: In “Confessions of a Winning Poker Player,” Jack King said, “Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career.” It seems true to me, cause walking in here, I can hardly remember how I built my bankroll, but I can’t stop thinking of how I lost it. – “Rounders” (1998)
I know it’s crooked, but it’s the only game in town. – Canada Bill Jones (c. 1840 – 1880), described as “the greatest three-card monte sharp to ever work the boats”, on being told by his partner George Devol that a Faro game in Cairo, Illinois was rigged.
We’re still down.
How down is she?
Desert Inn Casino Manager:
Desert Inn Casino Manager:
You’re a nice guy. You make me laugh. But our policy is: we can’t give your money back.
– “Lost in America” (1985)
Boredom is the conviction that you can’t change … the shriek of unused capacities. – Saul Bellow, “The Adventures of Augie March” (1953)
Anything becomes interesting if you look at it long enough.
– Gustave Flaubert (1821 – 1880)
She wanted to die, but she also wanted to live in Paris.
– Gustave Flaubert (1821 – 1880)
To me, at least in retrospect, the really interesting question is why dullness proves to be such a powerful impediment to attention. Why we recoil from the dull…surely something must lie behind not just Muzak in dull or tedious places but now also actual TV in waiting rooms, supermarkets’ checkouts, airport gates, SUVs’ backseats. Walkman, iPods, BlackBerries, cell phones that attach to your head. This terror of silence with nothing diverting to do. I can’t think anyone really believes that today’s so-called ‘information society’ is just about information. Everyone knows it’s about something else, way down.
– David Foster Wallace, “The Pale King” (2011)
This is crazy. I finally meet my childhood hero and he’s trying to kill us. What a joke.
Hey, I know a joke! A squirrel walks up to a tree and says, “I forgot to store acorns for the winter and now I am dead.” Ha! It is funny because the squirrel gets dead.
– “Up” (2009)
I’m a good poker player. I know that everyone says that about themselves, so you’ll just have to take my word for it. I’m also a good stock picker, which again is something that everyone says about themselves. At least on this point I’ve got a track record from a prior life to make the case. But I don’t consider myself to be a great poker player or a great stock picker. Why not? Because I get bored with the interminable and rigorous discipline that being a great poker player or a great stock picker requires. And I bet you do, too.
To be clear, it’s not the actual work of poker playing or stock picking that I find boring. I could happily spend every waking moment turning over a new set of cards or researching a new company. And it’s certainly not boring to make a bet, either on a hand or a stock. What’s boring is NOT making a bet on a hand or a stock. What’s boring is folding hand after hand or passing on stock after stock because you know it’s the right thing to do. The investment process that makes a great poker player or a great stock picker isn’t the research or the analysis, even though that’s what gets a lot of the attention. Nor is it the willingness to make a big bet when you believe the table or the market or the world has given you a rare combination of edge and odds, even though that’s what gets even more of the attention. No, what makes for greatness as a stock picker is the discipline to act appropriately on whatever the market is giving you, particularly when you’re being dealt one low conviction hand after another.The hardest thing in the world for talented people is to ignore our mental “shriek of unused capacities”, to use Saul Bellow’s phrase, and to avoid turning a low edge and odds opportunity into an unreasonably high conviction bet simply because we want it so badly and have analyzed the situation so smartly. In both poker and investing, we brutally overestimate the edge and odds associated with merely ordinary opportunities once we’ve been forced by circumstances to sit on our hands for a while.
The biggest challenge of our investing lives is not finding ways to process more information, or even finding ways to process information more effectively. Our biggest challenge is finding the courage to focus on what matters, to admit that more or quicker information will not help our investment decisions, to recognize that our investment discipline suffers mightily at the hands of the impediment of dullness. Because let’s be honest… the Golden Age of the Central Banker is a really, really dull time for a stock-picking investor. I’m not saying that the markets themselves are dull or that market price action is boring. On the contrary, this joint is jumping. I’m saying that stock pickers are being dealt one dull, low conviction hand after another by global Central Banks, even though they’re forced to sit inside a glitzy casino with lots of lights and sounds and exciting gambling action happening all around them.We have little edge in a Reg-FD public market. We have at best unknowable odds and at worst a negatively skewed risk/reward asymmetry in a market where policy shocks abound. And yet we find ways to convince ourselves that we have both edge and odds, making the same concentrated equity bets we made back in happier times when idiosyncratic company fundamentals and catalysts were actually attached to a company’s stock price. Builders build. Drillers drill. Stock pickers pick stocks. We can’t help ourselves, even if the deck is stacked against us here in the only game in town.
Investment discipline suffers under the weight of dullness and low conviction in at least four distinct ways here in the Golden Age of the Central Banker.
First, just as there’s a winner on every poker hand that you sit out, there’s a winner every day in the markets regardless of whether or not you are participating. The business risk of sitting out too many hands weighs heavily on most of us in the asset management or financial advisory worlds. We can talk about maintaining our investment discipline all we like, but the truth is that all of us, in the immortal words of Bob Dylan, gotta serve somebody. If we’re not telling our investors or our board or our CIO that we have high conviction investment ideas … well, they’re going to find someone else who WILL tell them what they want to hear. And for those lucky few of you reading this note blessed with access to more or less permanent capital, I’ll just say that the conversations we have with ourselves tend to be even more pressuring than the conversations we have with others. No one forces me to “make a play” when I have a middle pair and a so-so kicker, but I’ve somehow convinced myself that I can take down a pot just because I’ve been playing tight for the past hour. No one forced Stanley Druckenmiller – one of the truly great investors of our era – to top-tick the NASDAQ bubble when he bought $6 billion worth of Internet stocks in March 2000. Why did he do it?
