Subprime is Contained


This is my favorite photo of Ben Bernanke. It’s his last day as Fed Chair, and he’s leaving his office at the Federal Reserve Building in DC for the last time, pressing the elevator button as the doors close smoothly shut. There’s something about his expression and quiet smile here that’s just … everything … even though this is some months before his formal announcement that it would be unseemly for him to go work with any of the banks he regulated and so he’d be joining <<checks notes>> Citadel in an exclusive engagement as a “special advisor”.

I wonder if they got this photo in one take, or if they had to take multiple shots? Anyhoo, I digress.

I was thinking about Bernanke because of what he said multiple times in 2007, that subprime mortgage delinquencies, while “troubling”, would be “largely contained”, and that the Fed “sees no serious broader spillover to banks or thrift institutions from the problems in the subprime market.” It’s a famous line, of course. Infamous, I suppose.

I think what Jay Powell is currently saying about inflation and it being “transitory” may turn out to be equally infamous, and that Powell’s failure to react to soon enough to an inflationary storm may be as damaging as Bernanke’s failure to react soon enough to a deflationary storm. But that’s just my opinion. What is not my opinion, however, is that the financial media and our dominant narratives about the Fed are similarly focused on the timing of the Fed’s first tightening move.

Let me repeat that for emphasis: the narrative around the Fed is no longer IF the Fed will tighten, but WHEN the Fed will tighten.

After flirting with a narrative regime change for a couple of months, our Central Bank Narrative Monitor has now decidedly flipped from an Inflation-Focused regime to an outright Hawkish regime.

That’s not good for markets. The narrative tailwind we have measured and written about since April 1 is now a narrative headwind.

To be clear, we don’t see this as a strong headwind … yet. All of the narrative archetypes we measure around both central banks and security analysis are very weakly expressed these days, so this Hawkish narrative is just the most muscular of a puny lot. What that means in practice is that there is no common knowledge or even rough consensus on when the Fed will tighten. There is still plenty of room for Powell and crew to jawbone this into a happy place, to “soothe the market” as the Wall Street Journal likes to say. Seriously, it’s their go-to phrase now whenever they write about Powell. Did he “soothe the market” or not? Again, I digress.

If you think that market-world fundamentally changed over the past week or two, you are absolutely correct. The market narrative has shifted significantly, as every macro event will now be judged against a backdrop of “does that increase or decrease the chances of market-negative action by the Fed” as opposed to the decade-long dominant backdrop of “does that increase or decrease the chances of market-supportive action by the Fed”.

Put in a slightly different way, the best that the market is hoping for from the Fed today is that they won’t disappoint us too badly. There’s no stimulus to be had, no liquidity program to be administered. A Hawkish narrative regime means that we’re expecting bad news from the Fed sooner or later, and a weakly expressed Hawkish regime only means that there’s no agreement on whether that bad news will come sooner or later or much later, or whether failure to deliver the bad news sooner or later or much later is a good thing or a bad thing.

There’s lots of room in narrative-space today for Powell to “soothe the market” about inflation and bond yields.

You know, just like Bernanke soothed the market about subprime and mortgage-backed securities.



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 30+ 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 home all at the same time and finding no buyers … I don’t know what that signal is. The insane amount of housing supply in NYC/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.

  • 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”.
  • 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.
  • Middle class (ie, home-owning) blue color 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 color 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.
  • 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 just 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.

Just as in 2008, a lot of the ramifications of an insane shift in the available housing supply will only reveal themselves over time. We won’t be able to predict all of the market and real-world shocks that emerge from a collapse in the supply of existing homes for sale in the United States, but we will be able to expect market and real-world shocks. Maintaining an openness and awareness to the fact that there WILL BE market and real-world shocks emerging from a supply shock to the US housing market made all the difference in navigating 2008 successfully. I think it will be the same in 2021.

I’m still figuring out my take on all this. I’d love to hear yours!


We’re All Nigeria Now


Yes, I know that this is a Ghanaian funerary troupe, not Nigerian, but the meme is too spot-on to pass up.

Last week I was invited by an ET Pack member to join a 15-person Zoom call with some of the leading lights of DNC/Wall Street establishment doubleplusgood macroeconomic thought. If you follow this crowd you will recognize a lot of the names, but I’ll just give you the one that everyone knows – Paul Krugman.

Three random observations.

First, I have no idea how or why I was invited on this call. I’ve been blocked on Twitter by at least two of the participants, and I’ve had … umm … mean things to say about most of them. Second, you’ll be relieved to know that this was not an “unfettered” call a la Clubhouse, as reporters covering the Fed and economics beat from both the NY Times and the Washington Post were on the call to keep us “accountable”. Third, and you have no idea how much it pains me to say this, but I found Paul Krugman to be absolutely delightful. He was self-effacing, humble about the entire enterprise of academic economics, and he was wearing an insanely cool tee shirt from an obscure Russell Brand movie. I mean … wow!

Two not-so random observations.

First, 95% of the conversation was exactly as stultifying and maddening and off in academic good-leftie-soldier la-la land as you might expect. I think a good hour was spent arguing earnestly about the “multiplier effect” of the Covid stimulus bill, with exactly zero time spent discussing the real-world impact of Covid. Instead, it was all the usual shibboleths all the time … why every penny of student debt should be forgiven now, why a $15 minimum wage really wasn’t enough, why the “problem” with the Biden Administration was Joe Biden and his bizarro focus on individual working people rather than Labor (“Yay, Labor!”), and  – my personal fave – why this country desperately NEEDS higher inflation, but by-golly it’s just not happening.

