Fractures in the US Energy Independence Narrative


Every once in a very rare while, we see what we call a Missionary statement (an action or a speech by a famous person or organization that is widely distributed on a ubiquitous media platform) that has the potential to change the Common Knowledge (what everyone believes that everyone believes) about an important aspect of our investment lives.

For example, this February we highlighted the Missionary statement by the Tokyo Marathon organizers that they were canceling the 2020 race out of Covid concerns, leading to our view that the common knowledge around the business of sport was about to crack apart. This was in mid-February, well before anyone was considering (publicly, at least) canceling the Olympics or eliminating attendance in professional sports. For most people, the Tokyo announcement didn’t seem like a big deal, but when you spend your professional life immersed in narrative-world, as Rusty and I do, that announcement was like a car alarm going off, precisely because it was so different from the common knowledge of the time and it was presented so publicly.

Here’s another shockingly different and very public Missionary statement that’s striking us like a car alarm, published on October 12 in the FT:

Shale binge has spoiled US reserves, top investor warns (FT)

QEP’s Wil VanLoh says country’s oil production capacity is lower than believed

Wil VanLoh, chief executive of Quantum Energy Partners, a private equity firm that through its portfolio companies is the biggest US driller after ExxonMobil, said too much fracking had “sterilised a lot of the reservoir in North America”. “That’s the dirty secret about shale,” Mr VanLoh told the Financial Times, noting wells had often been drilled too closely to one another. “What we’ve done for the last five years is we’ve drilled the heart out of the watermelon.”

“Even if we wanted to, I don’t think we could get much above 13m” barrels a day, Mr VanLoh said. “I don’t think it’s physically possible, because we’ve messed up so much reservoir. I would argue that what the US was touting three or four years ago, in theoretical deliverability, is nowhere close to what we think it is now.”

To be clear, I have no idea if VanLoh is right about this.

What I DO know, however, is that this Missionary statement has the potential to wreck one of the common knowledge pillars of the energy sector narrative specifically and the US economic growth and US foreign policy narratives more broadly, that the United States has achieved energy independence through the fracking “revolution”.

We took a quick look with the Narrative Machine at financial media using the phrase “energy independence” in Q4 2015, Q3 2018 and Q3 2020.

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In all three of these narrative maps (each containing about 1,200 independent financial media articles), I’ve put a green oval around the Clean Energy narratives and a gold oval around the Politics/White House narratives. These are the constant narrative super-clusters within any time frame where we look at this question. What you’ll notice, though, is a new super-cluster in 2020 that I’ve marked with a blue oval, containing sub narratives that directly use the phrase “US Oil Independence” and its variants. This new super-cluster has the single largest article cluster with 9.3% of all articles published during the period, and more importantly occupies the center of the overall narrative map. Up/down/left/right doesn’t matter in these maps. Centrality does. Not only is “US energy independence” now explicitly a narrative super-cluster within a universe of articles that contain the words “energy” and “independence” – showing that it has cohered into a standalone narrative in its own right – but it is also the most central and influential narrative super-cluster within that universe.

But wait, there’s more. The overall narrative map in 2020 is much less cohesive than the overall narrative map in 2018. Numerically it’s about 40% less coherent, and visually you can get a feel for this by the greater number of individual clusters in 2020 and their greater dispersion from the map center off to the periphery. Our view is that a less cohesive map is a more complacent map, meaning that any narrative shock – like a Missionary statement that the US is NOT energy independent – is likely to wreak more havoc on the existing narrative system.

To be clear, it’s by no means certain that this Missionary statement will get picked up and amplified by other market missionaries in the near term. Also, until energy demand picks up and there’s an economic need to produce more than the current 11 million bbl/day, we won’t be able to test the proposition that 13 million bbl/day (our high water mark pre-Covid) is now the US production limit.

But Missionary statements like this don’t just go away.

Whenever we come out of this Covid recession and energy demand starts to pick up again, this Missionary statement will get some play. And depending on how other market missionaries pick up on it (or not), it could have a really broad impact, I think, on the entire US growth and economic strength narrative (and the politics around THAT), whether or not it is factually true.

Yes, whether or not it is factually true.

We live in Fiat World, where opinions expressed as news or fact pack just as much punch – if not more! – as actual news and actual facts. Whatever your view may be on the Truth with a capital T in regards to US oil reserves, I think we’ve all learned over the past 12 years that those views and that Truth can be wrong for a loooong time if the narrative is blasting loudly in a different direction. We’ll keep our eye on this for you and alert you to any signs of this Missionary statement getting more traction in narrative-world.


From Pillar to Post


Last week I wrote that markets would move from pillar to post up until the election, and this week I thought it might be useful to revisit the origin of that phrase. The expression was originally ‘from post to pillar’, and it referred to the practice of whipping some miscreant on a post and then moving them over to a pillory for display to a jeering crowd. Here’s someone in a pillory. Not sure if he’s been soundly whipped or not.

I suppose I can’t say that this is what “the market” feels like these days, what with the S&P 500 having its best week in months last week, and the QQQ having its best week in forever. But I do think this is what it feels like to have a view on the market or the election these days. Maybe you’ve already been whipped soundly for that view and maybe you haven’t. But anyone with a view has got to be feeling locked in a pillory. Anyone with a view has got to be worried that a whipping is just around the corner.

Three weeks ago, the common knowledge – what everyone knows that everyone knows – was that a Constitutional crisis was inevitable and that more stimulus was impossible. Last week, the common knowledge was that a “blue wave” was inevitable and that not only was more stimulus on the way, but it could easily be MOAR stimulus. This week … I dunno … it feels like we’re recognizing that the entire world is going to hell in a new Covid-wave handbasket. Next week … well, next week I’m expecting the aliens to land. Or for the large hadron collider at CERN to make contact with a parallel universe. Actually, that last bit is not a joke.

What we’re dealing with here in October 2020 is not risk. It’s uncertainty.

Decision-making under risk is something we’re all very practiced at. All of expected-utility theory, all of portfolio theory – ALL of it – is based on decision-making under risk, where probabilities and outcomes are knowable.

Decision-making under uncertainty, on the other hand, is something we have very little practice at (thank goodness!) and even fewer tools and theories. But there is a strategy that works. From the Epsilon Theory note Once in a Lifetime

The decision-making strategy designed specifically for uncertainty is Minimax Regret.

Minimax Regret was invented (or at least formalized) in 1951 by Leonard “Jimmie” Savage, one of the founding fathers of what we now call behavioral economics. Savage played a critical role, albeit behind the scenes, in the work of three immortals of modern social science. He was John von Neumann’s right-hand man during World War II, a close colleague of Milton Friedman’s (the second half of the Friedman-Savage utility function), and the person who introduced Paul Samuelson to the concept of random walks and stochastic processes in finance (via Louis Bachelier) … not too shabby! Savage died in 1971 at the age of 53, so he’s not nearly as well-known as he should be, but his Foundations of Statistics remains a seminal work for anyone interested in decision-making in general and Bayesian inference in particular.

As the name suggests, the Minimax Regret strategy wants to minimize your maximum regret in any decision process. This is not at all the same thing as minimizing your maximum loss. The concept of regret is a much more powerful and flexible concept than mere loss, because it’s entirely subjective. But that’s exactly what makes the strategy human. That’s exactly what makes the strategy real when the ultimate human chips of living and dying are on the table.

Minimax Regret downplays or eliminates the role that probability distributions play in the decision-making process.

Minimax Regret doesn’t calculate the odds and the expected utilities over multiple rolls of the dice. Minimax Regret says forget the odds … how would you FEEL if you rolled the dice that one time and got snake-eyes?