So, I’ll never forget it. January of 2000 I go into Soros’s office and I say I’m selling all the tech stocks, selling everything. This is crazy at 104 times earnings. This is nuts. Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day and I’m out. It is driving me nuts. I mean their little account is like up 50 percent on the year. I think Quantum was up seven. It’s just sitting there.
So like around March I could feel it coming. I just … I had to play. I couldn’t help myself. And three times during the same week I pick up a phone but don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So maybe I learned not to do it again, but I already knew that.
If living in the NASDAQ bubble can make Stan Druckenmiller convince himself that stocks trading at >100x earnings were a high conviction play only a few months after selling out of them entirely, what chance do we mere mortals have in not succumbing to 6-plus years of the most accommodative monetary policy in the history of man?
Second, every facet of the financial services industry is trying to convince you to play more hands, and we are biologically hard-wired to respond. I don’t have a good answer to Wallace’s question about why we all fear the silence and all feel compelled to fill the void with electronically delivered “information”, but I am certain that the business models of the Big Boy information providers all depend on Flow.So you can count on the “information” that we constantly and willingly beam into our brains being geared to convince us to join the casino fun. My favorite character in the wonderful movie “Up” is Dug the dog, who despite his advanced technological tools is a prisoner of his own biology whenever he hears the signal “Squirrel!”. We are all Dug the dog.
Third, Central Bankers have intentionally sown confusion in our ranks. Like the barkers on CNBC and the sell-side, the Fed and the ECB and the BOJ and the PBOC are determined to force us into riskier investment decisions than we would otherwise choose to make. This is the entire point of extraordinary monetary policy over the past 6 years! All of it. All of the LSAPs, all of the TLTROs, all of the exercises in “Communication Policy” … all of it has been designed with one single purpose in mind: to punish investors who choose to sit on their hands and reward investors who make a bet, all for the laudable goal of preventing a deflationary equilibrium. And as a result we have the most mistrusted bull market in history, a bull market where traditional investment discipline was punished rather than rewarded, and where any investor who hasn’t been totally hornswoggled by Fed communication policy is now rightly worried about having the policy rug pulled out from underneath his feet.
Or to make this point from a slightly different perspective, while there is confusion between the concepts of investing and allocation in the best of times, there is an intentional conflation of the two notions here in the Golden Age of the Central Banker. The Fed wants to turn investors into allocators, and they’ve largely succeeded. That is, the Fed doesn’t care about your picking one stock over another stock or one sector over another sector or one company over another company. They just want to push you out on the risk curve, which for the vast majority of investors just means buying stocks. Any stock. All stocks. This is why the quality bias that most investors have – preferring solid management, strong balance sheets, and good cash flow generation to their opposites – has been largely immaterial as an investment factor (if not an outright drag on investment returns) over the past 6 years. If the King is flooding the town with easy credit, the deadbeat tailor will do relatively better than the thrifty mason every time. But try telling a true-believer that quality is just an investment factor, no more (and no less) privileged than any other investment factor. Honestly, I’ll get 50 unsubscribe emails just for writing this down.
Fourth, our small-number brains are good local data relativists, not effective cross-temporal or global data evaluators. Okay, that’s a mouthful. Translation: the human brain has evolved over millions of years and human society has been trained for tens of thousands of years to make sense of highly localized data patterns. Humans are excellent at prioritizing the risks and opportunities that they are paying attention to at any moment in time, and excellent at allocating their behavioral budget accordingly. It’s why we’re really good at driving cars or, in primate days of yore, surviving on the Serengeti plains. But if asked to compare the risks and rewards of a current decision opportunity with the risks and rewards of a decision opportunity last year (much less 10 years ago), or if asked to compare the opportunity we’ve been evaluating for months with something less familiar, we are utterly flummoxed. It’s not that we can’t remember or think on our feet, but there is an overwhelming attention and recency bias in human decision-making. That’s fine so long as we share the market with other humans, much less fine when we share the market with machine intelligences that excel at the information processing tasks we consistently flub. Whether it’s trading or investing, humans are no longer the apex predator in capital markets, but we act as if we are.
So what’s an investor to do?
I can sum it up in one deceptively simple sentence: You take what the market gives you.
It’s deceptively simple because it implies a totally different perspective on markets than most investors (or allocators, frankly) bring to bear. It means approaching markets from a position of humility, i.e. risk tolerance, rather than from a position of hubris, i.e. return expectations. It’s all well and good to tell your financial advisor or your board or yourself that you’re “targeting an 8% return.” That’s great. I understand that’s your desire. But the market couldn’t care less what your desire might be. I think it’s so important to stop focusing on our “expectations” of the market, as if it were some unruly teenager that needs to get its act together and start doing what it’s told. It’s madness to anthropomorphize the market and believe that we can control it or predict its behavior. Instead, we need to focus on what we CAN control and what we CAN predict, which is our own reaction to what a stochastically-dominated social system like the market is going to throw at us over time. Tell me what your risk tolerance is. Tell me what path you’re comfortable walking. Then we can talk about the uncorrelated stepping stone strategies that will make up that path to get you where you want to go. Then we can talk about sticking to the path, which far more often means keeping risk in the portfolio than taking it out. Then we can talk about adaptively allocating between the stepping stone strategies as the risk they generate today differs from the risk they generated in the past. Maybe you’ll get lucky and one of the strategies will crush it, like US equities did in 2013. Excellent! But aren’t we wise enough to distinguish allocation luck from investment skill? I keep asking myself that rhetorical question, but I’m never quite happy with the answer.