At which point your humble correspondent could contain himself no longer.

“Look, I have no idea what the real-world multiplier effect of the stimulus package will be, but have you looked at the markets recently? If you look at Bitcoin … at energy stocks … at industrial commodities … at transports … if you look at the narrative within financial media … inflation isn’t a maybe thing. Inflation is a sure thing. I’ve been doing this a long time, and I’ve never seen a more powerful narrative take root and consolidate more quickly. Everyone in market-world today thinks that inflation is a sure thing and they’re acting on that common knowledge NOW.”

And then an entirely pointless conversation about Bitcoin broke out. Sigh. But then a miracle happened, which leads to my second not-so-random observation.

Paul Krugman brought the Bitcoin conversation back to inflation, not (as I expected) by making some ex cathedra pronouncement of neo-Keynesian orthodoxy that inflation was impossible and the Fed can control it easily anyway, but by asking an honest question. He said (and I’m paraphrasing here, but it’s close), “you know, I’m not so sure that the things we talk about all the time in economics – like aggregate demand, for example – are really things at all. We had a model back in the day for understanding deflation and the liquidity trap in the US, and that was Japan. What’s our model for understanding what might be inflation in the US today?”

At which point a latecomer to the Zoom call piped up. Her name is Lisa Cook. You should look her up. I predict you’ll hear her name a lot over the next four years. Again, paraphrasing. Again, it’s close.

“I don’t think you’re going to like what I think, because we all WANT to think that there’s some huge difference between developed economies and emerging economies, and of course the United States is the MOST developed economy so it can only be compared to its developed economy “peers”. So that’s where we always look for our models … Europe, Japan. I don’t think that’s right.”

“I think the model for what’s happening in the US economy today is Nigeria.”


Yes, this. The kleptocratic state. The weak state. The regulatory capture. The powerful intersection of media and politics. A vast inequality of wealth and opportunity. A national identity engulfed in the widening gyre, deteriorating into old allegiances on a daily basis. An economy far too reliant on one industry (oil for Nigeria, finance for the US). And yet … real growth that Europe and Japan can’t imagine … real potential … real examples of humanity and ingenuity and positive change happening every day on a local level and on a massive scale.

I’ve got to do some more thinking about this to figure out just how far the model extends, but it really struck me when I heard it. Would love to hear your thoughts if it strikes you, too.


Barking Dogs and Super Bowl Commercials


The dog that didn’t bark is the key to “Silver Blaze”, one of Arthur Conan Doyle’s most popular Sherlock Holmes stories.

Det. Gregory: Is there any other point to which you would wish to draw my attention?

Holmes: To the curious incident of the dog in the night-time.

Det. Gregory: The dog did nothing in the night-time.

Holmes: That was the curious incident.

Similarly in narrative-world, the absence of clear common knowledge – what everyone knows that everyone knows about markets – is often just as interesting or useful as its presence. And that’s what we’re seeing right now at a surface level in both of our Narrative Monitors coming into February (links here and here).

The dominant macro narrative structures are presenting questions – “what happens when inflation returns and how do we prepare for that?” and “what happens when fundamentals and valuations matter again and how do we prepare for that?” – without providing a strong or coherent answer to those questions.

Everyone is asking these questions. No one is settled on an answer. Wall Street is launching a thousand trial balloons right now to “answer” those questions for you. Or, to use a metaphor appropriate to this weekend, Wall Street is storyboarding a thousand Super Bowl commercials right now.

Most of these “answers” will fizzle, meaning that they will fail to generate flow into the investment product created for the “answer”. A few of them will click. A few of them will generate substantial flows, at which point every bulge bracket bank and investment manager will immediately copy that “answer” and that associated product. That’s how Wall Street common knowledge happens.

There’s no predicting which “answer” will click. I mean, no one thinks that their Super Bowl commercial is a dud going into the game, but only one or two will come out as the commercial that everyone knows that everyone knows was really special and witty and effective.

So we’re watching this process carefully, and you’ll be the first to know when we see signs that one of these commercials is working. Right now, and this is more my intuition than a detailed narrative machine analysis, I think the Bitcoin commercial is working pretty well (and yes, there’s an ET Pro note and an ET podcast about this).

One more thing … when I say that this is the narrative regime activity we’re observing at a surface level, it’s because we DO think that there is STRONG common knowledge in markets at a deeper level. We see two deep and strong narrative currents here:

  1. The Fed has got your back. Yes, there is definitely increased chatter about “tightening” and “tapering”, but this is chatter on top of a very strong and highly coherent narrative that the Fed will always bail out markets when push comes to shove.
  1. Fundamentals don’t matter. Yes, there is definitely increased chatter about “bubbles” and “stretched valuations”, but this is chatter on top of a very strong and highly coherent narrative that valuations and real-world catalysts simply don’t matter anymore.

Could these surface narratives of “tightening” and “bubbles” and “currency debasement” coalesce over time into something that moves deeper into the overall narrative framework? Absolutely, and that’s what we think we can track with our structural narrative measures of Strength and Cohesion. But right now neither of those measures are showing much at all. It will take one heck of a Superbowl commercial to move these needles!


The Zimbabwe Event


Covid funeral in Harare

Over the past week, 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 (the unreported numbers are certainly much higher) have exploded in this country of 15 million just in the month of January.

Unlike the ‘Ireland Event’ I’ve been writing about recently, the engine of this human and political tragedy is not the UK-variant virus (B117), but the South African-variant virus (501.V2). This is the ‘Zimbabwe Event’, and I believe it has significant real-world and market-world consequences.

