Wage Inflation Isn’t Coming. It’s Already Here.


George Soros has a great line that we’ve used a lot in Epsilon Theory notes. When he was asked how he could possibly have predicted what would happen when he famously “broke the Bank of England” in 1992, he replied in that growly Hungarian voice: I’m not predicting. I’m observing.

It’s the perfect catchphrase for the modern, narrative-savvy investor. It’s the perfect catchphrase for the Three-Body Problem market, where there is no algorithm for predicting markets (no closed-form solution, in the lingo), but only tools for calculating markets. Where there is no Answer for successful investing. But there is a Process.

I’m not predicting. I’m observing.

The Three-Body Problem

It’s a hard concept to wrap your head around, this difference between calculating the future and predicting the future, but it will change the way you see the world.

And your place in it.  

Here’s what I am observing:

Over the past four quarters, the United States has generated more wage inflation than at any point over the past 40 years.

Seeing is believing, so here’s the chart of average weekly earnings (weekly earnings, not hourly!) for Americans in private sector jobs from 1963 through today, measured quarterly.

Bloomberg: US Average Weekly Earnings SA, Quarterly Jan 1, 1963 – Mar 31, 2021

And here’s the same data on a monthly basis over the past 14 years:

Bloomberg: US Average Weekly Earnings SA, Monthly Jan, 2007 – April, 2021

These are the facts. These are not predictions. This is what has already occurred.

  • Q1 2021 wages were 7.7% higher than Q1 2020 wages.
  • Q4 2020 wages were 7.7% higher than Q4 2019 wages.
  • Q3 2020 wages were 6.2% higher than Q3 2019 wages.
  • Q2 2020 wages were 6.5% higher than Q2 2019 wages.

These are also facts. I am not making this up.

  • Over the past 10 years prior to the past 4 quarters, the highest single quarterly year-over-year wage growth was 3.6% in Q4 2018.
  • Over the past 20 years prior to the past 4 quarters, the highest single quarterly year-over-year wage growth was 4.5% in Q4 2006.
  • Over the past 30 years prior to the past 4 quarters, the highest quarterly year-over-year wage growth was 4.8% in Q4 1997.

You have to go back 40 years – to Q3 1981 – to find a higher quarterly year-over-year wage growth number (+8.5%).

This is not an anomaly. This is not a single quarter aberration. This is not transitory.

This is four straight quarters of the highest wage growth numbers in 40 years.

For those keeping score at home, the US inflation rate in 1981 was 10.3%.

Now I know what you’re thinking. You don’t believe me. Surely, you say, if this were true we would have heard some mention of this not-in-forty-years wage growth phenomenon. Surely, you say, someone involved in the creating or proselytizing or questioning the Fed’s dominant “transitory inflation” narrative would have mentioned this little nugget. I mean, it seems … relevant.

I think I know why you’ve heard nothing about this. Also, don’t call me Shirley.

The reason no one recognizes that remarkable wage inflation has already occurred is largely because of the intentional cartoonification of unemployment and wage data.

I’m using the word ‘cartoon’ in its technical sense here, as an abstraction of an abstraction. I’ve written about these cartoons of macroeconomic data in service to political ends quite a bit (in fact, earlier this week we published a nice short note on the cartoon that is CPI), but here’s the note that discusses the cartoon of average hourly wage earnings in great detail:

The Icarus Moment

We live in a Cartoon Age, an era not of alienation per Karl Marx, but of alienation per Groucho Marx.

What’s the cause, what’s the future, and what do we do about all this? 

And here’s an extended money quote from that note:

In the beginning, there was a desire to model the employment patterns of the U.S. economy to help policymakers figure out what was actually going on. So in 1884 (!) Congress established the Bureau of Labor Statistics (BLS) to do some counting and abstracting, and since 1915 (!) the BLS has been surveying employers to estimate how many Americans are working and how much they’re being paid. On the first Friday of every month, the BLS releases its report on the real-world employment patterns in the U.S. for the prior month. This data is an abstraction, to be sure, full of seasonal adjustments and model estimations, but it is a first level abstraction. This is not the cartoon.

One of the standard calculations that the BLS reports is the percentage change on a year-over-year basis in how much workers are being paid. Usually this wage growth report takes a backseat to the more famous “jobs report” of how many jobs were added or subtracted from the U.S. economy in the prior month and the even more famous “unemployment report” (which is actually based on an entirely different survey) of the percentage of Americans who were actively looking for work but were unable to find jobs. But when everyone and his cousin is either worried about wage inflation or hoping for wage increases, then the wage growth “number” takes on enormous importance. It’s the depiction and the narrative around the BLS wage growth calculation that is the cartoon. And that cartoon is everything for markets today.

The most basic way to look at wages for a monthly report would be to count up how much all workers got paid in that prior month. But that doesn’t work for a month-to-month comparison because different months have meaningfully different numbers of days. Unless you’re getting paid on a monthly or twice-monthly basis, then you’re going to be making less in February than you are in January. So the BLS uses the work week as their basic apples-to-apples comparison basis.

As far back as I can trace the theater of BLS reports — and that’s how one should think about these market data reports, as theatrical productions consciously designed to impact behavior — the “number” that’s reported isn’t the apples-to-apples comparison of weekly wages. Instead, it’s hourly wages. Why? Because back in 1915 this is how most people got paid. The abstracted idea of hourly wages connects with people more than the abstracted idea of weekly wages. It’s a more effective tool for eliciting a behavioral response, so that’s why our theatrical effort focuses on it every month.

But here’s the problem with the hourly wage abstraction. It requires introducing a new data estimation into the mix, one that has nothing (or at least very little) to do with the real-world concept we’re trying to represent, which is whether you’re taking home more money today than you did last year. That additional layer of abstraction is the average length of the work week.

Now this data estimation changes very little from month to month. Unlike the difference in work days from month to month, which can be meaningful and is incredibly easy to measure, the difference in work hours from week to week is an immaterial and almost certainly statistically spurious estimation. Here are the average number of hours in the work week since 2012.

Since 2012, the average length of the work week has been as low as 34.3 hours and as high as 34.6 hours. For more than SIX YEARS, the maximum deviation from the mean has been less than NINE MINUTES, less than ONE-HALF OF ONE PERCENT of the total work week. This is the flattest line you will ever see in any time series, and any month-to-month deviation from the mean is almost certainly a spurious statistical estimation. Meaning that the month-to-month differences in the average work week are so far inside your margin of error for this sampling and estimation process that you can have ZERO confidence that you are abstracting anything real. This is as bogus of an abstraction as you will ever see.

And yet it makes all the difference in the world for hourly wage calculations!

Why was the February wage growth number reported on March 9th as 2.6% rather than 2.9%?

Because the average work week in February 2018 was randomly estimated as being six minutes longer than it was a year ago.

Everything you read about what the March 9th wage growth number meant for your portfolio — the entire Goldilocks narrative of a “contained” wage inflation number combined with strong job growth — is based on a statistically spurious result. Everything. It’s all made up. None of it is real.

And yet, on the basis of the Goldilocks narrative, which was the all-day headline of the Wall Street Journal and the talking point of every Missionary on CNBC that Friday, the S&P 500 was up more than 1.7% on the day. That’s $415 BILLION of market wealth created in the S&P 500 alone, in one day, from a cartoon representation of annualized wage growth in the U.S. economy.

I wrote that in 2018. Here’s a chart of what’s happened since then to that average hourly work week that changes weekly earnings to hourly earnings:

Bloomberg: US Average Weekly Hours All Employees Private Sector SA, Monthly Jan, 2006 – April, 2021

You see what’s happening? We are now at an all-time high of estimated average weekly hours worked, which artificially depresses the average hourly earnings cartoon. If you just make your percentage comparisons off hourly earnings data, wage inflation doesn’t look nearly as bad. It’s still quite noticeable, but seems more of an anomaly, more of something that is “transitory”.

Bloomberg: US Average Hourly Earnings All Employees Private Sector SA, Y-o-Y %, Monthly Jan, 2007 – April, 2021

Again, there is absolutely no fundamental reason to report an hourly earnings number instead of a weekly earnings number. The BLS itself calculates the weekly number as their primary dataset to see what is truly happening with wages, and only converts to hourly wages because THAT WAS POLITICALLY ADVANTAGEOUS BACK IN FREAKIN’ 1915.

The investment question you hear constantly today is whether or not supply-driven inflation will eventually make its way into wage and price inflation. This is the wrong question. Or rather, it was the right question to ask a year ago, but now it’s been answered.

Wage and price inflation aren’t coming. They’re already here.

The right question to ask today is how bad this wage and price inflation cycle will be. I think it’s gonna be pretty bad, in large part because it’s not yet common knowledge. It’s not yet what everyone knows that everyone knows. It’s not yet contemplated as a potential outcome by our omnipotent market missionary, the Federal Reserve, who remains trapped – not by policy but by narrative – in its insistence that this cannot possibly be the start of a wage-price inflation cycle.

Inflation is transitory” is the new “subprime is contained”.

Do I think we will continue to see wage inflation running at 7% year-over-year? Not really. I dunno. I really don’t. I’m not here to predict. I mean, these things are always overdetermined, and if you want to tell me that last spring’s wage increases were a constructed illusion based on lots of low-wage workers getting booted and higher-wage workers staying on the job, I can’t say that you’re wrong. But I can tell you that month-over-month wage increases THIS spring are running at more than 10% annualized.

More importantly, I can tell you that it doesn’t matter.

Are all of these government wage and price reports constructed artifacts of a whole host of nudging and nudgeable factors? YES. That is my point! They are all cartoons. Intentionally so. Why? Because cartoons work. We are biologically hardwired and socially trained to respond to these cartoons, both as employers AND as workers. The cartoons work in both directions, to encourage deflationary expectations AND inflationary expectations.

When I observe the narrative coming out of last Friday’s jobs reports, I see employers coming to grips with the fact that they need to lift wages even more to satisfy their labor needs in a reopening economy. I see a new ballgame when it comes to wages and prices. A new ballgame that we haven’t played in forty years. A new ballgame where we are only in the first inning.

I’m not predicting. I’m observing.


I’m Trying To Understand Hedonic Adjustments


Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

With the intense sturm und drang around inflation right now, expect the next six months to yield intense hand-wringing and chin scratching over CPI, PCE and … hedonic quality adjustment. Quite often when people go to Twitter to rail about CPI, they say something like “Man, my cost of living doesn’t look like that! My tuition and health care costs are skyrocketing!” Savvy statisticians then respond with a flurry of charts that look like the one at right and say “the plural of anecdote is not data” or something similar.

So all those rising prices are being offset by all those falling prices and people are just noticing the prices that go up, right? Nope. The source of the data on that chart is the BLS, the U.S. organization charged with preparing the CPI data. The data has been sliced and diced like crazy.

The CPI index is not a cost of living measure! It is a hedonically-adjusted basket of assumptions that attempts to track some sort of cost vs. quality / total-utility metric over time. So what exactly is hedonic quality adjustment? Let’s ask the BLS:

Hedonic quality adjustment is one of the techniques the CPI uses to account for changing product quality within some CPI item samples. Hedonic quality adjustment refers to a method of adjusting prices whenever the characteristics of the products included in the CPI change due to innovation or the introduction of completely new products.

The use of the word “hedonic” to describe this technique stems from the word’s Greek origin meaning “of or related to pleasure.” Economists approximate pleasure to the idea of utility – a measure of relative satisfaction from consumption of goods. In price index methodology, hedonic quality adjustment has come to mean the practice of decomposing an item into its constituent characteristics, obtaining estimates of the value of the utility derived from each characteristic, and using those value estimates to adjust prices when the quality of a good changes.

The CPI obtains the value estimates used to adjust prices through the statistical technique known as regression analysis. Hedonic regression models are estimated to determine the value of the utility derived from each of the characteristics that jointly constitute an item.

There is a significant degree of modelling and massaging going on. The BLS dances around the CPI as cost of living measure question here (see question #9) and the media often inaccurately describe CPI data as changes in cost of living. This leads to a situation where people see prices ripping higher and CPI at 2.0% and it makes them want to yell at CPI.

Since I always think of TVs and cars as goods that have seen flat or falling prices over the years, I decided to have a quick peek at the real life vs. BLS-imagined price movements in the world of new vehicles. I made the arbitrary and grossly simplifying decision to use the Honda Accord and the Ford Mustang as my cars because they have been popular for more than 30 years, there is plenty of historical pricing data, and their target demographics and brand image haven’t changed much over time.

Here is the Honda Accord, then and now:

The 1990 vs. 2020 versions are clearly not the same car, especially when you compare airbags (or lack thereof), ABS, computer-assist, and all that stuff. The tricky thing for non-time-traveling humans, though, is that roughly the same socioeconomic cohort that bought Ford Mustangs or Honda Accords in 1990 is in line to buy those same cars in 2021. If you hedonically-adjust away the improvements, you are not talking about cost of living anymore, you are talking about quality-adjusted or utility-adjusted cost of living. And the result is a super-squishy approach that requires a litany of assumptions and leads to model output that is more a vague approximation of some utility-adjusted price, not an index that reflects actual real life changes in price.

The next chart is one I created that shows the evolution of the BLS new vehicle price data (red) along with the average price of a Honda Accord and a Ford Mustang each year. Funny enough, the price of a car and the average hourly wage move up at about the same speed (probably not a coincidence!). That’s how Honda Accords and Ford Mustangs remain workhorse middle class cars for over 30 years. If the price was truly remaining flat as the BLS series implies, we’d all be driving BMWs (and eventually McLarens) as wages go higher in a fairly straight line and car prices remain unch.

Did the price of cars go up, or stay flat since 1990? It’s a surprisingly difficult question to answer!

Nominal prices of cars went up about 150%. Hedonically-adjusted car prices barely moved[1]. Real car prices (adjusted for wage growth) were flat. My brain is becoming a pretzel.

And for good order this analysis is not sensitive to what kind of car you pick. All the lines look about the same, the only difference is the upward gradient of the slope, never the direction.

And when it comes to new vehicles, here are some quality changes that might trigger a hedonic adjustment:

If you’re curious, here is the BLS explainer for hedonic adjustment, which includes this fun stuff:

If the item being modeled is men’s shirts, the independent variables might be sleeve length and fiber composition; a simplified version of a hedonic model for men’s shirts might be:

Here all shirts are either short sleeve or long sleeve and either cotton/poly or 100% cotton. After doing the statistical processing BLS might estimate that ß1 = 0.15 and ß2 = 0.25. This indicates that a long sleeve shirt is 15 percent more valuable than a short sleeve one and that a 100% cotton shirt is 25 percent more valuable than a cotton/poly blend shirt.

If the BLS data collector is forced to replace a short-sleeve cotton/poly shirt in the CPI sample with a long sleeve 100% cotton shirt, the CPI would adjust the price of the old item by the features in the new item, leading to a price adjustment of about 49 percent (e0.15+0.25).

If the price of the original shirt had been $20 and that of the replacement shirt $30, rather than using a $10 increase in price for that sample observation, the CPI would adjust the original shirt for sleeves and cotton content resulting in a price estimate of $29.84 (20*e0.15+0.25). This adjustment attributes most of the price difference between the shirts to the change in characteristics and an increase of only $0.16 is shown.

With 46% of the products in CPI hedonically adjusted, it’s hard to know what CPI is actually telling us. Here is a good description of the problem from the Praxis Advisory blog.

While theoretically attractive, hedonic adjustment misses a key point. In all likelihood the good purchased was for the same or slightly higher price, regardless of quality (have Lexus cars dropped in price over the last 5 years?) Consider the following example. Say the only product that Americans purchase are M&M candies—100 M&Ms in a bag that costs $1.00. Each person is limited to one bag.

Through the miracle of productivity, a way is found to fill each bag with 110 M&Ms that is now priced at $1.10. Hedonic adjustment would say that the bag really only costs $1.00 and that the CPI has not increased, since each M&M still costs a penny each. But the cost of the bag of M&Ms has gone up. And since each person must buy a bag, instead of an individual M&M, their cost of living has gone up by 10%. They must fork over an extra dime even though they’re getting more for their money. We can’t buy individual parts of a new car; we have to buy the whole car, complete with quality improvements. And the whole package costs more, improved or not.

While hedonic adjustment may accurately reflect productivity increases, they don’t accurately reflect America’s cost to live. These adjustments accrue to businesses (which in turn don’t provide adequate raises) and the federal government (which in turn under-compensates Social Security recipients).

Which is all fine and good. But we’re still left with this:

A Honda Accord cost $12,000 in 1990 and it costs $25,000 now.

A Mustang was $9,000 and now it’s $27,000.

The BLS has new car prices close to unchanged over the past 30 years.

Here’s the best my pretzel-brain can do to reconcile this. Here are my takeaways:

  • People think CPI is a cost of living index, but it’s not. Stop comparing CPI to how your cost of living has changed.
  • That said, the BLS does not push back very hard on the idea of CPI as a cost of living index!
  • Even though CPI is not a cost of living index, CPI is still used for cost-of-living adjustments to Social Security and other benefits. CPI is also used to price TIPS.
  • There is a point of abstraction at which the original object is no longer recognizable. It is possible that CPI is such an abstraction and this explains why it does not compute with the everyperson’s day-to-day experience. We are all staring at Salvador Dalí’s “Persistence of Memory” screaming “that’s not a clock!” It IS a clock. But it’s also not a clock.
  • Prices for an item can go up or down and that item’s contribution to CPI can be in the same direction, the opposite direction or zero.
  • Interestingly, hedonic adjustments only act as deflators. Say the airline crams another seat in your row, eliminates carry-on bags and otherwise makes your flight less happy and hedonic. Does the hedonically-adjusted price of your airfare increase? Nope.
  • CPI is a model output dependent on a huge string of assumptions, not necessarily a true reflection of price changes for goods and services purchased by individual consumers.
  • Just because you hear 14 scary inflation anecdotes tomorrow, don’t assume all or any of those price movements will impact CPI in the way that you expect. They might! Or they might not.

This has been my best attempt to better understand the inner workings of CPI and why it looks and smells so different from reality. There is no easy answer to this conundrum as evidenced by this long discussion on the topic on the Social Security dot gov website, but I think this article from Bloomberg on the history of CPI sums it up pretty well:

The first architects of price indexes appreciated the degree to which these numbers are nothing more than vague approximations that, precisely because they rest on such shaky foundations, can be put toward political ends.

Sounds about right. Have a plaid and/or ludicrous day.

[1] I am fairly sure hedonic-adjustment of new vehicle prices started in 1998 / 1999 but I couldn’t find the precise answer.

Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.


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What Sort of Business is Investment Banking?


Rusty and I are thrilled to announce that Marc Rubinstein will be joining us as a guest contributor to Epsilon Theory.

Marc has over 25 years experience as an analyst and investor in the financials sector which he distills into a free weekly newsletter, Net Interest, which I think is a really great read! Between 2006 and 2016 he was senior analyst and portfolio manager on the Lansdowne Global Financials Fund, a fundamental long/short equity fund focused exclusively on the global financials sector. Prior to that, Marc was an Institutional Investor ranked analyst on the sell-side, most recently at Credit Suisse, where he was a managing director overseeing its European banks team. As well as writing Net Interest, Marc is an active angel investor in fintech. He can be contacted via his newsletter or on Twitter (@MarcRuby).

As with all of our guest contributors, Marc’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

Last weekend, Credit Suisse closed its books on the quarter and announced a big loss. It’s a peculiar sort of loss because it stems entirely from a single client – Archegos Capital Management. According to the bank, its dealings with Archegos “negate the very strong performance that had otherwise been achieved by our investment banking business.” In other words, performance would have been really good, befitting of the bull market, were it not for that one pesky client. 

Which leads to a question: what sort of a business is this? Credit Suisse has over 1.6 million individual clients, over 100,000 corporate clients and tens of thousands of institutional clients. Yet a single client can blow through the profits made from all the others. 

It’s not the first time it’s happened. Over the years, investment banks have suffered huge losses – if not at the hands of a single client then at the hands of a single employee. We highlighted some rogue trading cases here a few months ago: Jérôme Kerviel cost his bank $6.9 billion; Nick Leeson cost his bank its solvency. 

Although the frequency of rogue trading incidents has diminished in the recent past, that hasn’t stopped investment banks from piling up some stinking losses. In the living memory of most market participants, Credit Suisse alone has:

  • Written down $2.85 billion of asset-backed bonds after they had been mispriced by traders. (February 2008)
  • Topped up $633 million of write-downs with another $346 million because “even internally the scale of those positions was a surprise for a number of people” and the CEO “was not aware of the existence of those positions on that scale.” (March 2016)
  • And now, a $4.7 billion loss on Archegos.

Welcome to the business of investment banking.

What do investment banks do?

Defined broadly, investment banks do a host of stuff for corporate and institutional clients. They advise on mergers and acquisitions and underwrite securities offerings; they facilitate trading of debt and equity instruments; they structure derivatives to allow clients to hedge or to take on risk.

The biggest of the bunch is Goldman Sachs. At a presentation at Harvard a few years ago, Goldman’s former CFO explained his business: “[A] client has a risk they don’t want or wants a risk they don’t have… we make it happen for them.”

More specifically, investment banks like Goldman intermediate a diverse set of risks:

  • They take risk, like when they lead an IPO. Last week, Goldman oversaw the IPO of Deliveroo in London. The stock fell 30% on the first day of trading and Goldman was forced to go into the market to support it, buying up £75 million worth of stock. Advancing margin loans to firms like Archegos is another example of taking risk, although usually it is mitigated by concentration limits and lending less than the value of the collateral. 
  • They match risk, by transferring it between parties. As a producer of oil, the Government of Mexico may want to protect itself against a drop in oil prices. Airlines, by contrast, may want to protect themselves against a rise in prices. Investment banks provide the search functionality for either side to find each other, but also transform the specific risk that each side holds (from Maya crude in the case of the Mexican government to jet fuel in the case of the airlines). 
  • They source risk, by seeking investment opportunities for clients. Credit Suisse did this badly when it packaged Greensill loans into an investment fund for clients. (Granted, this occurred in its asset management division rather than its investment banking division, but still.) Other times it may package structured notes or baskets of stocks for clients, enabling them to express a multitude of investment views. 

In short, investment banks traffic in risk. The entry-level investment bank recruit’s handbook is Liar’s Poker. In it, Michael Lewis writes:

Risk, I had learned, was a commodity in itself. Risk could be canned and sold like tomatoes. Different investors place different prices on risk. If you are able, as it were, to buy risk from one investor cheaply and sell it to another investor dearly, you can make money without taking any risk yourself. And this is what we did.

Buying and selling risk can be a profitable business, although it’s not as profitable as it used to be. Coalition Greenwich is an analytics company that tracks global investment bank revenues. The people there reckon that last year, investment banks earned nearly $200 billion of revenue, the most in over a decade. Sales and trading made up almost $150 billion of that, the rest being advisory and underwriting fees.

Prior to 2020, operating margins in the industry had been coming down, but last year they jumped to 44%. Such high margins require a lot of capital to generate. The sales and trading business in particular is quite capital intensive. Risk has to sit somewhere and in many cases it can hang around for many years. Deutsche Bank has a specific portfolio of interest rate derivatives, for example, whose average life is eight years. Unlike a simple agency broking model, full-scale risk intermediation requires banks to carry a large balance sheet. Consequently, the returns on equity are a bit more pedestrian. Prior to last year, industry return on equity was typically sub-10%; last year it jumped to 13%.

Source: Coalition Proprietary Analytics

Beneath these aggregate numbers, though, there’s a lot of ups and downs. Last year, Goldman Sachs did $21 billion of revenue in its global markets businesses but some days were good and some were bad. According to disclosures, Goldman lost money on 24 days over the course of the year. On two of those, it dropped more than $75 million on a single day. Yet the firm also scored some massive home runs, making over $100 million per day on no fewer than 50 individual trading days.

Goldman’s skew towards a high number of really profitable days was especially pronounced in 2020. The distribution of daily trading revenue is illustrated in the chart below. Last year’s distribution (the blue line) looks closest in shape to 2011, when the number of “home runs” was last as high, but in that year there were many more loss-making days offsetting the gains. 

Source: Net Interest, company data

As well as the daily ups and downs, which can be a function of market opportunity, there is also the ebb and flow of market share. In 2020, Goldman pulled in around 13% of the total fixed income revenues generated by the top nine global investment banks. Market share tends to be quite sticky over the medium term, since there’s an optimum number of firms clients are happy to deal with – they want more than five banks but they don’t need more than fifteen. Over the past ten years, the biggest loser of market share has been Deutsche Bank, whose share of fixed income trading dropped from around 13% in 2013 to around 9% last year. Importantly, though, Deutsche had to work really hard to lose that share, cutting back its presence in the market significantly.

A Competitive Market

Competition in the industry plays out through a competition for talent – which means the wage bill in the industry can be very high. One of the banks eager to make it into the top bracket of firms before the financial crisis was Barclays. Philip Augar tells the story in his book, The Bank that Lived a Little. He quotes the global head of HR: “We are the highest payer on the street. The competitors all say we are driving up pay rates… No other bank has a scheme like our long-term plan.” Between 2002 and 2009, Barclays’ long-term incentive plan paid on average £170 million each year to 60 people on top of their salary and bonus. Nice work if you can get it!

In those days, employees would typically get a 50% cut of the revenues. This led to perverse incentives where traders would seek to maximise revenue without regard for risk in order to expand the compensation pool. The financial crisis put paid to that and compensation rates have since come down. Those big balance sheets are the gift of shareholders and since the crisis they have demanded a greater share of the economics for supporting them. Last year, Goldman paid a record low 30% in compensation to employees.

Nevertheless, pay still remains relatively high in the industry. Deutsche Bank discloses annual compensation of each of the 2,300 “material risk takers” it employs. Last year, 684 of them took home more than €1 million of total pay and one of them took home more than €10 million.

There’s another way competition plays out, which we became witness to in the Archegos saga. Back in Liar’s Poker, Michael Lewis quotes a leading bond salesman at his firm: “The trading floor is a jungle.” It’s an accurate observation of the industry. We now know one of the reasons why Credit Suisse’s loss on Archegos was so big is that for other firms involved it was so small. By unloading Archegos positions earlier, other firms were able to minimise their losses while at the same time making them worse for Credit Suisse. There’s a zero-sum aspect to the game. 

The situation reminds me of something a divisional head at Morgan Stanley once told me. Reflecting on his competitive strategy, he quoted General George S. Patton: “No bastard ever won a war by dying for his country. He won it by making the other poor dumb bastard die for his country.”