You know, there’s this mythology around poker tournaments that the path to success is a succession of all-in bets where you “read” your opponent and make some seemingly brilliant bluff or call. I’m sure this mythology is driven by the way in which poker tournaments are televised, where viewers see a succession of exactly this sort of dramatic moment, complete with commentary attributing deep strategic thoughts to every action. What nonsense. The goal of great poker players is NEVER to go all-in. Going all-in is a failure of risk management, not a success. I’m exaggerating when it comes to poker, because the nice thing about poker tournaments is that there’s always another one. But I’m not exaggerating when it comes to investing. There’s only one Nest Egg (“Lost In America” is by far my favorite Albert Brooks movie), and thinking about investing and allocation through the lens of risk tolerance rather than return expectations is the best way I know to grow and keep that Nest Egg.
Taking What The Market Gives You has specific implications for each of the four ways in which the Golden Age of the Central Banker weakens investor discipline.
1) For the business risk associated with maintaining a stock-picking discipline and sitting out an equity market that you just don’t trust … it means taking complementary non-correlated strategies into your portfolio, as well as strategies that have positive expected returns but can make money when equities go down (like trend-following strategies or government bonds). It rarely means going to cash. (For more, see “It’s Not About the Nail”)
2) For the constant exhortations from the financial media and the sell-side to try a new game at the market casino … it means taking what you know. It means taking what you know the market is giving you because you have direct experience with it, not taking what other people are telling you that the market is giving you. Here’s my test: if I hear a pitch for a stock or a strategy and I find myself looking around the room (either literally or metaphorically) to see how other people are reacting to the pitch, then I know that I’m being sucked into the Common Knowledge Game. I know that I’m at risk of playing a hand I shouldn’t. (For more, see “Wherefore Art Thou, Marcus Welby?”)
3) For the communication policy of the Fed and the soul-crushing power of a risk-free rate that pays absolutely nothing … it means taking stocks that get as close as possible to real-world economic growth and real-world cash flows in order to minimize the confounding influence of Central Bankers and the game-playing that surrounds them. There’s nowhere to hide completely, as the volatility virus that started with the end of global monetary policy coordination in the summer of 2014 will eventually spread everywhere, but there’s no better place to ride out the storm than getting close to actual cash flows of companies that are determined to return those cash flows to investors. (For more, see “Suddenly Last Summer”)
4) For the transformation of the market jungle into a machine-dominated ecosystem … it means either adopting the same market perspective as a machine intelligence through systematic asset allocation strategies, or it means focusing on niche areas of the market where useful fundamental information is not yet aggregated for the machines. In either case, it means leaving behind the quaint notion that you can do fundamental analysis on large cap public companies and somehow gain an edge or identify attractive odds. (For more, see “One MILLION Dollars”)
One final point, and it’s one that seems particularly apropos after watching some bloodbaths in certain stocks and sectors over the past week or two. Investor discipline isn’t only the virtue of great investors when it comes to buying stocks. It’s also the virtue of great investors when it comes to selling stocks. I started Epsilon Theory a little more than two years ago in the midst of a grand bull market that I saw as driven by Narrative and policy rather than a self-sustaining recovery in the real economy. For about a year, I got widespread pushback on that notion. Today, it seems that everyone is a believer in the Narrative of Central Bank Omnipotence. What I find most interesting, though, is that not only is belief in this specific Narrative widespread, but so is belief in the Epsilon Theory meta-Narrative … the Narrative that it is, in fact, Narratives that drive market outcomes of all sorts. My hope, and at this point it’s only a hope, is that this understanding of the power of Narratives will inoculate a critical mass of investors and allocators from this scourge. Because the same stories and Narratives and low conviction hands that shook us out of our investment discipline on the way up will attack us even more ferociously on the way down.
When I look over my shoulder What do you think I see? Some other cat lookin’ over His shoulder at me.
– Donovan, “Season of the Witch” (1966)
I see why you like this video camera so much.
It’s not quite reality. It’s like a totally filtered reality. It’s like you can pretend everything’s not quite the way it is.
– “The Blair Witch Project” (1999)
Over the past two months, more than 90 Wall Street Journal articles have used the word “glitch”. A few choice selections below:
Bank of New York Mellon Corp.’s chief executive warned clients that his firm wouldn’t be able to solve all pricing problems caused by a computer glitch before markets open Monday.
– “BNY Mellon Races to Fix Pricing Glitches Before Markets Open Monday”, August 30, 2015
A computer glitch is preventing hundreds of mutual and exchange-traded funds from providing investors with the values of their holdings, complicating trading in some of the most widely held investments.
– “A New Computer Glitch is Rocking the Mutual Fund Industry”, August 26, 2015
Bank says data loss was due to software glitch.
– “Deutsche Bank Didn’t Archive Chats Used by Some Employees Tied to Libor Probe”, July 30, 2015
NYSE explanation confirms software glitch as cause, following initial fears of a cyberattack.
– “NYSE Says Wednesday Outage Caused by Software Update”, July 10, 2015
Some TD Ameritrade Holding Corp. customers experienced delays in placing orders Friday morning due to a software glitch, the brokerage said..
– “TD Ameritrade Experienced Order Routing, Messaging Problems”, July 10, 2015
Thousands of investors with stop-loss orders on their ETFs saw those positions crushed in the first 30 minutes of trading last Monday, August 24th. Seeing a price blow right through your stop is perhaps the worst experience in all of investing because it seems like such a betrayal. “Hey, isn’t this what a smart investor is supposed to do? What do you mean there was no liquidity at my stop? What do you mean I got filled $5 below my stop? Wait… now the price is back above my stop! Is this for real?” Welcome to the Big Leagues of Investing Pain.