My emails to you about the Ireland Event – an explosion in Covid cases in Ireland over the last few weeks in December, driven by a combination of relaxed social mitigation policies and the introduction of a more infectious SARS-CoV-2 virus from the UK – focused on two questions:

  1. how likely is a rolling series of B117-driven Ireland Events in the United States? (very, imo)
  2. where are we in the timeline for the first of these US-based Ireland Events? (2 to 3 weeks from today, imo)

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. I consider this is to be a classic example of financial market narrative complacency, where all of the narrative risks are to the downside for markets.
  1. 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 (the original PHE study showing similar lethality has been revised upwards). 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.
  1. 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 now vaccinated. As I mentioned in last week’s note, 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 highly problematic new 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.
  1. The potential for reduced vaccine efficacy AND increased infectiousness AND increased lethality is at the heart of why I think the Zimbabwe Event is so important, both in real-world and in market-world. We don’t yet have any hard evidence on diminished vaccine efficacy for 501.V2, but what we do know is that antibody protection from prior baseline Covid infections, which has shown itself to be very effective in preventing a subsequent baseline Covid infection, is much less effective in preventing subsequent 501.V2 Covid infections. This suggests, of course, that our current vaccines, which largely duplicate the antibody protection that you would get from a prior baseline Covid infection, will be similarly less effective against 501.V2. As for increased infectiousness and increased lethality, we also don’t have as much hard evidence as we do with B117. But the observations in case numbers and deaths we have throughout Southern Africa for 501.V2, from South Africa proper all the way up to Rwanda, are at least as staggering as we see in the UK, the EU and Israel for B117.

In real-world, I think it is impossible to overstate the destabilizing impact of 501.V2 on the politics of a weak state. That’s true in a relatively wealthy weak state like South Africa, much less an insanely poor weak state like Zimbabwe. I mean, the power vacuum that currently exists in Zimbabwe, where three prominent Ministers die within a week and every function of civil government has effectively collapsed … is staggering. 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 a war of nations. Some of these wars will be entirely internal to existing borders. More of these wars will cross those borders. Some of these wars will include major powers. War and regime change. That’s the real-world legacy of the spread of these SARS-CoV-2 variants like B117 and 501.V2, and not just in countries like Zimbabwe. South Africa, too. Iran, too. Russia, too.

In market-world, I think it is impossible to overstate the destabilizing impact of a Covid variant that is vaccine-resistant. To be clear, I don’t know that we have that in 501.V2. If I did, then I’d be predicting a lot more than just a transitory punch to the market’s nose. But what we DO have 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 that together with recent developments with B117 … put the Ireland Event together with the Zimbabwe Event … and yeah, I think you’ve got a tradeable punch coming to markets.


Ireland Event Follow-up: Shockwave


Yesterday the CDC held a press conference and released an analysis showing that they expected the more virulent UK-variant strain (B117) to account for 50% of Covid cases in the United States by the end of February. I’ve attached the CDC analysis here, and you can read a summary of the findings in this WSJ article:

For reference on our work on this topic, you can read the full ET note here: We’ve also released a podcast on our work, available on the ET website , and on Spotify and iTunes.

While on the one hand it’s gratifying that the CDC is validating what I wrote you last weekend, 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 45 days from now. That’s what this email 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 between an exponential process (B117 spread) and a linear process (vaccine delivery) just got pushed back. That’s extremely bad news for the linear process.

Consequence #2: if B117 is the dominant US strain by the end of Feb, the daily number of new Covid cases by the end of Feb will be MUCH 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.

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 path to recovery may be bumpy, but it is assured.”

If B117 becomes the dominant SARS-CoV-2 strain in the United States, that is a profoundly deflationary, risk-off, dollar higher, flight to safety event.

Will markets ultimately look through that event, particularly if the Fed says all the right things (which they will) and particularly if we get the JNJ vaccine in wide distribution soon (fingers crossed)? Sure. Absolutely, markets will ultimately look through the B117 threat.

But between today and that ultimate look-through, I believe there is a significant narrative shock coming to markets. 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 hit every risk asset like a ton of bricks.

When does that narrative shock occur? What creates the B117 common knowledge that hits markets like a ton of bricks? 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. That’s when everyone knows that everyone knows that our glidepath to recovery is not assured.

When do we hear about the first B117 cluster in the US? No idea. And the longer it takes, the less the impact on markets. But the cluster IS coming. As the kids would say, it’s just math.


The Ireland Event


Daily reported new Covid cases, Ireland, through Jan. 7, 2021

I’ll start with the conclusion. I believe there is a non-trivial chance that the United States will experience a rolling series of “Ireland events” over the next 30-45 days, where the Covid effective reproductive number (Re not R0) reaches a value between 2.4 and 3.0 in states and regions where a) the more infectious UK-variant (or similar) Covid strain has been introduced, and b) Covid fatigue has led to deterioration in social distancing behaviors.

A single Ireland event is a disaster. A series of Ireland events on the scale of the United States is catastrophic. In the aggregate, I’d expect to see a doubling of new Covid cases/day from current levels (today’s 7-day average is 240k/day), peaking somewhere around 500,000 new daily cases before draconian economic shutdowns (more severe than anything we’ve seen to date) would occur in every impacted major metro area. Hospital systems across the country would be placed under enormous additional strain, leading to meaningfully higher case fatality ratios (CFRs) as medical care was rationed. Most critically, this new infection rate would far outpace our current vaccine distribution capacity and policy. Assuming that vaccines are preferentially administered to the elderly, aggregate infection fatality ratios (IFRs) should decrease, but the overall burden of severe outcomes (death, long-term health consequences) will shift to younger demographics.