In the Archegos case, because the payoff was non-linear and situations like it come up relatively infrequently, there is little incentive for firms to cooperate. Over the very long term, of course, that strategy can go awry. In 1998, fourteen of the largest investment banks in the world agreed to post $3.65 billion to take over all the assets of failing hedge fund LTCM. Only Bear Stearns declined to participate. Ten years later, the same banks refused to bail out Bear Stearns when it ran into its own troubles. 

But striving for a Nash equilibrium in a round of Prisoner’s Dilemma is not the sole reason some firms end up doing worse than others. Credit Suisse is in the crosshairs now, but it’s part of a broader phenomenon whereby European banks just aren’t that good at investment banking compared with American banks. They can be run by Americans, staffed with Americans, they can even have grown by acquiring American firms, but they’re not that good. Understanding why gets to the heart of what it takes to be good at investment banking. 

European Investment Banks

The first thing that differentiates European investment banks from US ones is that they weren’t founded as investment banks. We’ve discussed the origins of both Goldman Sachs and Deutsche Bank here before. Goldman was founded in 1869 as Marcus Goldman, Banker and Broker, with an initial focus on the commercial paper market. Deutsche Bank was founded one year later to provide long-term loans to German industry. It wasn’t until the 1990s that Deutsche Bank threw itself into investment banking, in response to the structurally low level of profitability it faced in its domestic banking market. In 1990, it acquired London based Morgan Grenfell and, after spending heavily in an attempt to build a global presence organically, went on to buy Bankers Trust in 1999. 

Credit Suisse has a longer legacy in investment banking and may even be seen as the creator of the first truly global investment bank. Credit Suisse entered the market via joint venture, first with White, Weld and Co. (later acquired by Merrill Lynch) in 1962 and then, in 1978, with First Boston. At the time, First Boston was one of the leading firms on Wall Street; Credit Suisse took a 25% stake and they each contributed capital to a joint venture. The deal was struck just before a change in the law made it an impossible structure to replicate. The Glass-Steagall Act had prevented US commercial banks from entering investment banking since 1933, but the stipulation was only extended to foreign banks in 1978. Consequently, Credit Suisse had a twenty year headstart on European banks buying into the US investment banking market. 

Through the 1980s, the relationship worked very well. Credit Suisse looked after the Swiss market; First Boston, the American and Australian markets; and the joint venture – CSFB – was responsible for Europe and the rest of the world. Across the three groups, the franchise became a top three player in M&A and established leading positions in equity and debt underwriting, with market shares of 11-15% and 9-15% respectively. 

However, as markets increasingly globalised, the three groups started treading on each others’ toes. In 1988, they were merged into a single firm headquartered in New York, in which Credit Suisse took a 45% stake (employees held 25% and institutional investors 30%). One year later, disaster struck. CS First Boston had become a leading player in the junk bond market. In 1988 it was ranked #2, behind Drexel Burnham Lambert. When the market collapsed, CS First Boston was left holding $1.1 billion of paper it couldn’t shift. With the firm’s future in doubt, Credit Suisse was forced to bail it out, taking majority control and slashing its headcount and balance sheet. 

CS First Boston never really recovered. Although it was run autonomously, it didn’t get the resources – either capital or staff budget – that other firms did. Staff defected in droves. Having been a top 3 player in M&A and underwriting in the 1980s, the firm slipped to top 5 in the 1990s. It had its license revoked in Japan following misconduct there and suffered huge losses in Russia. To restore its position, Credit Suisse acquired parts of Barclays’ investment banking business in 1997 and then Donaldson, Lufkin & Jenrette in 2000. Yet the DLJ acquisition turned out to be one of the most expensive in investment banking history; sixteen years later its goodwill was finally written off. 

One possible explanation for the sustained poor performance of European investment banks is that they are always playing catch-up. In an effort to close the gap with the market leaders, they take short cuts, taking on excessive risk either via leverage, concentration or duration. (On duration, it is notable that Credit Suisse still has an ‘asset resolution unit’ consisting of $14 billion of assets it’s been trying to get rid of for years; Deutsche Bank has a ‘capital release unit’ of $240 billion.) 

Another explanation is that they rely too much on models, over-intellectualising the risk management process. One Twitter thread describes how Credit Suisse’s Archegos exposure may have bypassed its risk models completely, even though the underlying risk was plain. We’ve discussed risk management here before, in Wimbledon and the Art of Risk Management, and the answers aren’t always in the models. Way back in 2012, Goldman’s CFO said, “While metrics and quantitative measures are an important part of risk management the judgment and experience of our people that overlay these models is a key component.” 

The fact is, for investment banks, risk management is their business. If they take risk, match risk and source risk, they can’t outsource the management of that to a chief risk officer; it’s the job of the frontline staff. How that all hangs together – how the incentives of staff are reconciled with the health of the firm, particularly in an environment where individual compensation can be very high – comes down to the culture of the firm. And culture takes a long time to build, longer than most participants in fast-moving markets have the energy to invest. 

British readers will be familiar with Trigger’s Broom (comedy gold, if you haven’t seen it). You can change the head multiple times, you can change the stick, but it stays the same broom. Credit Suisse has gone through four investment banking heads in the past ten years and its staff has turned over, but the culture remains the same. 

After announcing his Archegos losses, the CEO of Credit Suisse said, “Serious lessons will be learned. Credit Suisse remains a formidable institution with a rich history.” Unfortunately, it’s a rich history of not learning its lessons. 

Full disclosure: I was a managing director at Credit Suisse once and still have a soft spot for the firm. I really do hope they sort this out.

Marc Rubinstein has over 25 years experience as an analyst and investor in the financials sector which he distills into a weekly newsletter, Net Interest. Between 2006 and 2016 he was senior analyst and portfolio manager on the Lansdowne Global Financials Fund, a fundamental long/short equity fund focused exclusively on the global financials sector. Prior to that, Marc was an Institutional Investor ranked analyst on the sell-side, most recently at Credit Suisse, where he was a managing director overseeing its European banks team. As well as writing Net Interest, Marc is an active angel investor in fintech. He can be contacted via his newsletter or on Twitter (@MarcRuby).

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In Praise of Bitcoin


My go-to avatar, Ptolemy, the most famously wrong scientist ever, now with laser eyes!

One evening a few weeks ago, I was on a Zoom call with a bunch of academic, think tank and Fed economists for a Bitcoin discussion. A lot of names you’d know if you’re familiar with those circles, the most famous one being Paul Krugman (who, btw, I found to be charming, genuinely open-minded, and surprisingly humble about the entire enterprise of academic economics). I had been invited to be on the anti-Bitcoin ‘side’ of the discussion, but they needn’t have bothered. Because there was no pro-Bitcoin side.

Krugman led with a simple question – what’s the use case for Bitcoin? Not a theoretical thing, but an actual use of Bitcoin to solve a problem in the real world? – which led to an hour-long, extremely earnest and altogether unsatisfying conversation about financial transfers out of Venezuela, trade settlement and securitization on a blockchain, and Taylor Swift’s ability to control the scalper/resale market for her concert tickets.

All of which are real things. All of which are interesting things. All of which are good things. But none of which are what got 20 busy people on a Zoom call at 8 pm on a Thursday night.

None of which ARE Bitcoin.

Now, to be fair, there were no old-school Bitcoin maximalists on the call, or if there were, they were too intimidated to make an Austrian economics, hard money, neo-goldbug, Bitcoin-is-the-inevitable-global-reserve-currency argument in front of Paul Krugman. LOL.

But I finally couldn’t take it anymore.

Is this really why we got on the phone tonight? To talk about a novel form of digital rights management? To talk about payment transfers out of authoritarian third-world countries? Are these REALLY our questions about Bitcoin?

Answer: of course not. What got these academic, think tank and government economists on the phone that night was Bitcoin trading at $50,000. The question that everyone truly cared about, but a question that everyone danced around for the better part of an hour, was this: Is there any there there in the price of Bitcoin?

To which everyone, including the supposedly pro-Bitcoin contingent, said no. Not just no, but no, no, no. The price of Bitcoin was an illusion. The price of Bitcoin was the madness of crowds. The price of Bitcoin had no connection to any fundamental economic activity, just like gold had no connection to any fundamental economic activity, and thus – to this audience – could have no inherent value by definition.

I think this is very wrong. And I’ll tell you, like I told this Zoom call, why I think there is a lot of inherent value in Bitcoin.

Because Bitcoin is good art.

Or better yet, because Bitcoin is elegant and beautiful fashion, sitting at the intersection of art and commerce.

Most importantly, because owning Bitcoin has been an authentic expression of identity, an extremely positive identity of autonomy, entrepreneurialism, and resistance to the Nudging State and the Nudging Oligarchy.

I’ve been saying that Bitcoin is art for more than six years, from The Effete Rebellion of Bitcoin (Feb. 2015) to Too Clever By Half (Feb. 2018, my most popular note ever!) to Riding the Cyclone (June 2018) to The Spanish Prisoner (July, 2019), and it’s been a very frustrating place to be. Frustrating because public stances on Bitcoin are almost immediately turned into cartoons – either you’re the grumpy grandpa “Bitcoin is worthless!” cartoon or you’re the laser-eyed cultist “Bitcoin will be the world’s reserve currency!” cartoon, with no room in between.

The value-deniers, like the Zoom crowd the other night, think I’m agreeing with them when I say that Bitcoin is art. I’m not. The true-believers think I’m trolling them when I say that Bitcoin is art. I’m not. The creation of good art is – in my opinion – what we are put on this earth to do. It is our highest calling. It is my highest praise.

There is lasting value in good art, because it is a very scarce thing and it never gets used up.

Bitcoin is itself an NFT, a unique digital art work instantiated on a blockchain. It’s the most valuable NFT in the world. I don’t mean a Bitcoin, obviously that’s a fungible thing. I mean THE Bitcoin … the 21 million Bitcoins that make up the Bitcoin Project. The notion that Bitcoin would ever “go to zero” is ludicrous. Good art is always worth something. But how do we measure that something … how do we put a price on the value of good art at this particular moment in time? It’s a REALLY tough question.

There are no cash flows to art. There are no fundamentals to art. There is no “use case” to art.

There is only story. There is only narrative. There is only common knowledge – what everyone knows that everyone knows – about the value of art, common knowledge that emerges from our social interaction with story and narrative.

In every respect that matters, Bitcoin IS Epsilon Theory.

The Epsilon Theory Manifesto (June 2013)

Our times require an investment and risk management perspective that is fluent in econometrics but is equally grounded in game theory, history, and behavioral analysis. Epsilon Theory is my attempt to lay the foundation for such a perspective.

So yes, I’ve been saying that Bitcoin is art for a long time now. But what I haven’t been saying – or at least not as loudly – is that bit about identity, and that’s the part that needs to be shouted today. So here it is again, this time a little louder …

Most importantly, owning Bitcoin has been an authentic expression of identity, an extremely positive identity of autonomy, entrepreneurialism, and resistance to the Nudging State and the Nudging Oligarchy.

This, too, IS Epsilon Theory.

Clever Hans (Oct. 2017)

Trainers don’t break a wild horse by crushing its spirit. They nudge it into willingly surrendering its autonomy.

Because once you take the saddle, you’re gonna take the bit.

Why am I shouting about identity?

Because the artistic Bitcoin identity I admire and value has been subverted by the neutering machine of Wall Street and the regulatory panopticon of the US Treasury Dept.

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

Yes, the Nudging State and the Nudging Oligarchy strike back. They always do when it comes to money. Not with imperial stormtroopers or legislative sanction, but with golden handcuffs and administrative surveillance.

It’s not that the State and the status quo institutionalization of capital – call it Wall Street, for short – have any desire to ban Bitcoin. Why would they do that? No, far better to accommodate and swallow Bitcoin, like they have every other financial “innovation” for the past 1,000 years. Far better to neuter the censorship-resistant and anonymity-preserving aspects of Bitcoin, and turn it into another gaming table in the Wall Street casino.

In my dystopian vision, Bitcoin isn’t banned or criminalized. Pfft. That’s a rookie, weak State move. No, I see a future where everyone buys Bitcoin. Where you are encouraged to buy Bitcoin. Where Bitcoin is sold to you morning, noon and night. Where normie economists get on conference calls late at night because they’re Bitcoin price-curious.

Except it’s not really Bitcoin.

Instead, it’s Bitcoin! TM — a cartoon version of the OG Bitcoin, either a Wall Street-abstracted representation of the price of Bitcoin or a government-painted version of Bitcoin in Dayglo orange. Either way — abstracted or painted — your Bitcoin! TM is trackable and traceable, fully KYC and AML and FBAR and SWIFT and every other US Treasury acronym-compliant. Either way, your Bitcoin! TM has all the revolutionary potential of a bumper sticker and all the identity signaling power of a small tattoo on your upper arm.

Bitcoin! TM doesn’t stick it to the Man … Bitcoin! TM IS the Man.

Welcome to the MMXXI Hunger Games.

Hunger Games (Feb. 2021)

You’ve been told that the odds are ever in your favor. You’ve been told this for your entire life.

More and more, you suspect this is a lie.

This is no “democratization” of Wall Street. You’ve been played. Again.

The abstracted version of Bitcoin! TM is a Wall Street specialty.

What is Bitcoin! TM in abstracted form? It’s a securitization or representation of Bitcoin ownership that promises the price appreciation of Bitcoin without the hassle of Bitcoin ownership. It’s a casino chip that represents the price of Bitcoin. Michael Saylor, for example, is only too happy to sell you a MicroStrategy casino chip. Or maybe you’d prefer to play on the Canadian crypto ETF felt? Or try your luck at the wheel of a Morgan Stanley private fund?

Why does Wall Street loooove abstracted forms? Because there are no fundamental limits to how many of these Bitcoin! TM casino chips Wall Street can sell. It doesn’t matter if all the OG Bitcoin HODLers keep on HODLing. It doesn’t matter if the vast majority of all the Bitcoins ever mined never get caught up in the Wall Street neutering machine. There are an infinite number of games that can be created around the price of Bitcoin as a reference point, just like there are an infinite number of bets that can be made on a football game. There are an infinite number of rehypothecations and derivative representations that can be made off the millions of margined Bitcoins that have already been captured by Wall Street-custodied accounts.

The only limiting factor on how many of these Bitcoin! TM casino chips Wall Street can sell is the effectiveness of the narrative they have created around Bitcoin itself, that Bitcoin is a “hedge against inflation” and a “store of value” that is uniquely positioned to “protect your portfolio” against “dollar debasement” because it is “hard money” immune to “money printer go brrrr”.

It’s rather artistic in and of itself, right? Selling an unlimited number of Bitcoin! TM casino chips off a meme slamming unlimited fiat money printing? Creating an unlimited number of entertaining market games and venues where we can use our Bitcoin! TM casino chips?

If these narratives and casino games sound familiar, it’s because this is exactly the same process of abstraction, securitization and leverage that Wall Street has been using for the past twenty years with precious metals.

What is the GLD ETF? It’s gold! TM. What is a unit in an ETF basket of gold miner stocks? It’s gold! TM. They and their many kin are securitizations of gold ownership that promise the price appreciation of gold without the hassle of gold ownership. They are casino chips that represent the price of gold.

I’m old enough to remember when people bought and sold gold coins in private transactions. I guess we’d call that peer-to-peer today. I’m old enough to remember when well-meaning people would have earnest conversations about gold as a reserve currency, just like well-meaning people today have those earnest conversations about Bitcoin. I’m old enough to remember how quickly those conversations died out after State Street launched GLD in 2004 and took in a billion dollars in a few days. Turns out people didn’t really want the grumpy grandpa identity of owning physical gold in some Mad Max world as much as they wanted gold! TM in their financial portfolios as an abstracted insurance policy against central bank error.

It’s exactly the same with Bitcoin! TM today.

You think “institutional adoption” is driven by a spirit of personal autonomy, entrepreneurialism, and resistance to the Nudging State and Nudging Oligarchy? You think Paul Tudor Jones and Mike Novogratz want to BITFD? LOL.

The ONLY difference to Wall Street between gold and Bitcoin is that gold! TM is tired and Bitcoin! TM is wired.

The king is dead. Long live the king!

This is the artistic genius of Wall Street – the creation of new product to trade and new assets to manage, all through the alchemy of securitization and leverage. This is Flow.

It’s like Ash said about the chest-bursting xenomorph in Alien – you may not admire the creature itself, but you gotta admire its purity. Unclouded by conscience, remorse, or delusions of morality. Yep, that’s Wall Street.

Ditto the US Treasury.

If there’s a Western governmental institution that is more unclouded by conscience, remorse, or delusions of morality than the US Treasury, I am unaware of what that institution might be. But unlike Wall Street, which is motivated by Flow, the US Treasury has an entirely different (but highly compatible!) goal.

The goal of the US Treasury is to see all of the money in the world.

That’s really all it is. That’s what Anti-Money Laundering (AML) regulations are all about. That’s what Know Your Client (KYC) regulations are all about. That’s what Report of Foreign Bank and Financial Accounts (FBAR) regulations are all about. That’s what the Treasury-led Society for Worldwide Interbank Financial Telecommunications (SWIFT) is all about. That’s what the Bank Secrecy Act (BSA) is all about. None of these programs are really about taxes. None of these programs are really about catching crooks or fighting terrorists. All of these programs are really about information for information’s sake regarding the greatest source of power in the world and the raison d’etre of every government on Earth: money.

The US Treasury is the Eye of Sauron — a gigantic panopticon tower that sweeps the world with its unblinking gaze, seeking out the owners of power, i.e. money.

The US Treasury can’t see Bitcoin. It can, however, see Bitcoin! TM.

The giant all-seeing eye of the US Treasury is primarily built on two regulatory structures — the Bank Security Act (BSA) to compel transparency and reporting by financial institutions on their clients and themselves, and the Report of Foreign Bank and Financial Accounts (FBAR) system to compel transparency and reporting by individuals on their financial institutions and themselves. There are a dozen more acronyms and programs involved here, all overseen by Treasury’s Financial Crimes Enforcement Network (FinCEN), but to keep things simple I’m going to refer to all of this as the BSA/FBAR regulatory panopticon.

Everything in plain text in the next two paragraphs is regulatory policy as it currently stands with the BSA and FBAR. Everything in bold italics is a new policy proposed in the past few months and expected to go into effect shortly. Taken together, I think it will be clear how Treasury uses the combined BSA and FBAR instruments to mark your Bitcoin with a DayGlo orange fluorescent paint and create their highly visible version of Bitcoin! TM.

BSA — If you are in the business of money in any way, shape or form (what Treasury calls a “money transmitter”), and you do any of that business in the US, then you are subject to the Bank Secrecy Act. Note that this money transmitter designation and BSA jurisdiction explicitly includes peer-to-peer exchanges that work with self-hosted wallets. If you are subject to the BSA, then it is your affirmative obligation to collect complete identifying information regarding clients who transmit or receive more than $3,000 over your systems, and to collect and immediately report to Treasury complete identifying information regarding clients who transmit or receive more than $10,000 over your systems – including any cryptocurrency (“convertible virtual currency”) transmitted to or from a self-hosted wallet.

FBAR — If you are a US entity (citizen or resident, any type of US-registered corporate or trust structure, etc.) and you have any sort of account (banking, securities, custodial, etc.) with any non-US money transmitter, anywhere in the world, and at any time during the course of the year, you have in the aggregate across all accounts more than $10,000 in value in those accounts – including the value of any cryptocurrency holdings (“convertible virtual currency”) in those accounts – then it is your affirmative obligation to report complete identifying information regarding each of those accounts to the IRS in a Report of Foreign Bank and Financial Accounts (FBAR).

I think the intent here is crystal clear. Whatever rules were in place yesterday regarding transfers of dollars or rubles or pesos through US-touching money transmitters or by US entities … well, now those exact same rules are going to apply to Bitcoin. As soon as your virtual currency holdings land in any financial institution that cooperates with or does business in or is regulated by the United States … BAM! your Bitcoin is painted DayGlo orange and becomes the Treasury-preferred form of Bitcoin! TM.

When these regulations go into full effect, as I understand them, the only remaining safe harbor for keeping your Bitcoin hidden from the BSA/FBAR Eye of Sauron will be to maintain a self-hosted wallet that never connects with a money transmitter that does business in the US.

That’s a safe harbor for the moment, but ultimately nothing is safe from the Eye of Sauron. While 2019 guidance explicitly states that “a person conducting a transaction through an unhosted wallet to purchase goods or services on their own behalf is not a money transmitter”, and so is not subject to the Bank Secrecy Act directly, the December, 2020 proposed rule-making doc also included this doozy of a comment.

The Treasury Department has previously noted that “[a]nonymity in transactions and funds transfers is the main risk that facilitates money laundering.”

The Financial Action Task Force (“FATF”) has similarly observed that the extent to which anonymous peer-to-peer permit transactions via unhosted wallets, without involvement of a virtual asset service provider or a financial institution, is a key potential AML/CFT risk in some CVC systems.

FATF members have specifically observed that unregulated peer-to-peer transactions “could present a leak in tracing illicit flows of virtual assets,” particularly if one or more blockchain-based CVC networks were to reach global scale.

Importantly, as explained below, while data contained on some blockchains are open to public inspection and can be used by authorities to attempt to trace illicit activity, FinCEN believes that this data does not sufficiently mitigate the risks of unhosted and otherwise covered wallets.

That last paragraph doesn’t mince words. Even if the blockchain facilitating a crypto currency allows for “authorities” to trace transactions, “the risks of unhosted and otherwise covered [i.e., hidden from the Eye of Sauron] wallets” are too great to let stand. LOL. I think we all see where this is going.

The response I get from the Bitcoin and larger crypto community to what seems to me to be the clear intent and path of Treasury regulations is always this: well, good luck enforcing that!

Unfortunately, that’s the evil artistry of panopticons like the Eye of Sauron or Treasury’s BSA/FBAR regulatory structure: we are driven to willingly enforce their discipline on ourselves.

A panopticon is an institutional structure that creates a permanent feeling of being watched. Maybe you are and maybe you aren’t at any given moment. But you’re never sure that you’re NOT being watched. And if you ARE being watched, then you better ‘fess up and cooperate before you get your head stuck on an orc’s pike. Did I mention that the penalty for a willful failure to make an FBAR report was the greater of $100,000 or 50% of the unreported foreign assets?

Moreover, a panopticon structure allows you to see the behavior of others. And they of you. If the discipline imposed by the Watcher includes obligations to snitch — and that’s exactly what the Treasury requires here, with obligations on money transmitters to report on clients, and obligations on clients to report on money transmitters — a panopticon sets up a classic Prisoners Dilemma game, where the only equilibrium is for both the money transmitter and the client to volunteer information about the other.

Once you start looking for panopticons in our modern world, you will find them everywhere. And of course there’s an Epsilon Theory note on this.

Panopticon (March 2014)

“Transparency” has little to do with freedom and everything to do with control, and the more “radical” the transparency the more effective the control … the more willingly and completely we police ourselves in our own corporate or social Panopticons. 

You’re not opposed to “transparency” are you? Why would you be opposed to “transparency” unless you have something to hide? You’re not a … a … terrorist-lover, are you? No, I didn’t think so.

It’s not just that Wall Street and the US Treasury dominate policy.

Far more perniciously, they also dominate narrative.

And that’s why I’m writing this note.

Frankly, I doubt that the policy battle can be won. This has been my view since I first started writing about Bitcoin, and nothing has happened to change my mind. On the contrary, Treasury’s moves to make crypto visible and controllable have happened faster than I thought they would. I mean, I’m hopeful that we are at least at some point of policy equilibrium with the proposed rule changes to BSA and FBAR, an equilibrium that will at least allow self-hosted crypto wallets to exist in peace. But hope, unfortunately, is not a strategy.

Too Clever By Half (Feb 2018)

The inevitable result of financial innovation is that it ALWAYS ends up empowering the State. When too clever by half coyotes misplay the meta-game, that’s all the excuse the State needs to come swooping in.

Just as they did with Bear and Lehman in 2008. Just as they’re doing with Bitcoin today.

So, no, I don’t think I can help much in the policy battle.

But I think I can help a lot in the narrative battle.

Or rather, the Narrative Machine can help.

Inception (April 2020)

The systematic study of narrative, what we call the Narrative Machine, can be used for analysis, yes, but also as an active instrument to reclaim our autonomy of mind and our generosity of spirit.

Everything else is commentary.

I know you don’t believe me, but we’re going to change the world … you and me.

The Bitcoin narrative must be renewed.

Bitcoin has been an authentic expression of identity, a positive identity of autonomy, entrepreneurialism, and resistance to the Nudging State and the Nudging Oligarchy.

It can be again.

Wall Street and Treasury are running a psyop with their creation of Bitcoin! TM, and it’s necessary to think about Bitcoin in those psyop/narrative terms if the goal is to preserve an active community with an identity of autonomy, entrepreneurialism, and resistance to the Nudging State and the Nudging Oligarchy in the context of Bitcoin specifically and crypto more generally.

That’s my goal, anyway.

I’m not in this for Bitcoin-as-global-reserve-currency. I’m not in this for Number Go Up. I’m not in this for “store of value” against that gosh darn “dollar debasement”. I’m not in this for Flow. I’m not opposed to any of those things, and I don’t think you’re a Bad Person if those are your things. They’re just not my things. I’m in this for Bitcoin as good art and the inspiration it provides to a community that shares my values and goals for making a better world.

Phase 1 of this anti-psyop campaign is to identify Schelling points (game solutions that people arrive at by default in the absence of direct communication … also called focal points) so that people who share this goal of community organization and narrative reclamation can find each other.

I think that one of these Schelling points is maintaining a self-hosted wallet and the capacity for peer-to-peer connections away from the Eye of Sauron.

Starting today, Epsilon Theory will accept Bitcoin as payment for all annual subscriptions through our BTCPay server. It’s a plain vanilla Raspberry Pi set-up. We’re not holding ourselves out as crypto mavens. We’re signaling an identity of autonomy, entrepreneurialism, and resistance to the Nudging State and the Nudging Oligarchy in the context of Bitcoin.

Phase 2 of this anti-psyop campaign is to use the Narrative Machine to measure and visualize the narrative archetypes and story arcs of Bitcoin! TM. In exactly the same way that there are only, say, a dozen archetypal scripts for every TV sitcom episode ever filmed, or in exactly the same way that there are three acts to every modern movie screenplay, so is there an underlying structure and a finite number of underlying archetypes to the media coverage of every market entity.

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

Seeing is believing, and I think there is no better way to prove the existence of Bitcoin! TM, in both its Wall Street-abstracted and its Treasury-painted form, than to show the psyop in action. I think this sort of analysis and visualization will get a lot of people who would otherwise be quick to dismiss our claims to take a fresh look at the ways in which we have been nudged.