What happened last Monday morning, when Apple was down 11% and the VIX couldn’t be priced and the CNBC anchors looked like they were going to vomit, was not a glitch. Yes, a flawed SunGard pricing platform was part of the proximate cause, but the structural problem here – and the reason this sort of dislocation WILL happen again, soon and more severely – is that a vast crowd of market participants – let’s call them Investors – are making a classic mistake. It’s what a statistics professor would call a “category error”, and it’s a heartbreaker.
Moreover, there’s a slightly less vast crowd of market participants – let’s call them Market Makers and The Sell Side – who are only too happy to perpetuate and encourage this category error. Not for nothing, but Virtu and Volant and other HFT “liquidity providers” had their most profitable day last Monday since … well, since the Flash Crash of 2010. So if you’re a Market Maker or you’re on The Sell Side or you’re one of their media apologists, you call last week’s price dislocations a “glitch” and misdirect everyone’s attention to total red herrings like supposed forced liquidations of risk parity strategies. Wash, rinse, repeat.
The category error made by most Investors today, from your retired father-in-law to the largest sovereign wealth fund, is to confuse an allocation for an investment. If you treat an allocation like an investment… if you think about buying and selling an ETF in the same way that you think about buying and selling stock in a real-life company with real-life cash flows… you’re making the same mistake that currency traders made earlier this year with the Swiss Franc (read “Ghost in the Machine” for more). You’re making a category error, and one day – maybe last Monday or maybe next Monday – that mistake will come back to haunt you.
The simple fact is that there’s precious little investing in markets today – understood as buying a fractional ownership position in the real-life cash flows of a real-life company – a casualty of policy-driven markets where real-life fundamentals mean next to nothing for market returns. Instead, it’s all portfolio positioning, all allocation, all the time. But most Investors still maintain the pleasant illusion that what they’re doing is some form of stock-picking, some form of their traditional understanding of what it means to be an Investor. It’s the story they tell themselves and each other to get through the day, and the people who hold the media cameras and microphones are only too happy to perpetuate this particular form of filtered reality.
Now there’s absolutely nothing wrong with allocating rather than investing. In fact, as my partners Lee Partridge and Rusty Guinn never tire of saying, smart allocation is going to be responsible for the vast majority of public market portfolio returns over time for almost all investors. But that’s not the mythology that exists around markets. You don’t read Barron’s profiles about Great Allocators. No, you read about Great Investors, heroically making their stock-picking way in a sea of troubles. It’s 99% stochastics and probability distributions – really, it is – but since when did that make a myth less influential? So we gladly pay outrageous fees to the Great Investors who walk among us, even if most of us will never enjoy the outsized returns that won their reputations. So we search and search for the next Great Investor, even if the number of Great Investors in the world is exactly what enough random rolls of the dice would produce with Ordinary Investors. So we all aspire to be Great Investors, even if almost all of what we do – like buying an ETF – is allocating rather than investing.
The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug.
What we saw last Monday morning was a specific manifestation of the behavioral fallacy of a category error, one that cost a lot of Investors a lot of money. Investors routinely put stop-loss orders on their ETFs. Why? Because… you know, this is what Great Investors do. They let their winners run and they limit their losses. Everyone knows this. It’s part of our accepted mythology, the Common Knowledge of investing. But here’s the truth. If you’re an Investor with a capital I (as opposed to a Trader with a capital T), there’s no good reason to put a stop-loss on an ETF or any other allocation instrument. I know. Crazy. And I’m sure I’ll get 100 irate unsubscribe notices from true-believing Investors for this heresy. So be it.
Think of it this way… what is the meaning of an allocation? Answer: it’s a return stream with a certain set of qualities that for whatever reason – maybe diversification, maybe sheer greed, maybe something else – you believe that your portfolio should possess. Now ask yourself this: what does price have to do with this meaning of an allocation? Answer: very little, at least in and of itself. Are those return stream qualities that you prize in your portfolio significantly altered just because the per-share price of a representation of this return stream is now just below some arbitrary price line that you set? Of course not. More generally, those return stream qualities can only be understood… should only be understood… in the context of what else is in your portfolio. I’m not saying that the price of this desired return stream means nothing. I’m saying that it means nothing in and of itself. An allocation has contingent meaning, not absolute meaning, and it should be evaluated on its relative merits, including price. There’s nothing contingent about a stop-loss order. It’s entirely specific to that security… I want it at this price and I don’t want it at that price, and that’s not the right way to think about an allocation.
One of my very first Epsilon Theory notes, “The Tao of Portfolio Management,” was on this distinction between investing (what I called stock-picking in that note) and allocation (what I called top-down portfolio construction), and the ecological fallacy that drives category errors and a whole host of other market mistakes. It wasn’t a particularly popular note then, and this note probably won’t be, either. But I think it’s one of the most important things I’ve got to say.
Why do I think it’s important? Because this category error goes way beyond whether or not you put stop-loss orders on ETFs. It enshrines myopic price considerations as the end-all and be-all for portfolio allocation decisions, and it accelerates the casino-fication of modern capital markets, both of which I think are absolute tragedies. For Investors, anyway. It’s a wash for Traders… just gives them a bigger playground. And it’s the gift that keeps on giving for Market Makers and The Sell Side.