More technically, Minimax Regret asks how would you feel if you took Action A and Result 1 occurs? What about Result 2? Result 3? What about Action B and Result 4, 5, or 6?  Now out of those six potential combinations of action + result, what is the worst possible result “branch” associated with each action “tree”? Whichever action tree holds the worst possible result branch … well, don’t do THAT. Doing anything but THAT (technically, doing the action that gives you the best worst-result branch) is the rational decision choice from a Minimax Regret perspective.

The motto of Minimax Regret is not Know the World … it’s Know Thyself.

Because when faced with an uncertain event, where you only have one roll of the dice on a probabilistic event, that’s all we can know.


We are only given the world once. Usually that’s not a big deal from an investing standpoint, because the possible parallel universes aren’t that far apart in their market consequences. Over the next three weeks (and maybe longer than that!), the fact that we are only given the world once is a very big deal indeed.

My advice over this span … pay less attention to what the world is telling you about the future, and more attention to what your gut is telling you about yourself. Knowing yourself and your maximum regret does NOT necessarily mean playing it safe. I know lots of investors for whom playing it safe IS their maximum regret. What it means is just that – know thyself – and if you’re managing other people’s money – know them, too – and avoid action trees that hold the worst possible result branch given that knowledge.  

Just do that, and this will all be over soon enough, even if it feels like being in a pillory right now. Minimize that maximum regret and you’ll live to fight (and invest) another day. No matter what parallel universe we end up in!


The Best Hedge


Talking about our October narrative monitor reports released last Friday morning, both our Central Bank monitor and our Securities Analysis Methods monitor

As you may recall (and it’s in the monitor report if you don’t), the S&P 500 returns are typically positive in the month following an Inflation-focused regime reading (+1.6% on average), and typically negative in the month following a Fundamentals-focused regime reading (-0.9% on average). This may seem like a wash, but in our model portfolio construction we actually give substantially more weight to the negative signal of the Fundamentals-focused regime than the positive signal of the Inflation-focused regime.

Why? Because markets (and narrative impact on markets) happen at the margins.

Narrative signals are most impactful when they indicate a change in regimes. Narrative signals are most impactful when they exist at the edges of the narrative regime spectrum. Narrative signals are not a smooth variable, something to be z-scored, in the econometric lingo. They are a state of the world, which is why we use the term “regime”, and they change in quantum steps.

For Central Bank narratives, then, we’re most confident that we’re reading an actionable market signal when there’s a regime change (like we saw going into May when the narrative state of the world moved from the highly market-positive Fed Put regime to the slightly market-positive Inflation regime in April) or when the narrative state of the world is at the edges of the regime spectrum (Fed Put on the positive end, and Hawkish on the negative end).

Ditto for Securities Analysis Method narratives (the way that market participants talk to each other about how to think about stock prices). We’re most confident that we’re reading an actionable market signal when there’s a regime change (like we saw going into August when the narrative state of the world moved from the highly market-positive Technicals regime to the market-negative Fundamentals regime in July) or when the narrative state of the world is at the edges of the regime spectrum (Technicals on the positive end, and Fundamentals on the negative end).

So if you ask what our macro narrative signals are telling us as we go into October, they’re moderately bearish. We don’t have negative signals from both narrative monitors, but we do from the SAM monitor.

And then we had the first week of October. LOL. When I say LOL, I don’t mean that I think our macro narrative signals are wrong. I mean that I don’t think they matter very much.

From last Thursday night until 2:49 pm today, the only thing that mattered to markets was the news flow of a White House in free fall (so odds of a decisive Biden victory went way up with maybe a Senate switch, too) plus the news flow of an on-again multi-trillion dollar stimulus package, the combination of which led to the long end of the yield curve spiking ferociously (10-yr UST backing up from 0.66% to 0.78%) and an even more ferocious “Buy Cyclicals!” market narrative.

And then at 2:49 pm today, with a Trump tweet that the stimulus negotiations were kaput, that narrative and that trade collapsed, with the S&P 500 falling 2% in 15 minutes.

And then at 10 pm tonight, with another tweet that maybe stimulus negotiations could start back up again, futures are back to flat.


I understand the “Buy Cyclicals!” market narrative. It’s an instantiation of the Fourth Horseman / Inflation Cometh I’ve been writing about since October 2018 (“Things Fall Apart (Part 3) – Markets”). If there’s no big issue with a transition of Presidential power … if there’s a an unfettered path for the Democrats to unleash the mother of all fiscal stimulus packages with their MMT theology … well then, we’re off to the cyclical/inflation races! Until they raise taxes, of course.

I also understand the “Sell Cyclicals!” market narrative. If there’s no fiscal stimulus coming … if the Fed is pushing on the string of a string … if the outcome of the election (in whichever direction ) is contested and sparks the mother of all Constitutional crises … well then, we’re off to the defensive/deflation races! Until there’s a massive fiscal stimulus after all, of course.

So … I have no idea what’s going to happen next. These are essentially mutually exclusive paths. I mean, I’m sure there’s some muddle-through scenario here, and that’s probably what will actually transpire in November. But markets (and narrative impact on markets) happen on the margins. This market is going to continue to swing from pillar to post until that muddle-through event actually happens, and there is no hedge for that. Or rather, the only hedge is the best hedge – you take down gross exposure, not just net exposure. You reduce your market risk. You minimize your maximum regret.

Wall Street, like Hollywood, is geared to sell happy endings. Ultimately I think we’ll have, if not a happy ending for markets when this election is all said and done, then at least a happy-ish ending. But until THAT narrative takes shape, then it’s a narrative and market rollercoaster, where every marginal outcome is just a tweet or a Covid diagnosis away. No one has an edge in this environment, and anyone who says they do is kidding you or kidding themselves.

Stay safe! And when the smoke clears, let’s get to work.


Cartoon Network


I’m old enough to remember when cartoons were only on TV for a few hours each week, every Saturday morning.

I’m also old enough to remember when the market cared deeply about wage inflation. Unlike Saturday morning cartoons, this wasn’t a 1970s thing. It was all of two years ago. Back in 2017 and 2018, if you recall, we waited with bated breath on the first Friday of every month when the jobs numbers came out at 8:30 AM, so very anxious to see if wage inflation was going to come in “disappointingly low” and “miss expectations”. Again. Because, you see, if wage inflation was disappointingly low, then naturally the Fed should maintain extraordinarily low interest rates to “spur” inflation. Oh golly, we were SO concerned with wage inflation!

If you look up “concern trolling” in the dictionary, you’ll find a picture of our 2017-2018 narrative fascination with wage inflation.

All this lasted until it became impossible by late 2018 to claim that wage inflation was “disappointingly low”, so naturally we moved on to the REAL reason for insanely easy monetary policy … this addict market and its silly-town valuations collapse without it. I’m old enough to remember the bear market of Q4 2018 and Jay Powell’s Christmas Eve conversion dinner with Donald Trump. I bet you are, too.

Anyway, speaking of cartoons, I thought about our old friend wage inflation when I saw this tweet from Liz Ann Sonders at Schwab:

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Why is this important for the jobs report this Friday? Because the cartoon of our wage growth report is based on average hourly wages.

Why does the Bureau of Labor Statistics calculate the average hourly wages for all Americans, even though most working Americans get an annual salary? Because back in 1915 when the BLS was established for the purpose of supporting government policy with “data”, that’s how most Americans got paid and how all Americans thought about wages. Back in 1915, the common knowledge about wages was that it was an hourly thing. Everyone knew that everyone knew that wages should be talked about and thought about in terms of an hourly wage. So today, more than 100 years later, the BLS still goes through the now hilariously inappropriate statistical exercise of forcing all of our jobs through a monthly-hours-worked survey and calculation, even if we’re paid on a weekly, monthly or annual basis.  