Phase 3 of this anti-psyop campaign is simply to call things by their proper names. That starts with locating the value of Bitcoin in its elegant art and its ability (like all elegant art) to inspire great things away from the art itself. Yes, great things away from Bitcoin itself, so that even if Bitcoin! TM dominates financial markets (which it will), the story arc of Bitcoin doesn’t end there, but generates a thousand new initiatives to improve our world.

We don’t have to tell a story of price. We don’t have to tell a story of apocalypse. We don’t have to scold or “educate”.

We can tell an Old Story of autonomy of mind and generosity of spirit within a new context of Bitcoin and crypto.

You know, a couple of thousand years ago, a really smart guy — the most subversive, revolutionary guy you can imagine — had a good line. Render unto Caesar what is Caesar’s.

Bitcoin! TM definitely belongs to Caesar. It’s part of his game. But Bitcoin doesn’t have to be. It can be part of our game. Still. Again. And that will change everything.


Bitcoin Market Profile


Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021. Brent writes a daily email focused on FX markets that is my go-to source for understanding that enormous corner of the market, but in truth his writing is applicable to every aspect of investing.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

Funny how bitcoin topped on the exact day of the COIN IPO and dogecoin topped out on 4/20. Life is so rich. Now we get to see if every 2021DisruptorCo. CFO is already all-in on the “treasury cash balances into the coin!” idea or if there is more ammunition to buy the dip as levered retail cuts losses and faces margin calls just before they need to sell even more crypto to pay for tax bills coming due May 17. Should be an interesting few weeks for crypto and equities.

When an asset goes up 500% in 5 months, you can use your imagination when estimating drawdown possibilities but as discussed a few days ago[1], here are some possible buy-the-dip levels:

On the flip side, if you are long and looking for places to get out, I can help with that, too. One of my favorite charting methods is called Market Profile. It is a bit like point-and-figure charting, but also different. It synthesizes market data and cuts out noise. The two best resources if you are interested in learning about Market Profile are: This 350-page pdf from the CME, and the book Mind Over Markets (Dalton and Jones). I have also included my full explanation of Market Profile from “The Art of Currency Trading” as an appendix to today’s piece.

Anyway, the idea is that Market Profile identifies equilibrium zones in an asset by identifying and clarifying the relationship between price and time (see example in the box at right). The more a price trades over time, the larger the stack of letters will be against that price. For example, if you are using 60-minute windows and bitcoin trades $49,500 to $50,000 for 6 hours, those price points will each have 6 letters next to them. This slowly forms a series of equilibrium distributions that looks like the one in the sample box.

When I look at a market profile chart, I am mostly looking for two things: 1) the equilibrium zones and 2) the single prints. Single prints are prices that traded only one time period. They represent places on the chart where the price was not comfortable and could not find equilibrium. Gaps and price points that were quickly rejected show up as single prints. Single prints become important pivots going forward.

Now let’s have a look at the Market Profile of bitcoin since the Coinbase IPO:


  • There are three clear equilibrium zones, all $5000 wide. The top of the current zone is $52,000 so that is the first resistance. More patient or more bullish sellers can wait for $57,000, the top of the second equilibrium zone.
  • There is a series of single prints around $57,000/$59,000. This means that very little or no volume went through in that area and thus that becomes a massive pivot. Longs from the week of the COIN IPO are trapped at levels above that single print zone and will be happy to bail as it gets close. This further emphasizes the $57,000 level as huge resistance. Expect massive selling between $56,000 and $57,000.
  • Support is $42,000/$45,000 (the bottom of next equilibrium zone + 30% drawdown level). If $42,000 breaks, $26,000 is a possible crash support.

Personally, I’m bearish bitcoin until we see a serious post-COIN IPO cleansing. If you are patiently waiting to sell, the ideal place to layer some sell orders is just ahead of $52,000 or just ahead of $57,000. If we ever get a daily close back above $59,000, the entire post-COIN IPO dirtnap has been rejected and the bull trend will be back in force.

Appendix: Market Profile in The Art of Currency Trading (Wiley, 2019)

There are many ways to process the torrent of financial data that rushes through the global pipes every day. Bar and candlestick charts are the most popular presentation format for financial time and price movements but there are other equally valid ways of slicing and dicing the data. One alternative method of charting that I find useful is called Market Profile (also known as Market Picture). In this section, I will introduce the basics of Market Profile, discuss how I use it in my trading, and provide some options for further reading.

Most of the charts on my trading cockpit are in candlestick format. Market Profile is my second favorite way of looking at time and price data. There is a decent body of literature on Market Profile so consider this section a ‘quick and dirty’ on how I use Market Profile and if you find the topic interesting, check out the suggestions for further reading at the end.

The main benefit of Market Profile is that it gives you a quick and highly visual way of looking at several days’ worth of intraday price action. Here is the Market Profile for EURUSD from July 3 to July 10, 2013.

You can access Market Profile in Bloomberg by typing EUR {CURNCY} MKTP {GO} on Bloomberg. There is a similar option called “Volume at Price” in Reuters Eikon and you can find Market Profile in most professional charting systems. If you don’t have access to Market Profile on your system, it is easy and useful to create the charts yourself.

Some people like to create the Market Profile manually as the day progresses using graph paper and a pencil. It is a really good idea. Manual intraday charting gives you a great feel for how the day is developing and gives you a more visceral connection to the price action. You will probably find it gives you a stronger feel for your market. It also gives you a good idea of how the Market Profile is built from the ground up. When I have the time, I build Market Profile charts manually throughout the day. I find doing so helps keep me in the zone.

Each letter on the chart represents a block of time throughout the day (60-minute blocks are used in the example above). So if there are many letters in a row beside a price, it means that price traded many times throughout the day. Each column of letters represents a day and the date is indicated on the x-axis below each column. Look at the column of letters above July 10th, for example, and you can see that 1.2770 (the small letter u) only traded during one 60-minute period, whereas 1.2820 (where you see “GIKMOQS”) traded in 7 separate hours of the day. The more letters there are, the more the price traded during the day.

To build the chart manually, simply create a blank grid on graph paper with 10 pip intervals on the y-axis. Then put an A beside every price that trades in the first hour of trading, put a B next to every price that trades in the second hour of trading and so on. I suggest you try this for a few days and see how it feels. If your time horizon is shorter, you can use 30-minute or even 10-minute intervals. This can help with focus and concentration. When people read a suggestion like this in a book, nine times out of ten they just keep reading and forget about it. Don’t do that here. Build your own Market Profile charts during the day! It is a fantastic exercise that will make you a better trader.

Market Profile gives you the ability to quickly identify equilibrium zones. These are the areas where many letters form large clusters. The longer a row of letters, the more times a given price traded that day. To repeat, areas with many letters show equilibrium zones where a lot of trading took place.

At levels where there are very few letters on the other hand, the market traded only briefly before more aggressive sellers or buyers came in and quickly pushed the price away. This is all you really need to know to start using Market Picture. The key is to focus on the equilibrium and non-equilibrium zones.

The simplest trading strategy I use with Market Profile looks for what is called a SINGLE PRINT. A single print is a point on the market profile where there is only one letter because the price traded there but then moved away before the start of the next time period. When you see a single print, you can clearly see that the market rejected this price point aggressively and therefore this is a price point that you should consider a key pivot.

Let’s look at that same Market Profile chart again. On July 4th (07/04, as indicated on the x-axis) there is a series of single prints (all denoted by the letter Q) as EURUSD fell from 1.2990 to 1.2940. This happened after a very dovish ECB statement[1]. The most important thing to know is that price gapped through this level and therefore anyone who wanted to sell in the 1.2940/1.2990 window was unable to do so because the price did not remain there for long.

This means that rallies back towards that zone will likely be sold as players that missed selling on the way down will try to sell when price gets back up there. I would never trade a Market Profile single print (or any technical formation) by itself. Instead, I note the level as an important pivot and use it to maximize leverage and/or determine my stop loss when I come up with a view and take a position in this currency pair.

Let’s say now it’s July 5th and I am bearish EURUSD because I think yesterday’s dovish ECB statement will meaningfully change expectations for the currency going forward. We are trading at 1.2840 and I believe risk/reward in selling here is poor because we are too oversold. So I don’t want to get short here; I want to sell a rally.

The ideal trade is to wait for the price to get back towards the bottom of the gap down zone from July 4th. You can see from the chart that today’s high was around 1.2900/20. I would use other charting techniques like moving averages to further zoom in on the optimal entry level but with the information we have here it looks like 1.2900/40 is definitely the sell zone. This is an example of technical convergence as major resistance (today’s high 1.2900/20) and the edge of a single print zone (1.2940) are nearly the same. So we want to get short ahead of those two levels. Ideally other indicators also highlight the importance of the 1.2900/40 area and we are closer to a Five-Star trade.

With the information we have here, the optimal trade is to sell EUR just ahead of 1.2900 with a stop loss above the single prints. So in this case we leave a limit order to sell at 1.2898 and a stop loss at 1.2990. This is highly preferable to selling at 1.2840 because it allows us to take a bigger position with much better expected value. You can see the next day the high was 1.2900/10 so we went short and the price soon fell back to 1.2770 over the next day or two.

As mentioned earlier, trading is a game of inches. If you left your sell order at 1.2920 in this example, you missed the move back down.

There are many, many other interesting ways of looking at Market Profile charts. My main objective here was a) to make you aware of the existence of Market Profile and b) to inform you of how I use single prints as key pivots in my trading. As with everything in this book, I encourage you to internalize what you find useful and discard what you don’t. You need to develop your own style and your own methods. I’m just here to open some doors. Explore Market Picture and come up with your own ways to use it in your analysis.



Manheim Steamroller

Image of Wormwood, the father and slick car salesman from Matilda

Matilda Worst Used Car Salesmen Harry Wormwood

I’m fed up with all this reading! You’re a Wormwood, you start acting like one! Now sit up and look at the TV.

Matilda (1996)

A couple weekends ago I visited a car dealership to buy a new car.

Like most people, I look forward to this as much as I look forward to, say, going to the dentist or watching the Oscars. And like most people, I suspect you look forward to hearing someone complain about a car dealership experience about as much as you look forward to reading a rant about a bad airline experience.

Don’t worry – this is not that kind of story. But it is an unusual story.

I went to buy a car for a very ordinary reason. My wife is 8 months pregnant with our third child. Since my pickup truck can’t really accommodate three car seats, it was the obvious choice to take one for the team. So it is that I am now officially “regularly googling Korean-made three-row SUVs” years old.

Now, the whole car-buying experience is something I have more familiarity with than I’d like, having previously served in a professional capacity setting sub-prime auto loan pricing for one of the largest non-captive lenders in the space. Buy Rate shenanigans in the finance manager’s office, the economics of trade-ins, the loss severity impact of repossessed collateral – all of this garbage lives in the career-only skills section of my brain, next to dynamic named ranges, Black-Scholes formula components, state regulatory requirements for investment advisers and banking confidential information memorandum templates. In probably 90% of my life, I operate with barely enough knowledge to be dangerous. Lamentably, the world of purchasing an automobile is part of the other 10% where I have real knowledge – even if it is decidedly cursed knowledge.

All this, and still I left without a car. Which is not very interesting.

What IS interesting is why I left without a car. It wasn’t because of lack of inventory or credit availability or too much “cargo net and window tint” lagniappe or some guy pushing the undercoating option like he was $1,000 away from topping the monthly sales leader board. It wasn’t even because they wouldn’t honor the deal their internet sales manager had agreed to before I walked in the door.

It was because they couldn’t.

You have probably heard or read that used car prices are up this year.

You may not know how much used car prices have risen. For a variety of reasons (e.g. rental car company activity, some pent-up consumer demand, and yes, semi-conductor supply constraints), used vehicle values have skyrocketed since the early 2020 COVID trough. Manheim, Cox Automotive’s wholesale auction and consulting platform, publishes an index of these values.

Source: Manheim Consulting

As it happens, some auto segments are experiencing this pricing pressure more acutely than others. These are, to put it bluntly, extraordinary times for this particular good.

Source: Manheim Consulting

When yours truly rolled into a dealership with a detailed late model Toyota pickup with fewer than 15,000 miles on it for trade, it was already higher-than-average value collateral. Add to that the general price pressure on used vehicles and the particular spike in pickup prices, and you had an odd situation: wholesale, private sale and trade comps at other dealers were telling them that the vehicle I brought in was worth such a high percentage of a new version of the same auto that it broke their model.

The used car guy knew what the trade was ‘worth’, in the commoditized sense of what it had been getting at wholesale and the sky-high prices other area dealers were asking for at retail. But when you’ve spent 30 years taking trades with an expectation of netting a couple grand turning it around and now you’re being asked to price terrifyingly close to new inventory to approach that margin, you can start to see why he would balk. Consider as well that there is no certainty about how long this pricing pressure will last, and the risk that the dealership won’t be able to turn over its high-priced used car inventory in time starts to loom very large.

I could have accepted a lower value, of course, but all it took was one other dealership who was willing to bet on their ability to continue to pass through record, unprecedented used car pricing.

OK, interesting anecdote, but what’s the bigger story here?

Common knowledge among investors, allocators and business operators nearly always frames the proper response to inflation in terms of price direction. We want to know which assets will win if prices begin a steady rise upward, or if prices of a particular good, commodity or service are likely to spike. We want to know which businesses have pricing power, which can pass on input and labor costs without loss of demand.

And those are all good questions.

What that narrative misses, however, is the importance of sensitivity to price volatility in a path-dependent world. If you think that what’s happening in auto supply/demand and pricing is generally good for auto dealerships and the related industry infrastructure, you are probably right. But there will also be leveraged dealerships who participate heavily in inventory acquisition at prices and quantities that they can’t turn over before the pricing environment flips back. There will also be winners who figure out how to accommodate and navigate higher used price expectations in trades for new vehicles.

So it will be for every asset class, industry and business being identified as a ‘beneficiary’ of an inflationary regime or a ‘transitory inflationary spike’ in our ongoing collective dialogue. Even within a space likely to benefit from the direction of prices, expect the volatility of prices to transform some assets into steamrollers – and some into the steamrolled.

If there’s one thing I feel confident telling you simply because it is nearly always true, there are going to be a lot of investors and business owners who get the inflation trade 100% right. They will nail the timing, duration, direction and causes, whatever those things end up looking like. And for all that rightness, they won’t make a dime from it.

I think this will be a big reason why.


A Tiger Can’t Change Its Stripes


Oh, wait. That’s not a tiger. That’s a raccoon.

In Epsilon Theory-speak, a raccoon is a financial scammer, a fraud.

Raccoons are everywhere in the investment world. I hate raccoons.

Over the past few days you’ve probably seen an article or two about Bill Hwang and the collapse of Archegos Capital, Hwang’s hedge fund with an estimated $10-15 billion in assets that was levered up more than 5x across multiple prime brokers, and came tumbling down in a “margin call” last Friday. And yes, I’ll explain in a minute why I put that in air quotes.

Almost certainly, the article you saw about Bill Hwang described him as a Tiger Cub and not a raccoon, which is too bad. I’m trying to change that animal association with this note.

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

What is Reg FD? Specifically, it’s the 2000-vintage SEC regulation that requires publicly traded companies to eliminate selective disclosure of any information that could be deemed to be material and non-public. More broadly, Reg FD is my shorthand for the enormous efforts that the SEC and the DOJ have undertaken to make guys like Bill Hwang obsolete, even at the very real and very damaging cost of placing all private information in markets and all discretionary alpha generation under regulatory suspicion.

There are some dandy Epsilon Theory notes on Reg FD enforcement and its impact on alpha generation, notably here and here. From one of those notes, Pricing Power (pt. 3) – Government Collaboration:

In 2009 the SEC established an Office of Quantitative Research and an Office of Risk Assessment and Interactive Data, and – for operational surveillance – an Office of Analytics and Research within its Trading and Markets Division. In July 2013, the SEC announced the creation of a Center for Risk and Quantitative Analysis, to “provide guidance to the Enforcement Division’s leadership.” Taken together, these offices form the equivalent of the SEC’s version of the CIA. These offices are extremely well funded, draw some really top-notch people from the private sector, and coordinate closely with the FBI. Today’s SEC may not quite be the functional equivalent of the NSA from a data gathering and pattern inference perspective, but it’s nothing to sneeze at, either. And on the traditional surveillance side, the DOJ has been given amazing latitude by the courts of late to pursue widespread wire taps and related private communication intercepts across a wide swath of the financial services industry.

I can’t emphasize strongly enough the importance of these surveillance institutions as a tool in the political effort to transform capital markets into a political utility.

How? By taking sleepy regulatory edicts that were on the books but extremely hard to prosecute – such as the 2003 Global Research Analyst Settlement or, more importantly, Reg FD, originally adopted way back in August, 2000 – and using Big Data and Big Compute to turn them into powerful weapons.

Prior to 2009 it was very difficult for the SEC or FBI to identify any but the most egregious infractions of Reg FD, such as an email leaked by a disgruntled employee or a massive dumping or purchase of a stock. Since 2009, however, the SEC can sift through all of the trading in a company’s stock, look for what they consider to be suspicious patterns – which is by definition idiosyncratic outperformance, i.e., alpha generation – and then work backwards to create a link with, say, a 1-on-1 meeting at a sell-side conference between the company’s CFO and an analyst from the trading firm.

Basically, everything that gave Bill Hwang his “edge” – all of his contacts with corporate management who were willing to whisper in his ear, all of his go-to strategies of piling-in and piling-on with other hedgies – all of that has been in the SEC and DOJ crosshairs since 2009.

Julian Robertson famously broke up the Tiger Management band as the Nasdaq bubble burst in early 2000, and the so-called Tiger Cubs went their separate ways, seeded by Julian and his investors. Hwang set up Tiger Asia, where he had great returns for many years by following the playbook that had worked so well for him in the mothership, and he became a billionaire in his own right. That playbook, however, which was probably a hot steaming mess of collusion and insider trading even before Reg-FD, was certainly a hot steaming mess after Reg-FD, and once the SEC really started to enforce all this in 2009, it was only a matter of time before the feds nailed Hwang to the wall.

That happened in 2012, when the SEC brought criminal charges for insider trading against Tiger Asia and Hwang personally, charges that Hwang et al pleaded guilty to and paid a $60 million fine to resolve. Hwang was sentenced to one year probation. Again … LOL.

Tiger Asia had to be wound down, and like Stevie Cohen did with his similarly implicated (but never criminally convicted) SAC Capital, Hwang turned his hedge fund into a “family office” – Archegos Capital. But within a few years Hwang started taking outside investors and was back in full swing as a hedge fund master of the universe. Just like Stevie did with his “family office”, Point 72. Again … LOL.

Did Hwang learn his lesson and change his raccoon … err, tiger stripes? Okay, this time I’m actually going to laugh out loud. Bwahahahaha!

What Hwang learned was how to avoid getting caught.

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

In the days and weeks to come, you’ll hear the usual suspects say that swaps and derivatives are the “problem” here. Pfft. The problem is doing business with convicted criminals like Bill Hwang.

Want my keenest Wall Street observation? Once a raccoon, always a raccoon.

Want my best financial services career advice? Never do business with a raccoon. Never.

Tigers can’t change their stripes. Neither can raccoons.

At some point in your career, maybe more than one point, you’ll be sorely tempted to invest with or partner with a raccoon. Why? Because the money will be really, really good. Because the raccoon will convincingly explain to you that Others took advantage of his “passion” for the deal or the business opportunity in the past, that he’s really a misunderstood bull or bear or tiger, not a thieving raccoon. This will be a lie. It will end up costing you money, and maybe a lot more than that, if you give in to the temptation. Just like it did for the banks that decided to work with Bill Hwang after his 2012 conviction.

It seemed like such a no-brainer. Under almost any conceivable conditions (almost!), market risk on the total return swaps that Hwang was proposing could be hedged more cheaply than the trading fees, structuring fees and net interest margin that these banks charged Archegos, yielding a “risk-free” income stream of millions of dollars per year. Besides, Bill Hwang is such a charming man. Such a family man. Such a godly man. This is a man we can trust!

So here’s how the Archegos scam worked. An investment portfolio based on total return swaps and spread across a lot of prime brokers had two wonderful qualities for a raccoon like Hwang:

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

Laissez les bon temps rouler!

So how did this scam fall apart?

Well, here’s what did NOT go wrong for Hwang. I don’t think Hwang blew up because positions like Viacom and Discovery went horribly south on him. I don’t think he blew up because he got a margin call, as you and I understand the term. Look at all of the positions that are getting liquidated … this portfolio wasn’t down before it got sold out beneath him. To be sure, the last month or two hasn’t been great for the what-me-worry, infinite-duration stocks that Archegos loved to press. But even if he was doubling down on losses in true degenerate gambler style, this isn’t a portfolio that has broken down to a degree that would clearly put your prime brokers into all-out panic mode.

This is a portfolio that needed the sails trimmed, not blown out.

So why did the banks blow it out? I think something else triggered the decision by Goldman Sachs and Morgan Stanley to exercise whatever liquidation provisions they had in their custody and counterparty/credit agreements with Archegos. I think this was a “margin call”, not a margin call.

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

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

If I were a betting man (and I am), I’d be prepared to wager a not insubstantial amount of money that both of these for-cause reasons to tear up the ISDA and liquidate the Archegos positions came into play, with the DOJ letter being the spur to the general counsels at Goldman Sachs and Morgan Stanley et al having a phone call and enjoying a “wait, you have how much exposure to Bill?” moment.

See, that’s the thing with running the Bialystock Con … you can never let your investors (or lenders) compare notes.

A few minutes later, the head trader at Archegos gets a phone call from Goldman.

“It seems that you are in violation of section (18b), subsection (iv) of your ISDA, so we’re going to need $15 billion in cash in the next thirty seconds, otherwise we will begin liquidating your positions with massive, multi-billion dollar block trades. Yes, we’re going to do this just as sloppily as we can. Also, as per section (27), subsection (i) it is our responsibility to notify you that we have received inquiries from statutory regulatory authorities of appropriate jurisdiction in regards to your trading accounts. Have a nice day!”

While he’s listening to this, the head trader’s assistant informs him that Morgan Stanley is on hold.

I have no idea if this is how any of the events on Thursday and Friday actually went down. Almost certainly it’s not. But that’s how I’d write the screenplay.

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

But that’s just the first wave of bag-holders, the forced sellers whose losses on these positions are big enough to be a problem for markets in and of themselves. The second wave of bag-holders … well, that’s us.

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

Hunger Games

You have been told that the odds are ever in your favor. You have been told this for your entire life.

More and more, you suspect this is a lie.

I’m not saying that Hwang is responsible for all of this. I think he’s responsible for some of this. 

And I think there are a lot more Bill Hwangs out there.

The Best Way to Rob a Bank

The collapse of Greensill Capital is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.

There is a tide that is flowing out today, and it’s revealing Lex Greensill and Bill Hwang in 2021 just as surely as it revealed Jeff Skilling in 2001 and Bernie Madoff in 2008. The big trade around Skilling and Madoff wasn’t directly on their specific scams and frauds, but on what their specific scams and frauds showed us about systemic rot in the financial system. It’s exactly the same with Greensill and Hwang today. The big trade isn’t on some company that Greensill was propping up through “supply-chain lending” or on some company that Hwang was short-squeezing or pumping. The big trade isn’t even on some common denominator sponsor for both Greensill and Hwang like Credit Suisse (although … wow). No, those are one-off, idiosyncratic trades. Interesting prop trades, sure, but limited.

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


A Conversation with Howard Marks


Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

McLaren P1 supercar
This is not Howard Marks’ car. Or is it?

Today, I’m writing about Howard Marks’ most recent memo, which you can find here: Oaktree Capital – Something of Value.

Major bonus: I sent my note to Mr. Marks as a courtesy in case he had any feedback (because he is a legend and I’m scared of authority figures). He was kind enough to get back to me. He didn’t just reply with a one-line email, he gave me almost an hour of his time. So herein, I combine the original piece I wrote with my notes from a 60-minute phone call with Howard Marks. Enjoy!

Howard Marks has been a great investor and one of the best finance writers in the business for decades. He has been writing must-read investor letters since I was in high school. His latest memo “Something of Value” contains much insight, particularly about why traditional value investing is likely permanently impaired as a strategy and why Growth vs. Value is a false dichotomy.

The Marks letter spans 18 pages so my piece today will scratch the surface. If you have time, go read the memo from Howard Marks first, then come back.

Here is my quick review + summary + partial rebuttal + phone interview excerpts. Just so it’s clear: the indented quotes are from the memo and the left justified, larger font quotes are from our phone call.

Howard Marks on value and efficient markets

With unlimited computing power widely available to most investors in the world, stocks that are cheap on simple metrics like price/earnings etc. are probably cheap for a reason. Unlike pre-internet, when you had to scour annual reports in a library to find company metrics, everyone now has access to detailed company financials. If you want to be a value investor, more imagination is required than simply running a P/E or P/S screener on Yahoo! and buying whatever pops out.

In ye olden days, it was hard to get timely and accurate corporate information and so simply buying cheap things worked because not everyone knew what was cheap. There is no reason to think that should work going forward.

Here is the key quote from Marks’ note:

In the past, bargains could be available for the picking, based on readily observable data and basic analysis. Today it seems foolish to think that such things could be found with any level of frequency. If something about a company can be easily read in an annual report, or readily discovered by a mathematically competent analyst or computer, it stands to reason that, in most cases, this should already be appreciated by the marketplace and incorporated in the prices of the company’s securities. That’s the essence of the Efficient Markets Hypothesis.

Thus, in the world we live in today, investing on the basis of rote formulas and readily available fundamental, quantitative metrics should not be particularly profitable. (This is not necessarily true during market downturns and panics, when selling pressure can cause prices to decouple from fundamentals).

That last sentence is the key—and it should also be stated in reverse. That is: growth can also outperform value during manias and bubbles as buying pressure can cause prices to decouple from fundamentals.

Essentially what this all comes down to is that markets are mostly efficient but efficiency breaks down at times due to behavioral factors. Markets defy EMH and decouple most aggressively from fundamentals during manias and crashes. Despite the wide availability of home computers and financial data, for example, value still outperformed from 2000 to 2007 as the NASDAQ bubble unwound and mean reversion following the dotcom mania (and crash) eventually brought things back into balance.

Value and growth cycle back and forth… Each time value underperforms (like now), prognosticators find a new explanation for why that might be permanent, not cyclical. If anything, though, what stands out to me is that the ratio of the growth and value indices looks to oscillate fairly consistently around 1.00.

Growth vs. Value performance vs. percent of Americans that own a computer
Growth vs. Value performance vs. percent of Americans that own a computer

I initially read the memo as a bit of an assertion that “value is dead”, but that’s not right. Marks explained to me on the phone that that is not what he meant.