Why do I think it’s important? Because there are so many Investors making this category error and they are going to continue to be, at best, scared out of their minds and, at worst, totally run over by the Traders who are dominating these casino games. This isn’t the time or the place to dive into gamma trading or volatility skew hedges or liquidity replenishment points. But let me say this. If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily “news”. You’re going to be whipsawed mercilessly by these Hollow Markets, especially now that the Fed and the PBOC are playing a giant game of Chicken and are no longer working in unison to pump up global asset prices.
One of the best pieces of advice I ever got as an Investor was to take what the market gives you. Right now the market isn’t giving us much, at least not the sort of stock-picking opportunities that most Investors want. Or think they want. That’s okay. This, too, shall pass. Eventually. Maybe. But what’s not okay is to confuse what the market IS giving us, which is the opportunity to make long-term portfolio allocation decisions, for the sort of active trading opportunity that fits our market mythology. It’s easy to confuse the two, particularly when there are powerful interests that profit from the confusion and the mythology. Market Makers and The Sell Side want to speed us up, both in the pace of our decision making and in the securities we use to implement those decisions, and if anything goes awry … well, it must have been a glitch. In truth, it’s time to slow down, both in our process and in the nature of the securities we buy and sell. And you might want to turn off the TV while you’re at it.
The Gross-out: the sight of a severed head tumbling down a flight of stairs. It’s when the lights go out and something green and slimy splatters against your arm.
The Horror: the unnatural, spiders the size of bears, the dead waking up and walking around. It’s when the lights go out and something with claws grabs you by the arm.
And the last and worst one: Terror, when you come home and notice everything you own has been taken away and replaced by an exact substitute. It’s when the lights go out and you feel something behind you, you hear it, you feel its breath against your ear, but when you turn around, there’s nothing there.
– Stephen King
You’re gonna need a bigger boat.
– “Jaws” (1975)
Back in my portfolio manager days, I was a really good short seller. I say that as a factual observation, not a brag, as it’s not a skill set that’s driven by some great intellectual or character virtue. On the contrary, most short sellers are, like me, highly suspicious of all received wisdom (even when it is, in fact, wise) and have weirdly over-developed egos that feed on the notion of “I’m right even though the world says I’m wrong”. But what set me apart as a short seller were two accidents of experience. First, I didn’t come out of Wall Street, so I wasn’t infected with the long-bias required of those business models. Second, my professional career prior to investing was all about studying mass behaviors and the informational flows that drive those behaviors.
Here’s why that’s important. The biggest difference between shorting and going long is that shorts tend to work in a punctuated fashion. One day I’ll write a full note on the Information Theory basis for this market fact, but the intuition is pretty simple. There’s a constant flow of positive information around both individual stocks (driven by corporate management) and the market as a whole (driven by the sell-side), and as a result the natural tendency of prices is a slow grind up. But occasionally you’ll receive an informational shock, which is almost always a negative, and the price of a stock or the overall market will take a sharp, punctuated decline. The hardest decision for a short seller is what to do when you get this punctuated decline. Do you cover the short, pocket a modest gain, and look to re-establish the position once it grinds higher, as it typically does? Or do you press the short on this informational validation for your original negative thesis? It’s an entirely different mindset than that of most long-only investors, who – because they have the luxury of both time and informational flow on their side – not only tend to add to their positions when the stock is working (my thesis is right, and I’m raising my target price!) but also tend to add when it’s not working (my thesis is right, and this stock is on sale!).
Solving the short seller’s dilemma requires answering one simple question: is the story broken?Is the informational shock sufficient to force long-only investors to doubt not just their facts, but – much more crucially – their beliefs, thus turning them into sellers, too? The facts of the informational shock are almost immaterial in resolving the short seller’s dilemma. Your personal beliefs about those facts are certainly immaterial. The only thing that matters is whether or not the river of information coming out of the sell-side has shifted course in a way that swamps the old belief structures and establishes new Common Knowledge.
In the meantime, what we’ve been experiencing in markets is the plain and simple fear that always accompanies a broken story. The human reaction to a broken story is an emotional response akin to a sudden loss of faith. It’s a muted form of what Stephen King defined as Terror … the sudden realization that the helpful moorings you took for granted are actually not supporting you at all, but are at best absent and at worst have been replaced by invisible forces with ill intent. The antidote to Terror? Call the boogeyman by his proper name. It’s the end of the China growth story, one of the most powerful investment Narratives of the past 20 years. And that’s very painful, as the end of something big and powerful always is. It will require investors to adapt and adjust if they want to thrive. But it’s not MORE than that. It’s not a sign of the investment apocalypse. It’s the end of one investable story, soon to be replaced with another investable story. Because that’s what we humans do.
Here’s a great illustration of what fear looks like in markets, courtesy of Salient’s Deputy CIO and all-around brilliant guy, Rusty Guinn.
These are the cumulative pro forma (i.e., purely hypothetical) returns generated by selling (shorting) the high volatility S&P 500 stocks and buying an off-setting amount of the low volatility stocks (0% net exposure, 200% gross exposure). The factor is up 10% YTD and 15% from the lows in May. Now just to be clear, this is not an actual investment strategy, but is simply a tool we use to identify what factors are working in the market at any point in time. There are any number of ways to construct this indicator, but they all show the same thing – investors have been embracing low volatility (low risk) stocks ever since Greece started to break the European stability story this summer, and that dynamic has continued with the complete breakdown of the China growth story. This is what a flight to safety looks like when you don’t trust bonds because you think the Fed is poised for “lift-off”. This is the fear factor.