I am not making this up.

You can see where this is going. If salaried Americans work fewer hours in September as they help their kids navigate a terribly challenging school situation – but receive the same salaries regardless – this will show up as a wage inflation “shock”. It’s not a real shock, of course. No one is getting a raise. But because of the way this particular data cartoon is constructed by the BLS, a decline in monthly hours worked for salaried employees will mechanistically increase their “hourly wages”. And because of the sensitivity of the calculations to a stable monthly-hours-worked survey number (I wrote a long Epsilon Theory note about this and other data cartoons if you want to dig in here: The Icarus Moment), it only takes a small decline in average monthly hours worked – say twenty minutes – for a spurious 1% increase in wage inflation.

So look … it’s possible that for whatever reason, all this time off from work won’t show up in a major way within the BLS monthly hours worked survey. It’s also possible that no one cares if there’s a shockingly high wage inflation number this Friday, and these spurious results can get explained away pretty quickly. But there are plenty of algos that trade these releases immediately as they are reported, and this is classic example of how an algo can get really wrongfooted when the underlying ultra-stable data series goes haywire. Forewarned is forearmed.


The Beachball Theory of Volatility


It’s very difficult to keep a beach ball submerged underwater when you’re playing around in a swimming pool. No matter how hard you try to keep it under … pushing it, sitting on it, laying on top of it … it seems to have the mind of a trapped animal, turning and spinning to get to the surface at all costs.

I think exactly the same thing is true when it comes to volatility in markets.

Recently, every central bank in the world with a truly sovereign currency has made a commitment to keep sovereign rates at ZIRPy levels or better … forever. Or if not forever, then what passes for forever in banker-speak. The upshot of all this, given that the Central Banker Omnipotence narrative is still the most powerful force in global markets, is that interest rate volatility has collapsed all over the world, all at the same time. And because all of these central banks have told us that they are at least yield curve control-curious, interest rate volatility hasn’t just collapsed for short-term interest rates, but across the entire yield curve.

Now that’s wonderful news for sovereign borrowers. Corporate borrowers, too. Probably it’s good news for investors in Treasuries or Bunds or whatever, although that can get … tricky … particularly with longer-dated bonds if we get past the deflationary mega-shock of Covid-19 and the central bank commitment or firepower for yield curve control comes into question. But it’s definitely bad news in two quarters – rates trading desks on the sell-side and global macro funds on the buy-side.

It’s bad news for rates traders because their desk is now the most boring place in the world. There’s no juice, no spread … no profit. It’s bad news for global macro funds because their strategies are almost always long carry and so almost always depend on differences between countries, particularly interest rate differences and currency exchange rate differences. (Rusty has a fantastic article on this from 2018: The Many Moods of Macro).

And this is where the beach ball comes in.

Here’s the big question for global macro funds and FX trading desks and multi-asset managers: will the collapsed volatility in global interest rates result in similarly reduced FX volatility, or will it result in increased FX volatility?

If you believe that currency exchange rates are – at their core – a reflection of interest rate differentials between countries (and this is pretty much the standard view of FX fundamentals), then crushing volatility in rates is definitely going to crush volatility in FX. In fact, when you stop to think about it, it’s probably going to crush volatility in everything.

But if you believe that currency exchange rates are – at their core – a reflection of narrative differentials between countries, then there’s no ironclad mechanism that forces FX volatility down when interest rate volatility goes down. This is what I believe.

And if you also believe, as I do, that the business of Wall Street and global banking requires narrative differentials between countries, that in fact their business is the creation of these narratives to drive trading activity, then it’s just a matter of time before we see the emergence of new national difference narratives that drive FX volatility (and other asset class volatility) regardless of the iron grip central banks have on interest rate volatility. Like “OMG, there’s a second Covid wave in Europe”. This is the beach ball.

It’s not a beach ball of volatility based on fundamentals. It’s a beach ball of volatility based on narratives. And not even the concerted action of every central bank in the world can keep that underwater for long.


Adventures in Hollow Market – SoftBank


Six years ago I wrote a series of Epsilon Theory notes on what I called the Hollow Market (here, here, and here), my phrase for a market structure where humans trading to express an interest in the fractional ownership of a real-world company accounts for less than 30% of market activity, where liquidity might seem normal on the market surface but is nonexistent once the shell of normality is pierced, and where the opportunity for market mischief by pools of capital allied with new technologies is immense.

Well, all of those factors are only worse today, and Softbank is the result.

By now you’ve probably read the articles, both from mainstream financial media: SoftBank unmasked as ‘Nasdaq whale’ that stoked tech rally (FT); SoftBank’s Bet on Tech Giants Fueled Powerful Market Rally (WSJ)

and from non-mainstream media: Connecting the Dots: How SoftBank Made Billions Using The Biggest ‘Gamma Squeeze’ in History (ZeroHedge)

and maybe you’ve read some articles or Twitter threads from very smart options traders who think there’s less to this than meets the eye: (Benn Eifert)

and maybe you need a quick Epsilon Theory refresher course on delta and gamma and how these invisible threads pull at the more visible equity market: Invisible Threads: Matrix Edition (ET from October, 2015)

So I want to be careful in what I’m saying …

First, everything that happens in markets is overdetermined – which is a ten-dollar word that means there are way more smart and plausible reasons for why something happened than are needed to actually explain it – and I’m sure this is no exception.

Second, I don’t have special knowledge about SoftBank’s trading strategy or a comprehensive view into their counterparties’ trading desks. I hear things, you hear things, we all hear things. I think I probably hear more than most, but I’m not an insider on any of this.

Third, I’m not a lawyer.

So put it all together and here’s what I’m saying …

I don’t know if this is what SoftBank did. But this is how I would do it. Although I wouldn’t because I think it’s probably illegal.

Step #1: I’d buy “story stocks”. I’d buy billions of dollars worth of large-cap and mega-cap stocks that get enormous press coverage and trade at a high multiple.

Step #2: I’d buy call options on these stocks. I’d spend another billion dollars or two in call option premium across a wide range of strikes and tenors. I’d do this over as many accounts and in as small an individual trade amount as possible. I would tell all of my friends. I would funnel funds and purchases through as many cut-outs as possible. I would look for story stocks where there was an organic, retail option buying wave, and I would increase/shift my Step #1 holdings into those stocks. I would describe my call option strategy with the metaphor of rolling as many snowballs down the hill as I can, trying to make them bigger and bigger snowballs, trying to merge them with other snowballs, so that eventually I trigger an avalanche in derivative, invisible threads that tie the visible market together.

I’d be doing all this for two reasons.

First, I’d want to use the leverage that’s inherent in a call option that’s being bid up to force my counterparties to buy a lot of stock in the open market to hedge the position on their books. This is the ‘gamma squeeze’ that the ZeroHedge article is talking about. If you’ve ever been on a trading desk, you know what this feels like. You’re not in the business of taking a view one way or another on a stock, so if your book gets too lopsided in the risk you’re taking for a particular view, you MUST hedge that risk. The result, of course, is that as the underlying stock goes up (my Step #1 positions!), more and more retail investors buy new call options, which is exactly what I want in my snowball strategy.