“Market inefficiency is mostly cyclical now. In the past it was structural.”

What he meant was that structural inefficiencies that once existed are gone and will never come back. Pre-internet, there was alpha sitting around all over the place. Anyone with a calculator, a basic understanding of DCF, and a strong work ethic could scoop up that alpha because markets were structurally inefficient. Now, markets are structurally efficient and veer into inefficiency only during cyclical periods of extreme emotion. You either need to use a behavioral approach, or you need to understand the companies, industries, and technologies way better than anyone else. That level of understanding requires a much deeper knowledge than one can glean by scrolling through publicly-available data.

Howard Marks on growth

The memo avoids declaring a new paradigm to justify current record-high valuations … but it definitely feels like it wants to declare a new paradigm! For example:

It’s also worth noting with regard to truly dominant companies that are able to achieve rapid, durable and highly profitable growth that it is very, very hard to overprice them based on near-term multiples. The basic equations of finance were not built to handle high-double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter.

The last line is definitely debatable and the entire paragraph is kinda debatable, but not quite the language you see from #truebelievers in presentations for various NEWECONOMYDISRUPTORS™ ETFs. “The shares of frictionless businesses are reasonable to own at any price, multiple, or valuation because super long duration assets have nearly infinite cash flows!”  While this sort of 1999ish statement has now made its way into the mainstream narrative, Mr. Marks stops just short of making it.

The idea that some companies have infinite cash flows discounted at a near-zero interest rate means valuation no longer matters for some companies is the same numerator mistake everyone made in 2000 (near-infinite growth of the World Wide Web… For, like, ever!). To be clear, a) the denominator story now is different from 1999 and b) Mr. Marks never says valuation doesn’t matter, but he gives more than a passing nod in that direction as he suggests there may be a few companies out there right now where almost any valuation could be seen as reasonable. One other note: just because US government yields are at 1.5% or companies can borrow at low rates, that doesn’t mean company WACCs are 1.5%. Take a look at the WACC for a few of your favorite companies. It’s not zero and it’s not even close!

Anyway, I found Marks’ arguments against value more compelling than his arguments in favor of growth, but the whole memo got me thinking.

One big message I took from the memo is that investors should not get married to one style. Trade and invest flexibly using the logic of what style makes sense at any given moment in the regime you find yourself. That does not mean you have to chase the current fashion, it just means you should think for yourself and be flexible. Don’t rigidly declare yourself a value investor or a growth person.

Another takeaway for me is that even the smartest people in the world (like Howard Marks) risk overweighting recent information. This is not a criticism of Mr. Marks, just a hard-to-avoid fact for all human beings. Recent news, information and performance are easier to remember than prior (or future!) performance. I could also be wrong and there is something truly new and different about today’s crop of tech companies. I’m open to that possibility, but I also doubt it. There have always been companies perceived to be dominant and expected to achieve rapid, durable growth as far as the eye can see. As Marks says:

John Templeton warned about the risk that’s created when people say, “It’s different this time,” but he also allowed that 20 percent of the time they’re right. Given the rising impact of technology in the 21st century, I’d bet that percentage is a lot higher today.

Personally, my guess is that the number is still well below 50%. On the phone, I tried to press Mr. Marks on this topic because it’s the most interesting aspect of the letter. When a “value guy” who correctly identified 1999 as a bubble in real time and sidestepped it nods to the idea it might be different this time … that’s interesting!

When I pressed him on the phone he said:

“Yes, you could say I’m struggling with a partial conversion.”

“Drill down and be open-minded.”

His defense of a more open-minded position on “highly-valued” tech is rooted in the idea that you cannot make blanket statements about entire industries without having an intimate knowledge of the firms themselves. The quip he used was:

“All generalizations are flawed, except this one.”

So his feeling is that now, given the enormous growth rates and very low interest rate environment, you need to keep an open mind and understand each individual company, industry and technology. This clearly doesn’t square with the 1999 experience. Even the very best companies in 1999 were terrible investments. For example, if you bought Amazon in 1999 or 2000, you were underwater for 10+ years!

Sure it’s like 1999, but it’s not 1999, it’s 2021

Mr. Marks says we are experiencing something similar to the Internet Bubble in some ways but 2021 is vastly different in other ways. Rates are low and the Fed is not hiking. Some assets are overvalued and in a bubble, but some are not. To make blanket statements like: “stocks are too high” or “tech is overvalued” is not the right approach. He believes you need to drill down and make more granular assessments, whether it’s crypto, tech or old economy stocks.

He did make it abundantly clear that he still believes that valuation always matters. He spent about 10 minutes emphasizing and reiterating that he does not currently believe and will never, ever believe that valuation does not matter.

“Value vs. growth is a false dichotomy.”

Marks said his grandmother used to joke: “What do you like better: summer or the country?” Value vs. growth is not a spectrum, it’s two sides of the same coin.

“It’s not what you buy, it’s what you paid.”

He said: “I’m going to sell you my car, do you want to buy it?” I mumbled for a second and he clarified: “The question makes no sense.” Every asset you buy is a combination of the intrinsic worth of the asset and the price you pay. Looking at one or the other in isolation is dumb. People define “value” as cheap, but they are often talking about price, not worth.

… “carrying low valuation parameters” is far from synonymous with “underpriced” ….

Traditional capital-V Value Investing is all about numbers: ratios, book value, cash flow, price-to-earnings, etc… Meanwhile, Growth Investing is all about the company: Tell me the story, what a great product, DISRUPTION!, huge moat, revenue growth, innovators!, viral founder, and so on. Again, this is a false dichotomy. Good investors should be looking at both, not one set of variables in isolation from the other.

I don’t believe the famous value investors who so influenced the field intended for there to be such a sharp delineation between value investing, with its focus on the present day, low price and predictability, and growth investing, with its emphasis on rapidly growing companies, even when selling at high valuations.  Nor is the distinction essential, natural or helpful, especially in the complex world in which we find ourselves today.  

“A high P/E stock can still be cheap.”

Real value investing is not about buying cheap things. It’s about buying assets for less than they are worth and waiting for the market to agree with your judgment. This might mean buying a stock at 70X earnings when it’s worth 250X earnings. Or it might mean a stock at 0.8X earnings is expensive because it’s going bankrupt. Good investors understand and study the relationship between price and intrinsic value and do not buy assets based on value metrics or growth stories in isolation.

Even famous so-called value investors like Ben Graham and Warren Buffett made as much or more money in growth as they did in value. I did not know that! Super interesting.

Graham went on to achieve enviable investment performance although, funnily enough, he would later admit that he earned more on one long-term investment in a growth company, GEICO, than in all his other investments combined.

Buffett, the patron saint of value investors, also practiced cigar butt investing with great success in the first decades of his career, until his partner, Charlie Munger, convinced him to broaden his definition of “value” and shift his focus to “great businesses at fair prices,” in particular because doing so would enable him to deploy much more capital at high returns.

This led Buffett to invest in growing companies – such as Coca-Cola, GEICO and the Washington Post – that he could purchase at valuations that were not particularly low in the absolute, but that he found attractive given his understanding of their competitive advantages and future earnings potential.  While Buffett has long understood that a company’s prospects are an enormous component of its value, his general avoidance of technology stocks throughout his career may have unintentionally caused most value investors to boycott those stocks.  Intriguingly, Buffett allows that his recent investment in Apple has been one of his most successful.

“Don’t place arbitrary or artificial constraints on your portfolio. It’s not about being best at a particular game, it’s about choosing the game you can win.”

Unless you are forced by mandate, don’t corner yourself into a particular style. Just like in trading I say it’s best not to be a breakout trader or a mean reversion guy or anything similar… In investing, it’s best not to pigeon-hole yourself as a value guy or a growth woman etc. Intellectual flexibility and adaptation lead to long-term outperformance, not the expert application of a single investing style.

This is relevant right now with regard to the bullish ESG story. ESG investing might be the best thing to do ethically, but from an investment point of view it’s hard to imagine the thing that everyone in the upper echelons of finance loves (and is actively and publicly signaling it loves) will outperform the things that everyone thinks are icky. I mean, Philip Morris is one of the best-performing stocks of all time, and a big part of this is because for much of its existence, people would not touch it.

 “No asset is so good that it can’t be overpriced.”

Marks started at Citicorp in 1968, in the midst of the Nifty Fifty bubble [1] and that experience (like my 1999 experience) puts him always on alert for bubbles. Here’s a quick excerpt from a 2018 Wharton piece:

Marks recalled that when he took a summer job in Citibank’s investment research department in 1968, investors were crazy for the “Nifty Fifty” — 50 large-cap, blue-chip growth stocks in America that included IBM, Xerox and Coca-Cola. He said they were selling for “astronomical” prices of 80 to 90 times earnings. That compares with the average price-to-earnings (P/E) ratio for the S&P 500 in the post-war period of about 16 times earnings.

Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.

Formative experiences shape behavior for decades. Everyone forms strong bonds to salient early-life experiences, whether those experiences involve investing or life outside finance. If you grew up in the Great Depression, you reuse aluminum foil. If you grew up in the 70s, you scrimp on gas.[2] If you came of age in 1999, you might find the smell of highly-valued tech particularly pungent. As a general rule, these sorts of bias are bad.

Marks noted in our conversation that this predilection for bubble detection can be both a blessing and a curse. While it might save you from going all-in levered long at the most egregious moments of euphoric overvaluation, it can also lead you to be too cynical. It can lead to gigantic missed opportunities.

While the idea that some companies can be good investments at what appear to be sky-high valuations didn’t resonate much with me because I feel the same thing was said in 1999, it did resonate with me big time when Marks said his partial conversion on the 2020 disruption economy is in some measure motivated by this realization:

“I was too skeptical in the past. Skepticism can lead to knee-jerk dismissiveness.”

When he said those words, my brain lit up a bit because I have suffered from the same bias of excess dismissiveness many times. Healthy skepticism is great. Reflexive cynicism and dismissiveness is bad. Marks’ comment hit home for me and the conversation may have influenced my less skeptical view of NFTs a few weeks later (see AM/FX: The metaverse contains infinite Pop-Tart® cats). If I was wrong about the iPhone and I was wrong about bitcoin (and Twitter… Who’s ever going to use that???)… Maybe next time I should be more open minded? And perhaps less wrong?

The risk, of course, is you end up on the other end of the spectrum—that’s not good either!

Reflexive cynicHighly skepticalHealthy skepticRational optimistUnrealistically
optimistic / gullible

I have been too far left on this spectrum, and so has Howard Marks

While I want to be less knee-jerk dismissive overall, my observation right now is that there is a large swath of the investment community wearing the Growth Investor blinkers and that has put them too far to the right on the spectrum from cynic to unrealistic optimism and beyond.

These investors see booming top line growth and economic disruption and low rates as far as the eye can see but ignore the other side of the equation. They see a McLaren P1 and think: “Wow, I want that!” and then pay Howard Marks $22 million for it when it’s really worth more like $2 million.

Marks is worth around $2B, so I am assuming this is the car he drives. I could be wrong.

Meanwhile, value investors are looking for 1992 Toyota Tercels they can buy for $800 and resell for $2,000. The right philosophy is to look at all the cars and see which ones you can get for less than fair value.

McLaren P1 - good value at $450k / overpriced at $22m

Easier said than done in the stock market, obviously, but I think it’s a good framework.

In ten years, I bet we will look back at many of the outsized investment winners of 2020 and see them as flukes. Separating skill from luck is notoriously difficult in finance. Evaluating the performance of any strategy or fund manager by how it, he or she performed in 2020 could be the epitome of Taleb’s fooled by randomness. I think “persistent investing skill” and “performance in 2020” are more likely to be inversely than positively correlated.

Many fund managers who delivered stellar performance in 2008 left investors disappointed in 2009. It is the aggregate performance of managers and strategies over multiple years that matters, not 2020 outcomes.

Anyway, a lot to chew on here. I thank Howard Marks for the memo and for being so generous with his thoughts and his time. There is no reason he needed to spend an hour talking to me on the phone, and I sincerely appreciate that he did.

Finally, Mr. Marks suggested I check out this 1962 Warren Buffett interview, just for fun. It is fun!

[1] A year or so before man landed on the moon and 18 months before the letters “LO” were transmitted over the ARPANET in what is widely viewed as the birth of the internet.

[2]> See: Malmendier and Shen, Scarred consumption (2021) https://voxeu.org/article/scarred-consumption and Severen and Benthem, Formative Experiences and the Price of Gasoline (2019) https://www.nber.org/papers/w26091

Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.


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The Best Way to Rob a Bank


The best way to rob a bank is to own a bank.

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

Yeah, that’s Lex Greensill at Buckingham Palace in 2019, receiving a CBE (Commander of the Order of the British Empire) from Prince Charles for … wait for it … “services to the British economy”. LOL.

And yeah, that’s former UK prime minister David Cameron, positively beaming in this photo that his publicist chose for the 2018 announcement that he would be joining his good friend Lex Greensill as a “special adviser” to the company, keen to assist with the company’s mission to “democratize” supply-chain finance and “transform construction finance with Big Data and AI”. I mean, that’s what the white paper says, so it’s gotta be true.

Today, David Cameron is waking up to headlines like this in the UK press:

Hope all those free rides on Lex’s personal fleet of four private jets (all bought by Greensill Capital’s German banking subsidiary and leased back to Lex, btw) were worth it, David.

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

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

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

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

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

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

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

Second best way is to find a really big bank to buy up all the crap loans you originate, and that’s where Credit Suisse comes in. After the GAM debacle in early 2019, there was zero question that the loans Greensill had been selling to Credit Suisse for years were just as stinky as the loans they had sold to GAM. And yet Credit Suisse did … nothing. Actually, that’s not fair. They purchased MORE of the securitized loans from Greensill than ever before. They marketed their funds HARDER than ever before.

I’m sure it’s just a coincidence that Softbank put $500 million into the Credit Suisse funds after their 2019 Greensill investment.

I’m sure it’s just a coincidence that Credit Suisse was the lead advisor to Greensill when they raised hundreds of millions in new capital at a valuation of $7 billion all of … [checks notes] … four months ago.

I’m sure it’s just a coincidence that Credit Suisse and Greensill found a Japanese friend-of-Softbank insurer, Tokio Marine, willing to put a wrapper around the Greensill loans so that Credit Suisse could market these Greensill lending facilities as … one more time, wait for it … a safe-as-houses money-market fund.

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

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

Yep, imagine that. Like I say, it’s a story as old as capital markets. Here’s a fun fact. Did you know that Credit Suisse has paid more than $9 billion since 2009 in legal penalties and settlements?

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

So here we are. The ECB is now asking whether or not the situation is “contained”.

Will it be contained? Will all this be swept under the rug? Probably. Apollo is apparently going to buy the shell of the Greensill trading platform for less than $100 million (down from $7 billion a few months ago), and bury this as deep into the bowels of the Earth as it is possible to be buried. Pretty much all of the Greensill directors have resigned and claimed the Sgt. Schultz / Hogan’s Heroes defense (“I see nothing! I know nothing!”), including Lex’s brother (I guess Elon is not the only one who likes to keep board seats in the family). So I am certain that we will hear this week from the ECB and other bank regulators that the situation IS, in fact, contained.

And I’m also certain we’ll be treated to another barf bag Softbank earnings deck this quarter, where Masayoshi Son waves his hands with extra vigor to explain away the Greensill “investment”. Here are some of my personal faves from last year’s virtuoso performance in narrative construction after the Wework debacle. Again, I am not making this up.

Then again … maybe Lex Greensill is feeling a wee bit abandoned by his erstwhile friends at Softbank or General Atlantic or the UK government. Maybe Gupta’s GFG steel business or some of these Softbank/Vision Fund companies can’t find short-term financing to replace their sweetheart deals at Greensill, and lots of people lose their jobs. Maybe there’s a bad email at Credit Suisse. There’s always a bad email.

So maybe this won’t be swept under the rug after all. And if it’s not …

This is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.


A Freaky Circle


Source: Thor Ragnarok

A quick but important note: We don’t have a dog in this fight. But we are conflicted. We have subscribers at almost all of the firms being mentioned. Our principals have done business with many of them. We’ve been clients of some, too. We like most of them. On both sides. We also don’t really care what any of them think. Make of it what you will, but clear eyes, even with us.

THOR: How did you…

KORG: Yeah, no. This whole thing is a circle. But not a real circle, more like a freaky circle.

THOR: This doesn’t make any sense.

KORG: No, nothing makes sense here.

Thor: Ragnarok (2017)

The whole of Thor: Ragnarok is pretty outstanding, as far as action-comedy films go. But the prison scene is almost certainly my favorite.

The premise is absurd. Thor – the guy in the picture above who isn’t a walking rock, if superhero movies aren’t your thing – is trying to escape a room that is plainly a circular hallway by dashing forward. It is a silly thing to do in the first place. Most circles boast that pesky feature whereby moving forward in one direction always brings you back to where you started. This room, however, is further designed so that running in one direction on the circle apparently doesn’t permit you to run all the way around the circle. You are, perhaps randomly or perhaps predictably (the audience never learns, exactly), transported back to where you began.

Why go through the trouble of creating a freaky circle whose magical affectation simply recreates the most basic identifying feature of a garden-variety circle, that is, that trying to go forward will only bring you back to where you started? As Korg and Thor both observe, the whole gag doesn’t make any sense.

All of which is why it’s perfect. And why it’s a perfect meta-joke. The freaky circle makes sense neither as a prison element nor a plot element. Making it both, however, makes it work for both. You, the audience, now feel a bit of the “Wait, what? Why?” confusion that Thor felt. Brilliant. Absurd.

But for all its absurdity, doesn’t it also feel a little bit familiar?

After all, the usual shenanigans of our financial world bear the same garden variety features that they ever did: too-big-to-fail gain privatization and illiquidity/loss socialization. A half dozen institutions discovering how to leach value via transactions and flow on every novel method to “democratize investments“. The rest of the nominal agents of the investment and corporate world leveraging the prudent man rule to capture as much value from principals as possible before the music stops, all under the guise of “yay, alignment.”

Nothing new under the sun and all that.

And yet somehow the ways in which each of these garden variety features manifest has been made so impenetrable, so arcane, so purposefully complex that we’re left to wonder why they even bothered with the layers of artifice in the first place.

In other words, it’s freaky circles as far as the eye can see.

But I think that you, Korg, Thor and I got something wrong. It does make sense if we think less about what it means for us and more about what it means for the designer of the room. And there is only one possible reason why the designer of the circular prison – or, say, the construction finance lender who was transforming their industry using AI and Big Data – would create a Rube Goldberg device that caused us to end up in exactly the same place we were going to end up anyway.

They do it because it is helpful to them that it doesn’t make any sense to us.

We wrote about it briefly before – but I just keep coming back to this Dyal – Owl Rock SPAC tie-up.

I’m still not sure what to make of it.

As we explained in that prior piece, Dyal is a private equity manager that, through funds it raises from the capital of big institutional asset pools (think pensions and university endowments), buys stakes in the management companies and general partners of other asset managers. It has a particular expertise buying stakes in private equity and credit shops.

Here’s what we wrote about the “Blue Owl” deal in December:

The TLDR is this: one of Dyal’s funds bought a minority stake in one of the biggest private credit shops in 2018. Their funds bought a minority stake in a big direct lending / BDC sponsor firm earlier this year. The latter (HPS) formed the sponsor to a SPAC (Altimar) that has made a proposal that would merge the former (Owl Rock) with Dyal (the GP), its minority private equity investor.

Russian Nesting Deals, Epsilon Theory, December 3, 2020

This was weird enough on its own. But if there’s a strong signal for “you’re on to something” here at Epsilon Theory, it is when publishing something brings a paucity of attention in our comment section and social media – but a lot of direct attention from people in the industry. And this one did exactly that.

Sure enough, within a matter of weeks, we read of not one but two lawsuits from portfolio companies the Dyal funds had bought stakes in – Sixth Street Partners and Golub Capital – seeking injunctions against the proposed merger/IPO with the SPAC sponsored by the Dyal affiliate.

If this is not your world, know that these are not tiny shops. This isn’t a single-store franchise in Des Moines standing up to corporate. Once upon a time, Sixth Street may have been your usual spin-out-half-of-a-Goldman-desk-in-2009-and-see-what-happens story, but the erstwhile special sits team that formed this company has built something really big and really successful. Different backstory for the Golub team, but same end-game. This is a huge private credit shop.

While we’re at it, you could say the same thing for Dyal. Their ideas for how to exploit the underserved market need for liquidity for the owners of asset manager GPs germinated well after those of Petershill (Goldman) and roughly around the same time as those of Blackstone. Who are Goldman and Blackstone? Yeah, in this niche, that’s the universal Jeopardy question to the answer, “The two firms you absolutely would not want to compete against if building a new investment industry-focused private equity business from scratch.” Even so, Dyal still built a leadership-level position. Theirs is a ridiculous achievement. They’re absolutely enormous. Good for them.

Same for Owl Rock. The placard on this particular door hasn’t been around very long, but anyone who doesn’t know Doug Ostrover doesn’t know anything about this corner of our industry.

And so, because these are all legitimate Big Boys, and because these firms in question are already in partnerships with one another that must work, the internecine lawsuits themselves are a Big Deal.

The basic contention of both Sixth Street and Golub is that (1) they have a consent right to the transfer of ownership in their companies and (2) there are demonstrable breaches and/or reasons to believe that breaches of confidential information would be inevitable and endemic to the contemplated post-merger business model of Blue Owl – the contemplated Dyal/Owl Rock entity. In other words, Sixth Street and Golub think they get to vote on the deal, and they think there’s no way that Dyal, their financial sponsor – which as Blue Owl will now be a direct competitor in the credit space – can credibly say they can or will abide by confidentiality requirements about their activities.

I have no idea if the former claim is true.

Most private equity investments take place through a series of limited partnership vehicles. It is certainly quite common for a private equity partnership to require consent to transfer an interest from one limited partner (LP) to another. The same is true for most direct private equity investments in companies. Likewise, a change in control of the management company with an advisory agreement with a fund will usually trigger a consent or proxy process among the fund’s limited partners. Securities laws governing investment advisers require it, in fact, although since the client is technically the fund and not its limited partners, there IS an aggressive posture a private equity manager might take that runs an end-around on LPs. They rarely do so, and usually proceed with the usual LP consents. After all, if the purpose of the change in control is to create equity value for the private equity manager, there’s no quicker way for a company reliant on raising new funds to destroy that value than to piss off their big LPs. In this case, the LPs are being asked to consent, so that’s not really the question.

The question is whether a change in control of the management company to your usual private equity limited partnership would trigger an affirmative consent right for the underlying investments of that partnership. That would be really unusual. Then again, what Dyal is doing involves a level of partnership that is really unusual in private equity, and they are, in a sense, potentially in the same business as the companies they acquire. It is entirely reasonable that the purchase or operating agreements might contemplate such a consent right, and entirely reasonable that they might not, but without reading the actual, unredacted documents it is impossible to know.

As to the second claim? Look, you do a deal like this because you want a public market for your interests. Maybe because you want more independence and upside that currently belongs to your parent. Maybe because you know that when it comes to scale in this industry, more is almost always better. The reason you have to tell limited partners in the funds you manage that you are doing a deal (since one does not really tell one’s clients “duh, because I want cash for my super-illiquid equity interest some day, you dummy”) is because of “resources” and “access to deal flow.” All of which makes it sort of awkward when you also have to say to portfolio companies and courts, “We will prevent any sharing of information that would constitute competition with our own portfolio companies.”

Sort of like telling your clients “We will never use flour” and then issuing a press release that says, “We are excited to launch our new bread-making business.” They aren’t literally contradictory, but I mean, c’mon. Some lawyers are gonna make the tiresome expression “robust controls” do a hell of a lot of work in the next few months.

So maybe they get some kind of injunction and maybe they don’t. In any case, no matter how strongly you might feel about it, my gut feeling is that no one’s gonna stop a deal over the latter claim. Courts and regulators have created such a powerful narrative around “yay, robust controls!” that even if one party is literally telling their own LPs that doing things the controls would make really, really hard is the justification for doing the deal, our collective willingness to believe that information will not be shared in Bad Ways knows no bounds.

As for the former claim – which, again, may or may not have merit – Dyal has made their position abundantly clear:

Sixth Street is attempting to assert the existence of a consent right that we believe simply does not exist. We appreciate the broad support from investors, partner managers, and other key stakeholders. The strategic combination is tracking towards a close in the first half of this year.

Statement by David Wells, Outside PR for Blue Owl, as quoted in Institutional Investor

That may be true, too! The funny thing about it, though, is that at least some of this “broad support” appears to be a wee bit engineered. I know it would have been better to make a “manufactured consent” reference, but if you’re jonesing for Chomsky, you’re reading the wrong Epsilon Theory co-founder.

What do I mean by “a wee bit engineered?”

Well, the parties that the PR guy is presumably referring to (other than other portfolio companies) are, namely, the limited partners of the various Dyal and Owl Rock funds, the voting shareholders of the Altimar SPAC and the shareholders of the various Owl Rock-sponsored BDCs. In other words, a lot the people who do get to vote on the deal. OK, the people who get to vote on advisory contracts that are conditions to close the deal. Same difference.

Thing is, a number of the largest limited partners in the Dyal and Owl Rock funds and a couple of the largest shareholders in the Owl Rock-sponsored BDCs who have the effective right to consent to the transaction are also companies who own a piece of an Owl Rock management company holding entity. Little perk of being willing to seed private BDCs with a 9-digit wire transfer. In other words, there appear to be a range of institutions who may not necessarily be aligned with other LPs and shareholders.

In most cases, those institutions probably have an unencumbered right to vote, but even if they decided because of affiliation concerns or conflicts not to do so or to do so at a capped level, a non-abstention non-vote (i.e. where you just sit on the ballot) is still helpful to one leg of the 1940 Act’s proxy rules. And if even that weren’t true, it remains true that narratives of “unfairness” or “imprudence” begin with the big, credible institutions – or they do not begin at all. Because the fiduciary rule is built around this concept, the implied consent of the largest, most credible institutional players not only removes the risk of assent, but may even create risk to dissent.

Who are those institutions? For the most part, really sharp, well-run places with good folks running them. Like the State of New Jersey.

Source: New Jersey Division of Investments, December 2020 Monthly Director’s Report

And Rhode Island.

And maybe Oregon. Truth be told, I’m not sure if Oregon took Owl Rock up on the management company stake or not, although it seems to me they certainly would have been eligible for it at a $150 million commitment to ORCC III. Fun fact: they announced that commitment at the same time they announced a $125 million allocation to a Sixth Street European specialty lending fund. Small world.