Three final Narrative-related points…
First, while the breakdown in the China growth story has reached a tipping point over the past week, this is just the culmination in what has been a two year deterioration of the entire Emerging Market growth story. The belief system around EM’s has been crumbling ever since the Taper Tantrum in the summer of 2013, and it’s the subject of one of the most popular Epsilon Theory notes, “It Was Barzini All Along”. Everything I wrote then is even more applicable today.
Second, I see very little weakness in either the US growth story (best house in a bad neighborhood, mediocre growth but zero chance of recession) or the Narrative of Central Bank Omnipotence. Do I think that the Fed is being stymied in its desire to raise short rates in order to reload its monetary policy gun with conventional ammo? Yes, absolutely. Do I see a significant diminution in the overwhelming investor belief that the Fed and the ECB control market outcomes? No, I don’t. Trust me, I’m keeping my eyes peeled (see “When Does the Story Break?”), because in many respects this is the only question that matters. If this story breaks, then in the immortal words of Chief Brody when he first saw the shark, “You’re gonna need a bigger boat.”
Third, while I’m relatively sanguine about the China growth story breaking down, as I’m confident that there’s a value story waiting in the wings here, I’ll be much more nervous if the China political competence story continues to deteriorate. This is a completely different Narrative than the growth story, and it’s the story that one-party States rely on to prevent even the thought of a viable political opposition. In highly authoritarian one-party nations – like Saddam’s Iraq or the Shah’s Iran – you’ll typically see the competence Narrative focused on the omnipresent secret police apparatus. In less authoritarian one-party nations – like Lee Kuan Yew’s Singapore or Deng Xiaoping’s China – the competence Narrative is more often based on delivering positive economic outcomes to a wide swath of citizens (not that these regimes are a slouch in the secret police department, of course).From a political perspective, this competence Narrative is THE source of legitimacy and stability for a one-party State. In a multi-party system, you can vote the incompetents (or far more likely, the perceived incompetents) out of office and replace them peacefully with another regime. That’s not an option in a one-party State, and if the competency story breaks the result is always a very dicey and usually a violent power transition. I am seeing more and more trial balloons being floated in the Western media (usually with some sort of Murdoch provenance) that indicate “dissatisfaction” with this or that cadre. And it’s not just a markets story any more, as grumblings over the Tianjin fire disaster appear to me to have grown louder over the past week. I haven’t seen this sort of signaling coming out of China in 20 years, and it certainly bears close watching.
War is too important to be left to the generals. – Georges Clemenceau (1841 -1929)
Competition has been shown to be useful up to a certain point and no further, but cooperation, which is the thing we must strive for today, begins where competition leaves off. … If we call the method regulation, people will hold up their hands in horror and say ‘un-American’ or ‘dangerous.’ But if we call the same process cooperation these same old fogeys will cry out ‘well done.’ – Franklin Roosevelt (1882 – 1945)
The New Yorker magazine’s cartoons of the plump, terrified Wall Streeter were accurate; business was terrified of the president. But the cartoons did not depict the consequences of that intimidation: that businesses decided to wait Roosevelt out, hold on to their cash, and invest in future years.
– Amity Shlaes, “The Forgotten Man” (2007)
Quite possibly the TVA idea is the greatest single American invention of this century, the biggest contribution the United States has yet made to society in the modern world. – John Gunther, “Inside USA” (1947)
This is the greatest advertising opportunity since the invention of cereal. We have six identical companies making six identical products. We can say anything we want. How do you make your cigarettes?
Lee Garner, Jr.:
I don’t know.
Lee Garner, Sr.:
Shame on you. We breed insect repellant tobacco seeds, plant them in the North Carolina sunshine, grow it, cut it, cure it, toast it…
There you go. There you go.
[Writes on chalkboard and underlines: “IT’S TOASTED.”]
Lee Garner, Jr.:
But everybody else’s tobacco is toasted.
No. Everybody else’s tobacco is poisonous. Lucky Strikes…is toasted.
– “Mad Men: Smoke Gets inYour Eyes” (2007)
“How the Children Played at Slaughtering,” for example, stays true to its title, seeing a group of children playing at being a butcher and a pig. It ends direly: a boy cuts the throat of his little brother, only to be stabbed in the heart by his enraged mother. Unfortunately, the stabbing meant she left her other child alone in the bath, where he drowned. Unable to be cheered up by the neighbours, she hangs herself; when her husband gets home, “he became so despondent that he died soon thereafter”. – The Guardian, “Grimm Brothers’ Fairytales have Blood and Horror Restored in New Translation” November 12, 2014
The California Public Employees’ Retirement System said it missed its return target by a wide margin, hurt by a sluggish global economy and an under-performing private equity portfolio. The nation’s largest public pension fund said its investments returned just 2.4% for its fiscal year, ended June 30, far below its 7.5% investment target. – Los Angeles Times, “CalPERS Misses Its Target Return by a Wide Margin” July 13, 2015
When a market malfunctions, the government should not let market sentiment turn from bad to worse. It should use powerful measures to strengthen market confidence. – The People’s Daily (official China newspaper), July 20, 2015
My favorite scene from Mad Men is the picnic scene from Season 2. The Draper family enjoys a lovely picnic at some park, and at the conclusion of the meal Don tosses his beer cans into the bushes and Betty just flicks the blanket and leaves all the trash right there on the grass. Shocking, right? I know this is impossible for anyone under the age of 30 to believe, but this is EXACTLY what picnics were like in the 1960’s, even if a bit over the top in typical Draper fashion. There was no widespread concept of littering, much less recycling and all the other green concepts that are second nature to my kids. I mean … if I even thought about Draper-level littering at a Hunt picnic today my children would consider it to be an act of rank betrayal and sheer evil. I’d be disowned before they called the police and had me arrested.