Second, I’d want to use all of this option buying activity to drive up the implied volatility of these stocks. In other words, I want to see the price of ALL options (or at least all call options … the skew is a feature for me, not a bug) to go up. I not only want to trigger a gamma avalanche (taking advantage of convexity on price), but I also want to trigger a vega avalanche (taking advantage of convexity on volatility) … I want to make the call options themselves go up in price, separate from the mechanistic increase in option price driven simply by the underlying stock going up in price. Now this may seem odd. If I want to encourage more and more call buying activity, why would I also want to make those call options more expensive in and of themselves?

Because I need to exit the trade.

Step #3: I’d sell call options on these stocks. To be clear, I’d be selling way out-of-the-money covered call options throughout this process. But as the price action got more and more furious and my Step #1 stocks and Step #2 call options got bid up more and more, I’d be selling call options more and more aggressively. I’d be pocketing as much premium as I could on my underlying Step #1 stocks, and if I get called away at these crazy prices … well, that’s just fine. I’d be offsetting my long call options with these short call options (setting up a call spread). I’d just be outright selling some of my long call options at a nice profit. I’d be doing all of this, while at the same time I’d be starting new snowballs down the hill wherever it makes sense.

But that’s just me.

Where’s the illegal part of this? It’s in Step #2 where you’re trying to funnel these call option buys through as many cut-outs and allied accounts as possible. It’s what Cornelius Vanderbilt would have called “making a corner” and Andrew Carnegie would have called “painting the tape”  … creating non-bona fide trades to give the illusion of volume and activity and interest … but with the modern twist of acting through trades in derivative securities rather than trades in the underlying security itself.

Like I say, I’m not a lawyer. And these aren’t the clear and obvious wash trades that are the classic examples of painting the tape frauds. But a snowball strategy like this – where the intent is to create a market illusion – was Cornelius Vanderbilt’s go-to robber baron move back in the mid-19th century, and the intent of all of the Wall Street reforms of the early 20th century (including the formation of the SEC) was to eliminate these constructed market illusions. Today, of course, Wall Street regulators are in on the act. It’s all edge cases and cheesing, all the time.

What’s the takeaway? I’ve got two, one specific and one general.

The specific takeaway is whenever the WHY? is answered in narrative-world – WHY have tech stocks run-up so much? WHY did we have the sell-off in the past few days? It’s SoftBank’s fault! – this narrative answer will dominate price action for a good while to come. That means steady downward pressure on all of the megacap story stocks that led the market up over the past few months. A narrative that answers the WHY? is the most powerful narrative in markets, and it lasts until another narrative answer rises to combat it (which always happens … eventually). This is true whether or not the narrative answer – it’s SoftBank’s fault! – is a little bit true or a lot true or not true at all. Right now this narrative answer to the WHY? has legs, and it’s going to play out like all dominant narratives always do.

As for the general takeaway, I don’t think I can say it better than I did five years ago:

“I suppose that’s the big message in this note, that you’re doing yourself a disservice if you don’t have a basic working knowledge of what, say, a volatility surface means. I’m not saying that we all have to become volatility traders to survive in the market jungle today, any more than we all have to become game theorists to avoid being the sucker at the Fed’s communication policy table. … Nor am I suggesting that anyone fight the Fed, much less fight the machine intelligences that dominate market structure and its invisible threads. Not only will you lose both fights, but neither is an adversary that deserves “fighting”. At the same time, though, I also think it’s crazy to ignore or blindly trust the Fed and the machine intelligences. The only way I know to maintain that independence of thought is to identify the invisible threads that enmesh us, some woven by machines and some by politicians, and start disentangling ourselves. That’s what Epsilon Theory is all about, and I hope you find it useful.”


September Monitors and Election Risk


First, we published our September Central Bank and Securities Analysis narrative monitors yesterday, which you can access here and here. There’s no change in the narrative regime from August to September in either monitor … an inflation-focused regime (typically market-positive) remains dominant in Central Bank narrative-world, and a fundamentals-focused regime (typically slightly market-negative) remains dominant in Securities Analysis narrative-world.

The “internals” on these narrative regime measures show a weakening in strength for the Central Bank inflation-focused regime, although the narrative cohesion and sentiment remain at crazy high levels. Put simply, there’s less drum-beating today in financial media about what the Fed is doing (less attention is being paid to ALL of the standard Fed narrative regimes), but more drum-beating about the Fed’s uber-dovish stance on inflation than any other story about the Fed, and it’s an insanely focused and market-positive drumbeating.

As for the fundamentals-focused narrative regime in Securities Analysis, we continue to see a lot of strength and positive sentiment, with a slight decline in cohesion. We believe this means that stories and news about macroeconomic fundamentals (is the US economy “bouncing back”? are we seeing “signs of growth”?) will continue to dominate market outcomes. If the stories and news remain positive, that’s constructive for markets. If they’re not …

Second (and relatedly), I saw this graphic in the FT today and wanted to use it as a follow-up to last week’s post, where I said that the time to be thinking about portfolio adjustment for the inflation genie getting out of the bottle is now, but that there was a strong chance IMO for the Mother of All Recessionary Shocks with the US election in November …


Not gonna lie, I don’t think this VIX election premium is big enough. This isn’t a “fiscal cliff” we’re talking about here, which was about as manufactured a “crisis” as I’ve seen. This is an honest to god non-trivial chance that we have an intractably disputed election and Constitutional crisis in the United States, against a backdrop of widespread violence in American cities. If that sounds like a VIX of 30 to you … well, bless your heart.

I’ll write more about this next week, because I also think that the rally coming out of successful transition of power and diminution in urban violence could be historic, as well. But as November 4th approaches, I get less and less confident that we can avoid a deflationary shock of epic proportions. Particularly when you consider that the Fed is going to be as much of an ultimate arbiter on the election outcome as the Supreme Court and the US military.


The Inflationary Shock Recipe


Before I share the two charts that have kinda thrown me for a loop, a quick housekeeping item. The screenshare recording and presentation deck for the webinar we hosted last Thursday on our new narrative monitor – Security Analysis Methods – has been posted on the ET Pro website here: If you didn’t get a chance to join us live (or even if you did), I hope you get a chance to check out the work we’re doing with this narrative monitor. Understanding whether market participants are primarily focused on either multiplesfundamentals, or technicals in the way they talk and think about investing is both an important signal in and of itself (IMO), and is the starting point for asking and answering a lot of crucial questions about how investing actually works today.

And now onto the charts …

The first chart shows US Household Formation (the annual change in the number of occupied housing units, both owned and rented) on a monthly basis over the past 30 years.

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It’s rare to find a chart that speaks for itself, but this one does. Most of this spike is people buying empty homes. The rest of this spike is people renting empty apartments. Together, this is maybe the most bullish data point I’ve seen since the GFC for real-world spending and economic dynamism. This is the sort of real-world behavioral change that absolutely drives real-world inflation higher. Maybe much higher.

The second chart shows the 21-day correlation between the S&P 500 and 10-yr US Treasury yields. It was part of a Credit Suisse report by their derivatives strategist, Mandy Wu (who I think does solid work), and reprinted in a Bloomberg article titled “Bonds No Longer Work to Diversify Stock Risk, Credit Suisse Says”.

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Unlike the Household Formation chart, this one doesn’t speak for itself. The crux of the chart is the little red box at the bottom right … for the first time in a long time, when stocks go down, yields are going up. And since yield is the inverse of price in bond-world, we’re seeing the price of both stocks and bonds move in tandem … stocks go up in price AND bonds go up in price or stocks go down in price AND bonds go down in price.