Current US gov’t policy rejects the possibility of an Ireland event, largely because of what I believe is a politically-motivated “analysis” by the CDC that models more than 100 million Americans already possessing Covid antibodies, prior to any vaccination effort. Using data from flu monitoring programs in prior years, the CDC models project that 70 million Americans have already gotten sick with symptomatic Covid, but decided to just write it off as a bad cold and never got tested! I am not making this up. Obviously enough, if >30% of Americans are already effectively immunized against Covid because they’ve already gotten sick, then it’s very difficult to hit the Re numbers of 2.4 – 3.0 that Ireland is currently experiencing. I think this is nonsense, because NO ONE brushes off Covid symptoms the way they might have brushed off flu symptoms in the past. But this CDC model is why prominent Covid missionaries (to use an Epsilon Theory term) like Gottlieb and Fauci have said that they expect daily case numbers to decline from here on out, not accelerate, and this is why I think a potential Ireland event is NOT priced into any mainstream market expectations or political expectations for 2021.

Unfortunately, once it becomes apparent that an Ireland event is occurring, it’s too late to stop it.

In our human-scale, linear world, we experience exponential growth like this: nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! But by the time we start to really pay attention to an exponential growth process – typically at the cluster stage – the process is already too entrenched to stop it, absent incredibly harsh social measures like you see being reinstated (!) in China. No government in the West is prepared to even talk about these measures, much less implement them. So we’re always surprised by the BOOM. If an Ireland event occurs here, it will be no exception.

A full-blown Ireland event is driven by both the more virulent UK-strain AND a deterioration in social distancing behaviors. Either taken alone is bad enough. It’s the combination, though, that’s catastrophic. Irish health authorities estimate that their starting point for Covid Re was something between 1.1 and 1.4 (meaning that, on average, one person infected with the SARS-CoV-2 virus would pass it along to 1.1 – 1.4 new people). They blame deteriorating masking/social distancing for the majority of their “event” (say, a 0.9 – 1.1 increase in the Re number), and the UK-variant for the balance (say, a 0.5 – 0.7 increase in Re). This is very much in line with the latest research from Public Health England, which estimates that the UK-variant Covid virus is approximately 40% more infectious than the baseline virus. Notably, the UK-variant is, relatively speaking, significantly more infectious than the baseline virus for “close contacts” (not face-to-face, up to 2 meters apart) rather than “direct contacts”, meaning that the UK-variant virus is particularly successful at bridging the air gap between strangers or short-duration contacts in an indoor space. This is … ummm … troubling. As lax as we all have gotten with our mask wearing and our social distancing outside of the home, the UK-variant dramatically reduces the margin of error we have with mask wearing and social distancing outside of the home.

For the same reasons that we humans typically don’t recognize an exponential growth process prior to the cluster, cluster, cluster stage, we have an even harder time appreciating the impact of even a small increase in the effective reproduction rate of Covid. A 40% increase in Re has an enormous impact on how many people will be infected by Covid. For example, let’s assume that the current Re for the United States is something like 1.4 (I think it’s probably higher than that in areas like SoCal, and going up everywhere as Covid fatigue takes hold). With a 5-day infection cycle (assume you pass along the virus to 1.4 new people within 5 days of contracting the virus yourself, i.e. before you become symptomatic), a single Covid case will result in a grand total of 2,296 Covid infections over a 100-day period. Now let’s increase that Re by 40%, so that it’s not 1.4 but is 2.0 … now that single Covid case will result in more than 2 MILLION total Covid infections over a 100-day period.

This is the power of exponential growth.The numbers get silly … I mean, take that Re up to 3.0 (the high end of the current Ireland estimate), and a single Covid case will result in 5.2 BILLION total cases over a 100-day period, about 60% of the entire human population on the planet … and obviously our social behaviors around the disease would change dramatically well before we got to that point. But the real challenge of all this from a social behavior perspective is the nothing, nothing, nothing … case, case, case … cluster, cluster, cluster … BOOM! nature of any exponential growth process. That Re of 2.0 that results in 2 million total infections from a single Covid case over 100 days? On Day 30 there are only 127 total cases. Not noticeable at all. On Day 50 there are just over 2,000 total cases. Barely noticeable. Let’s say you’re an elected political leader. Are you really going to take the steps that are necessary to stop this process – like shutting down domestic travel to and from an infected area, like physically quarantining entire cities – over a few hundred cases? Not a chance. Even if you’re right … even if you prevent a catastrophic outcome through your actions on Day 30 or Day 50 … your voters will never know that you were right. They will only experience the lockdown pain, and they will never credit you for the catastrophe averted.

I think we’re already at Day 30 in a dozen states. I suspect we’re already at Day 50 in a few.

So look, maybe I’m wrong about all this. Maybe we’re already well along the path to herd immunity, and one-third of Americans currently have Covid antibodies through prior exposure or vaccination. Maybe we’ll all rediscover that old-time religion when it comes to mask wearing and social distancing outside of the home. Maybe governors and the new Administration will focus on containing the UK-variant through domestic travel restrictions. Maybe we’ll wake up tomorrow with a new urgency about vaccine distribution.

Maybe. But my spidey-sense is really tingling on this one.


What Does Inflation Mean For Your Portfolio?


We published our January Narrative Monitors earlier this week, which you can grab online here and here (also, if you need a refresher course in how to read these Monitors, don’t forget our webcasts and primers here and here). I’m going to focus on the Central Bank Monitor in this email, because we’re seeing something in this analysis that is unique in our historical dataset.