Probably South Carolina, too, although if so, perhaps they’ve made the decision to merge that management company interest into the line item reporting their LP commitment on CAFRs. There are plenty of sharp allocators down there, so it seems like a reasonable assumption.

In short, Asset Manager A is merging with Asset Manager B, into whose equity securities Asset Manager A has already caused its own clients to invest, and to whom Asset Manager A has caused others of its own clients to lend money to, and is doing so through the acquisition by a SPAC sponsored by Asset Manager C, into whose equity securities Asset Manager A has also caused its own clients to invest, meaning that clients of Asset Manager A who had intended for their capital to be deployed on an arms-length basis are now effectively becoming both creditors and equity owners of Asset Manager A by merits of their enlistment of them as a vendor, and effectively both paying and receiving transaction fees and expenses to and from Asset Manager C, respectively. And this is able to happen, at least in small part, because Asset Manager B has granted equity ownership that would gain value in a transaction involving Asset Manager B to very large investors in their products who accordingly have a significant say in the outcome of a vote involving a transaction involving Asset Manager B.

Or, in the immortal words of Ray Stevens:

Source: Some YouTube Video of the Ray Stevens classic “I’m My Own Grandpa”

Alternatively, if you are a small LP or BDC investor who is wondering what is going on here, and you weren’t large or important enough to merit getting a seed deal, let me translate the message to you:

Oh no! Anyway Blank Template - Imgflip

But here’s the real conundrum:

I’m pretty sure there’s not anything illegal going on here.

Unless there’s a real cause embedded in the agreements among these parties, I’m not sure there’s anything tortious going on here.

Hell, I’m not even sure there’s anything wrong going on here.

When Owl Rock gave all those big pensions and endowments effective GP ownership for their seed investments, what they were doing wasn’t unusual. It certainly wasn’t illegal. It was an entirely rational response to the power of a large block of capital with an appetite for risk. It is a power (because of my seat, not relatively unimportant me) I have some experience wielding. In my prior life, we squeezed external manager fees into oblivion because we could and because we felt that we should. We bought a stake in Bridgewater for Texas Teachers, an opportunity that came to us because we were a huge, strategic, long-term limited partner. An opportunity you probably didn’t get to see.

We got to negotiate better structures than the deals you probably got, not because we were smarter or more charming, but because we were representatives of a $100 billion+ pool of assets. We also selected a hedge fund seeding / incubation partner whose offering included potentially getting us GP stakes in various funds in the same way all these big pools of capital did. I’m a big fan of the guys at Reservoir we ended up hiring to do exactly that.

There is nothing inherently nefarious about offering those deals. And nothing inherently nefarious about accepting them. Maybe you disagree. Fine, in which case I am nefarious, because I not only accepted these deals, I demanded them as a representative of an asset owner.

Nor is there anything inherently nefarious about the big institutions who will participate in the Altimar PIPEs that will grease the gears of this whole construction, or whatever benefits were offered to them in exchange for their support. Yes, even though it’s Koch and whatever other bogeyman some might be tempted to summon to make all this seem blatantly evil, which it isn’t.

Still, if you are a smaller institutional limited partner in some of these funds wondering why you’re being jawboned about why “this is going to give us access to so much more in-house expertise!” and why “these lawsuits are no big deal!” and why “this isn’t a distraction, we are still aligned with you!”, so vote vote vote, I hear you.

And if you were a retail investor in the public BDC because you liked the yield and felt like your interests were served by the mutual self-interest of other equity owners, but then discovered that maybe some owners were more equal than others, and that maybe the goal of the adviser affiliate hired by the BDC wasn’t just to maximize the returns of the BDC but of the adviser, and that maybe you’d like to express that with your vote, and that maybe you’d like to join with other BDC investors in doing that since clearly they’re in the same shoes with you and…oh.

I hear you, too.

If I were a ‘partner manager’ with business overlaps, I would probably be hopping mad, and that’s without even being party to any of the ‘partnership’ discussions. And yet, if I were a limited partner in one of the funds managed by the advisors in question, I would probably still vote yes on my proxy for the new advisory contract. First, because the GPs in question are really good at what they do and, in some cases, just about the only game in town. A no vote isn’t going to get me those cheap co-investment rights on the next fund, and that probably matters more to my stakeholders than whether some not insignificant conflicts are being appropriately managed – or even that it is possible to manage them. Second, because the problem here, at least in my opinion, isn’t that the people here are bad or that they’re doing extremely bad things for investors.

The problem is that investors in 2021 are sold on a meme of markets in which equity owners and limited partners are “protected” by the mutual self-interest of other equity owners and limited partners (and boards, LOL) without taking into account that nested ownership structures allow powerful institutions to create incentive structures which manufacture…er…compliance for enough of the “important” participants to eliminate the effective agency of small institutions and individuals.

The problem is that we have decided to vest immense power into narratives about “incentives” and “alignment” and the ability to have “robust controls”, when we know that each of those things is fragile to any change in assumptions about the underlying aims of the principals and agents involved. Here’s a rule of thumb for you: they want a clear path to liquidity, and everything else is just pretty words.

The place this game leads us toward is a circular prison. Those who were sold on the “democratizing power” of vehicles like BDCs and SPACs that give “access to asset classes previously only open to big institutions” will realize that, as with every other investment, the sponsors will take their cut, and the big asset pools will take their cut, and the GPs that end up having lent money to themselves with their clients’ money will take their cut, and at the end of the day, what you get is whatever they couldn’t claim.

Same as it ever was.

The only difference is that the artifice through which all of this is achieved is far more obtuse, far more engineered, far more designed for the purpose of allowing those parties to do those things without opposition. I’m not saying that the Blue Owl transaction is unique. Quite the contrary. I am saying it is par for the course in outcome, except that its very structure is designed to distract or abstract from the manifold conflicts embedded in it to make that outcome more likely. It is a freaky circle, a thing which ends up at the same place but accelerates and ensures its outcome.

And makes us wonder what the hell is actually going on.

I DON’T know what that outcome will be for Dyal limited partners. I DON’T know what it will be for Owl Rock limited partners or shareholders in its various BDCs. I DON’T know what it will be for Dyal portfolio companies. These are really good investment firms with really smart people. If anyone can make a weird-ass, convoluted deal work, it’s them.

What I DO know is that everything we are telling limited partners and shareholders about the democratization and alignment of their interests across markets, not just for this particular deal, is complete nonsense.

If you know how to parse those two truths, please let me know.


The Fed’s Kryptonite


This piece is written by a third party because we think highly of the author and their perspective. It may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.


Last November in Blue Wave I wrote:

“The coming stimulus isn’t a panacea! It means massive deficits will persist. They will require higher taxes and incredible amounts of US Treasury issuance. Higher TAXES and rising LONG-YIELDS (all else equal) are the price for stimulus. The former drags on growth and earnings while the latter will require a Fed response that occupies its balance sheet. If the Fed does not act, higher yields will derail risk assets, just as they did at the end of 2018.”

For months, I’ve written that equity market participants have been ignoring the possible tradeoffs that come with massive stimulus: higher taxes and higher yields. I have strongly suggested that stimulus won’t place the economy back on some exceptional pre-pandemic growth trajectory. Sustainable growth comes from innovation and productivity gains – not from stimulus checks. Moreover, I have argued that the Fed’s ability to stimulate (asset prices or the economy) has been limited because rates and yields are already so close to zero. For some time, I have reasoned the risk of a rise in yields has been asymmetrically high.[1] Now that I believe the risk of non-transitory inflation is elevated without the durable and sustainable growth to justify it (a change in view), the Fed is confronted with an even thornier problem. In stark contrast to my view, the popular meme has suggested fiscal policy wouldn’t have any negative impacts, and equities would continue to rise on the multiple expansion that low rates would assure.[2]

Yesterday, as the 10-year yield hit 1.6%, equities sold off. How much higher might yields go? Something as seemingly straightforward as the impact of inflation on bond yields is the subject of debate in academic circles. Thank goodness I’m not an academic; I care about what makes sense rather than about defending any particular school of thought. The first order effect of inflation on yields (‘reflation’) has merit, but it has its limits. Based upon Fisher’s real rate of interest framework, and despite the obvious shortcomings of his Quantity Theory of Money (QTM), this idea is generally accepted.[3] However, one must consider other factors. Ultimately, the analysis of yields must center on market participants’ expectations for the Fed’s reaction to both inflation and Treasury supply. Said differently, term premia depend largely on uncertainty around the future path of rate policy. For now at least, it appears the current pace of Fed purchases isn’t keeping yields in check. Under current circumstances, inflation is the Fed’s kryptonite.


Let’s discuss three forces that may move Treasury yields; they are interdependent. First, there’s inflation. Next, there’s Treasury supply. Third, there’s the Fed reaction function, which ultimately plays the most crucial role. What about the idea taught in college neoclassical economics class that the interest rate is the clearing price for money at which savings equals investment?[4] This kind of market determined interest rate equilibrium exists only in a reserve constrained regime (i.e. –gold standard), in which the monetary policy authority does not set the price (i.e. – interest rate). Today, the Fed serves as a monopolistic price setter of interest rates. By deciding how it conducts OMOs (open market operations; i.e. – the scope and duration of Treasury purchases), the Fed influences bond prices and sets interest rates. Quantitative easing is a form of OMO that acts directly on long yields, whereas traditional OMOs (in a system with fewer reserves) acted on short-duration Treasuries.[5] Consider this: theoretically, if there were no Treasury issuance, the Fed could simply create reserves and use those reverses to directly fund Treasury deficits.[6] It could do so without Treasury issuance and without creating reserves to buy those Treasuries. However, Treasury issuance and the Fed’s operations around it are the principle determinant of yields across the curve. QE was a game changer.[7]

Inflation is the only wildcard that might interfere with its game plan. As I discussed in my most recent paper Inflation Perspiration, I’m now concerned about inflation for the first time since the GFC ended. Fed communications that it intends to tolerate inflation above target under its new average inflation targeting framework will only go so far. It’s rarely had to deal with fiscal policy stimulus well in excess of what is necessary to close the output gap. Exacerbating this dynamic are still challenged supply chains. We are seeing this in semiconductors. Commodities, too, are screaming inflation, as the fiscal stimulus and supply chain disruptions are global in scope. The Fed might want to have a conversation with the executive branch to indicate that a policy mistake could lead to inflation that forces a hike or leads to higher market yields about which the Fed decides to do nothing. Markets do that: they correct for interventions by acting in unforeseen ways. In this case, the reflexivity is occurring in yields. In coming days, it will be interesting to see whether or not the belly of the curve begins to flatten. The belly tends to move first, and if 5-year yields begin to pick up relative to 10s, then it may indicate that expectations about the probability of a hike are increasing. If 5-10 continues to steepen, it could indicate that the rise in 10-year yields is more about fears about supply.[8] Either way, long-duration yields and term premia reflect uncertainty around the path of future rate policy.

Bond Yields: Inflation

Let’s first consider inflation and how it might work to impact Treasury yields by first order effect through inflation (Fisher). Consider this identity:

i = r* + E(π) where i = nominal rate, r* = the real rate, and E(π) = expected inflation.

One needn’t accept QTM, for this framework to be useful. By this definition, an inflation expectation is built into nominal yields, but it’s important to recognize that this expectation may be adopted over time as inflation becomes self-reinforcing. Arguably, yields represent the opportunity cost associated with 1) choosing saving versus consuming or 2) choosing one form of savings versus another.[9] What is the market mechanism by which yields adjust to inflation? When some economic actors perceive durable or storable goods as being more expensive in the future, their preference may shift from saving (in the form of Treasuries) to buying those goods now. That is to say, the fixed income from the Treasuries will buy less of the same refrigerator later. For this reason, they might sell Treasuries, convert them to cash, and use the cash to buy a fridge. As these expectations are adopted, more market participants sell their Treasuries, this will result in successively lower prices for Treasuries (higher yields) until the yield is eventually high enough that it meets the market expectation for inflation. A new market consensus about future inflation brings yields to a new equilibrium (all else equal and with no government intervention).[10] This is but one dynamic.

The owner of Treasuries foreseeing inflation may also decide, rather than change his/her preference to consume rather than save, to change the form of savings. Logically, s/he may wish to own an asset whose stream of cash flows (unlike Treasury bond) changes with inflation. Perhaps commercial real estate with short term leases or LIBOR based loans might fit that bill. Even when reframed as Keynes might, the reason for this change in ‘liquidity preference’ is because that person wants to transform the Treasury into cash and (quickly) redeploy the cash into an asset that benefits from inflation. No matter how it’s cast, it seems plausible that yields may rise with inflation because the cash flow from Treasury ownership is less valuable in real terms.[11] In this way, inflation, disinflation and deflation may still exert some power over yields. In turn, as yields rise as part of this dynamic, this may tighten financial conditions enough to reflexively control demand-driven inflation without Fed intervention.[12] Perhaps, the Fed will allow that now.

Bond Yields: Reaction Functions

There’s a second order effect of inflation: it causes the Fed to react – creating uncertainty around the future path of rates and yields. It’s likely even more important than inflation’s first order impact, as the Fed has an arsenal of tools designed to manage rates and yields (including unlimited reserve creation as part of QE). Thus, what rising long-yields and greater term premia are saying is that the bond market expects inflation to prompt the Fed to raise rates. Mathematically, yields over ‘n’-periods are given by the geometric average of the short rates that prevailed in each period. Thus, if the expectation is for persistently low short-rates, long-yields should be anchored to that expectation.

There’s another way to think about this through bond market dynamics. If bond investors are confident the Fed won’t hike, they will buy the long-end and sell short the short-end to fund the purchase. In turn, this carry trade arb knocks down long yields towards funds. The more certain market participants are that Fed funds in anchored, the less term premium remains after the arb occurs. The risk to the carry trade always comes from a change in the cost of funding (short rates). This arbitrage is a form of duration transformation, and so is QE. When the Fed ‘quantitatively eases,’ it takes the following steps: 1) it creates excess reserves (i.e. – issues FRNs or cash); 2) it creates a reserve liability on its balance sheet; and 3) it buys Treasuries with the excess reserves. All of this effectively funds short (issues FRNs) to buy long and transforms the duration of longer-duration Treasuries into that of cash (i.e. – none). The Fed’s willingness to do this ‘arb’ is only constrained by its own expectations about inflation!

For this reason and others, the Treasury yield curve likely does not steepen as much as we’ve seen it historically. We usually see 3-month 10-year spread above 300 basis points at its widest. We’ll be lucky to see it above 200 basis points this cycle. It certainly can’t bull steepen anymore with funds at zero. The bear steepening will be self-moderating because the market and economy can’t take a move much above 2% on the 10-year, as the regression in Figure 1 shows. Lastly, were the steepening to persist for too long on persistent inflation, the Fed might be forced to hike, but it would be more likely that higher long-yields would do the Fed’s work for it. Bond volatility hit its low last September and again in March. Exhibit 2 of the Appendix may provide some context for just how much bond volatility the Fed is willing to tolerate. It seems like the MOVE index could go back to the 90, which is the regression prediction.

Bond Yields: Taper Tantrums

The Fed reaction function is also important when it comes to absorbing Treasury supply.[13] ‘Taper tantrums’ are yet another way to characterize what happens when there’s uncertainty about the path for future policy. This is what market participants generally talk about when they speak of the ‘taper tantrums’ during periods like 2013 and 2018.[14] In 2018, yields rose to 3.25% at the end of the year. It wasn’t Fed policy in reaction to inflation that did it, it was the Fed’s attempt to normalize its balance sheet. It perceived inflation was persistent enough for it to begin selling its Treasuries just prior to maturity. PCE had been above 2% since July 2018, so the Fed maintained its confidence about taper in its December meeting. A taper tantrum followed this stubborn communication around the trajectory of policy. Equities sold off, and yields reflexively fell in response to this risk off. This led to an early 2019 inversion of the U.S Treasury yield curve. Because financial markets and the banking system, upon which the economy relies, don’t function well with an inverted curve, the Fed does not tolerate it for long.

Figure 1 shows the downtrend in 10-year yields since 1994 (RH; orange). That downtrend is banded by a regression at 1SD (yellow) and 2SD (red). The regression suggests that about a month to 6-months after an extreme (2SDs) in yields, equity market corrections occur.  We observed this in early 2000, mid-2007 and 2018. In turn, a yield curve inversion often follows, and the Fed is often forced to cut. That cut normally results in a bull steepening. It’s also interesting to observe that yields typically fall after the initial and extreme move above trend only to rebound to just above the trend prediction (blue dotted), just as they did in 2001 and 2008. Yields appear to be doing something similar now. In those instances, equity selloffs persisted. Here’s where the reflexivity comes in again: if equities sell off further, they may do some of the Fed’s work for it. Capital may flow back into Treasuries from equities and may drive 10-year yieldsdown – perhaps, even enough that the Fed does not need to increase the pace of bond purchases. The difference now is that yields are already so close to zero in the ZIRP (zero interest rate policy) world.

Convexity hedging is another reaction function, which is often discussed when yields begin to rise quickly. This one is market based. At times it’s overblown, but in light of how active the mortgage market has been at such low rates, it’s worth discussion here. Unlike most bonds, mortgages demonstrate negative convexity. Convexity is the rate of change in duration when prices change. When rates fall, mortgages tend to be prepaid and refinanced. This shortens portfolio duration (negative convexity). As rates rise, and holders of mortgage securities see the duration of their portfolios increase, they sell Treasuries to shorten the duration of their portfolios. Exacerbating the dynamic now are low bond yields; convexity is higher when interest rates are lower. Thus, smaller moves in yields mean a bigger change in portfolio durations and require more Treasury sales. At times, this activity may exacerbate moves in the Treasury market. The Fed plays a role here, too, as it owns ~35% of the MBS market and it does not hedge.

Bond Yields: Equities

I have often rebutted the argument that low rates and yields mean higher P/Es as a matter of logic. They don’t, and higher yields because of inflation without durable growth are unwelcome in equity markets. First, low yields do not drive multiples higher. Only lower yields can do that. Near the S&P’s recent high, the 10-year yield was at 61bps. Last I check ed, Fed funds have been near zero for quite some time. Second, P/Es (once converted to equity yield) can’t be compared to Treasury yields until after adjusting for inflation. Only when real yield moves lower is inflation good for equities relative to Treasuries. Currently, real yields are creeping higher. Third, an assessment of P/Es requires not just a comparison to real rates, it also depends on what market participants require as an equity risk premium (ERP), which moves with expectations for earnings.[15] Surprisingly, required real ERP for equity investors has been increasing since 1990. As it has since July, Exhibit 1 of the Appendix shows that ERP (red) looks quite expensive. It is currently about 1.5SD rich to the regression prediction line (lower ERP indicates less premium and, thus, more expensive).

Not all equities will be impacted alike if inflation presents more persistently than most believe. Mature large, cap technology companies whose revenues streams from the cloud and subscription software services and whose cash flows are more like bonds than equities may be impacted more than growth technology names. Likewise CRE REITs whose portfolios have sticker, long-term leases and utilities won’t fair as well in an inflationary environment. Cyclical commodity and energy companies could benefit, albeit, eventually inflation makes life difficult if costs can’t be passed through to customers. Small caps, in particular, remain recklessly overvalued as retail flows have inflated their values.


The economy and markets are highly sensitive to interest rates and yields. The equity market’s reaction to 10-year yields at just over 3% in 2018 seems to provide some anecdotal evidence of this. The Fed will try to avoid persistently higher yields at all cost; normally QE would enable the Fed to fund short to buy long and keep bond yields under control. However, inflation complicates its motives. Profligate fiscal policy, unlike monetary policy, can be quite effective at prompting an inflationary overheat if the stimulus significantly enough exceeds the amount of the output gap. The first two rounds of stimulus have largely filled that gap. With annualized fourth quarter 2019 GDP at $21.75 trillion versus annualized fourth quarter 2020 GDP at $21.49 trillion, down 1.2% year-over-year, there is a good chance that another $1.9 trillion in fiscal spending will put year-over year GDP growth up between 6% and 7%. Moreover, the release of 50% of pent up savings (currently 13% of disposable income) could release another $250 billion into the economy.

Inflation caused by demolition of the output gap could be exacerbated by supply chains that are just now starting to heal from a supply-side shock. In semiconductors, the cause of the current shortage is a mixture of factors: demand spikes for consumer electronic products like laptops due to the pandemic-driven WFH trend, slowdowns in chip production also caused by the pandemic, bottlenecks due to an outsource of chip production to firms like Taiwan Semiconductor Manufacturing Company (TSMC), and lingering effects from the trade war. These shortages alongside a rally in commodity prices (supported by global stimulus especially in China), could make inflation more persistent as supply chains take time to heal. The Fed is in a tough spot. Where’s Lois Lane when you need her?


Exhibit 1: ‘Real’ Equity Risk Premium (blue) Shows Equities Are > 1SD Rich versus Trend

Exhibit 2: BofA MOVE Index versus the VIX


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[1] Please see Check In: To Infinity and Beyond, August 17th, 2020 and see Exhibit 2 of the Appendix.

[2] I have continuously asserted that low rates alone do not lead to multiple expansion; only lower rates can do that and only assuming that risk premia stay constant. So close to the zero bound, traditional policy is stuck.

[3] As Eric Tymoigne of the Levy Institute argues: “Changes in interest rates do not reflect changes in the opportunity cost induced by inflation in the present/future consumption arbitrage, they reflect changes in uncertainty that affect the stock equilibrium between liquid and illiquid assets.” As it turns out, this statement is far less profound than it first appears because, as he later states, “[the] condition of indifference [due to expectations for changes in interact rates] may include the concerns about inflation via the introduction of an inflation premium in nominal rates, but these concerns are included in the broader concerns of liquidity and solvency.”

[4] This identity holds in a closed economy.

[5] The plethora of system reserves necessitated a shift to the use of IOER as the Fed’s principal tool to manage to the funds target rate.

[6] Of course, this isn’t the way the system works!

[7] QE also helps the Fed signal its commitment to its policy to keep rates anchored.

[8] The two are not mutually exclusive as long-yields are the geometric average of short-yields.

[9] Keynesians disagree on what I take to be a technicality.

[10] This of course, assumes that different market participants have different expectations for inflation. I don’t see this as a fallacy of composition, as this is often the way markets work as they move in and out of equilibria, which are something of an academic fiction and if they do exist are usually short-lived, as George Soros argues in his Alchemy of Finance.

[11] As I will point out, it is the comparison of real 10-year yield to earnings yield that may make equities less attractive relative to bonds as inflation rises – but only if real yields are rising, too. There are also other factors to consider.

[12] On the other hand, some believe that most inflation comes from supply shortages that tighter financial conditions will only exacerbate by constraining supply further (i.e. – limiting the availability of loans that might be used to increase capacity). This is the flip side of the argument I’ve been making that low rates create overcapacity that keeps inflation low.

[13] This could also be looked at as constraining the supply to non-Fed buyers.

[14] Risk-asset markets rallied significantly because the Fed was focused on lowering yields on MBS, and that QE program purchased mostly MBS securities. This program had palpable economic impact through lower borrowing costs for homes. Recall that this program was announced in September 2012, and while focused on MBS, it also helped keep longer-dated yields down – that is, until the Fed announced a taper in June 2013. The 10-year yield rose quickly in expectation of taper and the Fed was ultimately forced (in September 2013) announce no taper would occur and the 10-year yield fell again throughout 2014.

[15] ERPf =E/Pf – (Y – E(π)) where E/Pf is the forward earnings yield, Y is the nominal yield, and E(π) is expected inflation.


The Opposite of 2008


In late 2007 I started counting the For Sale signs on the 20 minute drive to work through the neighborhoods of Weston and Westport, CT. I’m not exactly sure why it made my risk antenna start quivering in the first place … honestly, I just like to count things – anything – when I’m doing a repetitive task. Coming into 2008 there were a mid-teen number of For Sale signs on my regular route, up from high single-digits in 2007. By May of 2008 there were 35+ For Sale signs.

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

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


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

I mean … my god.

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

1) Home price appreciation will not show up in official inflation stats. In fact, given that a) rents are flat to declining, and b) the Fed uses “rent equivalents” as their modeled proxy for housing inputs to cost of living calculations, it’s entirely possible that soaring home prices will end up being a negative contribution to official inflation statistics. This is, of course, absolutely insane, but it’s why we will continue to hear Jay Powell talk about “transitory” inflation that the Fed “just doesn’t see”.

2) Cash-out mortgage refis and HELOCs are going to explode. On Friday, I saw that Rocket Mortgage reported on their quarterly call that refi applications were coming in at their fastest rate ever. As the kids would say, I’m old enough to remember the tailwind that home equity withdrawals provided for … everything … in 2005-2007. This will also “surprise” the Fed.

3) Middle class (ie, home-owning) blue collar labor mobility is dead. If you need to move to find a new job, you’re a renter. You’re not going to be able to buy a home in your new metro area. That really doesn’t matter for white collar labor mobility, because you can work remotely. You don’t have to move to find a new job if you’re a white collar worker. Or if you want to put this in terms of demographics rather than class, this is great for boomers and awful for millennials and Gen Z’ers who want to buy a house and start a family.

4) As for markets … I think it is impossible for the Fed NOT to fall way behind the curve here. I think it is impossible for the Fed NOT to be caught flat-footed here. I think it is impossible for the Fed NOT to underreact for months and then find themselves in a position where they must overreact just to avoid a serious melt-up in real-world prices and pockets of market-world. Could a Covid variant surge tap the deflationary brakes on all this? Absolutely. But let’s hope that doesn’t happen! And even if it does happen, that’s only going to constrict housing supply still more, which is the real driver of these inflationary pressures.

Bottom line …

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

It’s just like 2008, except … the opposite.

In 2008, the US housing market – together with a Fed that thought the subprime crisis was “contained” – delivered the mother of all deflationary shocks to the global economy.

In 2021, the US housing market – together with a Fed that thinks inflationary pressures are “transitory” – risks delivering the mother of all inflationary shocks.

It’s the only question that long-term investors MUST get right. You don’t have to get it right immediately. You don’t have to track and turn with every small movement of its path. But you MUST get this question roughly right: Am I in an inflationary world or a deflationary world?

And yes, there’s an ET note on this. Because the Fourth Horseman is inflation.

Things Fall Apart – Markets

The Fed, China and Italy are the Three Horsemen of the Investment Semi-Apocalypse. They’re major market risks, but you’ll survive.