To be sure, we’ve seen this movie before. You can find lots of periods in US market history – many quite recently, and some which last for years – where there is a positive correlation between stock prices and bond prices (I prefer to call it a positive correlation between stock and bond price rather than a negative correlation between stock price and bond yield … just seems cleaner to me). But here’s what’s special about today. There has never been a positive correlation between stock prices and bond prices with Treasury yields so low. Never.

Combine these two charts with Jay Powell’s Jackson Hole-remote speech today, where he basically announced that it will be years before the Fed even thinks about raising rates because of inflation, and you get this: the time to start preparing your portfolio for an inflationary shock and the havoc it will wreak on what you think is a well-diversified portfolio of stocks and bonds is NOW.

I’m not saying you sell out of your bond portfolio now. I think we could have the Mother of Deflationary Shocks if we have a close election (that’s the subject for another note!), so I wouldn’t be making any big Treasury sales between now and Nov. 4th. I’m saying you figure out NOW what you’re going to do with your portfolio once we’re through the election.

Massive real-world household formation growth + positively correlated stock and bond prices + ZIRP forever and ever amen = an inflationary shock to your portfolio.

I don’t know when, and I don’t think it happens before the election, but this is the recipe.


Webinar on Security Analysis Narrative Monitor


Here’s the replay for the Security Analysis Narrative Monitor webinar we held via conference call and screenshare for ET Pro subscribers.

We think we can identify the periods where market participants are primarily focused on either multiples, fundamentals, or technicals in the way they talk and think about investing.

Each of these narrative regimes – multiples-focused, fundamentals-focused, and technicals-focused – generates a powerful signal of subsequent market dispersion (cross-sectional volatility) and subsequent market performance.

I’ve also attached the slide deck we used in the presentation here: ET Pro Narrative Monitor deck.


A Banner Day


Not just a two-fer to start off the dog days of August, but a three-fer.

First, the August edition of the Central Bank narrative monitor is out today. We’re still in an inflation-focused narrative regime, which is a positive regime for stocks (and an even more positive regime for precious metals). But the narrative strength of ALL of our Central Bank regime measurements is weakening, including the inflation focus. Combined with an insanely positive market sentiment towards Central Banks (the highest on record in the past five years), we think this is a VERY complacent market narrative structure when it comes to Central Bank support.

Second, we’re publishing today a one-off narrative monitor on Covid Vaccines. It’s the question we get more than any other: “Are Covid-19 vaccine narratives moving the market?” The short answer is yes, and exactly the way you think they are. The longer answer is yes, but it’s a short-term trading impact that only lasts for about a day and a half. I think you’ll really like this research note, and it’s a great example of the power of the Narrative Machine over different time frames.

Third, today we’re launching our second monthly narrative monitor – Security Analysis Methods. That’s a mouthful and it sounds boring, but I promise you it’s anything but. Even more so than the Central Banks monitor, I think this is the most powerful investment application we’ve developed yet. In a nutshell, we think we can identify the periods where market participants are primarily focused on either multiples, fundamentals, or technicals in the way they talk and think about investing. Each of these narrative regimes – multiples-focused, fundamentals-focused, and technicals-focused – generates a powerful signal of subsequent market dispersion (cross-sectional volatility) and subsequent market performance. These signals are particularly useful when regimes transition from one to another, and that’s exactly what we’re seeing going into August: a transition from a technicals-focused market narrative to a fundamentals-focused market narrative.

As we did with the Central Banks narrative monitor, we’ll be holding a webinar on Tuesday, August 11 at 2p ET to walk Professional subscribers through the Security Analysis Methods monitor. I’ll send out a calendar invite later this week, and we’ll have a replay and deck available if you’re not able to attend live.

Also on the calendar, we’ve moved our next ET Live! webcast from this Tuesday to this Thursday, August 6 at 2p ET. Hope you can join us as Rusty and I take your questions and talk about all things Epsilon Theory, including these new research projects. And one final note … with the incorporation of signals from both the Central Banks narrative regime research and the Security Analysis Methods narrative regime research, our Epsilon Theory Narrative Alpha (ETNA) model portfolios are, IMO, the most interesting thing happening in systematic investment strategies today. I’d love to show you what we’re doing and how we make these model portfolios available to institutional investors and asset owners, so if you’re interested in learning more, please give me a shout and we’ll set up a call!


Extend and Pretend


As the kids would say, I’m old enough to remember Charles Keating and Neil Bush.

I’m old enough to remember the slow-burning dumpster fire that was the S&L Crisis of the late 1980s, when politically connected bankers used their influence to enrich themselves and secure regulatory forbearance for their crappy loans, leaving depositors and taxpayers to pick up the tab.

I’m old enough to remember that Charles Keating was convicted on 17 counts of fraud, racketeering and conspiracy in California state court, and then 73 counts of fraud, racketeering and conspiracy in federal court, for which he served a grand total of … [checks notes] … 4 years in prison.

I’m old enough to remember that Neil Bush secured $100 million in loans to his undisclosed business partners while “serving” as a director at Silverado, loans that were never repaid and were part of an S&L debacle that cost US taxpayers $1.3 billion to resolve. Neil’s punishment for his outright fraud: a $50,000 fine, paid for by one of his daddy’s campaign contributors.

At the heart of the S&L Crisis was the regulatory forbearance granted to these thrifts, allowing them to extend and pretend their crappy loans for years. It was the perfect swamp environment for human slime molds like Keating and Bush to bud and spore.

And now the same thing is happening again with commercial real estate (CRE) loans in banks across the country. I don’t know who the crooks are this time around. But I know they’re out there, again using political influence to gain regulatory forbearance that allows them to extend and pretend their crappy loans. And soon enough we’ll have a new list of names to add to the rogue’s gallery of Keating and Bush and all the rest.

The regulatory forbearance I’m talking about this time is tucked deep inside the CARES Act, the legislation that most famously set up the PPP loans to support struggling small businesses as the Covid crisis hit. (h/t to my friend Jim Chanos for showing me this; of course he has short positions on this … good for him)

Here’s the language verbatim:


(a) DEFINITIONS.—In this section:

(1) APPLICABLE PERIOD.—The term ‘‘applicable period’’ means the period beginning on March 1, 2020 and ending on the earlier of December 31, 2020, or the date that is 60 days after the date on which the national emergency concerning the novel coronavirus disease (COVID–19) outbreak declared by the President on March 13, 2020 under the National Emergencies Act (50 U.S.C. 1601 et seq.) terminates.

(2) APPROPRIATE FEDERAL BANKING AGENCY.—The term ‘‘appropriate Federal banking agency’’— (A) has the meaning given the term in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813); and (B) includes the National Credit Union Administration.


(1) IN GENERAL.—During the applicable period, a financial institution may elect to— (A) suspend the requirements under United States generally accepted accounting principles for loan modifications related to the coronavirus disease 2019 (COVID–19) pandemic that would otherwise be categorized as a troubled debt restructuring; and (B) suspend any determination of a loan modified as a result of the effects of the coronavirus disease 2019 (COVID–19) pandemic as being a troubled debt restructuring, including impairment for accounting purposes.

(2) APPLICABILITY.—Any suspension under paragraph (1)— (A) shall be applicable for the term of the loan modification, but solely with respect to any modification, including a forbearance arrangement, an interest rate modification, a repayment plan, and any other similar arrangement that defers or delays the payment of principal or interest, that occurs during the applicable period for a loan that was not more than 30 days past due as of December 31, 2019; and (B) shall not apply to any adverse impact on the credit of a borrower that is not related to the coronavirus disease 2019 (COVID–19) pandemic.

(c) DEFERENCE.—The appropriate Federal banking agency of the financial institution shall defer to the determination of the financial institution to make a suspension under this section.