We think there are five narrative “archetypes” when it comes to central banks in general and the Fed in particular: Fed Put (signal for strongly positive market returns), Inflation (signal for moderately positive market returns), Dovish (signal for weakly positive market returns), Unemployment (signal for moderately negative market returns), and Hawkish (signal for moderately negative market returns). As has been the case for the past 9 months, the Inflation archetype is the strongest among these five. Nothing new or unique there. But …

  1. ALL of the narrative archetypes are now very weak. Inflation is only slightly stronger (meaning more central to the entire financial media conversation) than Hawkish, and all of these archetypes are near all-time lows in terms of the “gravity” they exert on our overall investment narratives.
  1. ALL of the narrative archetypes have absurdly positive sentiment. Meaning that for every possible narrative or sub-narrative scenario, the conclusion is that this is a positive for markets. Inflation about to run rampant? Bullish! Inflation concerns overblown? Bullish! Massive fiscal stimulus on the way to reduce unemployment? Bullish! Meh stimulus on the way and unemployment remains high? Bullish! Fed is on autopilot? Bullish! Fed is highly vigilant? Bullish!
  1. WITHIN these individual narrative archetypes (with the exception of Unemployment), there is almost zero narrative consensus or cohesion. For example, within the Inflation archetype, there are equally strong and extremely disparate (very little shared language) sub-narratives/memes/claims happening simultaneously, from “inflation is already here!” to “inflation is impossible!” to “the Fed won’t respond for years!” to “the Fed will respond now!”. There is no coherence to the Inflation narrative, no narrative agreement on what inflation means today, to a degree that we’ve never seen in the data.

This is what it looks like when common knowledge – what everyone knows that everyone knows – is being formed.

Here’s how it will play out in your own head.

Your first instinct will be to try to figure out on your own what inflation really and truly means for your portfolio. You will read about the history of inflation and think really hard about it. You will have some ideas and, depending on your ego, more or less confidence in those ideas. But then, on reflection, you will decide that you want to understand what everyone else thinks inflation really and truly means for your portfolio. You will do this by watching CNBC and reading Bloomberg Opinion articles and Goldman Sachs research reports and portfolio manager letters and the like. You will call this “doing your research” and “listening to smart people”. Over time you will begin to recognize a common thread running through what you hear and what you read. You will call this common thread an “investment thesis”, and you will find yourself nodding your head by the fourth or fifth time you recognize this common thread on what inflation really and truly means for your portfolio. You will begin to recognize this common thread in more and more of what you hear and read, and you will provide positive feedback in one form or another to the creators of this content. You will congratulate yourself on being smart enough to tease out this common thread from your “research” and you will begin to implement your “investment thesis” in your portfolio. Soon you will have conversations with other smart investors who have similarly identified this investment thesis from their research, and you will take great comfort in that. You will increase your position in the investment thesis.

I am not saying that your investment thesis is wrong. I am not saying that you will lose money with your investment thesis. On the contrary, if you are early with your investment thesis and that thesis evolves into common knowledge, I think you’ll make a lot of money.

I am saying that what you call an investment thesis is a narrative.

I am saying that the business of Wall Street and financial media is to create an investment thesis that makes you nod your head. I am saying that you will always find an investment thesis that makes you nod your head, and that this process of selling you an investment thesis that makes you nod your head is as predictable and as regular as the sun rising in the east and setting in the west.

Right now, Wall Street is trying to identify which inflation narrative will be an investment thesis that makes lots of people nod their heads.

Recognizing THAT – and maybe even trying to get ahead of THAT – is how you play the game of markets successfully.


The Spice Must Flow


A few weeks ago, we published an ET Pro note titled “The Bitcoin Metagame”, where I wrote about how Wall Street is now productizing Bitcoin as an inflation hedge, which – in order to accomplish this at scale – requires the application of a full-fledged AML and KYC regulatory structure to Bitcoin specifically and crypto more generally. Here’s the money quote:

My strong belief is that within a few years it will be illegal for an American resident or any entity subject to American law (or SWIFT) to transact in Bitcoin outside of a federally registered exchange and without a federal registered account.

To be clear, I think this is all probably a positive for the price of Bitcoin, and I am certain that this will increase liquidity and decrease volatility in Bitcoin. The entire goal here is to create “flow” in the form of a highly liquid, easily transacted financial product that Wall Street can administer. But it’s a death knell for any “revolutionary” application for Bitcoin, as it becomes just another highly regulated game in the Wall Street casino.

Also to be clear, I think it will take a couple of years for this highly regulated future to come to pass fully. But following announcements last Friday and earlier this week, it’s possible that I may be right a lot faster than I thought.

First, the Financial Crimes Enforcement Network (FinCEN, a division of the US Treasury) announced last Friday that they intend to impose new reporting requirements on private Bitcoin holders who try to move their Bitcoin outside of currently regulated entities like exchanges and bank custodians. If you want to withdraw your Bitcoin from a regulated account and send it to an unregulated private wallet, the new rule requires you to provide full KYC information to Treasury before you are allowed to make a withdrawal from your account.

Notably, the new rule now defines Bitcoin as a “monetary instrument” (not as a commodity as it has been treated by the SEC for securitization purposes), meaning that ALL of the laws and regulations that Treasury now applies to cash transfers can now be applied to Bitcoin transfers.

This is the narrative justification that Treasury will take to surveil Bitcoin activity and criminalize non-permissioned or non-declared activity between private wallets – we’re just treating it the same way we treat cash. You’re not opposed to that, are you? You’re not opposed to fighting terrorism, are you?