There’s a Fourth Horseman. And it will change EVERYTHING about investing

From that note, here’s what I think preparing your portfolio for an intrinsically inflationary world requires:

  • Your long-dated government bonds will no longer be an effective diversifier, and should be a tactical rather than a core holding. They’ll just be a drag. I bet they’re a big portion of your portfolio today.
  • Highly abstracted market securities will be very disappointing. Even somewhat abstracted securities (ETFs) won’t work nearly as well as they have. You’ll need to get closer to real-world cash flows, and that goes against every bit of financial “innovation” over the past ten years.
  • Real assets will matter a lot, but in a modern context. Meaning that I’d rather have a fractional ownership share in intellectual property with powerful licensing potential than farm land.
  • The top three considerations of fundamental analysis in an inflationary world: pricing power, pricing power, and pricing power. I could keep writing that for the top ten considerations. No one analyzes companies for pricing power any more.
  • When everyone has nominal revenue growth, business models based on profitless revenue growth won’t get the same valuation multiple. At all. More generally, every business model that looks so enticing in a world of nominal growth scarcity will suddenly look like poop.
  • Part and parcel of a global inflation regime change will be social policies like Universal Basic Income. I have no idea how policies like that will impact the investment world. But they will.
  • Most importantly, the Narrative of Central Bank Omnipotence will be shaken … maybe broken. Central Banks will still be the most powerful force in markets, able to unleash trillions of dollars in purchases. But the common knowledge will change. The ability to jawbone markets will diminish. We will miss that. Because the alternative is a market world where NO ONE is in charge, where NO ONE is in control. And that will be scary as hell after 10+ years of total dependence.

That’s what I wrote in 2018, and I still believe all that today. But here’s the thing …

Just as in 2008, a lot of the ramifications of this insane shift in available housing supply will only reveal themselves over time. We won’t be able to predict all of the market-world and real-world shocks, we will only be able to expect them. We will only be able to observe and respond to them.

This is the Three-Body Problem.

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?

There is no predicting what will happen in markets. There is no closed-form solution for figuring out an investment strategy that will thrive in a transition from a deflationary world to an inflationary world. There is only observation and response. Sorry.

And there’s no way that any one of us – no matter how open and aware we are to the changes that may be coming down the pike – can observe and respond to everything that is important to observe and respond to. But together? Aided by new tools and technologies that we call the Narrative Machine? Yeah, I think that can work.

I think that the Epsilon Theory Pack can work together to collect information on what’s really happening in both real-world and market-world, and then figure out effective strategies to deal with it.

I don’t want to crowd-source an investment strategy for a shift from a deflationary world to an inflationary world. I want to Pack-source it. 

Over the past two months, we’ve set up an online platform for paid Epsilon Theory subscribers that we call the ET Forum. It’s like Clubhouse, except that it’s, you know, actually our clubhouse, a safe space for thousands of ET-subscribing, full-hearted citizens and investors to share their efforts to see the world in a more clear-eyed way.

The ground rule for the ET Forum is the golden rule – treat everyone as you would wish to be treated. You are welcome to talk about markets, but please don’t be a raccoon. You are welcome to talk about politics, but please don’t be a rhinoceros. Anonymity is fine, although we hope (and believe) that you will make some strong friendships here. I know that I have!

As I write this note, there are hundreds of Pack members on the ET Forum actively researching how to observe and respond to a shift from a deflationary to an inflationary world, ranging from lawyers looking at changing trends in personal bankruptcy filings to realtors looking at changing trends in real estate transactions to investment analysts researching everything from gold miner capital allocation decisions to construction equipment rental utilization rates. Actually, that last one is mine, and if anyone has data on JLG aerial lift platform backlogs (i.e., is the McConnellsburg, PA parking lot filled with scissor lifts or totally empty, and what color are they painted?) I am all ears.

We call ourselves the Epsilon Theory Pack, because The Long Now is going to get a lot worse before it gets any better, and there is strength in numbers. Watch from a distance if you like, but when you’re ready … join us

Clear eyes, full hearts, can’t lose.


The Third Rail Switch


Karl Rove, presenting to the California GOP (Source: LAist)

For most of the last 40 years – at least since Tip O’Neill or one of his aides coined the term – the third rail of US politics has been Social Security.

It is strange to think about. We are all MMTers now, after all, and what’re a few trillion dollars among friends? In 2021, entitlement reform is a third rail in the same way that a high-voltage power line is a third rail. Sure, it will electrocute you, but who is going to go through the trouble of getting to it? We didn’t stop talking about entitlement reform because people were too afraid of it. We stopped talking about entitlement reform because neither of the two parties has even the faintest interest in it.

Yet even during its heyday, I would argue that Social Security was never really America’s third rail. Politicians talked about it all the time, even if half of their conversations consisted of calling it a third rail. A true third rail would be an issue or policy that everyone was too afraid to even bring up in that context. It would be a topic we were too afraid to discuss at all.

I think there are a handful of these topics. Teacher unions are one of them.

And that third rail status might be changing, if only for a short while.

The California GOP held its spring convention over the last few days. Now, hope springs eternal for the GOP in California in the same way (if far less credibly) that it does for Democrats in Texas. In a big state, there is always some narrative to spin about a huge population group that can be turned – or turned out – to shift historical voting behaviors. That is especially true if you’ve got at least one well-known hotbed of traditional opposition (e.g. anything north of Chico, or the People’s Republic of Austin, respectively) in the state.

In his address to the convention, Karl Rove expressed a typical flavor of this optimism. He argued that a diverse working class could be brought into the Republican fold in California. It was not too dissimilar from the arguments Donald Trump himself relied on in 2016. But this time, Rove and other speakers were light on mentions of former President Trump as a mechanism for achieving this electoral flip. Instead, they suggested the promotion of narratives around the various misdeeds and missteps of the San Francisco School Board, teacher unions and Thomas Keller superfan Gavin Newsom.

Politico covered some of this in an article over the weekend.

CAGOP: Putting TRUMP in rearview mirror? [Politico]

…The convention was largely devoid of any mention of the single biggest influence and driver of enthusiasm in the party’s grassroots over the last four years. Republican strategist Karl Rove failed to even mention Trump’s recent tenure in the White House — and suggested that the San Francisco School Board may be more on voters’ minds this year.

Now, I don’t know if Rove is correct. Speaking personally, I suspect that avoiding the mention of Trump in either a favorable or unfavorable light probably reflects more of a Roveian keep-your-options-open strategy than any kind of well-considered view on Rove’s part about what is going to matter to voters in any coming elections. At any rate, you don’t need me to develop your own opinion on the reality of how state GOP conventions are grappling with the World After Trump.

What I DO know is that in Narrative World, Rove isn’t entirely wrong. School boards spending time renaming Abraham Lincoln Middle School or something while many teacher unions oppose safe school re-openings and make fun of parents who ‘want their babysitters back’ absolutely makes for a powerful narrative. Is that narrative powerful enough to move teacher unions out of third rail status?

It is early, and the switches on this rail are very hard to throw.

On the one hand, the generally public sector union-friendly Democratic party has a decent control on power at the federal legislative level and in many states. On the other hand, you could observe that many of the same things are true about national media – and the narrative structure of teacher unions present in national media has changed over the last several months.

A lot.

To establish a baseline, we can take a look at just five years ago, in 2016. At that time, our analysis of linguistic centrality indicates that there were three distinct narratives about teacher unions: (1) unions in our area are fighting for a fair contract, (2) unions are joining the fight against testing obsession and (3) teachers and students alike are harmed by the underfunding of schools. While coverage obviously includes op-eds and editorials that were not always supportive, in general these were sympathetic, linguistically distinct, regionally cohesive narratives.

To visualize this in part, take a look at the network maps below, each of which roughly approximates our analysis of these narratives using the software from our friends at Quid. Nodes are individual articles about teacher unions in 2016. Bold-faced nodes generally represent those we have identified as being about a particular narrative, framing or topic. As usual, similarly colored clusters are very linguistically similar. Closeness and connecting lines also indicate dimensions of linguistic similarity. North, south, east and west have no meaning outside of distance and connectivity. The short of it is the same as above: these were generally central, distinct, internally cohesive narratives about teacher unions. When outlets wrote about each of these topics, they tended to use the same language, talking points and phraseology.

Source: Epsilon Theory, Quid

Through 2020, on the other hand, while there were distinct articles about each of these topics, in our judgment they had no influence on the narrative structure of teacher unions. In 2020 there was one narrative: “districts are discussing how and when to re-open schools.” That the nodes are nearly all in bold (i.e. that they are part of this framing) is not an accident. The topic permeated practically every discussion about teacher unions in 2020.

Source: Epsilon Theory, Quid

For the first 5-6 months of the pandemic, I would describe most of the coverage as sympathetic. By September, we think it can be observed anecdotally and subjectively that a meaningful change had taken place. We also think the data bear it out. Why do we think that?

Because there was no topic that became more about the role of teacher unions in American society than coverage of the resistance to re-opening put forward by the unions serving the Fairfax County Public Schools in northern Virginia.

Because that topic, local as it was, became among the most central, most interconnected clusters of the coverage of teacher unions in 2020.

Source: Epsilon Theory, Quid

It is a small cluster, to be sure – after all, this is only one among thousands of school districts in the United States. But we think this debate framed how the narrative of teacher unions in the pandemic would shift in late 2020 into 2021. In short, by Q4 of 2020, we think the narrative began to transition from “districts are discussing how and when to re-open schools” to “why are teacher unions opposing re-opening?”

In YTD 2021, this framing – no longer mostly confined to Fairfax County – had spread, as narratives do, to all corners of coverage. The threat of strikes in Chicago. Debates over teacher vaccination policy nationwide. Varying opinions of President Biden’s One-Day-A-Week plan. And yes, the same raging debates in California.

Source: Epsilon Theory, Quid

Readers’ opinions may differ on the reality of school openings. I’m guessing they probably changed a bit over time, too.

In my own town, I was supportive of closures in March. By July, I felt confident enough in the data to support elementary school openings but was suspicious enough of high schools that I considered them a legitimate superspreader risk. By mid-September I’d generally come to the conclusion with more data that my view was wrong – too conservative. By then I believed that high schools with appropriate precautions outside of raging hotspots could – and in my area where my opinion matters, should – re-open. Today, I have some concerns about high schools in emerging B.1.1.7 areas, but none that rise to the level of changing my mind.

Maybe your path was similar. Maybe you felt more comfortable with broad re-openings sooner. Maybe it took you some time. Maybe you’re not there yet.

No matter what you believe about the reality of school re-openings or the role teacher unions have played in school re-opening policy, and no matter how that belief changed over time, in narrative world the switch on this third rail has been flipped.

For better or worse, for the first time in a very long time, everybody knows that everybody knows it is now possible to openly discuss and debate the social role of teacher unions. That doesn’t mean that anything about the relationship schools have with these unions will change. It means that it can change.

I remain concerned that this is a conversation that can and will be easily co-opted by those with a political interest in creating conflict between groups that have every reason to be aligned. Still, we are where we are. In the same way that narrative shaped a conversation about the role of police going forward in 2020, this narrative can shape a conversation about the role of teacher unions and public sector unions more broadly. My money is still on the status quo.

But I’ve been wrong before.


Hunger Games


Epsilon Theory PDF Download (paid subscribers only): Hunger Games

And may the odds be ever in your favor!

You have been told that investing in the stock market is like betting on a sports game.

You have been told that you are a SPECTATOR in the game of markets, that you are WATCHING a game being played out in front of you by lots of different companies.

You have been told that you should make ‘bets’ on those companies based on how well you think those companies can play the game that you are watching. The companies will play the game and they will keep score by ‘beating’ or ‘missing’ on revenues and earnings and the like, and then that score will determine whether or not your bets pay off.

You have been told that the better you are at ‘analyzing’ the teams playing this game, the more ‘due diligence’ you put into studying the teams playing this game, the more money you will make with your bets.

You have been told that everyone can win with their bets, that this is how you, too, can achieve the wealth that you deserve.

You have been told that the odds are ever in your favor.

You have been told this for your entire life.

More and more, you suspect this is a lie. But if it is a lie … what then? What meaning exists in the stock market if this is a lie?

Over the past few weeks you have been told a new story. A brave story. A story of heroes. A story of meaning.

You have been told that by banding together and acting as one, you can “democratize” the stock market.

You have been told that you can slough off your market oppressors who “want companies to fail”.

You have been told that you can be a PARTICIPANT in the game of markets, that you can storm the playing field of companies, that you can take matters into your own hands and rescue a promising company under unfair attack.

And, yes, make some good money in the process. Why not? Seems only fair.

President Chamath Coin enlists Katniss to the cause.

Today, as you see the collapsing stock prices of the companies you supported, you suspect that this was a lie, as well.

And you’d be right.

Neither story is true. Neither story has EVER been true.

Both of these stories are narratives for our very own Hunger Games, a spectacle that chews up the participants in the arena while delivering enormous profits to the networks (media, financial and political) that put them on. Media networks count their profits in eyeballs, in the attention the Games garner. Financial networks count their profits the old-fashioned way, in the sheer volume of dollar-generating order flow the Games produce. As for politicians, they get their most valuable coin of the modern realm – an issue. The wackos on the left get to propose insane transaction taxes. The wackos on the right get to tell us how much liBeRtY we are enjoying by giving Ken Griffin all of our money. The very serious centrists get to tell us about how we need “a national conversation” about the T+2 settlement issues raised here.

And what about the rest of us? What about all of us reading story after story about the “Reddit Revolution” and what it means for us?

What do WE get out of the Hunger Games?

We are entertained.

This: the events of last week, with Gamestop soaring to $400/share and a subreddit chat group being the focal point of the “revolution” and Robinhood shutting down trades at the height of the frenzy and every hedge fund in the world degrossing at a mad clip and the usual Caesar Flickermans in politics and media trumpeting out a bullshit narrative of the little guy sticking it to The Man … changed NOTHING.

You were played. Again.

Also, this: the events of last week, with Gamestop soaring to $400/share and a subreddit chat group being the focal point of the “revolution” and Robinhood shutting down trades at the height of the frenzy and every hedge fund in the world degrossing at a mad clip and the usual Caesar Flickermans in politics and media trumpeting out a bullshit narrative of the little guy sticking it to The Man … changed EVERYTHING.

We had TWO Emperor’s New Clothes moments last week. Two moments that individually come around every 20 or 30 years. In one week.

What is an Emperor’s New Clothes moment? It’s when the meaning of a social institution changes on a dime. It’s when the common knowledge of a social institution – what everyone knows that everyone knows – changes on a dime.

I’ll express these two Emperor’s New Clothes moments as memes, which seems only appropriate.

Last week’s events accomplished every goal set out by the orchestrators of the Reddit Rebellion.

Goal #1: Melvin Capital’s ridiculous short position was obliterated, and there was much rejoicing by the usual Wall Street suspects who had set up their long positions in hopes that this narrative snowball they rolled down the hill would create just such an avalanche.

Goal #2: Both retail order flow and target stock volatility grew exponentially, creating windfall market maker profits. Sure, things got a little dicey there with that whole Robinhood clearinghouse thing, but all’s well that ends well.

But accomplishing these goals came at a price. The curtain was pulled back on what Wall Street really is, and The Man behind the curtain was revealed for everyone to see.

We all see it. We all see it.

Here’s the first thing we all saw:

We all saw that the thing that determines whether or not our stock market bets pay off is … other bets. We all saw that there is no “game of companies” taking place independently of our bets. We all saw that our bets, in and of themselves, can win the “game”, with absolutely zero input from the “team” that is supposedly out on the “field”.

What happened last week would be exactly like New York Jets fans getting together and deciding “hey, if enough of us bet on the Jets to beat the Patriots, that will CAUSE the Jets to beat the Patriots.” Insane, right?

But that’s exactly what happened.

Because unlike football, the bets ARE the game.

This is Secret #1. This is what Stevie Cohen and all the hedge fund masters of the universe know that you don’t.

The bets ARE the game.


Here’s the second thing we all saw:

We all saw that the rules of the game can be changed without warning if the game isn’t working out for the owners of the game. We all saw that the dominant retail broker platform (and non-dominant ones, too) were told by trading settlement rules makers to shut it down for a day. No warning. No hearing or discussion. Just a phone call that they were on double secret probation and could either come up with billions of dollars in cash … NOW … or shut it down.

What happened last week with Robinhood would be exactly like if the referees who were working that Jets versus Patriots game – the one that the Jets were miraculously winning – decided at halftime that the Jets would not be allowed to have the ball on offense in the second half unless they ponied up a couple of billion dollars in an escrow account. Insane, right?

But that’s exactly what happened.

Because unlike football, the referees OWN the game.

In this game, it’s not the people who make the biggest and most profitable bets who have the most money and the most power. No, it’s the referees. And by referees I don’t just mean the people who adjudicate the rules at the settlement clearinghouses. They’re basically the equivalent of, say, college football referees … an important but not that important subset of all referees. No, I want to focus on the equivalent of professional sports league referees, the top of the referee hierarchy, if you will. I want to focus on the people who place the ball on the 40-yard line or the 41-yard line in the Super Bowl, on the people who whistle a charge or a block on Lebron’s drive, on the people who call balls and strikes on Gerrit Cole. And who call the shots at the settlement clearinghouses, too, if you wanna know the truth. I want to focus on the people who adjudicate the bets and take a small fee from every transaction for their trouble. I want to focus on the market makers.

Last year, Citadel Securities, the market maker division of Ken Griffin’s financial empire and the largest market maker that executes retail trades, made $6.9 BILLION in net trading revenues. That’s more than twice their prior best year. They did this without taking ANY market risk. NONE.

Every time you push that button on Robinhood to buy something, Citadel Securities matches you with the seller and tells both of you what price you got. Every time you push that button on Robinhood to sell something, Citadel Securities matches you with the buyer and tells both of you what price you got.

And in that infinitesimal point in time when there is a tiny difference between what a buyer bids for a security and what a seller asks for a security, an infinitesimal point in time when Citadel Securities is BOTH buyer and seller of that security, an infinitesimal point in time that exists for EVERY market order that has ever occurred in the history of man … Citadel Securities is there.

They pocket that tiny difference. Not so tiny in the case of options. Definitely not so tiny when volatility spikes and that bid/ask spread widens dramatically. That’s what a market maker does, and that’s why they are the masters of this game. They literally make the market.

Citadel Securities doesn’t care if you’re buying or selling.

Citadel Securities only cares that you ARE buying or selling.

And you are. Business is good. Everyone all of a sudden wants to download that Robinhood app and start trading. You may have noticed that there are a lot of media stories about that.

Virtually all of the Robinhood orders go through Citadel Securities. Why them? Because they pay Robinhood top dollar for it. That’s how Robinhood makes money. Not by charging you a fee on your transactions, but by selling your Flow to Citadel Securities. What’s that line? When the product is free, yada yada yada.

Know who else Citadel pays top dollar to? Janet Yellen.

For the nanosecond that Janet Yellen was between jobs as Fed Chair and now Treasury Secretary, Citadel paid her $810,000 to deliver three speeches. Apparently that first speech was so riveting that they needed two more.

And you thought your ten-bagger in GME was a good investment. Imagine spending $800k to be best buds with the person who regulates your $7 billion in annual revenues.

It always amazes me how cheap it is to buy political influence. The best investment on Earth.

This is Secret #2. This is what Ken Griffin and all the market maker masters of the universe know that you don’t.

Market makers OWN the game.


Is any of this stuff illegal? Probably not. Maybe. I dunno. But here’s what I’d be asking if I were a Congressional staffer trying to figure out how to make my boss look good.

First I’d swear in CEO Vlad of Robinhood and ask him the following question:

Sir, are your internal controls so poor and your understanding of markets so rudimentary that you found yourself in violation of capital posting requirements to such a degree that your only option was shutting down client trades OR did the National Securities Clearance Corporation (NSCC) raise their capital posting requirements to a shocking and unprecedented level without warning?

Now, the answer to at least one side of this question must be yes. Maybe the answer to both sides is yes. But at least one MUST be. And if the answer to the latter side of the question is yes … well, then we need to ask the NSCC some questions. Start with the people who were on the phone with Vlad. I bet he remembers their names. I can promise you his lawyers remember their names. Work backwards from there. How did this decision to give Gabe and Stevie and all the other HF titans on the wrong side of this ridiculous trade a day to trim their sails and throw their ballast overboard come about? How did this process begin? Who made the first call?

I suspect many people will need to “refresh their recollection” of these events. Ah, well.

And then I’d call CEO Vlad of Robinhood back for some follow-up questions.

Because you see, mirabile dictu, in the days immediately after this extortionary rules change and emergency shutdown, Robinhood got $3.4 billion in new capital. Hmm. If a prime broker had pulled this stunt in institutional world, it wouldn’t have survived a single day. But Robinhood gets BILLIONS in more capital, more capital than it had ever raised in all of its investment rounds before. Combined. Hmm.

Per Matt Levine, “the VCs got a substantial desperation discount. (They bought convertible notes that ‘will convert into equity at a $30 billion valuation — or a 30% discount to an eventual valuation in a public listing, whichever is lower.’)”

Per the WSJ, “New and existing Robinhood shareholders participated in the deal, which is structured as a note that conveys the option to buy additional shares at a discount later, a person familiar with the matter said.”

So here are my follow-up questions for Vlad.

Sir, Bloomberg describes your latest financing round as being priced at, and I quote, a “desperation discount”. Who are the new participants in this financing, sir? Were the participants or the terms or any other aspect of this financing discussed alongside your negotiations with NSCC for permission to resume trading? And before you answer, sir, I would remind you that you are under oath.

And that’s when this gets interesting. Because of course the capital raise was part of the negotiations with NSCC, and of course the “new participants” will include a friend of Ken or a friend of Wes or a friend of Stevie, if not an outright market maker affiliate.

And the beat goes on.

Honestly, though, the investigations and legal issues around last week are a sideshow. None of these post mortems are going to change Wall Street. What happened last week wasn’t some aberration that can be reformed or punished so that we can return to some mythic Wall Street that never existed in the first place.

What happened last week IS Wall Street, and government regulators have ZERO interest in changing it.

All this “concern” that Janet Yellen and regulators suddenly have for the little guy, all of this “worry” that retail investors are getting themselves into trouble … bah! … complete theatrical horseshit. The only worry regulators had was degrossing contagion and whether they needed to step in to ensure big financial institutions (including hedge funds) didn’t go belly-up from all of their suddenly excessive risk.

So nothing changes, right?

Not if you expect Janet Yellen and Ken Griffin to do the changing.

President Griffin’s Snow’s Second Panem Address: “Unity”

Well, screw that.

We’re never going to get change in Wall Street from the top-down. We’re never going to get change from “reform”. We’re only going to get a change in Wall Street by the way that true and lasting change always comes, from the bottom-up and from individual action. The time to take that action is NOW. Why?

Because we all saw what we all saw last week.

That’s what it MEANS to have an Emperor’s New Clothes moment, to have a sudden shift in our common knowledge about the stock market. The common knowledge that the market is a derivative reflection of some real-world game of companies is gone. It’s over. It can’t be saved, no matter how many times Jim Cramer Caesar Flickerman says otherwise. There’s no more shushing and whispering about the two Big Secrets of markets. Everyone knows that everyone knows that 1) The bets ARE the market. 2) Market makers OWN the market.

Because we all saw what we all saw last week.

There WAS a revolution last week, just not the revolution you heard about. There was no ‘Reddit Revolution’. That’s not a thing. It’s just another story spun by those who would use you for fodder or feed. Or flow.

There was a Common Knowledge Revolution last week – the only revolution that really matters over the long haul – and that is what changes everything.

This is our chance to mobilize a critical mass of citizens, our chance to break out of the Sheep Logic that has gripped us for so long. It won’t be our only chance. But it’s a good one!

I don’t want to democratize control over Wall Street.

I want to diminish Wall Street’s control over democracy.

I don’t want to open up Wall Street to the little guy.

I want to reduce Wall Street’s pernicious power and control over the little guy.

I don’t want to create a new viral narrative of meaning for Wall Street.

I want to vaccinate against the faux narratives of meaning that Wall Street constantly evolves.

How do we do all that? Through policy action, investment action and personal growth. All are easier as a team. All are easier as a pack.

Policy action: We take every opportunity to press legislators and regulators to take leverage out of financial institutions. All of ’em. Every chance we get. And yes, I understand full well that taking leverage out of Wall Street means getting off zero interest rates. Yes, please!

Investment action: We take every opportunity to put our money where our mouth is. We invest to achieve fractional ownership positions in real-world companies with real-world cash flows. We invest in public markets as a transmission belt for placing our private capital with management teams who can utilize that capital to more productive ends than we can. You know, what a stock market is supposed to do. When it’s necessary to sit down at one of the casino tables that modern markets have become, we are armed with tools to measure and calibrate the narratives that determine price and flow around those tables. Even if it’s the only game in town, we refuse to be the sucker at the table.

Personal growth: It’s the question I posed earlier. It’s the only question that really matters.

But if it is a lie … what then? What meaning exists in the stock market if all this is a lie?

Meaning is found in calling a thing by its proper name. Meaning is found in the choice to engage with that properly named thing in the fullness of your identity and human autonomy.

Clear eyes. Full hearts. Can’t lose.

Or in full-blown Zen koan mode, my all-time fave …

Tanzan and Ekido were once traveling together down a muddy road. A heavy rain was still falling. Coming around a bend, they met a lovely girl in a silk kimono and sash, unable to cross the intersection.

“Come on, girl,” said Tanzan at once. Lifting her in his arms, he carried her over the mud.

Ekido did not speak again until that night when they reached a lodging temple. Then he could no longer restrain himself. “We monks don’t go near females,” he told Tanzan, “especially not young and lovely ones. It is dangerous. Why did you do that?”

“I left the girl there,” said Tanzan. “Are you still carrying her?”

― Nyogen Senzaki, Zen Flesh, Zen Bones: A Collection of Zen and Pre-Zen Writings (1957)

It’s the hardest thing in the world, right? To let go of all those thoughts and narratives that have been drilled into our heads for as long as we can remember. To let go of the narratives that we have been carrying around like so much dead weight for YEARS. To see the market with fresh eyes and yet not give yourself over to bitterness, but to engage with the market for the good that presents itself on its own terms.

On its own terms.

It’s not easy. It’s a two steps forward one step back sort of thing. I struggle every day with this letting-go process, especially with the “no bitterness” part, and I’d like to think that I’m more of an adept at this than most. But it’s so worth it. It’s so necessary if you’re going to invest a part of your life towards playing the game of markets.

This is the biggest game in the world. If you are a game player – as I am – you cannot resist it. The question is … can you survive it? I don’t mean financially. You’ll be fine. I mean, can you survive it with your autonomy and your authenticity and your honor intact?