In English, this means that banks can take loans that would have previously been classified under GAAP accounting as a troubled debt restructuring (TDR), with all of the increased scrutiny and loan reserves and hits to capital requirements that TDR requires, and instead classify them as “deferred loans” with much lighter regulatory oversight and knock-on effects.

How does a bank avail themselves of this favorable treatment for their CRE loans? Why through a modification – any modification will do – that can be ascribed to Covid-19 relief. How long does this suspension of GAAP accounting last? Why for the entire term of the modification – whatever that modification might be – no matter whether Covid-19 is still an issue over that term or not.

Do yourself a favor and check out the percentage of loans that went into the deferred bucket in the bank Q2 earnings reports, particularly in regional and super-regional banks. You’ve got some not-small banks where deferred loans are now north of 20% of their entire book and 2x or more of their tangible common equity.

Does putting a loan into the deferred bucket mean you no longer have to assign reserves against the loan? No. It’s not a complete whitewashing of your accounting requirements. But there is a significant difference in what regulators (and investors) believe is appropriate reserves for a loan in deferral and a TDR.

Is CRE a big enough securitized asset class and/or are the ultimate loan losses here enough to trigger another Great Financial Crisis … at least whenever the extend and pretend regulatory forbearance ends?

Chanos thinks yes, but I think no.

I don’t think securitized CRE loans are a big enough asset class to make this a truly systemic risk, where failed AAA-rated CMBS securities ripple through the entire financial system like a giant tsunami in the same way that failed AAA-rated RMBS did. I mean, non-agency RMBS was a $10 trillion asset class in 2008. CMBS is a fraction of that. Sure, the total amount of commercial real estate loans held on bank balance sheets is a big number, probably close to $5 trillion. But the securitized portion of that lending – the securitized portion that gets priced daily and shows up as a non-extendible and non-pretendable loss – that’s a lot less than $1 trillion in outstanding issuance.

But I DO think you’re going to get some failed AAA-rated CMBS here.

And I DO think that there are crucial parallels to sub-prime residential mortgages here.

And I DO think that we will have a slow-motion banking crisis – a la the S&L debacle of the late 1980s – that emerges from this.

More importantly, I absolutely think that the US economy in general and the commercial real estate market in particular is facing a polar vortex of a credit freeze from every regulated bank and shadow banking facility in the known universe.

Most importantly, I absolutely think that this triggers an even deeper recession in the real economy.

Can extend and pretend give the Keatings and Bushs of this generation of bankers a few more quarters of freedom and anonymity? Sure.

Can extend and pretend prevent give the illusion of liquidity and reasonable capital ratios and loan loss reserves? Sure.

Can extend and pretend create performing loans out of non-performing loans? Can extend and pretend create solvency? Can extend and pretend create monetary velocity and bank willingness to lend? Not a chance.

Bank lending is the oxygen that any real economy depends on for life itself. That oxygen has now been cut off, and no amount of Fed asset purchases or SPV facilities for S&P 500 companies can change that fact.

Buckle up, everyone.


Is This The Real Life?


I got a ton of email and engagement from Professional subscribers on my email last week regarding the narrative signals we were seeing in our Epsilon Theory Narrative Alpha (ETNA) – signals that give us a tech sector short in our sector rotation model portfolio. And for good reason. It’s one thing to put on a tech sector short position as a trade, even though it’s been a widow-maker trade for what … years, now? Seems like years. But the big questions – and the questions that underpinned almost all of the correspondence with subscribers – are these:

Are we seeing a reversal in the Growth > Value narrative?

Is this, at long last, the turning point for Value investing?

Short answer: yes and maybe.

I know that’s disappointing, but the slightly less short answer is, I think, more encouraging.

Slightly less short answer: yes and yes for a trade (weeks to months); don’t know and don’t know for an investment (months to years).

To explain what I mean by the slightly less short answer, let’s start with that email from last week (Tuesday, June 15):

As most of you are aware, last year we launched a set of S&P 500 sector rotation indices based on our research that we call Epsilon Theory Narrative Alpha (ETNA). We’ll have a number of announcements forthcoming shortly regarding ETNA, most notably that we recently signed a distribution and trade execution agreement with UBS around these indices, and if any ET Professional subscribers are interested in an update call (or an introductory call) on ETNA, I’d be happy to oblige.

But the reason I bring ETNA up today is that our market neutral model portfolio generated a rare set of signals coming into July … a significant short on the technology sector, based on the overwhelming narrative “drumbeating” regarding tech (Narrative Attention in our framework) in June. Our behavioral signals are contrarian – when the drumbeating gets really loud (and especially if happens fast), it’s time to get out – and, boy, was the tech sector drumbeating loud and fast in June! That short position looked pretty stupid for the first week and a half this month, as the tech sector continued to outperform every other sector (again, this is a market neutral model, so it’s the relative performance across sectors that we’re tracking here), but the past two days have been … gratifying. The tech sector reversal on Monday was particularly striking from a technical (no pun intended) perspective, but this is exactly the sort of behavioral “snap” that our narrative signals were anticipating. We’ll see if this tech sector underperformance continues over the rest of the month, but this break in the narrative potentially has broad implications, including a long bias towards value – whether that’s expressed as a value factor, as value-oriented sectors, or as a value style of discretionary investing.

Since that email, value continued to beat growth (and Dow beat Nasdaq) on that Weds and Thurs, gave back some of the ground on Friday, gave back a LOT of the ground this Monday, retook ALL of that ground and more this Tuesday, and then we had today – Weds, July 22.

Today started off like it was going to be a return to our regularly scheduled entertainment – growth over value, same as it ever was. But then, just like last Monday when all of this “stuff” started in the first place, tech/growth took a midday header and we ended up with another day of value ascendant.

So I’ll say this (again) … these midday out-of-the-blue reversals are exactly the sort of market behavior I expect when a dominant market narrative is breaking. These mysterious no-news reversals are exactly the market behavior you get when Common Knowledge shifts.

Here’s what I wrote back in 2014 (wow, I’ve been writing these notes for a long time!) in When Does the Story Break:

Fortunately for us, game theory provides exactly the right tool kit to unpack socially driven dynamic processes. To start this exploration, we need to return to the classic thought experiment of the Common Knowledge Game – The Island of the Green-Eyed Tribe.


On the Island of the Green-Eyed Tribe, blue eyes are taboo. If you have blue eyes you must get in your canoe and leave the island the next morning. But there are no mirrors or reflective surfaces on the island, so you don’t know the color of your own eyes. It is also taboo to talk or otherwise communicate with each other about blue eyes, so when you see a fellow tribesman with blue eyes, you say nothing. As a result, even though everyone knows there are blue-eyed tribesmen, no one has ever left the island for this taboo. A Missionary comes to the island and announces to everyone, “At least one of you has blue eyes.” What happens?

Let’s take the trivial case of only one tribesman having blue eyes. He has seen everyone else’s eyes, and he knows that everyone else has green eyes. Immediately after the Missionary’s statement this poor fellow realizes, “Oh, no! I must be the one with blue eyes.” So the next morning he gets in his canoe and leaves the island.

But now let’s take the case of two tribesmen having blue eyes. The two blue-eyed tribesmen have seen each other, so each thinks, “Whew! That guy has blue eyes, so he must be the one that the Missionary is talking about.” But because neither blue-eyed tribesman believes that he has blue eyes himself, neither gets in his canoe the next morning and leaves the island. The next day, then, each is very surprised to see the other fellow still on the island, at which point each thinks, “Wait a second … if he didn’t leave the island, it must mean that he saw someone else with blue eyes. And since I know that everyone else has green eyes, that means … oh, no! I must have blue eyes, too.” So on the morning of the second day, both blue-eyed tribesmen get in their canoes and leave the island.