Like many of us who were children in a Mad Men world, I can remember the moment when littering became a “thing”, with the 1971 public service commercial of an American Indian (actually an Italian actor) shedding a tear at the sight of all the trash blighting his native land. Powerful stuff, and a wonderful example of the way in which Narrative construction can change the fundamental ways our society sees the world, setting in motion behaviors that are as second nature to our children as they were unthinkable to our parents. It’s barely noticeable as it’s happening, but one day you wake up and it’s hard to remember that there was a time when you didn’t believe that littering was a crime against humanity.
This dynamic of change in meaning is rare, but it takes place more often than you might think. Dueling and smoking are easy examples. Slavery is, too. Myths and legends turned into nursery rhymes and fairy tales is one of my favorite examples, as is compulsory public education … a concept that didn’t exist until the Prussian government invented it to generate politically indoctrinated soldiers who could read a training manual. Occasionally – and only when political systems undergo the existential stress of potential collapse – this dynamic of change impacts the meaning of the Market itself, and I think that’s exactly what’s taking place today. Through the magic of Narrative construction, capital markets are being transformed into political utilities.
It’s not a unique occurrence. The last time investors lived through this sort of change in what the market means was the 1930s, and it’s useful to examine that decade’s events more closely, in a history-rhyming sort of way. What’s less useful, I think, is to spend our time arguing about whether this transformation in market meaning is a good thing or a bad thing. It is what it is, and the last thing I want to be is a modern day version of one of those grumpy old men who railed about how Roosevelt was really the Anti-Christ. What I will say, though (and I promise this will be my last indication of moral tsk-tsking, for this note anyway), is that I have a newfound appreciation for why they were grumpy old men, and I feel keenly a sense of loss for the experience of markets that I suspect my children will never enjoy as I have. I suspect they will never suffer in their experience of markets as I have, either, but there’s a loss in that, as well.
It’s totally understandable why status quo political interests would seek to transform hurly-burly capital markets into a stable inflation-generation utility, as summed up in the following two McKinsey charts.
Both of these charts can be found in the February 2015 McKinsey paper, “Debt and (not much) deleveraging”, well worth your time to peruse. Keep in mind that the data used here is from Q2 2014, back when Greece was still “fixed”, the Fed had not proclaimed its tightening bias, and China was still slowing gracefully. All of these numbers are worse today, not better.
So what do the numbers tell us? Two things. First, there’s more debt in the world today than before the Great Recession kicked off in 2008. All the deleveraging that was supposed to happen … didn’t. Sure, it’s distributed slightly differently, both by sector and by geography – and that’s critically important for the political utility thesis here – but whatever overwhelming debt levels you thought triggered a super-cyclical, structural recession then … well, you’ve got more of it now. Second, it’s impossible to grow our way out of these debt levels. Japan, France and Italy would have to more than double their current GDP growth rates (and again, these are last year’s more optimistic projections) to even start to grow their way out of debt. Right. Good luck with that. Spain needs a triple. Even the US, the best house in a bad neighborhood, needs >3% growth from here to eternity to start making a dent in its debt. Moreover, every day you don’t achieve these growth levels is a day that the debt load gets even larger. These growth targets are a receding target, soon to be well out of reach for every country on Earth.
The intractable problem with these inconvenient facts is that there are only three ways to get out from under a massive debt. You can grow your way out, you can inflate your way out, or you can shrink your way out through austerity and/or assignment of losses. Door #1 is now effectively impossible for most developed economies. Door #3 is unacceptable to any status quo regime. So that leaves Door #2. The ONLY way forward is inflation, so that’s what it’s going to be. There is no Plan B. What sort of inflation is most amenable to modern political influence? Financial asset inflation, by a wide margin. Inflation in the real economy depends on real investment decisions by real businesses, and just as in the 1930s most business decision makers are sitting this one out, thank you very much. Or just as in the 1930s they’re “investing” in stock buy-backs and earnings margin improvement, which doesn’t help real world inflation at all. What political institutions are most capable of promoting inflation? Central banks, again by a wide margin. Just as in the 1930s, almost every developed economy in the world has a highly polarized electorate and an equally polarized legislature. The executive may be willing, but the government is weak. Far better to wage the inflation wars from within the non-elected walls of the Eccles Building rather than the White House.
Now … how to wage that inflation war with the proper Narrative armament? No one wants inflation in the sense of “runaway inflation”, to use the phrasing of doomsayers everywhere. In fact, unless you’re speaking apparatchik to apparatchik, you don’t want to use the word “inflation” at all. It’s just like Roosevelt essentially banning the word “regulation” from his Cabinet’s vocabulary. Don’t call it “regulation”. Call it “cooperation”, Roosevelt said, and even the grumpy old men will applaud. So today China calls it a “market malfunction” when their stock market deflates sharply (of course, inflating sharply is just fine). Better fix that malfunctioning machine! How can you argue with that language? But at least the political mandarins in the East are more authentic with their words than the political mandarins in the West. Here we now call market deflation by the sobriquet “volatility”, as in “major market indices suffered from volatility today, down almost one-half of one percent”, where a down day is treated as something akin to the common cold, a temporary illness with symptoms that we can shrug off with an aspirin or two. You can’t be in favor of volatility, surely. It’s a bad thing, almost on a par with littering. No, we want good things and good words, like “wealth effect” and “accommodation” and “stability” and “price appreciation”. As President Snow says in reference to The Hunger Games version of a political utility, “may the odds be always in your favor”. Who doesn’t want that?