The new rule, now in an accelerated two-week comment period (meaning, there is zero interest in receiving actual comments on the rule), will go into effect in early January. France, the Netherlands and Switzerland have already imposed new laws with a very similar construction. This is happening.

Second, yesterday the SEC informed Ripple that the company (and the company’s founders in a personal capacity) would be sued in federal court for selling an unregistered security in the form of XRP tokens. This is not a small thing. XRP is the third largest cryptocurrency by value in the world after Bitcoin and Ethereum, about $22 billion before this news hit, and if the SEC is successful in this case it is a crippling blow for every other crypto token and the entire decentralized finance (DeFi) movement.

Again, I’m not a bear on the price of Bitcoin. If that’s your focus, then none of this is bad news. But I am absolutely a bear on the ability of Bitcoin and crypto to drive social change. If that’s your focus, then the news could not be worse.

As always when it comes to Wall Street and its partnership with regulatory agencies, the spice must flow.


A Disturbance in the Force


A quick announcement and then a quick observation on a nascent shift in the narrative that we’ve identified in both our Central Bank Monitor and our Security Analysis (the language of Wall Street) Monitor. Both Monitors are attached to this email.

The announcement is that we are relaunching our podcast series, placed on long hiatus since Rusty and I spun out as an independent company more than two years ago. In ET Podcast #1: Is That All There Is?, I’m joined by renowned cryptocurrency miner and trader @notsofast for a wide-ranging conversation on Bitcoin and crypto. We pick up directly on the topics I discussed in last week’s ET Pro notecan Bitcoin preserve its revolutionary potential after a Wall Street bear hug? I’m highly skeptical, but @notsofast has some ideas on how to make this work.

The observation is that we are seeing language in both the Central Bank and Security Analysis narrative regimes that would have been unthinkable even a few months ago, language that is market-negative. It’s not enough to change the market-positive narrative regimes in place today, but it’s definitely enough to make my risk antennae start to tingle.

In Central Bank narrative-world, we are seeing our first observations of “hawkish” language in a VERY long time. As Rusty puts it, maybe it doesn’t seem particularly hawkish to say that “maybe, if things get really crazy with fiscal policy, just maybe we might need to use monetary policy to correct that craziness”, but in comparison to the months and months where we are told that the Fed is not even thinking about thinking about thinking about raising rates … this is notable.

In Security Analysis narrative-world, we are seeing our first observations of “multiples” language in a VERY long time. Again, maybe it doesn’t seem very challenging to say that “maybe it’s useful to think about some stocks being cheap and some stocks being … ooh, close your ears if this word offends you … expensive relative to earnings or sales or something connected to real world business activities, and maybe it’s useful to think about profitless growth being less desirable than profitable growth”, but again, it’s a very different song than what has been played in financial media for a looong time. Not a dominant song, for sure, but one worth listening for.


The Bitcoin Metagame


We talk a lot about the “metagame” in Epsilon Theory, which is a ten-dollar word for the idea of not missing the forest for the trees. It’s so easy to get caught up in the day-to-day “game” of price movement in markets and the day-to-day “game” of tweets and polls in politics, that it can be hard to step back and see the larger metagame that will actually end up controlling all of those day-to-day games over time. Or at least it can be hard for me! That’s why I find it so useful to force myself to step back and look for shifts or inflection points in the larger metagames of markets and politics, shifts that typically show up first in the narrative around a certain topic. We look for these shifts rigorously in our narrative monitors on Central Banks and Market Analysis (December monitors published today!), and I’ll write about what we’re seeing there in a follow-on email. But today I want to talk about what I’m seeing in an ad hoc analysis of Bitcoin, because I think we are seeing an inflection point in the overarching narrative and metagame for Bitcoin that has direct implications for professional investors.

Again, by metagame I am NOT talking about price action. Yes, the price of Bitcoin has been going up, up, up. That’s important, and it has a bearing on what I’m writing about today, but more as symptom than as cause. What I am talking about goes by different names depending on where you’re reading or hearing about Bitcoin. I’ve seen it referred to as the “institutionalization” of Bitcoin, the “integration” of Bitcoin, the “Saylorization” of Bitcoin (after Michael Saylor, the CEO of MicroStrategy tkr: MSTR, who has famously turned his company’s stock into a Bitcoin tracking stock … up >300% ytd), and many other terms. You will get some flavor of what I’m talking about in any financial media article you read about Bitcoin today, whether it’s a personality-driven article (Paul Singer/Mike Novogratz/Paul Tudor Jones/Stanley Druckenmiller is buying Bitcoin! Shouldn’t you?) or a macro-driven article (Dollar down and rates up? Hedge that with Bitcoin!) or any other sort of article, but I don’t think it will hit you (or at least it didn’t me) unless you step back and look at ALL of the financial media articles simultaneously for the language and memes that run through them as a common thread.

This common thread, and what I mean by the metagame of Bitcoin, is the productizing of Bitcoin. Not in the sense of a specific investment “product” like an ETF or a fund or a de facto tracking stock like MSTR, but in the transformation of the meaning of Bitcoin from an intentionally rogue and counter-culture network that “is a dagger striking at the heart of central banks” (that’s a quote from a leading Bitcoin community guru with hundreds of thousands of followers who yelled at me this weekend for my clear misunderstanding of the “revolutionary power” of Bitcoin) into …. just another table in the Wall Street casino.

Wall Street is redefining Bitcoin to be an Inflation Hedge™ product. You know, like gold. But cooler. More now. Did we mention it’s up a ton this year?