The generalized answer to the question of “what happens?” is that for any n tribesmen with blue eyes, they all leave simultaneously on the nth morning after the Missionary’s statement. Note that no one forces the blue-eyed tribesmen to leave the island. They leave voluntarily once public knowledge is inserted into the informational structure of the tribal taboo system, which is the hallmark of an equilibrium shift in any game. Given the tribal taboo system (the rules of the game) and its pre-Missionary informational structure, new information from the Missionary causes the players to update their assessments of where they stand within the informational structure and choose to move to a new equilibrium outcome.

Before the Missionary arrives, the Island is a pristine example of perfect private information. Everyone knows the eye color of everyone else, but that knowledge is locked up inside each tribesman’s own head, never to be made public. The Missionary does NOT turn private information into public information. He does not say, for example, that Tribesman Jones and Tribesman Smith have blue eyes. But he nonetheless transforms everyone’s private information into common knowledge. Common knowledge is not the same thing as public information. Common knowledge is simply information, public or private, that everyone believes is shared by everyone else. It’s the crowd of tribesmen looking around and seeing that the entire crowd heard the Missionary that unlocks the private information in their heads and turns it into common knowledge. This is the power of the crowd watching the crowd, and for my money it’s the most potent behavioral force in human society.

Prior Epsilon Theory notes have focused on the role of the Missionary, and I’ll return to that aspect of the game in a moment. But today my primary focus is on the role of TIME in this game, and here’s the key: no one thinks he’s on the wrong side of common knowledge at the outset of the game. It takes time for individual tribesmen to observe other tribesmen and process the fact that the other tribesmen have not changed their behavior. I know this sounds really weird, that it’s the LACK of behavioral change in other tribesmen who you believe should be changing their behavior that eventually gets you to realize that they are wondering the same thing about you and your lack of behavioral change, which ultimately gets ALL of you blue-eyed tribesmen to change your behavior in a sudden flurry of activity. But that’s exactly the dynamic here. Even though there is zero behavioral change by any individual tribesman for perhaps a long period of time, such that an external observer might think that the Missionary’s statement had no impact at all, the truth is that an enormous amount of mental calculations and changes are taking place within each and every tribesman’s head as soon as the common knowledge is created.

For almost the entire duration of the game, the activity is internal and invisible, not external and visible, but it’s there all the same, bubbling beneath the behavioral surface until it finally erupts. The more tribesmen with blue eyes, the longer the game simmers. And the longer the game simmers the more everyone – blue-eyed or not – questions whether or not he has blue eyes. It’s a horribly draining game to play from a mental or emotional perspective, even if nothing much is happening externally and regardless of which side of the common knowledge you are “truly” on.

If you haven’t observed exactly this sort of dynamic taking place in markets over the past five years, with nothing, nothing, nothing despite what seems like lots of relevant news, and then – boom! – a big move up or down as if out of nowhere – I just don’t know what to say. And I don’t know a single market participant, no matter how successful, who’s not bone-tired from all the mental anguish involved with trying to navigate these unfamiliar waters.

These punctuated moves don’t come out of nowhere. They are part and parcel of the Common Knowledge Game, no more and no less, and understandable as such.

I know that was a terribly long quote, so probably skipped by most. But the skinny is this:

The more I see these midday mysterious reversals in the growth/value relationship, the more I think that there is a Common Knowledge shift happening and not just a month-by-month shift in the Wall Street drum-beating for this sector or that sector.

I know we’ve got the latter, that month-by-month shift in Wall Street drum-beating, and that’s good for a trade.

I suspect that we’ve got the former, a shift in the Common Knowledge, but I need to see more narrative data to be sure. If confirmed … that would be more than a trade. It would be a long-term investment thesis, in this case a reversal in the multiyear growth-and-tech-uber-alles strategy that has laid waste to value investing.

A Common Knowledge shift is a Big Deal. It’s not something I want to jump the gun on proclaiming, and there’s no need to time this down to the nanosecond, precisely because it IS a long-term investment thesis. I expect to gain a lot more insight on this as we launch our Factor Narrative Monitor sometime in August.

And whatever I discover, you’ll be the first to know.


The New Monitors Are Here!


I don’t expect everyone to be as excited about the arrival of the new ET Professional Narrative Monitors as Steve Martin was about the arrival of the new phonebooks … but it’s close!

Here’s the replay for the Narrative Monitor webinar we held via conference call and screenshare for ET Pro subscribers:

I’ve also attached the slide deck we used in the presentation here: ET Pro Narrative Monitor deck.


Another Brick in the Wall


Three brief observations today, all of which deserve more thought and a longer note. Would be delighted to hear any of your ideas on these topics, as we figure all this out together.

One – and the titular subject of today’s note – the Fed’s expansion of their corporate bond buying SPV makes credit default swaps (CDS) useless as a portfolio hedging instrument. Here are the 1-year and 5-year US investment grade (IG) CDS index charts.

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If you need a refresher course in how to read or understand CDS spreads, check out the ET Pro CDS primer: Everything You Always Wanted to Know About CDS … But Were Afraid to Ask. The point here is that with direct Fed intervention to prop up IG corporate credit (and HY, too, through junk bond ETF and “fallen angel” purchases), credit default swaps are no longer effective hedging instruments. You can’t fight City Hall and you can’t fight the Fed, and that means that our long/short investment quiver just lost a bunch of its best arrows.

Sigh. It’s not depressing so much as it is sad. It’s just another brick in the wall of the transformation of capital markets into a political utility. That’s a mixed metaphor, but you get what I mean. Seriously, it’s just sad.

Two – and this is the biggest thematic macro idea I’ve got – everyone is underestimating the degree to which the EU and Japan and China got their Covid-19 response right, and the US and the ROW got their Covid-19 response wrong. Take a look at Covid-19 stats over the past three weeks … ubiquitous testing + contact tracing works, and the EU proves it. The upshot is that the EU in particular is going to have a much more vibrant internal market economy than the US for the next 18 months … maybe much longer than that. So long as Covid-19 remains endemic and uncontrolled in the US – and there is nothing to suggest that is going to improve in 2020 – Europe will ‘take share’ from the US in global free trade regime benefits and enjoy a large internal market that looks much like its pre-Covid self.

I have no idea what the right way to play this macro idea would be … weak dollar / strong euro? … long EU banks / short US banks? … I dunno. But for the first time in my adult lifetime, I am more bullish on European growth fundamentals than US growth fundamentals. Honestly, I feel weird and kinda dirty just typing those words. But it’s the truth.

Three – and I have no idea what to do with this, but I think it’s vitally important – there’s a fascinating new Gallup report out on American pride. The skinny: “US National Pride Falls to Record Low”.

You really have to read this to get a feel for the breadth and depth to which Americans’ pride in being American has been pummeled over the past four years in general and the last year in particular. Even among Republicans, fewer are “extremely proud” of being an American than at any point since this poll began 20 years ago.

Just check out this demographic breakdown. The numbers for young Americans (18-29) and nonwhite Americans are heartbreaking.

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Like I say, I don’t know what to do with this … yet. But I think it’s everything.


The PPP Narrative for Asset Managers


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

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

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

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

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

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

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


Children of Men


[first lines]

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

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

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

— Children of Men (2006)

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

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

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

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

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

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

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

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

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

I used to think yes. Now I think no.

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

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

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

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

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

So they will.