There are two problems with the odds being always in your favor.
First, the casino-fication of markets ratchets up to an entirely new level of pervasiveness and permanence. By casino-fication I mean the transformation of the meaning of market securities from a partial ownership interest in the real-life cash flows of real-life companies to a disembodied symbol of participation in a disembodied game. Securities become chips, pure and simple. Now there’s nothing new in this gaming-centric vision of what markets mean; it’s been around since the dawn of time. My point is that with the “innovation” of ETF’s and the regulatory and technological shifts that allow HFTs and other liquidity game-players to dominate the day-to-day price action in markets, this vision is now dominant. There’s so little investing today. It’s all positioning. And in a capital-markets-as-political-utility world, the State is now actively cementing that view. After World War I, French Prime Minister Georges Clemenceau famously said that war was too important to be left to the generals, meaning that politicians would now take charge. Today, the pervasive belief in every capital in the world is that markets are too important to be left to the investors. These things don’t change back. Sorry.
Second, if you’re raising the floor on what you might suffer in the way of asset price deflation, you are also lowering the ceiling on what you might enjoy in the way of asset price inflation. That’s what investing in a utility means – you’re probably not going to lose money, but you’re not going to make a lot of money, either. So to all of those public pension funds who are wringing their hands at this fiscal year’s meager returns, well below what they need to stay afloat without raising contributions, I say get used to it. All of your capital market assumptions are now at risk, subject to the tsunami force of status quo politicians with their backs up against the debt wall. Their market-as-utility solution isn’t likely to go bust in a paroxysm of global chaos, any more than it’s likely to spark a glorious age of reinvigorated global growth. Neither the doomsday scenario nor the happy ending is likely here, I think. Instead, it’s what I’ve called the Entropic Ending, a long gray slog where a recession is as unthinkable as a 4% growth rate. It’s a very stable political equilibrium. Sorry.
As the title of this note suggests, we’ve been down this road before in the 1930s. But the historical rhyming I see is not so much in the New Deal policies that directly impacted the stock market as it is in the policies that established a real-life utility, the Tennessee Valley Authority (TVA). That’s because the nature of the existential threat posed by overwhelming debt to the US political system was different in the 1930s than it is today. When FDR took office, the flash point of that systemic threat was the labor market, not the capital market. Sure, the stock market took its hits in the Great Depression, but the relevance of the stock market to either the overall economic health of the country or – more importantly to FDR – his ability to remain in office was dwarfed by the relevance of the labor market. It’s another one of those changes in meaning that seems bizarre to the modern eye or ear. What, you mean there wasn’t 24/7 coverage of financial markets in 1932? You mean that most Americans didn’t really know what a stock certificate was, much less own one? To succeed politically, Roosevelt had to change the meaning of the labor market, not the capital market, and that’s exactly what he did with the creation of the TVA.
The TVA was only one effort in an alphabet soup of New Deal policies that FDR rammed through in his first Administration to change the popular conception of what the labor market meant to Americans. Other famous initiatives included the National Recovery administration (NRA) and the Civilian Conservation Corps (CCC), and the common thread in all of these efforts was a VERY active Narrative management embedded in their process from the outset, with photographers and journalists hired by the White House to document the “success” of the programs. Everything I write in Epsilon Theory about today’s pervasive Narrative construction also took place in the 1930s, in amazingly similar venues and formats, down to the specific words used.
The Narrative effort worked. Not necessarily in the permanence of the institutions FDR established (the Supreme Court declared the NRA unconstitutional in 1935, and the CCC faded into obscurity with the outbreak of World War II), but in the complete reshaping of what the labor market meant to Americans and what government’s proper role within the labor market should be. Yes, there were important things lost in FDR’s political achievements (and plenty of grumpy old men to complain about that), but let’s not forget that he was re-elected THREE times on the back of these labor market policies. If that’s not winning, I don’t know what is. And if you don’t think that lesson from history hasn’t been absorbed by both Clinton™ and Bush™, you’re living in a different world than I am.
One last point on the TVA. It’s still around today as a very powerful and oddly beloved institution, and I think its lasting political success is due in large part to the fact that it – unlike the other alphabet soup institutions – was explicitly a utility. Who doesn’t like the stability of a utility in the midst of vast inequality? Who doesn’t like the odds being ever in their favor? The more that I see today’s policy impact on markets described in utility-like terms – words like “stability” and notions like “volatility is bad and a thing to be fixed” – the more confident I am that the TVA political experience of the 1930s is coming soon to the capital markets of today. Scratch that. It’s already here.
So, Ben, let’s assume you’re right and that current events are rhyming with the historical events of the last time the world wrestled with an overwhelming debt load. Let’s assume that a politically popular shift in the meaning of markets to cement its public utility function is taking shape and won’t reverse itself without a political shock of enormous proportions. What’s an investor or allocator to do, other than become a grumpy old man? Look, the hardest thing in the world is to recognize structural change when you’re embedded in the structure. If reading Epsilon Theory has given you a new set of lenses to see the relationship between State and Market, then you’ve already done the heavy lifting. From here, it’s a matter of applying that open-eyed perspective to your portfolio, not of buying this or selling that! Everyone will be different in their particular application, but I think everyone should have three basic goals:
re-evaluate your capital market assumptions for a further transformation of those markets into state-run casinos and political utilities, understanding that whatever crystal ball you’ve used in the past is almost certainly broken today;
adopt an investment process or find investment strategies that can adapt to the structural changes that are already underway in capital markets, understanding that the patterns of belief and meaning we think are “natural” today can change in the blink of a central banker’s eye.