Why is Wall Street doing this? Because this is how you make real money in financial services. You don’t make real money in financial services by being smarter, or by having a really, really clever idea, or by HODLing this rather than HODLing that. No, you make real money by capturing flow. You make real money by selling product that directly addresses fear and greed. Fearful of inflation and fiscal profligacy and dollar decline? Bitcoin! Greedy for something that’s up a couple of hundred percent and all the smart money is grabbing? Bitcoin! There is enormous money to be made on Wall Street by creating a new inflation hedge investment product that all the cool kids are talking about, and capturing the flow around THAT.

So that’s what Wall Street is going to do. They’re going to – pardon my language – sell the shit out of Bitcoin. It will come in dozens of forms and formats, each cheaper to own and transact in than the last, and it will be sold to you morning, noon and night. You will want it for your portfolio. Maybe you already have it in your portfolio. If you do, look for cheaper ways to get it in your portfolio … this is a product, not an insight or something that requires expertise.

There’s just one barrier between Wall Street and this happy expansion of their inflation hedge casino gaming section … Bitcoin isn’t a regulated security. It’s still this outlawish thing where people can transact in a non-KYC and non-AML environment. It’s still this outlawish thing where people celebrate their ability to transact in a non-KYC and non-AML environment.

What happens when there’s an obstacle between Wall Street and a pile of money? The obstacle is removed. With extreme prejudice.

My strong belief is that within a few years it will be illegal for an American resident or any entity subject to American law (or SWIFT) to transact in Bitcoin outside of a federally registered exchange and without a federal registered account.

And that will be an interesting day for the retail owners of Bitcoin, particularly the Original Gangster retail owners of Bitcoin, the ones who celebrate their peer-to-peer, uncensored transactions, the ones who want to plunge that dagger into the heart of central banks. That will be an interesting day for the original (and still dominant) narrative of Bitcoin.

I think the Wall Street who-cares-let’s-make-mo-money narrative wins out. It always has in the past, so I really don’t know why this would be any different. I think that the end result of all this, when all the regulatory dust settles and the OG gnashing of teeth ends, is that the price of Bitcoin is higher.

But that’s not why Wall Street is productizing Bitcoin. It’s not the price that really matters when you’re trying to capture flow. It’s the liquidity that matters. It’s the volatility that matters.

I’m not going to predict the future price of Bitcoin as this Wall Street productizing effort proceeds. I think it goes up, but who knows? What I will absolutely predict, however, is that Bitcoin trading liquidity goes way up and Bitcoin price volatility goes way down. THAT is the market and political metagame that Wall Street must control around Bitcoin in order to generate flow.

So they will.


Tyger, Tyger


We’ve all heard the old line that investment managers, like tigers, can’t change their stripes. Or as the line has evolved over time, that investment managers shouldn’t change their stripes. It’s a line that’s been heartily embraced by consultants as it allows them to create a cottage industry in measuring “style drift”, which is a wonderful device for firing underperforming value managers (ie, all value managers) in a way that absolves the consultant’s investment board client of any responsibility. “No, no … it’s not us. It’s you.”

Is style drift a thing? Of course it’s a thing. Active management IS style drift. That’s what active managers DO. If their process and their analytical focus aren’t working, then they “adapt” and “evaluate” and “improve” and “bring in” (all words that sound much better than “drift”) change in their process and analytical focus in order to improve performance. They hope. If you look for style drift in your underperforming managers, guess what … you will ALWAYS find it. It’s like discovering that water is wet. It’s like discovering that gambling is taking place at Rick’s Place in Casablanca.

In fact, I’ll go one step further. Style drift is WHY you hire an active manager. Otherwise, just buy a factor exposure and be done with it. No style drift there!

My point here is not to defend active management. My point here is that the evolution of the old line from “managers can’t change their stripes” into “managers shouldn’t change their stripes” is a constructed, intentional change in narrative, a vital part of the primary full-employment narratives for consultants: “Yay, diversification!” and “Yay, risk management!”.

The evolved saying is wrongheaded. The old saying is Truth with a capital T.

Exactly like tigers, investment managers CAN’T change their stripes. I don’t mean they can’t change their process and analytical focus. I don’t mean they can’t change in the sense of what the consultants call “style drift”. I mean that an investment style and the learned adjustments/drifts/change to that style are not an investor’s tiger stripes!

Your tiger stripes are your immutable investment DNA. Your tiger stripes are the psychological make-up and the grammar you use to make sense of the investment world. [there’s an oldie but goodie ET note on all this, btw, “Adaptive Investing: What’s Your Market DNA?”]

You can’t change this in yourself. Your managers can’t change this in themselves. I can’t change it in myself. And we shouldn’t try. But we must KNOW this psychological make-up and investment grammar. We must know it in our managers, yes. We must know it even more so in ourselves.

I’ll go first.

My psychological make-up as an investor is to see the flaw in all things. I do not have faith easily. I see an unending sea of mendacity in mass society, and an arc towards the quiet extinguishing of small-l liberal and small-c conservative virtues. I am, in market terms, a born short-seller. That is my DNA.

Three times in my professional life as an investor, I have felt a trade in my bones, by which I mean a certainty that there is a massive disjuncture between a real world poised for sharp secular decline and a market world at buoyant narrative highs. The first time was in the summer of 2008. The second time was in February of 2020. The third time is today.

The real world poised for sharp secular decline today can be summed up in these three charts.