I think that Epsilon Theory can help you do that. I think we can help you see markets for what they are. Not what you’ve been told they are, and not what you would like them to be. But what they actually are. And then how to engage with that reality with a full heart. Together.

This is what we DO. This is what we’ve done from the start.

We call it The Narrative Machine.

And we believe it’s our best shot at understanding a world that cannot be predicted, but can only be observed.

Because markets are not a clockwork. Markets are a BONFIRE.

Yes, we think this leads to specific investment strategies.

But more importantly, we think this leads to a strategy for LIFE. For making our way in a fallen world, where the electorate is polarized, the market is monolithic, and everyone seems to have lost their damn minds.

It’s not an Answer. It’s a Process.

The Long Now is going to get worse before it gets better, and there is strength in numbers. Watch from a distance if you like. But when you’re ready … join us.

Yours in service to the Pack. – Ben

Epsilon Theory PDF Download (paid subscribers only): Hunger Games


When Does the Game Stop?


This piece is written by a third party because we think highly of the author and their perspective. It may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

Pete published this yesterday (Feb. 1) on his website.


The current state of equity markets is part of a broader progression over many years, as was the South Sea bubble, which has many lessons applicable to current circumstances.

How Did We Get Here? What’s happening now in equity markets isn’t the product of some paradigmatic democratization of finance. It’s likely just another bubble that will end badly. In my view, the behavior fueling the bubble is the culmination of many factors as follows:

  • Monetary Policy. Monetary policy action has given retail and professional investors alike comfort that the Fed has their backs at all times. Despite the fact that policy space is non-existent, the chant ‘don’t fight the Fed’ is burned into peoples’ minds. Pavlovian responses are hard to break. Low rates have also enabled companies to issue inexpensive debt (as Apple just did) to buy back shares and increase share scarcity. Notwithstanding this scarcity, low rates do not lead to ever-higher valuation multiples. It takes lower-and-lower rates to do that. At zero, they can go no lower.
  • Fiscal Policy. Fiscal policy choices are almost always made to pander to political bases, but the extremely polarized environment has made decisions even less objective. Politicians should stop trying to get ‘likes’ and start leading by making adult choices. The fiscal policy driven explosion in money supply (M2) has helped fuel the manic demand for equities. The pandemic has made for hard choices, and the next phase of relief is a make or break decision for the economy… and not in the way most may think.
  • Technology. Social media has generally brought extreme behaviors to normalcy – whether its pornography, racism, gambling, or otherwise. Markets simply reflect the broader societal trend and have become more like casinos. That doesn’t mean the behavior or opinions should be censored, unless there is an overwhelming public purpose. For every retail investor who says F&*K IT I’M IN, there will be others – some professionals – who say F&*K IT, I’M OUT. That’s the mechanism that will correct for the current misbehavior. When markets lose credibility and rationality, investors tend to opt out.
  • Might the Game Continue? Surely, it could for some time. In particular, new stimulus (supplementary direct deposits) could continue to fuel the speculative bubble in equities despite the substantial economic tradeoffs in the form of higher taxes and rising yields.[7] Clearly, those in love with equities now aren’t considering much beyond the next time they see a confetti bomb. Even this only delays the inevitable.
  • May I Make a Suggestion? I implore legislators to consider revising the income limits for the stimulus checks. Give more to the lower income families who need it most. The $150,000 joint AGI limit on stimulus checks is absurd (at more than twice the median household income)! It may make you popular, but it’s profligate and irresponsible. At least some portion of it is being used to speculate in equity markets, and it risks overheating not only equity markets but the economy. If the latter happens, the Fed will need to raise rates sooner than it has guided (i.e. – it’s almost never guidance), and that will be a cataclysmic occurrence for markets and the real economy. Target the measures to necessities: rent forbearance, food, healthcare, unemployment assistance, small business loans, etc.


Recent price action in OTC equity markets and in roughly a dozen names with high short interest is the culmination of a broader progression. It amplifies the observation that many markets – equity markets in particular – now have little to do with the fundamentals of underlying assets.[1] What Bitcoin has in common with GameStop is the idea of asset scarcity paired with a vague narrative that ‘something big’ is happening. Shorts squeezes occur on limited supply. As the argument goes, Bitcoin is in limited supply.[2] Its success, and the reason for it, has emboldened speculation in equities. Some market participants have discovered that the value of the chairs go up the fewer chairs there are. Here’s the problem: eventually there’s just one person in a chair. The rest have nada. This kind of speculation based on scarcity isn’t new. It happened in Holland in 1636 in tulips. It happened again in 1719 with the South Sea Company… and again and again.

This is more than just a sexy story about everyman beating the big dogs.[3] It has real and broad implications. Importantly, overvaluation and mispricings in equity markets have impacted pricing in corporate credit markets. In a number of cases, companies have smartly used irrationally overpriced equities to refinance debt and maintain unprofitable operations.[4] Reflexively, this delays the repricing in equities as bankruptcy risk is diminished. A new generation of arrogant, day traders is only partly responsible. They will eventually learn – just as we all have at some point – the hard way. We’ve seen it before, and it should come as little surprise. Whether you trade out of Mom’s basement, from a nice living room with a couple of kids running around, or in a suit on Park Avenue, markets don’t discriminate. As far as they’re concerned, stupid is as stupid does – eventually, at least. Just wait … the game will stop. It’s a matter of when not if.[5]

Has the market’s malfunction finally become so obvious that the credibility of equity markets is at risk? Targeted short squeezes are not a new phenomenon nor is gamma (or leverage) in options markets. Their most recent manifestation is new. The recent squeeze serves as a convenient and plausible explanation for recent hedge fund de-grossing and last week’s market selloff, but it’s far from the only cause. Credibility in markets is essential and fragile. Paired with extremely bullish sentiment, an already extant valuation bubble, high corporate leverage, extremely high retail margin levels and institutional gross exposures, uncertainly around new virus strains, and little visibility around earnings, the end of the recent squeeze (when it finally happens) could serve as a catalyst for a broader de-risking.[6] Bubbles can pop at any time and for any reason with post facto attributions typically pointing to the most recent and obvious event.


There’s an expression popular in Brazil: “Estou rindo para nao chorar.” It translates: “I’m laughing, so I don’t cry.” It’s laughable that the same politicians that want more regulation are now complaining about Robinhood curtailing activity when it was regulatory capital requirements that necessitated it. Those requirements serve an important public purpose; they assure the stability of the financial system. Moreover, politicians are complaining about payment for order flow, but that’s precisely what allows for commission free trading. In other words, without institutions paying for Robinhood’s flow, because Robinhood has no significant revenue directly from its online clients, it could not exist. While not surprising, it’s somehow still frustrating to hear visceral responses from the likes of AOC and others designed exclusively to pander to their bases without having even a remote understanding of market structure.

The fact that Citron’s Andrew Left and other media named short players have ‘capitulated’ may be a signal that the game is about to stop. Short interest will fall just as the pool of greater fools buying those same overvalued stocks begins to dwindle. As fewer short players participate, ‘borrow’ will loosen and diminish the scarcity. When the pool of speculators is finally exhausted – and it will be – it will be a lesson hard learned for those still in the trade. That’s what markets always do eventually; they humble all of us over time. It’s simply part of the learning curve over a long enough period of time. (Day trading for a few years does not qualify). Ultimately, markets punish those who make overly emotional or uninformed decisions. In this case, it’s taking more time than usual because of the sheer number of social media participants, most of whom haven’t seen a real selloff. The South Sea Bubble, too, was a populist event based on the public being ‘given access’ to an asset previously reserved for the elite; it took nine years to build and popped in a year.

What we’ve been witnessing is not some democratization of investing, it’s the kind of mob behavior that is almost always associated with bubbles and the catastrophe that follows. A Bloomberg story articulated it well: “The absurdist morality tale over the unalienable right of Redditors to pump up meme stocks and punish Wall Street has obscured a more reckless impulse.”[8] In order for a company like GameStop to experience a continued rush in its stock price, a few things would need to happen over time. First, it would need to generate far more revenue and quickly perform unlikely operational miracles. Revenue has fallen almost 50% from 2012 to 2021 and even optimistic projections have it rising only modestly for 2022 and 2023. Because of irrational equity markets, it could certainly do at-the-money (ATM) equity offerings as AMC has done to take advantage of its current equity valuation. That could buy it more time to fight the secular decline in its business and help it to reinvent, but no matter who joins the Board, the Chew-ification of the company has massive risk. It will take time. I participated I the restructuring of Atkin Nutritionals long before Rob Lowe became spokesman. It’s slog.

I had no idea that this was ‘a thing,’ but according to the above referenced story, Robinhood sends confetti to users when they trade: “Whenever Robinhood sends confetti to app users who place a trade, for example, it’s ‘kind of like with slot machines, they’re so colorful and loud and noisy,’ Mothner said. ‘Those little jolts feed the desire to keep going.’” Like just about everything on social media, the rush is fueled by bravado and ‘likes,’ which are pretty ephemeral. Retail may be ‘winning’ against the ‘elite’ now, but that doesn’t frame the conflict properly. We are all losers against the rest of the world if our free market system for pricing risk loses credibility. Ever hear of JT Marlin? The new Boiler Rooms are simply the online stock forums. Pump and dump is alive and well; it’s just been reinvented in a more insidious form. Eventually, thoughtful investing will return, but only after those who can least afford to lose money, lose it.

Gamma Hammer

There’s been some suggestion that the short squeeze impacting mostly hedge fund short positions is causing a broader hedge fund de-risking. It’s certainly a sexy narrative to suggest that retail traders are forcing a broad deleveraging amongst hedge funds, but is it true? Well, it’s almost impossible to know. However, market sentiment can be fragile, as Lu Wang and Melissa Karsch wrote: “Wednesday’s plunge widened to encompass stocks in the broader category of ‘recent winners.’ First among those was the ARK Innovation ETF (ticker ARKK), which surged about 150% last year with wagers on momentum-driven tech stocks.”[9] I’d written about how ARKK was a posterchild for the foolishness afoot in my last piece Fantasy World. Also according to the same authors in a different story, Goldman clients experienced the biggest one-day decrease in gross leverage on Thursday. Still, at 237%, leverage sat in the 96th percentile of a one-year range.[10] There could be more de-risking to come especially because margin leverage at retail accounts is also at all-time highs.

Leverage has proliferated in other ways. Options are, indeed, one of them. When a customer (retail or otherwise) comes in to place an order to buy an out-of-the-money option, a market maker (as opposed to an agency participant) will sell that customer the call option. That short call may sit on the market makers balance sheet; if so, the market maker is at risk. A short call is synthetically equivalent to short stock. The farther out of the money the option’s strike price, the lower the delta to that option (i.e. – its share equivalent). Nonetheless, in order to offset its short exposure, the market maker will usually buy the share equivalent of that option in underlying shares – creating a bid for the shares and potentially driving up the price. If the underlying price moves closer to the strike price for that option, the customer  may begin making money while the market maker may begin losing money (all else equal) – unless it buys more shares. In fact, gamma is the leverage on an option that makes the owner synthetically longer (and the market maker synthetically shorter) as the underlying stock price approaches the strike price. The market maker must buy more shares in response to this change.

As a squeeze occurs, this impact is exacerbated because it happens quickly – forcing the market maker to aggressively buy shares. This is how the power of the retail crowd was amplified – through leverage. It’s a temporary impact and not a paradigm shift. Now that this dynamic is well-known, the game is likely to stop as market makers aren’t dummies (just the opposite). They will take steps to hedge or modify their participation in irrationally priced securities. Some brokerages have already done so. They must protect their own capital positions in a highly regulated environment. As for some hedge funds, the squeeze in their short share positions may have prompted a temporary de-leveraging as prime brokers required more capital and eliminated margin on impacted names and potentially impacted ones, but this specific effect won’t be the singular reason for a broader selloff. This is not to say a broader selloff won’t occur, as the equity markets find themselves precariously positioned. Sometimes it doesn’t take much to break the back of sentiment.

Going South

Remembering a bit of history might help us learn from its mistakes. In the 18th Century, England was a class-based society (some might say it still is). The lower classes did not have access to markets unless permitted to do so by the elites. Such opportunities were scarce. Until 1711, when the South Sea Company formed, England had been engaged in the War of Spanish Succession. Spain and Portugal were in control of most of South American trade. Parliament looked for ways to fund its war efforts. They included two lotteries – yes, lotteries. The lotteries lost credibility when it became clear the government was providing a deferred annuity instead of a lump sum prize that it had funds to pay. The government also owed a significant sum to various private creditors, including debt owed to the public through those lotteries. The company was endowed with the exclusive right to trade with South America, under the assumption it would be able to do so after a treaty was signed.

In return for this, The South Sea Company underwrote the English National Debt. In other words, the existing national debt was cancelled and restructured as equity in the new Company, which issued shares to the former creditors with the promise of about a 6% dividend. The purpose of a series of conversions between the company’s formation and into 1719 intended for debt holders and annuitants to receive a haircut to their principal in exchange for shares. They converted an illiquid investment into shares that could be readily traded. Unsurprisingly, shares backed by the implicit government guarantee were considered safe – despite the lack of cash flow. The paper form also provided for a convenient way to hold and move money – far easier than coinage. A final conversion occurred in early 1720 alongside a delay in the dividend.

To increase confidence after the dividend deferral, the company talked up its stock based on the value of its potential trade in the New World. The share price rose from £128 in January 1720, to £175 in February, to £330 in March and to £550 at the end of May. A credit backstop of £70 million made available by the Parliament and King may have made this investment seem all the more bullet proof – despite the fact the company was not generating significant revenue and the validity of trade routes remained in international dispute. According to Historic UK, the frenzy spread to other companies:

“One company floated was to buy the Irish Bogs, another to manufacture a gun to fire square cannon balls and the most ludicrous of all ‘for carrying-on an undertaking of great advantage’ but no-one to know what it is! The country went wild, stocks increased and huge fortunes were made.”

We all know how it ended; fortunes were lost and then some. There was no one specific catalyst for the collapse except that reality eventually collided with the hype. There were no greater fools left to buy the shares of a company that could not deliver on its promises, and scarcity alone was not enough to maintain its value.

Aside from the scarcity effect, there are a plethora of other similarities between the speculation of today and during the South Sea bubble. One of the most obvious similarities would seem to be the involvement of the government, which throughout history has had a penchant for distorting incentives and giving people a sense of empowerment only to make to leave them in the cold. A second would be the involvement of a public that bought the bogus narrative late in the game. As Bloomberg reporters Greifeld and Ballentine wrote about GameStop’s impacts:

“The mania quickly spread to other meme stocks like BlackBerry, AMC Entertainment and Express, which each soared to highs unseen in years. The surge in trading activity, and the tremendous volatility it caused, prompted Robinhood and other online brokerages to restrict purchases of some of the Reddit-fueled names, sparking outrage on both sides of the aisle in Congress, and sowing darker, conspiratorial motives among WSB users.”

This sounds eerily familiar to what happened 300 years ago. There is also no coincidence that government sanctioned gambling made the populace then comfortable with this kind of risk taking.

There are also some important differences. One of them is that the retail investors on Reddit and elsewhere may be bag men and not even know it. Levels of sophistication on these forums vary widely. Anybody can start a meme that gores viral. Nobody knows their intention.[11] Unlike 300 years ago, there is no fraud being perpetrated by the companies or the hedge funds that are at the center of the anger. In contrast, the South Sea Company did perpetrate such frauds by over brokering its prospects. This is what the plethora of SEC and FINRA regulations to protect retail investors is designed to do. It was never contemplated to protect retail investors from themselves unless there’s fraud. This problem is far thornier as it involves First Amendment rights. The forum users are likely misleading each other – I’m guessing in most cases innocently and unwittingly. While the collapse of the South Sea bubble led to systemic issues and suicides, standing alone, the current mania would be unlikely to result in a market de-grossing. However, this was already likely to happen given the fantasy world in which equities currently exist. The condition has simply been laid bare in a unique way this time around.


Unfortunately, nobody likes it when their parents tell them they are being reckless, but wrapping the car around a tree and barely getting out alive often does the trick. It’s part of growing up and part of learning to invest. I was 18 once, and it happened to me. I learned to pay attention while driving. Many of my peers who are far more bullish than I – that’s pretty much all of them – are relying on a burst in GDP and earnings to support higher index price forecasts. Let’s get real. It’s the stimulus you’re relying on. That’s it. GDP will likely spike because of it. The extent of the spike is an exercise in finger wetting. SA strong GDP print won’t be the driver for equities. GDP hasn’t mattered for a long time, and I doubt it will change risk appetites much in 2021.

Earnings on the other hand are where I believe the disappointment will come. While for years they haven’t mattered much either, the stark reality now is that the Fed can’t act within its non-emergency framework to help support risk assets. All else equal, only lower rates boost asset values; rates are zero and bond yields are close. I also believe an extraordinary risk exists in too much fiscal stimulus to the wrong recipients. This could lead to a further overheat in the equity markets and in the real economy. The latter could necessitate a hike long before the Fed is ready. That is one sure fire way to prick this bubble and to hurt Main Street in the process. Sometimes less is more, Nancy, Chuck and Mitch. Be macro-prudential and not grandiose. I know it’s hard.


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[1] Newbies Discover Penny Stocks and 1 Trillion Shares Get Traded. https://www.bloomberg.com/news/articles/2021-01-14/one-trillion-off-exchange-shares-traded-is-latest-froth-marker

[2] This part of the narrative around Bitcoin makes little sense as it can be readily substituted for by other forms of crypto. At some point, the manufactured scarcity narrative will likely fall apart.

[3] Many Reddit forum users and others are far more sophisticated than often characterized with some encouraging groups to ask their brokers not to lend out shares – increasing scarcity and exacerbating the squeeze.

[4] AMC, in particular, provides a spectacular example of how a company uses the equity markets to continue to fund itself and maintain ultimately unsustainable levels of leverage. The company has done what any smart operator might. When equity markets are open, it issues shares. It has been doing so using the ATM (at-the-market) process, which makes dilution to existing shareholders less obvious. It has raised over $800 million in proceeds, which has provided it with ample liquidity for at least this year. Thus, despite a business in secular decline and a pandemic, it now has about $1.4 billion in cash.

[5] I wrote my first piece entitled Robinhood Rally in September of 2019. It pointed out the importance of retail investing in boosting equity valuations. Also see: https://www.businessinsider.com/stock-market-crash-3-pieces-investing-advice-stock-market-bubble-2021-1.

[6] Interestingly, most bubbles pop when leverage forces losses. ‘Gamma’ is just a fancy way to talk about the leverage an options creates for its holder or a counter-party to that holder.

[7] What drives rising long-dated yields is a more complex discussion, which most mischaracterize. However, when speculation is in force, market participants tend to eschew long-duration risk free assets for equities. This leads to a rise in risk-free long-dated yields – just as the converse occurs on risk-off. This is not in fact driven directly by inflation, which has no direct way to impact long yields. Counteracting this effect is the Fed’s messaging about inflation and rate policy staying low for longer (i.e. – the Fed reaction function). Because long yields are the geometric average of short yields over time, this keeps long yields low. Carry trade arbitrage is the mechanism for it (buy long fund short). Uncertainty around future policy is the most important reason for term-premia to exist. Should the economy overheat because of excess stimulus, the expectation could change relative to the trajectory of rates, and yields could rise.

[8] GameStop Mania Is Delivering a Dangerous Rush to the Reddit Mob, by Katie Greifeld and Claire Ballentine. “But what’s been obscured of late by the morality tale over the unalienable right of Redditors to pump up meme stocks as a way to redistribute wealth is this: that many of these mostly young men, cooped up with little else to do during the pandemic, have banded together for the pure, unadulterated rush of gambling and hitting it big, again and again.”

[9] https://www.bloomberg.com/news/articles/2021-01-27/hedge-fund-favorites-are-telltale-leaders-in-broad-stock-selloff

[10] https://www.bloomberg.com/news/articles/2021-01-29/hedge-fund-pressure-lingers-with-short-sellers-targets-rallying

[11] Meet the GameStop investor upending the stock market with cat memes, reaction GIFs, and fundamental analysis. https://markets.businessinsider.com/news/stocks/gamestop-investor-deepfuckingvalue-roaring-kitty-reddit-stocks-wall-street-2021-1-1030022004. Perhaps at $4 it made sense!


The Invulnerable Hero*


Die Nibelungen: Siegfried (1924) : Hollywood Metal
Siegfried bathes in dragon’s blood, from Fritz Lang’s Die Nibelungen (1924)

The Invulnerable Hero* is among our most treasured and recurring tropes.

It is the core feature of the great German epic, the Nibelungenlied. You probably know it better as the story of Siegfried from Wagner’s treatment of the story in his famed Ring Cycle. Siegfried slays a dragon and bathes in its blood, that is, everywhere except for the spot on his back covered by a drifting linden leaf. He thus becomes invulnerable to harm except in this very spot.

To those of you more familiar with the Greek epics, you will no doubt see the parallels with the story of Achilles. Thetis takes an infant Achilles to the River Styx and dips him into its waters. He thus becomes invulnerable at every spot but the one covered by the fingers by which his mother held him beneath the Styx: his ankle.

For the more cultured among us, we have our Superman story. Our invulnerable hero with practically every possible advantage and a weakness to one substance that, like the Achilles heel, is so iconic an expression of the trope that it is now a euphemism for a singular weakness or point of failure. Kryptonite. And no, nerds and/or Ben, please do not email me your pedantic notes on red sun radiation, etc.

Still, there’s a funny thing about Invulnerable Hero* stories. Though we know the hero is all but invulnerable, and though we know that the only real conflict in our story is one which might threaten their single point of vulnerability, the stories are rarely about the vulnerability itself. The stories are about their great battles, their great triumphs and the roles they play in the other stories of their time. Stories which pose them practically no threat.

And even though those stories aren’t the real story, they still matter.

I know that we all want to believe that the story of GameStop is really about regular people sticking it to institutions that have done the same thing to others for years. That a revolution has taken place.

I could give you my suspicions that most of the volume and capital that have driven the short squeezes have come not from Reddit or other retail investors but from institutions (read: other hedge funds) who quickly devised strategies to predict where the energy produced by these groups would be directed next. But they would be only suspicions. Pretty strong ones, mind, but still suspicions all the same.

I also think there’s a certain misguidedness to so much of what has taken place, driven by the belief that it’s short-sellers who are the ones who most aggressively manipulate the system and do harm to the average investor. I can think of many cases where this is specifically true, and I can think of many cases where this is categorically false, cases in which this group of investors have been among the only truth-tellers left, opposed by the same financial media that patronizes retail investors today. Lazy fund-of-fund diligence analysts, hubris-and-implicit-debt-laden macro funds and 2-and-20 long/short funds minting decamillionaires by delivering 30% net exposure to the S&P and the occasional branded Patagonia vest have each extracted far more real value from the average investor and citizen.

But leave both of those things aside. Because it’s still a good story. It’s a story I think people will remember. It’s a story that still matters, even if it isn’t 100% true and even if its target was maybe a bit off-the-mark.

But it also isn’t the real story. It isn’t the Invulnerable Hero* story.

The real story is the one that lies underneath: it is the story of the source of cascading events in markets, of short squeezes and events in which those squeezes lead to large de-grossing events in which funds rapidly reduce their exposure and cause the kind of broader market events that do have real-world effects. It is the story of the heel of Achilles, the shoulder of Siegfried, the kryptonite of Superman.

It is the story of leverage.

It is the story of the gross exposure which we have collectively decided is the birthright of these institutions.

As they have many times before, regulators, financial media and financial institutions are responding to make sure that this Achilles heel doesn’t lead to the kind of wildfire event that it very well could. As they have many times before, they are doing so not by addressing the Achilles Heel of leverage and excessive gross exposure, but by seeking to prevent whatever proximate cause threatens to expose that weakness. Last year it meant our government providing a bid for assets that had none. In this case, that means our government and institutions doing what they can to prevent the establishment of new positions by retail investors.

When the dust settles in the next couple days, you’ll get the usual laughing “This time it’s different…not!” thinkpieces from Very Respectable Investors, and they’ll be mostly right. Short squeezes aren’t new. De-grossing events aren’t new. Goofy run-ups happen all the time. But there is a new common knowledge that applies to a much broader audience.

The place where Achilles was held when he was dipped into the River Styx is now common knowledge. The spot covered by the linden leaf on Siegfried’s back is now common knowledge. Superman’s home planet is now common knowledge.

Soon, the fact that hedge funds have long been and are now even more actively scraping, watching, predicting and pouncing on public, pseudo-private and private social networks will become common knowledge. Their realization that they can free-ride on asymmetric, illiquidity-driven trades that don’t create the same regulatory risk as their own public agitation and collusion might will become common knowledge.

That an entire industry is vulnerable to and will itself join in cannibalistically with this kind of coordinated attack will soon become common knowledge.

I suspect that the gatekeepers and regulators will have to face the choice: do they want free and fair markets for the pricing of capital in which everyone plays by the same rules, or do they want to protect the birthright of the hedge fund industry to run high levels of gross exposure and substantial explicit and implicit leverage that will continue to necessitate these impartial emergency restrictions and rescue packages?

We know what they’ve chosen before.

Maybe this isn’t the revolution some were hoping it would be. But it might be a policy inflection point. There might be an opportunity to build a movement around fairness, truly free markets and the rule of law.

Let’s tell those stories.


The Zimbabwe Event


Covid funeral in Harare

Over the past two weeks, three senior Cabinet officials in Zimbabwe (including the Foreign Minister and the Infrastructure Minister) have died from Covid. Not gotten sick. Died. More broadly, reported Covid cases and deaths have exploded in this country of 15 million just in the month of January. The unreported numbers are certainly much higher, as about 90% of Zimbabwe’s population works outside of the formal economy, and the majority of Zimbabweans have little to no access to the healthcare facilities that report these official case and death numbers.

through Jan. 21 (source: worldometers.info)
through Jan. 21 (source: worldometers.info)

The societal unraveling that is taking place in Zimbabwe – a desperately poor country where per capita GDP is less than $1,500 and declining – is staggering.

Two days ago, the government’s Information Minister tweeted that his fellow Cabinet members had been “eliminated” and called the nation’s doctors “medical assassins”. He deleted the tweets yesterday and apologized “if anyone was offended”. Nurses at a major hospital in the capital city of Harare are on strike because they are provided a single cloth mask and bakery aprons as PPE. The Defense Minister has accused China of “botched experiments” that brought Covid to Zimbabwe, and has said that she will only accept a vaccine if it is manufactured locally. Today, the government announced that it “plans to buy” cheapo Chinese and Russian vaccines, but can only afford to cover two-thirds of the country’s population. The Harare elite have taken to hoarding – not food, but oxygen– to the point where hospitals are placing newspaper ads promising to pay top dollar for any remaining supply.