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


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


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

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

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


The Pent-Up Demand Narrative


In our ET Professional updates over the last few weeks, we have repeated one particular refrain.

The dominant COVID-19 narrative today is a “short and deep” economic impact.

There’s a corollary narrative here that we think is particularly important for investors, and it’s a narrative that we think is closely tied to real-world data that investors can track on their own.

The corollary COVID-19 narrative today is “pent-up demand” that drives the up-slope of a V-shaped recovery.

The “Short and Deep” Narrative

Here’s on overview of what we’re seeing in the Narrative Machine.

The narrative maps below represents all major outlet US equity markets coverage since March 1, with the bold-faced connections and nodes representing articles with language characterizing the economic effects as “temporary” or “short-term” or “V-shaped” in the first map, or language relating to “lasting” or “long-term” or “L-shaped” economic effects in the second map.

The way to read narrative maps is to look at the number and frequency of bold nodes, yes, but much more importantly you should look at the centrality and the connectivity of the bold nodes.

In the first map, focused on the language of short-term COVID-19 impact, you can see how this language is deeply connected to each of the most central clusters (general market commentary, fiscal and monetary policy, corporate earnings, etc.), and extends from those central clusters into nearly every other peripheral cluster on nearly every market sub-topic. The one exception would be any cluster that focuses on the energy sector. No one is talking about the oil & gas industry with short-term or V-shaped recovery language!

In the second map, however, focused on the language of long-term COVID-19 impact, the only topic with concentrated use of and connections driven by this language is unemployment (dark green cluster on right of graph). There is widespread pessimism about just how “short and deep” the labor market and employment effects will be, but that pessimism is isolated to only those topics.

Language about the short-term economic effects of COVID-19 is pervasive in the way we talk about markets today.

Language about the long-term economic effects of COVID-19 is not.

US Equity Market Coverage Referencing “Temporary / Short-Term” Effects

Source: Quid, Epsilon Theory

US Equity Market Coverage Referencing “Lasting / Long-Term” Effects

Source: Quid, Epsilon Theory

“Short and Deep” implies “Pent-up Demand”

When you dig into what’s actually being said in these articles and transcripts about the short-term economic impact of COVID-19, you find a corollary narrative about pent-up demand.

A strong narrative structure, like we have with “Short and Deep”, means that NEW information or missionary statements tend to be accepted if they conform to the existing narrative, and tend to be rejected or marginalized if they oppose the existing narrative. This is what people often refer to as “confirmation bias” if you want to take a cognitive or behavioral economics approach, or you can express it as a rational outcome of Bayesian information theory if that’s your cup of tea.

We’re in the middle of earnings season right now, which means that most of the missionary statements we hear come from CEOs and CFOs on their quarterly earnings call, followed by buy-side and sell-side missionary statements about those calls, followed by media amplification of the missionary statements that fit the “Short and Deep” narrative and cartoonification or downplaying of the statements that don’t.

Since these earnings calls are focused on what just happened in Q1 and what is being experienced in Q2 (almost every company has pulled their long-range guidance) it is nearly impossible for these calls to change our minds about “Short and Deep”.

What happens instead is that the market reaction to many Q1 earnings calls is a positive response to news that was “not as bad as expected.” That’s not a prediction about those companies or their specific earnings situations (we really have no idea), but an observation that the narrative structure provided the language to absorb reports that could be aligned with the “depth” of the expected outcome. In other words, there’s a structural narrative asymmetry to positive earnings “surprises” today, not because these companies are doing surprisingly well in real-world, but because they compare well to what’s dominating the way we talk about these companies in narrative-world. Narrative expectations become a strong market tail-wind.

It’s not that market missionaries are lying about what they are experiencing in real-world. On the contrary, virtually every missionary statement we’ve looked at has been consistent in expressing clearly and earnestly the depth of the problem in Q1 and continuing into Q2. But that directness has in turn granted those parties credibility to express optimism about the briefness of the revenue/earnings problem, so that the narrative of “Yay, Pent-up Demand!” and rapid economic repair in Q3 and Q4 becomes common knowledge – what everyone knows that everyone knows.

And that’s the catalyst we think could reverse the current market-positive narrative structure.

If real-world demand for goods and services remains at these abysmal levels … if language about the long-term economic consequences of COVID-19 begins to spread beyond the unemployment cluster … then the common knowledge of “Pent-up Demand” will diminish and the narrative structure of this market can become profoundly skewed to the downside.

What investors should watch for

What would we be looking for to judge whether this narrative structure is reversing? Here’s our list:

  • 2H 2020 Guidance: The rubber will begin to meet the road in updated guidance on the second half of 2020 that we should begin to see following the relaxation of stay-at-home orders throughout late May and early June. Because of the “Pent-up demand” narrative, we expect a lot of the initial reports (correctly or incorrectly) to be passed through that existing framing. But the guidance from management that will follow that has a different objective – they want to beat, and they want to get grants with optionality priced to permit those beats to benefit them. We believe there will be more information (in terms of influencing investors to change their minds) in the guidance updates in June/July than in any corporate missionary behavior about COVID-19 to date.
  • Real-World Retail Knock-On Narratives: The delay in retail bankruptcies in expectation of liquidation sales that will accompany a relaxation in lockdowns is not a novel observation. There are, however, credit and real estate funds with meaningful exposure here that almost certainly sought and will seek to dampen impacts on Q1 – and yes, Q2 – marks by not accounting for the full coming destruction in value to which they are exposed. The same goes for oil & gas, where hope springs eternal on 1.1-1.3x marks which relax the typical commodity price-driven model approach on the basis of ignoring “short-term volatility.” Real world BKs cause real-world portfolio illiquidity. Be aware.
  • Second Half 2020 Lockdowns: As we discussed in a recent ET Live, we think that the fundamental corollary to housing prices in 2007/2008 is the actual, real-world ability of COVID-19 to cause new hot spots that lead to recurrence of stay-at-home orders in some US regions later in 2020. If these re-lockdowns occur, they will place enormous pressure on the “length of time” narrative about COVID-19’s economic effects.
  • Democratic Political Narratives: Investors should expect the COVID-19 pandemic to be ruthlessly politicized as part of the 2020 election in ways that it has not been politicized to-date. They should furthermore expect the promotion of new narratives – especially by the Democrats – about the economic reality and the length over which the effects of that reality will be felt. There will be “Trump sank us into a depression” narratives. They do not exist today – at all. They will be new, and they should be monitored.
  • GOP Political Policy: Election year politics don’t just show up in campaign slogans and rhetoric about “Trump sinking us into a depression” or “Trump doing everything to rescue Americans.” They show up in policy. The embedded assumption in markets that fiscal policy will keep supporting small businesses and households is part of the narrative structure now, and the White House cannot allow that narrative to falter. This IS their reelection strategy. Yes, the DNC will try to hang a depression narrative around Donald Trump’s neck. The President and the Fed and the GOP-controlled Senate, however, will continue aggressive policy action to ensure a strong S&P 500 and other cartoons of better-than-expected economic outcomes.

The nice thing about this list, I think, is that fundamental investors and allocators are well positioned to evaluate these items. You don’t need AI or a massive team of analysts or even the Narrative Machine to keep up here. Meanwhile, though, we will keep focusing our research on the short-term versus long-term linguistic structure of how we talk about markets. Together, we will get through this!


The Bear Stearns Bounce


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

And then I tweeted this on Feb. 26.

A screenshot of a cell phone Description automatically generated

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

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

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

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

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

And then we had the Bear Stearns Bounce.

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

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

And so here we are in 2020.

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

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

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

So here’s my opinion.

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

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

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

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