First, sharply declining loan demand in the real economy, particularly by small firms (this is from the quarterly Fed survey of bank lending officers):

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Second, sharply declining confidence by small businesses that they can weather the Covid storm (this is from a Goldman Sachs report, and if you account for survivorship bias in the survey, the results are even more depressing):

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Third, the fact that a second wave of endemic Covid is now raging essentially unchecked across the entire United States, as measured by cases, hospitalizations and deaths (this is from The Covid Project maintained by The Atlantic, and is a compilation of state-reported data for the US):

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We are spent. I mean that in a societal and individual sense. I mean that in a psychological sense. I mean that in an economic sense. I mean that in a physical, real world sense. But at the same time we are spent, we are now faced with the true storm of Covid-19. Everything that is happening in France and Italy today will be happening in the United States in two weeks. These are not the conditions for a recession. These are the conditions for a global depression.

I feel this in my bones. And yet.

In the summer of 2008 and February of 2020 I saw the trade to, yes, make money from those real world calamities. I do NOT see the trade here.

Why not? Because there IS good news on the horizon in the form of the Pfizer vaccine. Wonderful news! News of a vaccine that will, unfortunately, come too late for the real world damage of this plague over the next three months, but news that can drive a tremendously supportive narrative in market world.

Why not? Because capital markets are a political utility, and neither the Fed nor, ultimately, the White House or Congress will ALLOW capital markets to reflect the real world damage that I feel in my bones is coming.

I can’t change my tiger’s stripes. I see what I see, and I think what I think, and I feel what I feel. My investor DNA has never been more at odds with my knowledge of narrative and politics. The gulf between real world distress and market world resilience has never been greater in my eyes. But I don’t know what to DO with that, other than share it with you.

Please stay safe,


Schrödinger’s Price


We’ve written about Erwin Schrödinger’s famous thought experiment several times in Epsilon Theory, notably here, here, and here. To reprise the intro to one of those notes …

“Most people confuse Schrödinger’s Cat with the Observer Effect. It’s a lot weirder and more important than that.

Here’s what Schrödinger’s Cat is NOT. There’s a live cat inside a box, and the act of opening the box to see the cat will break one of two glass vials also inside the box. If Glass Vial A is broken, a deadly poison is emitted that kills the cat. If Glass Vial B is broken, nothing happens and the cat stays alive. This is an example of an Observer Effect – that the act of observation determines the outcome.

In the true Schrödinger’s Cat thought experiment, the poison gas vial isn’t broken by the observer opening the box, but could break open by chance over some period of time. As in the Observer Effect experiment, though, there’s no way to know if the cat is alive or dead without opening the box.  After you open the box, the observer knows for sure whether the cat is dead or alive. But before you open the box?

The insight of Schrödinger’s Cat is that the cat is alive AND the cat is dead before the box is opened. It’s not merely unknown whether the cat is alive or dead. The cat is actually alive AND actually dead at the same time.

Wait a second, Ben. What do you mean the cat is actually alive AND actually dead at the same time? Obviously that’s not true. The cat is either alive OR dead. There is a state of the world where the cat is dead, and there is a state of the world where the cat is alive. Maybe we can’t know whether the cat is alive or dead, but it MUST be one or the other. That’s reality.

Schrödinger is saying no, that’s not reality. Schrödinger is saying that reality is – in reality – probabilistic. That the actual physical reality is that the cat is both alive AND dead at the same time. Maybe our human experience of reality does not allow us to have pets that are alive and dead at the same time, but that’s our fault, not reality’s fault.

I’m being a little facetious, because Schrödinger developed his famous thought experiment as a critique of quantum physics, and it’s now used to describe different theories of superpositioning in that weird world, where the smallest building blocks of nature should theoretically exist in multiple states of nature simultaneously. In the macro world of real-life humans doing real-life things, a cat is truly either alive or dead, not both.”

Or is it?

In our real-life world of investing in markets, we frequently deal with real-life cats that are both alive AND dead at the same time.

Case in point, the largest liquid market for any single security on Earth: US Treasuries.

As of this morning, there are two very distinct forward pricing structures taking shape for 10-yr USTs (this phenomenon exists across the yield curve, but I’ll just focus on 10-yrs). There’s “Blue Wave” positioning, where Biden takes the White House and the Senate flips to the Dems, as well, and there’s every other election scenario.

In the Blue Wave scenario, the cat is dead … 10-year yields blow out to something between 1.00% and 1.25%.

In the anything-else scenario, the cat is alive … 10-year yields compress to something between 0.65% and 0.75%.

Barclays put out a note this morning estimating that the standard deviation in moves in 10-yr rates on election results alone is something like 25-30 bps, which is … staggering when the current 10-yr yield is 0.80% (oops, as I write this, we’re out to 0.85% … this is nuts!). And I put “on election results alone” in italics because, obviously enough, there’s a lot more happening in the world that could contribute to Treasury prices moving in one direction or another by a LOT.

Next Tuesday we will open the box and see if the US Treasury cat is alive or dead. But until next Tuesday the US Treasury cat is both alive AND dead.

This has been our real-life investment reality for the entire month of October. This has been our real-life investment reality for every asset class, not just USTs. This will be our real-life investment reality when everyone takes their month-end portfolio mark at 4p today … an entire portfolio that is both alive AND dead.

I wish I had some words of wisdom on how to invest when our actual honest-to-god reality is an exercise in quantum superpositioning, but other than the topics of prior notes – sell (lower your gross) until you can sleep at night & minimize your maximum regret in periods of technical uncertainty – I really don’t. But I will leave you with this.

Next Tuesday’s event isn’t the last box we will be opening over the next few months. It’s the first of many.


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:

Chart, bar chart

Description automatically generated

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.