This is the ‘Zimbabwe Event’, and I believe it has significant real-world and market-world consequences.

Like the ‘Ireland Event’ I’ve been writing about recently, what is happening in Zimbabwe (and every country in Southern Africa) is driven by a combination of relaxed social mitigation policies AND the introduction of a more infectious SARS-CoV-2 virus variant.

What is different is that Zimbabwe is a “weak state”, not a strong, stable state like Ireland.

What is different is that Zimbabwe is being hit by the South African-variant (501.V2), not the UK-variant virus (B117). 

The “Weak State” Difference

The stress of the Covid pandemic is enormous in ALL countries, and it is stress at EVERY stratum of society. The poor are dying. The middle class is dying and getting poorer. The elite are not dying quite as much, but they’re not getting richer and the difference in outcomes between some elites and other elites is enormous.

This broad societal stress results in popular discontent and elite conflict in every country on Earth.

Rich country or poor country, weak state or strong state, big nation or small nation … doesn’t matter. ALL nations are experiencing much higher levels of popular discontent and elite conflict today, which means that ALL governments are experiencing much higher pressure for regime change and leadership transitions.

In a strong state – meaning a nation that has the institutions, traditions, narrative legitimacy and state-supporting common knowledge to accommodate a peaceful leadership transition even under times of intense stress – you can survive a Covid Event without violent regime change.

In a weak state – meaning a nation that does NOT have the institutions, traditions, narrative legitimacy and state-supporting common knowledge to accommodate a peaceful leadership transition under times of intense stress – you cannot.

Weak states do not have an effective political steam valve for popular discontent and elite conflict, resulting in war and violent regime change when a Covid Event hits.

The United States is a strong state. It is, arguably, the strongest state in the world, with an institutional legitimacy and broad-based popular loyalty to those core institutions that has few peers. The United States has many political steam valves for the expression of popular discontent and elite conflict.

If the events of January 6th and the storming of the Capitol can happen in the United States, can you imagine what’s possible in Harare? In Tehran? In Moscow?

In a desperately poor country like Zimbabwe – and there are a lot of Zimbabwes in the world – the violence of popular discontent and elite conflict is obvious enough. When the core functions of a domestic government effectively collapse, civilian life in these circumstances quickly becomes, as Hobbes would say, nasty, brutish and short. The outcome of these circumstances is ALWAYS war. First a war of all against all, then a war of organized factions, then (often) a war of nations. Some of these wars in the Zimbabwes of the world will be entirely internal to existing borders. Some of these wars will cross those borders. Some of these wars will include major powers. 

I think 2021 will be a Year of Civil War in weak states that are desperately poor.

The market couldn’t care less about that, of course, whatever the human enormity of this violence might be.

But the dynamics I’m describing are not only true for an insanely poor weak state like Zimbabwe, but are also true for a relatively wealthy weak state like South Africa. Or Iran. Or Russia.

If you don’t see that the Navalny protests and the growing popular discontent with Putin and his billion dollar palace and all that is both made possible and accelerated by the enormous stress that Covid has placed on the Russian economy and public health … well, I think you’re missing the larger picture here. By the same token, I also think it’s clear that there is real and significant elite conflict behind the protests you see on TV, similarly stemming from that stress on the Russian economy. Clausewitz famously said that war is the continuation of politics by other means. In weak states, though, the reverse is also true: politics is the continuation of war by other means. Right now, Russia is a political war of all against all. Can Putin survive this political war? Sure. But if he does, it won’t be pretty. My bet is that he “retires for health reasons”.

I could absolutely see the same thing happening with Khamenei in Iran. Or MBS in Saudi Arabia.

I think 2021 will be a Year of Unexpected Regime Change in weak states that are relatively wealthy.

The market will care about this a great deal.

The S. African-Variant (501.V2) Difference

My notes about the Ireland Event focused on two questions:

1) how likely is a rolling series of B117-driven Ireland Events in the United States? (very, in my opinion)

2) where are we in the timeline for the first of these US-based Ireland Events? (2 to 3 weeks from today, in my opinion)

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

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

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

1) There is a sharp difference in general media coverage of the risk of viral variant spread versus financial media coverage of the risk of viral variant spread. 

While there’s an almost willful ignoring of the virus variants in major financial media, this is not the case with major non-financial media, where coverage of the news and risks of viral variant spread shows both “coherence” and “strength”, to use our narrative structure terms. Notably, however, even in non-financial media, the sentiment associated with articles about viral variant spread is oddly … positive. Like it’s really not a big deal and with Team Biden at the helm we got this covered! Yay, Team Biden! I think this is a classic example of narrative complacency, particularly in financial media, where all of the narrative risks right now are to the downside.

2) There are now four independent medical studies showing that the B117 variant is both more infectious AND more lethal than the baseline virus, versus zero medical studies showing only the same lethality (you can download a PDF copy of the most recent NERVTAG paper here). 

While the mathematical truth is that increased lethality is not nearly as “dangerous” from a public health perspective as increased infectiousness, from a popular perspective just the reverse is true. Stories of increased lethality carry a lot more narrative punch than stories of increased infectiousness. When there’s a confirmation of the lethality data (and I think it’s a when, not an if), that’s a hard hit to the “variants aren’t a big deal” narrative.

3) We now have multiple examples of a B117-driven Ireland Event, not just in Ireland and the UK, but also now in Portugal, Spain and Israel, and coming soon to the rest of continental Europe. 

The ‘Israel Event’ is particularly chastening, as the explosion in Covid cases occurred despite the most advanced vaccination program in the world, with close to 40% of the population vaccinated even as the Event occurred. As I wrote last week, one of the major consequences of a more infectious viral strain is that the percentage of the population that must be vaccinated before herd immunity brings down the R-number is significantly higher than with a less infectious viral strain, so that even 40% is only a modest help in limiting new infections. Also, and this is even more problematic news, Israel reports that a single dose of the vaccines that originally contemplated a two-dose regimen is notably less effective than was suggested in clinical trials. Whether this reduced efficacy for one dose of a two-dose vaccine is because of something particular to the B117 variant is unknown. Either way, that gets us to the last and more important point.

4) The potential for reduced vaccine efficacy is at the heart of why I think the 501.V2 variant is so important, both in real-world and in market-world. 

On Monday, we got the first hard evidence on vaccine efficacy versus 501.V2 (you can read the full Moderna press release here), largely duplicating the findings of South African studies earlier this month of antibody protection from prior baseline Covid infections. These are in vitro tests (lab tests) on the sera (blood) of vaccinated (Moderna analysis) or previously Covid-infected (S. African analysis) patients to measure how much “neutralizing” the antibodies in this vaccinated or previously Covid-infected sera gives you against the new virus variant. There will always be some degradation in neutralizing efficacy, but it’s a matter of degree as for whether you can keep going with the existing vaccine or whether you need a booster shot or whether you need to develop a new vaccine or what. The results from both studies, showing a “six-fold reduction in neutralizing titers” (vaccine protection) and an “eight-fold reduction in neutralizing titers” (prior Covid-infection protection) are on the okay side of “meh” but are still pretty “meh”. These are “yes, but” results.

YES, the current Moderna vaccine appears to be technically effective against 501.V2, meaning that it should provide a greater than 50% chance of protection against serious illness from contracting Covid. My interpretation of a “six-fold reduction in neutralizing titers” is that it’s roughly as effective as last year’s flu vaccine would be for this year’s flu (happy to be corrected on this by anyone who knows better). That’s not nothing! It’s a lot, in fact. BUT it’s a far cry from the efficacy we’ve seen in clinical trials against the non-variant virus, which is really outstanding.

In market-world, I think it is impossible to overstate the destabilizing impact of a Covid variant that is vaccine-resistant.

And to be clear, 501.V2 is probably not that variant. If it were, then I’d be worried about a lot more than just a transitory punch to the market’s nose. Also to be clear, I don’t think 501.V2 in the United States is even in the case, case, case phase of the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! cycle of exponential virus spread. B117 is the immediate threat here, not 501.V2.

But what we DO have with 501.V2 is the start of a vaccine-resistant Covid variant narrative.

I hope that’s all it ever is … the start of a vaccine-resistance story that never develops into a vaccine-resistance reality! But for market-world, the mere existence of a narrative like this, even in an embryonic state, is enough to drive tradeable market events.

Put this together with recent developments with B117 … put the imminent impact of a US-based Ireland Event together with the long-term and geopolitical impact of Zimbabwe Events … and yeah, I think you’ve got a tradeable punch coming to markets.


Off Wall Street and Off-Off Wall Street


Rusty and I are thrilled to announce that Brent Donnelly will be joining us as a guest contributor to Epsilon Theory.

Brent is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021. Brent writes a daily email focused on FX markets that is my go-to source for understanding that enormous corner of the market, but in truth his writing is applicable to every aspect of investing. You’ll see what I mean when you read his latest post below!

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

What is off-Wall-Street and off-off-Wall-Street?

In New York City, there is Broadway, where the lights are bright and the famous plays like Hamilton, Rent and The Lion King run. Then, there is Off Broadway, venues with seating capacity from 100 to 499 that show some fairly well-known but obviously less epic productions. Third, there is Off-off-Broadway, which began as a “complete rejection of commercial theatre”. These are the sub-100 seat venues that show experimental drama and theatre.

Similar, but different, is the information ecosystem for trading and investing. While we tend to focus on the highbrow outlets like FT, Reuters, The Economist and others, there are other less highbrow outlets that carry useful information and market-moving clout.

The point of this note is to do a medium-deep dive into a few off and off-off Wall Street joints that you may not know about and may find useful.

Here’s a diagram that shows my best effort to classify the major investment and trading information outlets according to the year they were founded and whether they are highbrow or lowbrow. This classification is subjective and was not as easy as I thought it would be. For example, which is more highbrow … The Economist, or The Wall Street Journal ?

I hope no one is insulted by my choices and just to be 100% clear: lowbrow is not synonymous with bad! Some of my favorite things are lowbrow. To me, lowbrow just means something that is not highly intellectual; something that appeals to the median  person on the street. For me, that can be good (movies like Old School, music by Post Malone, and quality chicken wings) or bad (American Pie sequels, music by Pitbull and boiled peanuts). The matrix is inspired by those New York Magazine matrixes from the 2000s. Here it is:

The curvature of the chart over time is interesting. The only publications that survive in the long run are highbrow. This makes sense to me intuitively as parody and lowbrow tend to be more faddish and fashionable while intellectual rigor is timeless.

But before we get into the discussion of FinTwit, Reddit and TikTok, you may wonder: Why does any of this matter? There are four reasons:

1. There is interesting and unique analysis on Twitter and Reddit that you won’t see anywhere else.

This is true whether you trade macro (best stuff is on Twitter) or single names (craziest stuff is on Reddit).

2. Retail opening new accounts and gambling with stimulus checks is the rocket fuel driving bubblicious, crazy moves in single names.

You cannot fully understand this until you witness the amount of overconfidence, indiscriminate buying, straight up silliness and outright gambling going on. In 1999, I belonged to a bulletin board called The Underground Trader. When a stock started to trend on there, it might rally 3%-5% in a few hours. Now, when a stock starts to trend on r/wallstreetbets, it can go up >100%. See GameStop (GME) in recent weeks, for example.

The chart at right shows the rocket ship formation in GME as the massive short interest ran head on into the r/wallstreetbets hype machine. There are other factors behind the rise in GME but even Jim Cramer has been talking about the subreddit’s influence on this particular single name.

These next charts from Bloomberg and FinTwit give you another indication of the explosion of interest from retail. Note that retail investors tend to prefer things that are cheap and things that have significant leverage.

This stuff matters hugely at the penny stock level as retail interest can completely overwhelm supply. There was a day last week where 20% of all US equity volume was made up by five microcaps and 6 of the top 10 most active stocks were priced under $1. Obviously it’s easier for cheaper shares to trade higher volumes but this sort of activity in microcaps is highly unusual. To quote from this Bloomberg article:

“I thought it was pretty odd,” said Saluzzi, co-head of equity trading at Themis Trading. “I’ve been around for a long time, I’ve seen people in chat rooms and retail investors saying ‘we can make some money – it’s easy.’ There’s a risk it may not end well.”

3. Retail is an important driver of the bull market / bubble in financial assets.

While retail is the dominant player in many single names now, there is most likely an impact at the index level as well with TSLA, AAPL and other index members attracting much of the new long-only money. You cannot go short in a Robinhood account and very few people seem to buy puts so the money is either long or levered long with some multiplier above 1. Every stimulus announcement sees a massive inflow into crypto and retail equities and there is no reason to expect that to change.

Poorly-targeted stimulus (See Scott Galloway here, for example) and ultra-loose monetary policy are driving assets higher. The more you understand the retail story, the more you will be prepared to take the other side of the bubble when it comes crashing down. As I have said many times, but would like to say again: It’s easier to make money long a bubble, not short. The two recent USA bubbles (internet 1999 and housing 2005) both popped well after the Fed’s first rate hike. Even if you think this bubble is crazier and that markets learn from the past, the bursting of the current bubble is still somewhere way, wayyyy down the road. Here’s a Bloomberg story:

Stock froth boiled after $600 checks. Now $1,400 may be coming.

Here’s what happened in the market around the time the government sent people $600 earlier this month. Penny share volume mushroomed. A company that sounds like a word Elon Musk tweeted rose 1,100%. Tesla added $130 billion, IPOs doubled and options trading exploded.

Coincidence? Maybe — though a lot of people doubt it. They can’t help notice how tiny traders with money to spend keep turning up in the vicinity of almost every market spectacle these days. Now, more federal aid may be on the way, and Wall Street pros are bracing for what comes next.

“If the additional $1,400 goes to the same income levels it did before, we are highly likely to see additional speculation in stocks, which could continue to inflate an already-existing bubble,” Peter Cecchini, founder and chief strategist of AlphaOmega Advisors LLC, said in an interview.

4. It’s fun!

The fourth reason to spend some time on FinTwit and Reddit is that there are a ton of smart and funny individuals posting hilarity. Recall the fun and games around Davey Day Trader in April and May. Here are a few examples from one of my favorite follows on Twitter, a parody account called Dr. Parik Patel.

So what are these things anyway?

What is FinTwit?

Let’s talk briefly about Twitter, then move on down the spectrum. I am finding more and more in recent years that FinTwit can be a source of unique and super smart information. (In case you don’t know: FinTwit sounds like a putdown but it’s just short for “Finance Twitter”). Writers like Jon Turek, Lyn Alden, and Nathan Tankus rose to prominence on FinTwit and are among the gurus that share in-depth writing on the site. Jens Nordvig publishes great stuff all the time, and you can get a view of what pre-eminent thinkers like Ben Hunt, Tim Duy, and Scott Galloway have on their minds. Hard to say if FinTwit is lowbrow or highbrow: It’s both.

It takes a while to properly curate a list of Twitter handles to follow and it’s not as simple as just cutting and pasting someone else’s list because it’s a matter of taste and preferred topics. That said, next week I will send out a survey and try to aggregate everyone’s favorite Twitter handles and see if we can come up with a nice master list.

As you drop down the highbrow axis, you eventually get to r/wallstreetbets.

What is r/wallstreetbets?

Let’s start from the top level and work down. Reddit is a community-curated message board where posts of value are upvoted and content deemed unworthy is downvoted. The result is a marketplace of ideas that is nearly impossible for marketers and corporations to infiltrate and a system where quality mostly rises to the top. The culture is smart, snarky, funny, self-referential and full of in-group lingo. Reddit is broken into over one million topic-based communities called subreddits. One of those millions of subreddits is a beautiful and amazing cesspool of intellect and degenerate financial market gambling called r/wallstreetbets.

The main screen says: “r/wallstreetbets: Like 4chan found a Bloomberg terminal”. Members of the community are called “degenerates”. The r/wallstreetbets subreddit currently has 1,888,019 members.

If you go into r/wallstreetbets (WSB for short), you will find a community of funny, rude, self-deprecating and reckless speculators riffing on various market-related activities. The focus tends to be one or two stocks and the primary investment thesis is almost always to YOLO as many calls as possible in the thing that is about to…

There is a lot of despicable and sophomoric language but mixed in there are some good ideas and some well-informed speculators. For every dumb post, there is  (for example) a quality analysis of the SEC uptick rule and how its enforcement or lack thereof can impact a stock with more than 100% of free float outstanding.

In WSB lingo, strong hands are called “diamond hands” and weak hands are called “paper hands”. Profits are called “tendies” as in chicken tenders, as in the ultimate luxury food. One sample post I just scrolled to reads as follows: “TSLA – Best $100K I’ve ever spent. When do I hop off the tendie coaster???” and then shows a screenshot of an absurd gain on super low delta calls in a Robinhood account.

A lot of the memes and posts and culture are self-effacing, self-deprecating and traders brag just as much about huge losses as they do about huge gains. It’s ridiculous but much of what is on there is clearly real and it’s serious money being wagered, much of it borrowed money or entire 401ks.

Under the fun headlines and silly posts, you will see some impressive deep dives usually under the flair: “DD” for due diligence. Every post is headed with a “flair” or heading. The most popular flairs are: Meme, gain, loss, YOLO, and DD. At right you see a DD post that then goes into some CFA type analysis that you might otherwise have read on Seeking Alpha or some similar site.

The community is heavily invested in hopes for a continuation of the GME short squeeze right now, so there are many posts like the one on the left below (turning the $1,200 stimmy check into more than $10,000) and random cheering:

Obviously some of the screenshots could be faked but overall it seems to me that many, many young traders have a majority of their net worth ($25k to $100k) invested in one or two stocks or a few OTM calls with hopes that those stocks will continue to rocket. So far so good for them!

Bull market, dude.

You can have a look for yourself, just Google r/wallstreetbets.

As you follow the y-axis lower and lower on my original “investment information ecosystem” chart on Page 2, you will notice way down in the corner, down below zero on the 0-1o lowbrow/highbrow scale is: “TikTok Finance”.

What is TikTok finance?

TikTok Finance is generally an extremely hype-heavy cringey place where inexperienced traders pump questionable strategies to an audience of inexperienced investor-trader-gamblers.

A CNBC story explained it this way:

TikTok for financial advice? Young people are turning to the video app for tips to weather the recession. Amid TikTok’s surge in popularity, a growing number of users are turning to the app for personal advice. As of mid-June, the #investing tag on TikTok had racked up 278 million views. Experts caution that accounts offering guidance may be skipping important lessons and hawking get-rich quick schemes.

If you are brave, watch this clip where two TikTok influencers describe their stock market strategy. If you are easily triggered, just read my abridged excerpt below. And keep in mind as you read it, that these two TikTokkers have 115,000 followers. Here is an excerpt:

We get this question all the time and honestly the answer is very simple… How do we make money from home? So basically, we just trade stocks on Robinhood. It’s free to sign up and they actually give you a free stock to sign up … so they’re paying you to sign up.

I know trading sounds intimidating…

Here’s my strategy in a nutshell: I see a stock going up and I buy it … And I just watch ‘til it stops going up. Then I sell it and I do that over and over and that’s how we pay for our lifestyle. What I like about this is … the fact we don’t have to go to a 9-5 job. We can focus on things we actually enjoy doing.

This month I turned $400 into $14,000 (see screenshot at right)

The terminology! “You get a free stock when you sign up” makes me cringe and it comes up all the time in the TikTok, Robinhoodie world. Here it is again at 7:34 of this video from a poker vlogger looking to sign up new Robinhoodies and WeBulls via an affiliate link. Key quote: “Last time I did this, I got an Apple stock, which is ka-razyyy!?”

You get the idea, but here are a few of the comments below that TikTok influencer video:

It’s not as funny as it seems

While much of what I have posted above is comical and good clean fun (and certainly something I would have been actively engaged with in my 20s!), it also points to a less funny issue: the ongoing gamification of stocks and the lack of seriousness with which many now view financial markets.

As asset prices decouple further and further from the real economy and a rising percentage of unprofitable companies come to market, a new generation buys a stock not because they believe in the company and its products and want to share in its future profitability. They buy stocks as a substitute for sports gambling or to stifle the unending boredom of the pandemic. They bet their entire stimmy check on deep OTM options in a YOLO move to bragpost @ their online friends.

In 1999 the main overriding thesis was “internet gonna change the world”. Now the overriding thesis is “stonks only go up”. The market is turning into a meme machine, a cartoon of its former self, as Neb Tnuh might say.

Brain science shows the prefrontal cortex is not fully developed until age 25. Young men crave novelty and risk-taking as their prefrontal cortex develops and this risk-taking is a healthy part of growing up. Now the real world is shut down and does not offer much risk. There are no cliffs to jump off, or skate parks open, or places to drive way too fast to. So the risk-taking happens on a stock betting app fueled by extreme and experimental monetary policy geared toward higher asset prices. Funded with stimulus checks.

I am not claiming superiority here, I took more than my share of unnecessary and excessive personal risks from ages 18 to 25. It’s what you do at that age. But there were better things to do at that time then play the stonks game on my phone.

The orthodox view of financial markets (or “the boring Boomer view” as they would say on Reddit) is that the stock market is where companies go to raise money for investment and expansion in the real world. Now, the cynical view is the majority view: the market is a place where founders and insiders cash out and executives turbocharge stock-based compensation via buybacks. That’s not good. When capital markets are a source of ridicule, not respect, it hurts capitalism and it inevitably hurts America. It’s all fun and games until someone loses their 401k.

Anyway … As this bubble takes on more and more air and I witness most of the exact behaviors that defined the euphoria in 1999, I feel more and more like an old man yelling at clouds.

Until the Fed reacts, just keep on dancing!

Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.


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UK-Variant SARS-CoV-2 Update


That’s a London scene from the post-apocalyptic zombie flick 28 Days Later on the left, and a London scene from the pre-apocalyptic March Covid lockdown on the right. I say pre-apocalyptic because today’s Covid situation in London with a 70% prevalence of the B117 SARS-CoV-2 virus is a lot worse than the situation last March. No zombies yet, but 2021 is young.

Last Wednesday we published our analysis of behavioral Covid fatigue + UK-variant SARS-CoV-2 spread in the United States.

And we released a podcast on our work, also available on Spotify and iTunes

Last Friday, the CDC held a press conference and released an analysis showing that they expect this more virulent UK-variant strain (B117) to account for 50% of Covid cases in the United States by the end of February. We’ve stored a PDF of the CDC analysis on the Epsilon Theory website here, and you can read a summary of the findings in this WSJ article

Over the weekend, the two most prominent US Covid missionaries – Scott Gottlieb and Tony Fauci – both publicly reversed their stance on the trajectory of Covid spread. Gottlieb’s twitter threads on the B117 threat were particularly urgent, noting that “new variants may change everything. They’ll be 1% of all cases by end of next week, with hot spots in Florida and Southern California.” 

While on the one hand it’s gratifying that the CDC is validating what we wrote, on the other hand it’s pretty scary to contemplate the consequences of the B117 UK-variant virus accounting for 50% of all US cases 40 days from now. That’s what this update note is focused on – the consequences – because they are sorely underplayed in the WSJ article summarizing the CDC report. 

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

Consequence #2: if B117 is the dominant US strain by the end of February, the daily number of new Covid cases by the end of February will be significantly higher than today. This is the point that was completely missed in the WSJ article. B117 doesn’t become the dominant strain because it “defeats” the baseline strain. This isn’t a football game. B117 becomes the dominant strain by spreading even faster than the current fast-spreading baseline virus. The math here is as inexorable as it is sobering, and it means that the rollover in Covid cases and hospitalizations we are currently seeing is a temporary reprieve in advance of an even tougher battle. 

How tough? I dunno. Depends on how much we ignore the B117 threat and take this rollover in the holiday Covid surge numbers as an all-clear sign. An ‘Ireland event’ is a combination of two things – introduction of a more infectious virus AND a relaxation of Covid mitigation behaviors like social distancing and avoidance of indoor groups. Right now, we have it within our power to move both of these necessary conditions in the right direction. But we’re not. On the contrary, we’re moving both of these necessary conditions in the wrong direction, and by the time it becomes clear that we’re risking an Ireland event … well, it’s too late to prevent it. You can only hope to control it.

How do you control it? How do you respond politically to an Ireland event in the United States, where (extrapolating current UK numbers to the US) you could have 8,000 Americans dying from Covid every day? You shut down. And I don’t mean a Covid theater shutdown. I don’t mean an LA County shutdown, with its 50+ exemptions for any politically relevant constituency. I mean a true shutdown. I mean businesses and individuals shutting themselves down.

If B117 becomes the dominant SARS-CoV-2 strain in the United States over the next few weeks, I believe it will create a chain of events that are profoundly life-killing, job-destroying, and misery-producing. 

And I don’t believe that ANY of this is priced into markets.

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

But does it matter?

Does it matter to market-world if this profoundly deflationary, risk-off, dollar higher, flight to safety chain of events occurs in real-world?

Will markets look through all this, particularly if the Fed and White House say all the right things?

LOL. Of course they will.

I have zero doubt – ZERO – that markets will ultimately look through the B117 threat, even if that threat is realized through unprecedented real-world shutdowns and trauma. 

But between today and that ultimate look-through, I also believe there is a significant chance of a narrative shockwave hitting risk assets, particularly those securities tied to a “Covid recovery” theme. You can’t jawbone the virus. You can’t declare by fiat or by narrative that B117 isn’t happening. This IS happening, and the common knowledge that this IS happening will punch our now dominant investment narratives of “earnings recovery” and “reflation” and “the worst is over” square on the nose. Maybe its just one good punch. But it’s a punch nonetheless.

What creates the B117 common knowledge that impacts markets?

I think it’s whenever we get news of the first cluster of B117 cases in the US. 

Right now we’re still in the case, case, case phase of the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! cycle of exponential spread. You can still close your eyes and pretend B117 isn’t happening in the case, case, case phase. But once that first cluster hits the news … well, you can’t ignore that. That’s when B117 becomes common knowledge. That’s when every market missionary starts talking about it, not just Covid missionaries like Gottlieb and Fauci. That’s when every investor knows that every investor knows that our glidepath to recovery is not assured. 

When do we hear about the first B117 cluster in the US? No idea. If Gottlieb is right about 1% of US Covid cases originating from B117 by this Sunday, that’s a big number that would almost surely contain clusters and significant community spread. I think that news would hit risk assets pretty hard. But if Gottlieb is wrong and it takes longer to move into the cluster, cluster, cluster phase, then there’s more time for market-supportive “we can look through B117” narratives to develop. Bottom line: the longer it takes for B117 clusters to appear, the less the impact of B117 common knowledge on markets. 

But the cluster IS coming. As the kids would say, it’s just math.